Expanding Opportunities for Investors and Retirees: Private Equity

Hal S. Scott is the Emeritus Nomura Professor of International Financial Systems at Harvard Law School and John Gulliver is the Kenneth C. Griffin Executive Director of the Program on International Financial Systems. This post is based on their Committee on Capital Markets Regulation report.

In recent years, U.S. companies have raised more equity through private offerings available only to institutional and high-net-worth investors than through initial public offerings available to the general public. In addition, the number of U.S. public companies has been steadily declining, and private start-up companies are frequently reaching billion-dollar valuations without opening up to the public for investment.

In our report, Expanding Opportunities for U.S. Investors and Retirees: Private Equity, we examine whether U.S. policymakers should expand access to investments in private companies through private equity funds – investment vehicles that invest in the securities of private companies and that are not registered as investment companies with the Securities and Exchange Commission (“SEC”). Private equity funds include buyout funds that acquire controlling stakes in businesses and venture capital funds that invest in young private companies with high growth opportunities.

We find that private equity funds have a well-established performance history that justifies expanding investor access to them, and we recommend three ways to do so. First, legislative reforms to expand access to direct investments in private equity funds. Second, SEC reforms to expand access to public closed-end funds that invest in private equity funds. And finally, Department of Labor (“DOL”) reforms to enable 401(k) plans to invest in private equity funds.

In Part I on private equity fund performance, we explain the many factors that allow private equity fund managers to generate attractive returns for long-term investors. We then describe the measures used to evaluate the returns of private equity funds and review the existing academic literature on the returns of private equity funds, which finds that private equity funds have historically outperformed public equity markets while also offering portfolio diversification benefits. Finally, we review institutional investors’ asset allocations to private equity funds.

In Part II on expanding investor access to private equity funds, we describe the legal and regulatory restrictions on access to private funds and the policy basis for these restrictions. Chapter 1 addresses how Congress and the SEC have restricted access to private funds through the accredited investor standard, which prohibits the 87% of investors with less than $1 million in assets or $200,000 in annual income from directly investing in private funds. Congress has also restricted access to private funds through the qualified purchaser standard, which prohibits the 98% of investors with less than $5 million in investments from directly investing in private funds that have more than 100 investors. For simplicity, we refer to investors that do not meet the accredited investor and qualified purchaser standards as “retail investors.”

Chapter 2 explains that Congress and the SEC have applied these restrictions on the presumption that retail investors are not financially sophisticated, so they need the protections afforded by mandatory disclosure requirements in the public market, and that they cannot bear the economic risks associated with private funds. However, we find that private equity funds provide frequent and extensive disclosures to investors and that private equity funds are not excessively complex investments. In addition, retail investors have access to investment advisers that can provide the requisite sophistication to invest in private equity funds. Moreover, private equity funds have a long history of outperforming public equity markets, with lower volatility than public markets.

We therefore recommend that Congress allow retail investors to invest in private equity funds, so long as access is provided by a financial professional with a duty to act in the best interest of the retail investor. We then describe additional regulatory protections that Congress and the SEC could apply to private equity funds that are available to retail investors in this manner, such as threshold scale and experience criteria.

In Chapter 3, we explore whether public funds are legally permitted to invest in private equity funds. Public funds are investment vehicles that are registered as investment companies with the SEC and are generally open to all investors. As such, they are a potential vehicle for expanding retail investor access to private equity funds. However, certain statutory and SEC restrictions on public funds restrict their ability to invest in private equity funds.

Because public open-end funds (i.e. mutual funds) are statutorily required to allow investors to redeem shares on demand, which requires funds to sell their underlying assets, the SEC only permits them to invest 15% of their net assets in illiquid assets (including private equity funds). Because mutual fund inflows and outflows can be volatile, we do not recommend expanding the scope for public open-end mutual funds investment in private equity funds.

On the other hand, public closed-end funds are not subject to redemption requirements, because their investors generally obtain liquidity by selling their fund shares in secondary markets, which does not require a public closed-end fund to sell its assets. However, the SEC presently only allows accredited investors to invest in public closed-end funds that invest more than 15% of their assets in private equity funds. We recommend that the SEC allow retail investors to invest in these public closed-end funds. We explain that public closed-end funds are subject to extensive disclosure requirements as to their asset allocations to specific private equity funds and the management and performance fees charged by these funds. The SEC could further protect retail investors by requiring that public closed-end funds only invest in private equity funds subject to additional regulatory requirements, including that the affiliated manager of the private equity fund have an investor base with a material institutional component.

Part III addresses expanding retirement saver access to private equity funds. In Chapter 1, we describe the two primary forms of employer-sponsored retirement plans: defined benefit plans and defined contribution plans with a focus on 401(k) plans. Over the past twenty years, private-sector employers have shifted retirement assets away from defined benefit plans, where they directly bear the risk of a shortfall in plan assets, and towards defined contribution plans, where they do not. We find that the shift away from defined benefit plans and towards defined contribution plans could be hurting U.S. retirees, because defined contribution plans earn lower returns than defined benefit plans. We then describe a key difference between the two types of employer-sponsored retirement plans—defined benefit plans invest in private equity funds, whereas defined contribution plans generally do not. Finally, we show that private equity funds have positively contributed to the performance of defined benefit plans.

In Chapter 2, we explain that, as a technical matter, 401(k) plans can legally invest in private equity funds. In practice, however, 401(k) plans generally do not invest in private equity funds because the employers that sponsor these plans (and other plan fiduciaries) are concerned that offering investment options with exposure to illiquid assets, such as private equity funds, would unduly expose them to liability for breach of their fiduciary duties. We explain the basis for these meritless, yet burdensome, claims.

In Chapter 3, we further address the ERISA provisions and DOL regulations that expose 401(k) plan fiduciaries to litigation risk for offering investment options with exposure to private equity funds. First, we address the requirements that apply under ERISA’s Section 404(c) safe harbor, which protects plan fiduciaries from legal risk from decisions made by plan participants. Most importantly, these provisions require that plan participants have the control necessary to shift among a broad alternative of investment options. As a result, plan fiduciaries offer plan participants the ability to shift assets among investment options on a daily basis. We then explain how a 401(k) plan could invest in private equity funds while still providing participants with the ability to shift among investment options on a daily basis. Ultimately, we recommend that the DOL provide guidance as to how a plan fiduciary can offer investment options with exposure to private equity funds while qualifying for the Section 404(c) safe harbor. Second, we address the legal risk that a plan fiduciary can face from investment decisions made by plan fiduciaries, such as investing in an asset class with excessive fees or one that underperforms. We recommend that the DOL establish a new safe harbor for such legal risk that should apply if plan fiduciaries have complied with a diligent and independent process for selecting investments. We note that our recommended safe harbor approach is generally consistent with recent efforts by the DOL to create a safe harbor for annuities. We believe that private equity funds warrant similar treatment.

The full report can be accessed here.

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