401(k) funds: An opportunity for PE? Considerations are prompted by DOL guidance

The following article is from Grant Thornton.

Workplace retirement funds represent about $7.9 trillion in potential capital. With fewer companies being traded on public stock exchanges, private equity (PE) funds offer new opportunities for returns and diversification.

A historical reluctance

Fiduciaries of defined contribution (DC) plans (e.g., 401(k) plans) that are subject to the U.S. Employee Retirement Income Security Act of 1974 (ERISA) have traditionally been wary of including PE and other alternative asset classes in plan lineups. Over the years, 401(k) plan sponsors and others have been subject to an endless parade of fee and other class-action litigation. The lawsuits’ intense focus on fees and expenses has been a key driver of these plans’ shift away from actively managed investment funds and toward index funds. It is little wonder, then, that PE’s perceived high cost, opacity and illiquid nature have been obstacles to greater adoption by DC plans.

The new guidance

Recently, the Department of Labor (DOL) provided guidance to fiduciaries on how they can consider PE for DC plans in a manner consistent with ERISA’s strict fiduciary duties. Though this guidance is not a safe harbor from legal liability, fiduciaries responsible for selecting DC plan investment options will likely view this new guidance as a useful framework.

The new DOL guidance is quite limited: It addresses only broadly diversified investment options, such as target date funds, which have relatively small allocations to PE. The diversified fund could itself make PE investments or it could gain PE exposure through a fund-of-funds structure. Regardless of whether the diversified fund invests in PE directly or indirectly, it must in fact consist of mostly liquid asset classes. The DOL suggests that the diversified fund could have up to 15% exposure to alternatives, such as PE.

Standalone PE funds on plan lineups, in which participants directly invest, are not covered by this guidance and continue to remain largely out of reach, not least because the vast majority of plan participants are not accredited investors.

Law firm Stradley Ronon Stevens & Young, LLP, offers some additional insights on the new DOL guidance. Specifically:

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 exception from “plan assets,” may instead opt to offer their products to a third-party manager, who would manage the diversified investment vehicle.

The guidance presents a potential opportunity for the asset management industry. However, the creation of PE offerings suitable for inclusion in 401(k) plans raises a number of issues that must be carefully considered.

Additional issues

In addition to the structural considerations and disclosure obligations noted above, there are numerous tax issues involved in designing a potential product tailored to the DOL guidance.

Outside of tax concerns, what’s the best approach to diversification? How do you discern the suitability of alternative investments? Determine the risk profile?

In addition, plan sponsors should assess key attributes of asset managers themselves, such as degree of monitoring, underlying business or industry of assets, experience and competence of the fund manager, compliance infrastructure and any outsourced functions.

The unique reporting procedures for PE funds have technology implications. Can the sponsor deliver and report all the required information in a timely manner?

While PE in 401(k)s offers possibilities for both investors and funds, careful thought must be given to the way offerings are developed.


Michael C. Patanella
National Asset Management Sector Leader, Audit Partner
T +1 212 624 5258

Steven Winter
Partner, National Tax Sector Leader for Asset Management
T +1 212 624 5434

*Reprinted with permission