With good reason, private equity (PE) firms are abuzz about the recent Information Letter from the U.S. Department of Labor (DOL), which permits PE firms to market PE funds as components of target date, target risk, or balanced funds.
On June 3, the DOL issued an Information Letter under the Employee Retirement Income Security Act (ERISA). The letter concerns PE investments as components of professionally managed asset allocation funds that are offered as investment options for participants in defined contribution plans. The Information Letter addresses only PE investments offered as part of a professionally managed multi-asset class vehicle structured as a target date, target risk or balanced fund, and includes additional provisions regarding such vehicles. This Information Letter constitutes new guidance given in response to several employee lawsuits against companies that had included alternative investments in target-date funds.
Part of the DOL’s rationale for the recent change was that PE investments have long been used by portfolio managers at defined benefit funds, but not in defined contribution plans. U.S. Secretary of Labor Eugene Scalia put it this way: “This Information Letter will help Americans saving for retirement gain access to alternative investments that often provide strong returns.” Further, Chairman of the U.S. Securities and Exchange Commission Jay Clayton said that the Information Letter “will provide our long-term Main Street investors with a choice of professionally-managed funds that more closely match the diversified public and private market asset allocation strategies pursued by many well-managed pension funds as well as the benefit of selection and monitoring by ERISA fiduciaries.” Additional insights into the DOL’s views are provided in their news release concerning the new guidance.
At the end of 2019, Americans’ 401k holdings totaled $6.395 trillion (at the end of 2020’s first quarter, that number had fallen to $5.575 trillion, largely due to the pandemic’s impact on financial markets). PE firms are eager to act on the vast new pool of investment dollars made available by this new guidance. But the risk to individual investors is significant, and future actions related to this guidance to contain that risk remain unclear as yet. Not all parties are happy with the guidance. Some critics note that average retail investors are unlikely to grasp all the intricacies of how these funds operate; indeed, some money managers are disavowing these funds because they themselves don’t fully understand them.
In the Information Letter, signatory Louis Campagna, the DOL’s Chief of the Division of Fiduciary Interpretations in the Office of Regulations and Interpretations, cautioned that the responsible plan fiduciaries should consider whether any fund “has limited the allocation of investments to PE in a way that is designed to address the unique characteristics associated with such an investment, including cost, complexity, disclosures and liquidity, and has adopted features related to liquidity and valuation designed to permit the asset allocation fund to provide liquidity for participants to take benefits and direct exchanges among the plan’s investment line-up consistent with the plan’s terms.” Campagna went on to say that the “valuation of PE investments is more complex because PE investments often have no easily-observed market value, and there is often an element of judgment involved in valuing each of the portfolio companies prior to their sale by the investment fund or other liquidity event” such as a public offering. These statements hint at a direction toward providing more information about PE funds’ inner workings –thereby limiting individual investors’ downside risk.
Financial Considerations for PE Firms
So, what might PE firms consider as they prepare to pursue this opportunity? In the absence of any regulatory guidance or action (yet), we are limited to inferences from Campagna’s remarks regarding the valuation, liquidity and complexity of these investments. The following considerations draw upon Protiviti’s collective expertise in managing risk related to financial reporting:
- PE fund operators will probably have to provide greater transparency to individual investors. We anticipate the emergence of a standardized information structure so that investors can easily compare the performance of these products.
- PE fund operators may be required to value their portfolios more frequently and submit public filings congruent with other investment instruments available to the general public. PE firms may reasonably expect a new level of rigor for financial reporting when it’s shared with less-sophisticated retail investors.
- PE firms may incur new legal risks if individual investors appeal to the government or regulators in the event of losses related to misstatement of PE funds’ financials.
This is a story that has only just begun, but that warrants close monitoring in the months and years to come as markets and regulatory authorities respond to the new guidance. Even as we were writing this, the Security and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) issued an alert about compliance issues and deficiencies in private fund advisors. PE firms will want to refer to the OCIE’s list of deficiencies as fund operators identify possible points of scrutiny they may need to address. No laws have been made or changed yet – and while it’s difficult to determine when such developments may come to pass, some rule-setting seems inevitable. For many PE firms, managing, sharing and documenting the information surrounding funds like these is new territory. Every PE firm will want to be first among its competitors to anticipate and respond to new regulations surrounding the opportunity.
Jeff Miller with Protiviti’s Business Performance Improvement practice contributed to this content.