Private equity fund and other sponsors should take note of a recent U.S. Department of Labor Information Letter regarding the inclusion of private equity and other alternatives in defined contribution (DC) plans subject to the U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA). Though not a safe harbor from liability, the letter provides a useful framework for plan sponsors and other plan fiduciaries in evaluating whether to add private equity funds and other alternatives to a participant-directed plan lineup.
By way of background, 401(k) and other participant-directed ERISA plans have traditionally shied away from including private equity and other alternatives principally because of the cost and illiquid nature of those asset classes. Widespread litigation brought against plan sponsors and service providers, on a wide range of theories, including the allegation that the fiduciary selected overly expensive investment options, has only compounded this reluctance. Still today, alternative investments remain a relative rarity in DC plans.
The DOL letter provides a roadmap of sorts for the plan sponsor or other fiduciary responsible for selecting a broadly diversified investment option, such as a target date fund or a balanced fund, with allocations to private equity (and, by extension, other alternatives). The diversified fund could itself make private equity investments or it could gain private equity exposure through a fund-of-funds structure. Regardless of whether the diversified fund invests in private equity directly or indirectly, it must indeed be diversified with mostly liquid asset classes. The DOL hints that the diversified fund could have up to15 percent exposure to alternatives, but on this point, no explicit cap is stated or required.
The letter, therefore, does not offer comfort to plan sponsors for offering a private equity or other alternatives fund as a standalone investment option into which plan participants directly invest, which would separately raise securities laws issues. Nor the does the letter offer guidance to plan sponsors on offering an investment option that has significant exposure to private equity or other alternatives.
Plan sponsors who are interested in private equity and other alternatives will seek products that are sufficiently liquid to facilitate participant withdrawals and exchanges. The plan sponsor may also inquire whether the private equity holdings will be valued according to accounting standards, and if the risk disclosures regarding the private equity investments will be sufficient for, and understandable to, plan participants in their consideration of whether to invest in a diversified investment option that has exposure to private equity. Fee pressure seems likely.
Private equity fund sponsors may wish to consider whether they would want to manage all or part of the diversified fund. This vehicle will likely hold “plan assets,” and, therefore, operate in accordance with ERISA (including the fiduciary duties and prohibited transaction rules), though this depends on how the fund is structured. Fund sponsors who have no interest in being subject to ERISA, and who have historically relied upon the venture capital operating company (VCOC) exception from “plan assets,” may instead opt to offer their products to a third-party manager, who would manage the diversified investment vehicle.