The U.S. defined contribution retirement system is massive, estimated at $12.4 trillion at the close of 2024. While not all plans are governed by the Employee Retirement Income Security Act (ERISA), ERISA and its associated rules and case law significantly impact how employers build investment menus.
Last month, it was reported that the White House was weighing a directive to bring private equity into 401(k) plans.
To help provide some scale, the U.S. private equity marketplace is currently estimated at roughly $820 billion, while the publicly traded U.S. equity market stands at approximately $52 trillion.
When looking at the scale of what it may mean for defined contribution plans to begin allocating to private equity, there is one clear winner: private equity managers. For other stakeholders, the benefits become less clear.
The private equity investment return thesis is a relatively simple one.
- Identify fragmented industries and acquire privately owned companies in that space
- Consolidate regional firms within an industry
- Enhance efficiency and upgrade management
- Optimize the capital structure, typically through adding leverage to the model
- Increase earnings
- Exit
As an investor in this space, you are expecting a potential return premium from one or more of the following sources:
- Improved active management – Can the PE firm execute better than the prior owners
- Leverage impact – Using debt to grow creates leverage in shareholder value
- Liquidity premium – Any investor who cannot have their money returned on demand requires a premium on their return
All three return levers make sense in theory, but are fraught with risks under deeper review.
Active management – Every public and privately owned company works hard to maximize value for shareholders. Changing management will change outcomes, but not necessarily for the better. Frequently, experienced managers from unrelated industries cannot learn the new industry and change the trajectory of the business, which can lead to the second risk.
Leverage impact—The fastest way to create immediate shareholder value in a private equity acquisition is for the acquired company to borrow money to replace the value of the equity investment. However, borrowing carries a cost that adds additional risk to the business's success.
Liquidity premium—Liquidity premiums are real. Any investment that doesn’t allow for immediate redemption at current value should demand a higher return due to its lack of flexibility.
Defined Contribution Setting
The challenges for private equity in defined contribution plans come directly from their potential sources of return.
Active Management – Much like active management of mutual funds, active management of private equity businesses is expensive. The cost of the management must be netted against the investment returns. A typical private equity firm earns a 2% annual management fee on committed capital. They frequently get preferred equity or issue convertible debt to ensure their capital commitments are protected, even if their shareholders are not.
Leverage impact—Leverage increases potential return, full stop. However, it also incurs cost and risk. Debt issuance adds additional costs to the business, crowds out growth investment opportunities, and reduces protection in downturns. Any investor who wishes to increase return through leverage can do so in less expensive ways, like levered ETFs, which carry much broader diversification.
Liquidity premium—Liquidity premiums are very difficult to capture in defined contribution plans since the duration of employment is unknown at the plan or participant level. Typically, plans demand participant-level liquidity, and investment managers with illiquid products have to engineer alternative arrangements to provide participant-level liquidity. These engineered solutions create costs that directly reduce the implied liquidity premium.
From the perspective of a private equity manager, accessing the $12.4 trillion defined contribution marketplace would be nitrous to an already explosive market, and the fees and deal opportunities it would unlock for private equity managers are undeniable.
The benefits to the fiduciaries who bear the risk of poor disclosure, obtuse valuations, and high fees are far less clear. Whether the White House proceeds or not, the financial services marketplace is working to make this an asset class of the 2020s. In life, there are no free lunches, and private equity is no exception. Buyer beware.
Multnomah Group is a registered investment adviser registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice.