Debate: Does Private Equity Warrant a Spot in Retirement Accounts?

Source: Startupsventurecapital



Does Private Equity Warrant a Spot in Retirement Accounts?
The debate is fierce, ranging from investor discrimination to poor performance.
By Nir Kaissar and Barry Ritholtz
Bloomberg, September 16, 2020





The Trump administration has set in motion a plan that would effectively allow 401(k) plans for American workers to invest alongside buyout firms. The Labor Department said in June that the move will bolster investment options for consumers and let them access an asset class that can provide better earnings than stocks and bonds. Consumer groups blasted the plan, claiming that high-fee private equity firms are inappropriate for unsophisticated investors because the industry locks up clients’ money for years and backs risky, debt-laden businesses. Bloomberg Opinion writers Nir Kaissar and Barry Ritholtz met online to debate the merits of the plan.

Nir Kaissar: Everyone should have equal access to financial markets. Every time I say it, I’m amazed by the pushback. In any other context, the idea that everyone should be treated equally would go virtually unchallenged.

Not so when it comes to investing. U.S. securities laws openly discriminate against some investors, mostly based on the size of their wallet. Probably the best-known example is the exclusion of ordinary investors from private markets. Investors typically access private assets such as venture capital and private equity through private funds. But securities laws restrict those funds to “accredited investors” who meet certain income and net worth hurdles, and which exclude more than 90% of Americans.

The purported justification is that ordinary investors need protection – that they’re too unsophisticated to navigate the arcane and sometimes shady world of private investments. But as any money manager will tell you, there’s no correlation between a fat paycheck or a big bank account and financial sophistication. And the more obvious problem: How can ordinary investors become more sophisticated without access to markets?

Last month, the U.S. Securities and Exchange Commission opened the door to private markets a bit wider. It amended the definition of “accredited investor” to include, among other things, investors with financial knowledge, experience or certifications, including certain employees of private funds, who don’t otherwise qualify. But even after the change, most Americans will still be excluded from private markets.

Those who support giving access to some investors while excluding others must answer some thorny questions. Who should be excluded and on what basis? And who should be the arbiter of those exclusions, today and in the future? In her statement accompanying the SEC’s action, Commissioner Hester Peirce asks, “Why should I, as a regulator, decide what other Americans do with their money?” The question answers itself.

Barry Ritholtz: What purpose would it serve to allow private equity options in retirement funds? This is not about civil liberties or voting rights; rather, these are expensive, opaque, and often underperforming assets that are difficult to understand and even more difficult to select. Equal access sounds good in theory but in actual practice it is a disaster.

So I would re-frame this question: “Should regulators paternalistically protect investors?”

The underlying question to this debate is whether you believe – as I do – that part of the charge for regulators is to protect people from themselves. This includes their own worst behaviors that operate against their own self-interests. We have mandatory seat belts laws and warnings on cigarette boxes and lots of other safety-related rules because we know that, left to their own devices, people make bad decisions that turn out to be very expensive for society.

We have limitations on investing margins, because we know how the excessive leverage movie ends. Recall when we changed the Net Capitalization Rules to allow brokerage firms to borrow more against assets, they quickly added lots of leverage and then promptly blew themselves — and the economy — up. We do not have to ask “Why don’t we give investors equal access to leverage like institutions have?” Experience has taught us the answer: they cannot manage it without getting into big trouble.

Whether it is the loss of economic productivity or the higher costs of health care, our behavior affects both ourselves and everyone else in the economy. The same is true for the retirement crisis that has been building for decades. Indeed, Dodd-Frank regulations mandated that the SEC perform a study to find ways to reduce costs for retirement investors. The result was the proposed fiduciary rules, which were calculated to save some $17 billion per year to retiree investors in excess costs. Lobbying by Wall Street killed those savings. It is not a stretch to suggest the shortfall will likely be made up – in part – by taxpayers.

Even the best foundations and endowments, with unlimited resources and first choice of best performing funds, have a hard time selecting alternatives that outperform a 60/40 portfolio of stocks and bonds. The leftovers that will be trickled down to Main Street will be the dredges of the industry. Look no further to what mom and pop investors are offered in the hedge fund space.

Do we really need equal access to expensive and likely underperforming alternative Investments sold to unwitting and unsophisticated sheep just waiting to be shorn?

NK: I would rephrase your question: How paternalistic should America be with investors? We can probably agree that some regulation is necessary. Requiring full and honest disclosure when companies, funds or financial firms solicit investment is a good idea given the financial incentive to obfuscate and spin yarns. So are rigorous licensing requirements for investment professionals.

But singling out ordinary investors for exclusion from certain segments of financial markets makes little sense. There are lots of ways ordinary investors can hurt themselves financially, such as trading penny stocks or purchasing high-priced mutual funds. No one argues that those should be off limits.

Also, like private assets, hedge funds are limited to accredited investors, and yet a growing number of mutual funds and exchange-traded funds offer hedge-fund strategies to everyone. Those strategies are far more complicated than typical stock or bond funds, and no less complicated than private investments. Here again, no one seems concerned that ordinary investors are in too deep.

Nor is it evident that ordinary investors need special protection. Just because an investment is dangled in front of them doesn’t mean they’ll bite. Ordinary investors are increasingly turning to low-cost, buy-and-hold investment products, as evidenced by the great migration to index funds. So they’re perfectly capable of making smart financial decisions when given the opportunity.





I originally published this at Bloomberg, September 16, 2020. All of my Bloomberg columns can be found here and here


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