Will Private Equity and Private Debt funds break my 401(k)?

Everyone’s asking us about private equity and their 401(k) since the President signed an executive order in August allowing alternative investments to be available in employer retirement plans.

What is it?

Private equity and private debt funds have historically only been available to accredited investors who are in a financial position to take higher risks for the promise of higher returns. These funds are typically purchasing a portfolio of companies, real estate, or debts, holding those investments for years, then selling them and returning proceeds to investors.

What makes it problematic?

Private funds have some cons: 

  • They’re illiquid: you can usually only sell specific amounts on a specific schedule, if at all.
  • They’re expensive: the funds are typically performance-based, meaning the fund managers are taking large portions of gains, often with a minimum amount regardless of gain or loss.
  • They’re opaque: they’re often reporting performance using an “internal rate of return” metric, which is easily manipulated or “smoothed” to give the appearance of consistent, high returns.

Yale University’s endowment was one of the early adopters of this type of investing and it served them very well, until more recently. They are now making a widely-publicized exit from this type of investment.

If you’re interested in a deep dive into some of the challenges and you’re ok reading academic papers, Ben Bates wrote a good one recently. One finding: median returns are lower than public market returns over the past 4-5 years.

What does it mean to me?

Probably not much, if anything.

First, the sponsor of your plan has a fiduciary responsibility regarding the investments in the plan. So many sponsors may elect to exclude these funds.

We do think there’s something to monitor over the next few years: if you’re using target date funds, are those funds making investments into private funds as part of their holdings. 

What does Xena think?

Our investing philosophy continues to be centered around globally diversified, low cost, transparent index investing.