Private Equity Investments in Defined Contribution Plans
The US Department of Labor (DOL) recently concluded in Information Letter 06-03-2020 that, if properly structured, offering a professionally managed fund with a private equity component as an investment alternative in a defined contribution plan does not violate ERISA.
Profile of the PE Investment
The DOL reviewed specific, proposed professionally managed funds that contained private equity (PE) investments within collective investment trusts. The funds were not solely comprised of private equity but maintained other diversified investments and a liquidity component to manage the participant-directed deposits and withdrawals from the funds.
Evaluating Prudence of PE Investments
Under participant-invested 401(k) and other retirement plans, fiduciaries have a legal duty to select prudent investment options for participants who may choose to invest in those options.
Under Title I of ERISA, plan fiduciaries must also monitor designated investment alternatives under the plan for their continued prudence. Liability arises against the plan fiduciaries for losses resulting from their failure to satisfy those duties. See, e.g., 29 CFR 2550.404c-1(d)(2)(iv) and 29 CFR 2550.404c-5(b).
Whether an investment option containing PE is prudent is a question of specific facts and circumstances. A plan fiduciary must employ an objective, thorough, and analytical process that considers all relevant facts and circumstances when determining the prudence of an investment option.
For example, investing in private equity may present plan participants an opportunity for enhanced diversification of investment risk and greater returns over time by giving investors a stake in privately held companies during their early growth stages. Private equity investments may also hedge against market downturns by offering investment opportunities that do not necessarily move in tight lockstep with the broader public market.
Each fund reviewed had a private equity component and a sufficient pool of other assets to diversify the exposure of plan participants to the private equity investments. The other investments had a range of asset classes with different risk and return characteristics and investment horizons. The fund's overall exposure to the private equity investments were also capped at a specified portion of the fund's assets, with the remainder of the fund's portfolio invested in publicly traded securities or other liquid investments with readily ascertainable market values.
Special Features of PE Investments
Private equity investments tend to involve more complex organizational structures and investment strategies, longer time horizons, and more complex, and typically, higher fees. A typical private equity investment is structured to reflect the longer-term nature of the commitments required to achieve the investment's objectives. The typical structures also allow the vehicle's investment professionals to guide the management and operations of the portfolio companies in which the vehicle invests to maximize the returns for investors over a multi-year period during which investors' ability to redeem or sell to obtain a return of capital may be limited.
Factors to Consider
In determining the prudence of a PE investment, the fiduciary should consider:
(i) whether adding the particular asset allocation fund with a private equity component would offer plan participants the opportunity to invest their accounts among more diversified investment options within an appropriate range of expected returns, net of fees (including management fees, performance compensation, or other fees or costs that would impact the returns received), and diversification of risks over a multi-year period;
(ii) whether the asset allocation fund is overseen by plan fiduciaries (using third-party investment experts as necessary) or managed by investment professionals that have the capabilities, experience, and stability to manage an asset allocation fund that includes private equity investments effectively given the nature, size, and complexity of the private equity activity; and
(iii) whether the asset allocation fund has limited the allocation of investments to private equity in a way that is designed to address the unique characteristics associated with such an investment, including cost, complexity, disclosures, and liquidity, and has adopted features related to liquidity and valuation designed to permit the asset allocation fund to provide liquidity for participants to take benefits and direct exchanges among the plan's investment line-up consistent with the plan's terms.
Notice to Participants
The fiduciary must also furnish plan participants adequate information regarding the character and risks of the investment alternative to enable them to make an informed assessment regarding making or continuing an investment in the PE fund. Notice is especially important to fiduciaries claiming limited liability under ERISA section 404(c) for participants' exercising control over their own account investment and (see 29 CFR 2550.404c-1) and/or deciding that a particular investment alternative would be prudent to use as a qualified default investment alternative (QDIA) for the plan under 29 CFR 2550.404c-5.
A plan fiduciary does not violate its duties solely by offering a professionally managed asset allocation fund with a private equity component as a designated investment alternative for a defined contribution plan. This ruling presents an interesting opportunity for private equity looking for minority investors.