16 Reasons Pensions, 401ks Should Stay the Hell Away From Private Equity
Gambling retirement savings in private equity is a risk you can't afford to take.
In 2020, the Department of Labor pushed corporations to include the highest cost, highest risk, most secretive “private equity” investments ever devised by Wall Street in the 401k retirement plans they offer to America’s workers.
Then-Chairman of the Securities and Exchange Commission Jay Clayton claimed including private equity in 401ks would allow workers to choose “professionally managed funds that more closely match the… asset allocation strategies pursued by many well-managed pension funds.”
Both the DOL and SEC neglected, in 2020, to warn 401k plan sponsors and workers about the massive dangers related to gambling on private equity.
If you are a corporation that sponsors a 401k retirement plan for your employees or a worker who participates in a 401k, below is a preliminary list of just a few of the myriad dangers you should be aware of—risks which, contrary to then-SEC Chairman Jay Clayton’s naïve comments about “well-managed pensions”—not even the most sophisticated pensions fully understand.
This list is derived from several very public forensic investigations my firm has undertaken involving over $100 billion in pensions—funds in Ohio, Rhode Island, North Carolina and New York that lost big gambling in private equity, blithely unaware of the risks. Again, this list of 16 risks is incomplete—a starter kit for would-be private equity investors.
1. High-risk, speculative investments. Private equity offering documents generally prominently state (in capital, bold letters) that an investment in a private equity fund is speculative, involves a high degree of risk, and is suitable only for persons who are willing and able to assume the risk of losing their entire investment.
If you’re comfortable gambling your retirement savings and losing it all, then proceed onto risk #2.
Are you comfortable gambling your retirement savings and possibly losing it all?
2. High-cost, involving myriad opaque asset-based, performance and other fees and expenses. Private equity investments charge myriad opaque fees and expenses exponentially (10x) greater than traditional stock and bond funds. You’ll never know for sure the total cost of investing in these funds because disclosure of fees and expenses is generally incomplete.
My investigations often reveal annual fees in excess of 6% for large institutional investors. 401ks will pay even more.
3. Illiquid, lacking a public market. Private equity investments generally do not permit redemptions during the life (generally 10-13 years, but may be as long as 50 years) of these investments. The partnership interests offered are illiquid. No public market for the partnership interests exists and none will be developed. You won’t be able to redeem or sell.
4. Lack of transparency. These investments utterly lack a hallmark of prudence—transparency. The information they provide to 401k fiduciaries and other investors is limited, often incomplete and impossible to verify.
If you’re good with putting your retirement savings in a “black box” investment, then proceed by all means.
Are you good with putting your retirement savings in a secretive “black box” investment?
5. Largely “unconstrained” and may change investment strategies at any time. Private equity funds generally disclose specific risks related to investment strategies they may pursue. However, the managers reserve the right to pursue virtually any investment strategy—at any given time. Thus, it is impossible for investors to know for certain at any given time the composition of a fund’s portfolio, the appropriateness of the investments and the related risks.
Are you comfortable investing in potentially usurious payday loans to the poor and controversial life settlements purchased from the elderly terminally ill? If so, proceed to #6.
Are you comfortable investing in potentially usurious payday loans to the poor and controversial life settlements purchased from the elderly terminally ill?
6. Use of leverage. Private equity funds generally reserve the right to engage in borrowing, or leverage, on a moderate or unlimited basis. Leverage increases dramatically the risks related to investing in a fund and the degree of leverage may change at any time.
You have no control over and will never know the degree of leverage employed at any given time. That’s why you could lose everything.
7. No assurance of diversification. Since funds generally reserve the right to invest 100 percent of their assets in a given sector or investment, such as cash, there is no assurance of diversification. How does 100% invested in a single sector, 100% levered sound? Dicey?
8. Lack of comprehensive regulation in the U.S. Private equity funds are not subject to the same degree of regulation as mutual funds and other U.S. registered funds.
9. Heightened offshore legal, regulatory, operational and custody risk. Many private equity funds are organized and operate in offshore tax havens, such as in the Cayman Islands, which lack the legal, regulatory and operational safeguards offered in the U.S. Also, fund assets may be held, or custodied, offshore. Funds which are incorporated and regulated under the laws of foreign countries present additional, unique risks which 401k fiduciaries and investors should consider. Any problem with having your retirement savings held offshore in the Caymans?
10. Myriad conflicts of interest, self-dealing practices. Private equity funds generally disclose myriad conflicts of interest involving the investment managers to the funds and others. For example, the investment manager determines the value of the securities held by the fund. Such valuation affects both reported fund performance as well as the calculation of the management fee and any performance fee payable to the manager. The investment managers are subject to a conflict of interest because they can profit from inflating values. In the industry, it’s called “mark-to-make-believe.” Further, the performance fee structure creates an incentive to the investment manager to engage in speculative investments and thus is a potential conflict with the interests of the investors.
Mark-to-make-believe: When private equity managers unilaterally determine the value of their portfolio holdings to inflate fees and performance.
11. Business practices that may violate ERISA. Private equity fund offering documents often disclose that investors agree to permit managers to withhold complete and timely disclosure of material information regarding assets in their funds. Further, the fund may have agreed to permit the investment manager to retain absolute discretion to provide certain mystery investors with greater information and the managers are not required to disclose such arrangements. As a result, the fund you invest in is at risk that other unknown investors are profiting at its expense—stealing from you. Finally, the offering documents often warn that the nondisclosure policies may violate applicable laws. That is, certain practices in which the fund’s managers engage may be acceptable to high net worth individuals (or unknown to them) but violate laws applicable to ERISA plans. Comfy with violations of law in your 401k? Can you ever really be sure your 401k is in compliance with the law when the private equity managers disclose they may not be? Why would the DOL and SEC recommend investments that disclose they may violate the laws of the land?
Why would the DOL and SEC recommend investments that disclose they may violate the laws of the land?
12. SEC finds pervasive private equity bogus fees and illegalities. A majority of private-equity firms inflate fees and expenses charged to companies in which they hold stakes, according to a 2014 internal review by the SEC, raising the prospect of a wave of sanctions against managers by the agency. More than half of about 400 private-equity firms that SEC staff examined charged unjustified fees and expenses without notifying investors.
13. Private equity transaction fees securities law violations. Transaction fees charged by private equity funds, sometimes called the “crack cocaine of the private equity industry” because the fees are not traditionally subject to minimum performance requirements, are increasingly opposed by public pensions and have recently been the subject of an SEC whistleblower complaint filed by a senior private equity insider. The SEC whistleblower credibly alleged that private equity firms have been violating securities laws by charging transaction fees without first registering as broker-dealers with the SEC. If the private equity firms included in your 401k have been violating the state and federal securities laws, they may be required by the states and the SEC to refund to investors the transaction fees wrongfully charged.
14. Private equity monitoring fees tax law violations. With respect to private equity so-called monitoring fees paid by private equity owned portfolio companies, whistleblower claims have been filed with the Internal Revenue Service alleging that these fees are being improperly characterized as tax-deductible business expenses (as opposed to dividends, which are not deductible), costing the federal government hundreds of millions of dollars annually in missed tax revenue.
15. Private equity management fee waivers tax law violations. The IRS has in recent years been examining the propriety of private equity management fees waivers, which have allowed many fund executives to reduce their taxes by converting ordinary fee income into capital gains taxed at substantially lower rates, costing the federal government billions of dollars annually in missed tax revenue. Why would the SEC and DOL recommend investments to 401ks managed by tax dodgers?
16. Private equity under-reporting of massive fees. According to a recent New York Times article, the rates of return and hidden costs related to private equity are difficult for even investors in these deals to identify. While certain fees associated with private equity funds are widely known — managers typically charge investors 1 to 2 percent of assets and 20 percent of portfolio gains — other charges, including transaction fees, legal costs, taxes, monitoring or oversight fees, and other expenses charged to the portfolio companies held in a fund are less visible—including unauthorized or bogus fees.
According to a 2015 report by CEM Benchmarking, a consulting firm that offers pension fund performance analysis, more than half of private equity costs charged to pension funds is not being disclosed.
CEM concluded that the difference between what funds reported as expenses and what they actually charged investors averaged at least two percentage points a year. That is, estimated total direct limited partner costs amounted to 3.82 percent. CEM acknowledged this estimate is probably low. A 2007 academic paper found that the average private equity buyout fund charged more than 7 percent in fees each year.
In my forensic investigations of over $1 trillion in retirement plans, I have never encountered a pension that fully understood the dangers of investing in private equity.
For the DOL and SEC to suggest that 401k sponsors and workers will prosper—even recover their COVID-19 losses—through gambling on the highest cost, highest risk, most secretive investments ever devised by Wall Street is ludicrous. It’s a big win for Wall Street and a huge loss for retirement savers.
To learn more about protecting your retirement savings, see Who Stole My Pension?
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