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12.29.20

Understanding Private Equity Investments in Defined Contribution Plans
James Pellino

The Department of Labor (DOL) recently released an “information letter” in response to inquiries from the private equity industry as to whether private equity investments can be offered to defined contribution plans. Per the DOL’s response, it will allow defined contribution plans to offer indirect investment in private equity funds. Is this a good fit for your plan? Be careful before you decide to allow these options into your plan. 

As a primer, let’s discuss what private equity funds primarily do. Private equity funds invest in privately held companies whose stock is, by definition, not traded on public exchanges. They sometimes also acquire publicly held companies, but then convert them to privately-held status. Private equity fund managers generally seek to increase the value of their investments by infusing capital and improving target companies’ management and operations.

Private equity investment has grown rapidly, but the growth has begun to slow according to a recent industry analysis by Deloitte. According to Deloitte, as industry growth slows, private equity firms will continue to shift more time and resources from front office deal-making to growing profitability through restructuring and operational efficiencies.

Fiduciary Limits

Under the Employee Retirement Income Security Act of 1974 (ERISA), 401(k) plan fiduciaries must exercise their authority “with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” The inquiry sought guidance from the DOL asking whether a defined contribution plan fiduciary would violate the ERISA fiduciary standard by including a “multi-asset class vehicle” with a private equity component in its fund lineup. Those funds could be structured as target date, target risk or balanced funds.

The guidance covers only allocation decisions made by the fund’s asset managers in scenarios in which private equity would be one of multiple categories of equity investments within the fund. It does not cover any fiduciary or other ERISA issues that would be involved in a defined contribution plan allowing individual participants to invest their accounts directly in private equity investments. The guidance was clear that such direct investments in private equity investments present distinct legal and operational issues for fiduciaries of ERISA-covered individual account plans.

Related Read: Trending in the Right Direction With the New Electronic Disclosure Rules

Investment Decision Considerations

In giving its green light to such investments, the DOL laid out several factors that plan sponsors should keep in mind, given potentially problematic features of private equity investing for some plan participants. These include the typical multiyear holding period for portfolio companies, and the challenge in providing an accurate stock valuation before a sale.

According to the DOL’s letter, plan fiduciaries considering a private equity investment option in multi-asset class funds should consider:

  • Whether the fund has managers with “the capabilities, experience, and stability” to handle private equity;
  • Whether the proportion of the fund’s allocation to private equity investments is appropriate given the “cost, complexity, disclosures, and liquidity” considerations;
  • Whether the fund has “adopted features related to liquidity and valuation” that give participants the ability to shift their investment allocations “consistent with the plan’s terms”; and
  • Whether the fund is suitable in light of the plan’s “participant profile,” including their ages, contribution and withdrawal tendencies.

What this boils down to is that the plan fiduciary must act with due diligence in determining the suitability of private equity investments as part of the plan’s portfolio. While the thought of offering your participants an exciting new investment option can be tempting, very careful thought should be given as to whether allowing private equity investments into your plan is suitable and prudent for you participants. Be sure to consult with your financial advisors and legal counsel before taking any steps to introduce private equity investments into your plan’s portfolio.

For more information, contact Jim Pellino at jpellino@orba.com or 312.670.7444. Visit ORBA.com to learn more about our Employee Benefit Plans Services.

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