Ever looking for opportunities to make new money for the average American, the Trump administration earlier this month paved the way for a 401 (k) plan and similar individual accounts to invest in private equity funds.
According to Labor Secretary Eugene Scalia, this reflects President Trump’s determination, through the May 20 executive order, “to remove obstacles to the largest engine of economic prosperity the world has ever known: innovation, initiative, and encouragement of the American people.”
That’s a chance.
We have seen a number of proposals from private equity funds where the returns are really not calculated in a way that I think is honest.
Warren Buffett, May 2019
Private equity funds, which invest in companies not listed on the stock exchange and therefore do not have to report their finances or operations publicly, are among the riskiest and most opaque investment vehicles designed by Wall Street.
They often overload the acquired companies with large debts, reducing their long-term prospects even when they generate short-term profits for the promoter. And their capital may be tied to illiquid investment which makes it difficult for clients to get their money whenever they want.
Until now, ordinary Americans have been effectively banned from this sector because of the requirements of the Securities and Exchange Commission that they are only open to “Accredited” investors – generally those with income of at least $ 200,000 in recent years or net worth of at least $ 1 million, not including homes.
The agency does indeed place some restrictions on how the investment should be arranged. Direct investment in private equity companies by ordinary investors is still prohibited. Conversely, the private equity component must be placed in a larger diversified fund that has sufficient liquidity to pay off investors who want to get out immediately.
However, the change is a big advantage for private equity promoters, who have lobbied for years to get their gloves at an estimated $ 6.2 trillion in 401 (k) accounts and $ 2.5 trillion in each retirement account . They might hope that once the door is opened, some of the remaining restrictions will be erased.
Is this sector a good idea for the average owner of 401 (k)? I don’t usually offer investment advice through this column, so let me say: If I tend to invest my 401 (k) money in private equity, I hope my family will arrange to have my head examined.
Scalia certainly didn’t see things like that. In announcing the new June 3 guidelines, he called the rules changing the way to “help saving Americans retire access to alternative investments that often yield strong returns.”
Private equity companies have kept money flowing to politicians in recent years.
(Center for Responsive Politics)
He said the aim was to “equalize ordinary investors … to ensure that ordinary people who invest for retirement have the opportunities they need for safe retirement.”
Watch that word “often.” That is a common weasel word, the subtext of which is “alternative investment” often not provide strong returns.
It is appropriate to observe that Scalia does not distinguish itself as a rank of labor champion, which makes it the perfect choice to lead Trump’s Department of Labor when he was appointed last year.
Only this month, Scalia opposed the Democratic proposal to extend $ 600 in federal unemployment benefits past July 1. At that time, he said, “the circumstances that originally asked for $ 600 plus-ups would change.” That’s debatable, because more than 20 million Americans remain unemployed today.
Private equity funds are known as alternative investments in part because they operate in an alternative reality to traditional investments: They produce limited disclosures, or no useful disclosures at all; there is no generally accepted formula for measuring returns; and they will incur a much higher management fee than conventional stock, bond or money market funds.
“We have seen a number of proposals from private equity funds where the returns are really not counted in a way that I think is honest,” Buffett said at the annual Berkshire Hathaway meeting in May 2019, which holds the company’s investment portfolio. “If I run a pension fund, I will be very careful about what is offered to me.”
Charles Munger, vice chairman of Berkshire and Buffett’s longtime business partner, added his own observation that private equity firms sometimes extract reported returns by parking money in treasury bills but do not report ownership of low returns in their portfolio yields. “All they do is lie a little to make money,” he said.
Claims from the private equity sector to produce higher returns than conventional stocks and bonds have been regularly questioned. Whatever gross returns enjoyed by private equity firms are eliminated by fees collected by their promoters, usually 2% a year of the total value plus 20% of the profits.
As observed by Brett Arends from MarketWatch, by taking the average gross profit from the Standard & Poor’s 500 index at 12% per year (excluding inflation), private equity funds must set aside 17% gross profit per year just to equal the S&P 500. That’s not realistic, to say the least.
Analysis of notes written and posted after changes to the regulations of the Department of Labor by Ludovic Phalippou from Oxford University found that the gross return on private equity funds roughly matches the public stock index, but a disproportionate share of profits goes into the pockets of people in private equity.
PE is already above more than one trillion dollars waiting to buy companies that are beaten with the selling price of fire. There’s no need for retired workers, but hey – why let the crisis be in vain. PE has been lobbying for this change for years. @ceprdc@ DeanBaker13https://t.co/mjijmSzOg0
– Eileen Appelbaum (@EileenAppelbaum) June 4, 2020
“The number of PE millionaires,” he observed, “rose from 3 in 2005 to 22 in 2020, and most were affiliated with large PE companies.”
Private equity companies say that they remain popular among large institutional investors, which means they offer legitimate value.
Phalippou did not buy that argument. He attributed their popularity to conflicts of interest between institutional decision makers, and “low financial literacy between the two actors and even many agents – people who policymakers uniformly classify as” sophisticated investors. “
Private equity companies have stretched into Republicans and the Trump administration through liberal applications of cold money and influence. In 2018, these companies contributed nearly $ 110 million to candidates and political action committees, and this year (so far) around $ 77 million.
These contributions were roughly divided between Republicans and Democrats in the last two election cycles.
But the largest private equity firm, Blackstone Group, has recently sent most of its contribution to conservative and Republican recipients – around $ 18.5 million from $ 21 million in 2019-2020. One of the founders and chair of Blackstone, Stephen A. Schwartzman, is chief adviser to President-elect Trump during the 2016 transition.
Schwartzman made no secret of his desire to get retail investors’ money. “In life you must have dreams,” he said Conference call January 2017 with Wall Street analysts.
“One of his dreams is our desire and the market needs to have more access in retail to alternative asset products. … At the moment many people are not allowed to put them in retirement vehicles and other types. And one of the interesting problems when you have a new government is whether they want to continue with such a ban or not. “
Get the instructions, Mr. President? (Kudos to David Sirota to dig up this invaluable nugget.)
To put Schwartzman’s wishes in perspective, Eileen Appelbaum of the Center for Economic and Policy Research calculated that only 5% of available funds from 401 (k) and Individual Pension Accounts would reach $ 435 billion – “real money even for private equity millionaires and billionaires, “He wrote. “The value proposition for workers, whose retirement income is likely to be depleted by costs for returns that may not be realized, is far less clear.”
He’s right. The median 401 (k) account does not have enough in it to support its owner through a long pension.
That is an argument for maintaining the balance of risks and rewards in their portfolios, not for taking leaflets on high-risk and questionable “alternative investments”.
If the Trump and Scalia Labor Departments really care about the prospect of retirement from rank, they will warn them to stay away from private equity, not to open the door wider.
