In a world of disruption where one day’s winner is next week’s loser, private equity managers are fighting back.
The private equity industry, long dependent on defined benefit pension plans as major investors in its funds, has watched for over a decade as private sector pensions have frozen, closed, or moved to a fixed-income strategy known as liability-driven investment. To mitigate the shrinking of their investor base, private equity firms have set their sights on a giant and growing U.S. defined contribution market that stands at 90 million participants with a total $6.7 trillion in assets.
So far it has been an uphill battle as DC gatekeepers — retirement plan sponsors and their investment consultants — continue to keep this asset class off 401(k) plans. In its ongoing effort to climb on board, private equity’s latest shot off the bow is a significant change to the traditional structure of alternative investment fees that have enriched not just private equity firms but hedge funds and other asset managers as well.
Do retirement plans need to add private equity to often-crowded lineups of investment options, particularly when plan sponsors, seeking lower fund management fees, have been moving assets to passive index funds? Private equity managers insist the benefits of diversified portfolios — long the province of educational endowment funds and ultra-high-net-worth investors, as well as pension funds — should be the right of small retirement plan savers. They attribute some of the 76-basis-point average annualized outperformance of defined benefit plans over DC from 1995 through 2011 (according to Willis Towers Watson) to the inclusion of asset classes like private equity.
Michael Gaviser, a managing director at private equity firm KKR, points out that the long-term performance of this asset class has beaten the stock market for a decade. For example, the trailing ten-year internal rate of return, a performance measure used in private equity, was 12.6 percent on June 30, 2016, versus the 8.3 percent annualized return for the Russell 3000, according to Cambridge Associates.
So how will private equity find its place among myriad active and passive investment funds in retirement savings plans? Kevin Albert, global head of business development at Pantheon, thinks he’s figured out how to break the DC barrier. Albert joined the private equity fund-of-funds manager in 2010 with 29 years of experience as a private equity capital fundraiser for Merrill Lynch and Elevation.
“It was my dream to figure out why no one ever put private equity in DC schemes,” says Albert. “There is no law or regulation against it.”
Albert sees the threat of litigation looming over DC plans as the primary reason sponsoring employers avoid using what many view as a high-fee, leveraged, esoteric, private market investment. After all, aside from the fiduciary responsibility of the plan sponsors, retirement funds are ultimately the responsibility of noninvestment professionals — the plan participants.
To counteract the possibility of disgruntled DC plan participants teaming up with a plaintiff’s law firm to sue for, say, high fees — a popular theme in many 401(k) lawsuits — Pantheon is repackaging its strategy with a new fee arrangement that eliminates the management fee and charges only a performance-based fee on a percentage of assets. “We tried to make putting private equity into defined contribution plans a much tougher lawsuit by charging a percentage of assets, not a management fee,” says Albert.
To further strengthen its attractiveness, the performance fees accrue in a reserve account and are only paid to Pantheon when it outperforms the S&P 500 index. The fees are gradually paid out to Pantheon over a period of at least eight quarters, providing a cushion in the reserve, which is designed to rebate capital on the firm’s private equity strategy in scenarios of underperformance.
Pantheon is not the only firm trying to break into the DC market with a private equity strategy. Partners Group has structured three separate funds for three markets: the U.S., the U.K., and Australia. The funds provide daily liquidity and daily trading — a necessity for a retail-style DC fund and unique for an investment offering that delivers its returns from buyout funds with long lockups that typically don’t deliver any returns before three to five years.
The U.S. fund is up and running with assets, says Robert Collins, a managing director at Partners Group, who, like Albert, sees private equity funds working best in the “sticky” target-date wrapper where participants often set it and forget it. But Partners has not yet been able to sell its private equity product to DC sponsors. Instead, the firm has found a client that is using it in a U.S. private sector defined benefit fund it declines to name.
The offering enabled the client to immediately invest in an existing private equity fund with a liquidity mechanism that is not usually available in defined benefit plans — periodic liquidity in a ten-year fund, Collins says.
Will the new fee arrangement find its audience? Albert is sanguine on the chances. “I still think it’s a no-brainer,” he says. “We’re just getting started with the performance fee change.”
