Private Equity along with other illiquid contract investments like hedge funds, private debt, real estate are a potential Fiduciary Time Bomb for plans and their participants
Center for Economic and Policy Research’s Eileen Appelbaum recently said “Much as private equity firms may wish it were different, they have been mostly unable to worm their way into workers’ 401(k)s and abscond with their retirement savings,”[i] from a series of articles on how the new Trump DOL rules were connected to massive political donations by the Private Equity industry.[ii]
A report by University of Oxford professor Ludovic Phalippou shows that in the last 15 years, private equity firms generally have not provided better returns to investors than low-fee stock index funds. Prof. Phalippou has shown excess mostly hidden fees and expenses to exceed 6% killing net returns. [iii]
Noted founder of investment consulting firm Richard Ennis in quoting Beath & Flynn 2020 study says that private equity (as a class of investment) in fact ceased to be a source of value-added more than a decade ago. [iv]
Jeff Hooke of Johns Hopkins book the “Myth of Private Equity” goes into great detail on an asset class and its numerous fiduciary flaws. He documents that many performance claims are made up by the managers with no independent verification and are greatly exaggerated. [v]
The plan as I see it is to bury Private Equity into Target Date Funds where they can hide these Fiduciary Time bombs collect the massive fees and hope that they do not blow up. Their main claim for inclusion is excessive performance which is dubious at best.
A Private Equity like structure technically private debt has cost JP Morgan over $400 million in damages in 401(k) litigation. This private debt was put in a JP Morgan CIT, which was put in JPM broad bond CIT, with was put in a JPM stable value CIT.[vi] [vii] This type of layering is what I expect to see in Target Date CIT’s.
Former SEC Attorney Ted Siedle goes over the Fiduciary Breaches common in most Private Equity funds in his Forbes Column that should make any fiduciary nervous. [viii]
1. Private equity offering documents generally prominently state (in capital, bold letters) that an investment in a private equity fund is speculative, involves a high degree of risk, and is suitable only for persons who are willing and able to assume the risk of losing their entire investment.
2. Largely “unconstrained” and may change investment strategies at any time. Can engage in borrowing, or leverage, on a moderate or unlimited basis. No assurance of diversification since funds generally reserve the right to invest 100 percent of their assets in one investment. Heightened offshore legal, regulatory, operational and custody risk.
3. Myriad conflicts of interest, self-dealing practices. The investment manager determines the value of the securities held by the fund. Such valuation affects both reported fund performance as well as the calculation of the management fee and any performance fee payable to the manager. [ix] Naked Capitalism writes “The toothless and captured Institutional Limited Partners Association has proposed a fee disclosure template which has gone nowhere.”[x] It is widely known there is a massive underreporting of fees.
4. Business practices that may violate ERISA. Private equity fund offering documents often disclose that investors agree to permit managers to withhold complete and timely disclosure of material information regarding assets in their funds. Further, the fund may have agreed to permit the investment manager to retain absolute discretion to provide certain mystery investors with greater information and the managers are not required to disclose such arrangements. As a result, the fund you invest in is at risk that other unknown investors are profiting at its expense—stealing from you. Finally, the offering documents often warn that the nondisclosure policies may violate applicable laws. That is, certain practices in which the fund’s managers engage may be acceptable to high-net-worth individuals (or unknown to them) but violate laws applicable to ERISA plans. [xi]
5. Lack of disclosure has led to numerous violations some pointed out by the SEC, others pertaining to IRS like monitoring fees tax law violations and management fee waivers tax law violations.
These 5 points are a very abbreviated list of Former SEC Attorney Ted Siedle’s column on the Fiduciary Breaches in Private Equity funds in his 8/23/20 Forbes Column. [xii]
Even a small allocation to a Target Date Fund, with the excessive risk, lack of outperformance and excessive fees seem to make it a Fiduciary Risk.
If you have underlying Private Equity or are seriously considering it, get an independent legal opinion (from a firm that does not represent PE firms) that the actual underlying Private Equity contract passes ERIA fiduciary muster. Make sure your fiduciary liability insurance covers Private Equity many do not.
While the Trump DOL “get out of jail free card” letter may protect a plan from Department of Labor action on Private Equity, you are making a dangerous bet in litigation, that the judge will block transparency and discovery of these contracts.
With no proven performance advantage, grossly excessive fees, and numerous fiduciary issues there seems to be nothing but harm in adding Private Equity into your 401(k) plan.
Chris Tobe, CFA, CAIA is an expert on Private Equity Corruption writing the book Kentucky Fried Pensions, and dozens of articles.. http://www.christobe.com/alternatives/
[iii] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3623820 an Inconvenient Fact Private Equity Returns U.of Oxford Ludovic Phalippou