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Thrump has now signed an executive order allowing Wall Street to place “alternative assets” such as private equity funds or crypto, et al, into the 401(k) accounts held by 70 million American workers, totaling some $9 trillion in assets.
One thing Americans, and people in general, aren’t very good at, is saving money for retirement. (I certainly sucked at it) These days only 9% of Americans have a defined benefit pension plan. Tens of millions of Americans hold their retirement assets in 401(k) plans, which have no defined benefit and are known as defined contribution plans. A survey, last year found that about 40% of Americans are underfunding their contributions to the assets they will need for their eventual retirement (fingers crossed they’re able to retire on their savings). 5% of 401(k) account holders took hardship distributions last year to pay for current expenses, such as medical debt or school tuition. On top of that, almost a third of workers who change jobs end up liquidating their retirement accounts.
The financial press has been gushing about what a windfall this will be... for the private equity owners and managers, not the 401(k) account holders.
Why is private equity only getting in now on 401(k)’s?
Basically, up to now, federal laws barred the private equity industry from 401(k) accounts because of the high fees they charge (+/-20% on the invested funds) and the high risk nature of the investments they make. Private equity has been in the pension game for a while, handling some assets for state employee pension plans, union retirement funds, etc. (This was allowed because pension plan managers are considered to ‘sophisticated investors’, who are presumed to understand the subtleties of high risk/high fee investments.
What’s so bad about private equity being in your 401(k)?
In a word, it’s private. When an asset is held privately, the owner(s) get to say what it is worth. For example, I own a car. I say it’s worth $80,000. It is to me. It’s been incredibly reliable, gets 50 miles per gallon and it gives me space to display my well reasoned and insightful collection of bumper stickers.
Likewise, when private equity purchases an asset, they get to say what that investment is worth. Private equity’s business model involves buying assets, such as corporations, with high value assets, like pension plans or long term assets like PPE (plant, property & equipment), with borrowed money (leverage), selling off, or taking the assets and frequently bankrupting the corporation with debt that didn’t exist before the private equity fund came along. All along the way, they get to say this asset is worth this much. GAAP (Generally Accepted Accounting Principles) accounting rules don’t apply because private companies don’t make public reports.
Of course, the real monetary worth of a widget, asset or corporation can only be determined when item is offered for sale to a buyer, in an arm’s length transaction, with both the buyer and seller having knowledge of the relevant facts. But, until the private equity entity seeks to sell, they get to say what it is worth.
(BTW, my car is a 2015 Toyota Prius C)
Some examples of private equity’s activities include Toys R US, Joanne’s Fabrics and Red Lobster. One could be excused for thinking these deals make a lot of money, why else do them? Wouldn’t it be great to get in on some of these deals?
What is private equity’s track record of making money for investors?
It is very hard to say. Valuing the assets in a private equity fund, as I said, is up to the general partners and there is no check on their valuations, until the asset is up for sale.
Ted Seidle: Well, we don't really know because the values that these investments are assigned by the general partners, the people running these funds are manipulated. They're not verifiable.
And there there's a conflict of interest. If you ask me what's the value. Of a portfolio I'm managing for you, that I'm getting paid one or two or three or 5% on, I'm gonna inflate the values. It's a built-in conflict of interest, so there is a conflict of interest in valuing these investments. As a result, the valuations are at best optimistic.
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(Ted Seidle is a former SEC attorney that does forensic investigations of retirement plans, whether it's state pension plans or 401k plans.)
Since the value of the assets the private equity firm is essentially unknown, there is no way to determine how much money the firm returns to investors.
Private equity is very lucrative for the general partners, however. Thanks to the high fees they charge investors, not to mention taking a cut of the asset’s price, when they do sell, they have a guaranteed income stream.
Will private equity firms deliver the returns it promised, when the time comes for retirement?
That’s the $64,000 question.
As we were climbing out of the Great Recession, we had a period of really cheap interest rates, even free money for a little while. Private equity managers went to town, bidding up the prices of assets since money was so cheap. Now the fear is that private equity is loaded with overpriced assets, that are given optimistic valuations by the private equity managers and the assets won’t be able to be sold at those optimistic values and the private equity managers will not be able to cover redemptions by retirees without severely discounting those payout that the retirees were counting on, based on those optimistic valuations the managers made.
In closing…
The opacity of private equity allows the private equity mangers to shunt off unprofitable transactions onto its retail investors while keeping the profitable transactions for themselves, on top of the fee income investors paid in and leaving retirees up the proverbial creek.
...letting private equity access your 401k could effectively serve as a bailout [for private equity]. Your 401k could keep the private equity fee machine running. Your 401k could help private equity firms pay back the other investors they already owe.
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