On June 3, 2020, the Employee Benefit Security Administration of the U.S. Department of Labor (DOL) issued an information letter stating the fiduciary responsibility provisions of the Employee Retirement Income Security Act of 1974, as amended (ERISA) do not prohibit fiduciaries of 401(k) and other individual account plans from including diversified investment options with private equity exposure if various requirements are met.
This Client Alert provides a summary of the key points of the information letter and also explains important securities law matters private equity fund sponsors should consider in accepting participant-directed individual account plans into their funds.
The DOL Information Letter
The applicants for the DOL information letter inquired about the possibility of including private equity investments as part of a multi-asset class vehicle structured as a custom target date, target risk or balanced investment fund. Each asset allocation fund would have a sufficient pool of non-private equity assets to provide exposure of plan participants to a diversified range of asset classes with different risk and return characteristics and investment horizons. The asset allocation fund’s exposure to private equity would have a target allocation that does not exceed a specified portion of the fund’s assets, with the remainder of the fund’s assets invested in liquid investments with readily ascertainable market values. The fund would be managed by either a duly qualified professional investment manager or an investment committee of the plan sponsor with the assistance of an independent investment adviser fiduciary. In addition, such investments could be offered through a fund-of-funds structure rather than a single investment fund. It was emphasized, however, that in no instance would the private equity component of an asset allocation fund be available for direct investment by plan participants and beneficiaries on a standalone basis, the DOL noting that such direct investments would “present distinct legal and operational issues” for fiduciaries of individual account plans.
ERISA generally provides that plan fiduciaries must discharge their duties prudently and in the exclusive interest of the plan’s participants and beneficiaries. Most 401(k) and other individual account plans have participant-directed investments, and such plans typically are designed to satisfy the requirements of Section 404(c) of ERISA, which provides that individual account plan fiduciaries are not responsible for losses caused by participant investment selections among a menu of designated investment options offered under the plan if the requirements of Section 404(c) are met. One of these requirements is that fiduciaries must prudently select and monitor any designated investment options offered under the plan.
The DOL indicated that an individual account plan fiduciary may prudently select and monitor an investment fund consisting of an asset allocation fund with a private equity component as described in the letter in a manner consistent with ERISA’s fiduciary responsibility provisions. Given that private equity investments are more complex, have less liquidity, and typically do not have readily ascertainable market values, the DOL indicated plan fiduciaries should consider the following:
- whether adding such an investment fund would allow participants to invest in more diversified investment options with an appropriate range of expected returns, net of fees, and diversification of risks over a multi-year period.
- whether the investment fund is overseen by plan fiduciaries (using third-party investment experts as necessary) or managed by professionals who have the capabilities, experience, and stability to manage an investment fund effectively that includes private equity investments given the nature, size, and complexity of the private equity activity.
- whether the investment fund has limited the allocation of assets to private equity exposure in a manner that is designed to address the unique characteristics associated with such exposure and has adopted features related to liquidity and valuation designed to allow plan benefit distributions and direct exchanges among the plan’s investment line-up.
With respect to liquidity and valuation, the DOL indicated that a fiduciary could ensure that private equity investments in the investment fund not be higher than a specific percentage of the investment fund’s overall assets (citing as an example, the 15% limitation on illiquid investments applicable to registered open-end investment companies) and ensure that private equity investments be independently valued according to agreed-upon valuation procedures that satisfy the Financial Accounting Standards Board Accounting Standards Codification (ASC) 820 (“Fair Value Measurements and Disclosures”).
Consideration should also be given to whether inclusion of the investment fund would be consistent with the plan’s investment policy statement, participant demographics (e.g., ages, anticipated employee turnover, and contribution and withdrawal patterns), and plan design (e.g., the frequency of participants ability to change investment options and the ability of participants to access funds in the accounts through loans, withdrawals, and distributions).
The DOL indicated that fiduciaries should also consider whether participants will be furnished with sufficient information regarding the character and risks of the investment fund and its historical performance against benchmarks and fees to allow them to make an informed assessment regarding making or continuing an investment in the fund.
Private Equity Fee Arrangements
Concerns have been raised in recent years that private equity investments may not be suitable for individual account plans because they typically have higher investment management fees than mutual fund and similar investment vehicles included in these plans. However, the DOL confirmed, consistent with our long-standing belief, that the relevant inquiry should be the anticipated range of returns, net of fees, not fee levels themselves.
Other Regulatory Guidance on Private Equity Investments
The DOL is not the only regulatory agency that has been considering retail investor access to private equity investments. For example, on June 18, 2019, the SEC published the Concept Release on Harmonization of Securities Offering Exemptions (the “Concept Release”) to solicit public comment on exemptions from registration under the Securities Act of 1933. The Concept Release solicited responses to a wide range of questions, including whether the Commission should expand investment opportunities in private investment funds to “retail investors.” Specifically, the Concept Release asked for responses to the following question:
[w]hat restrictions should there be, if any, on the ability of [registered] closed-end funds . . . to invest in private funds, including private equity funds and hedge funds, and to offer their shares to retail investors? For example, should there be a maximum percentage of assets that closed-end funds . . . can invest in private funds? Should such closed-end funds be required to diversify their investments across a minimum number of private funds, if they are not restricting their offerings to accredited investors?
In addition, in December 2019, the Office of the Advocate for Small Business Capital Formation (“SBCF Office”), recommended to the Commission that it consider whether regulatory changes should be made in order to increase retail access to private investment funds, including funds pursuing private equity strategies, and whether such access could be had by allowing certain registered investment companies greater flexibility when investing in private funds. In its annual report for fiscal year 2019, the SBCF Office noted that
while the structure of public funds investing in private funds may be critiqued for a double-layer of management fees, reasonable fees may be justified where they afford investors asset management by professionals with experience in private markets, deal terms on parity with other sophisticated institutional investors, and an otherwise inaccessible diversified portfolio of private market holdings. Efficient fee structures should be prioritized in developing pooled vehicle solutions.
Securities Law Issues
When structuring investment products to be included on an individual account plan platform, investment managers should also be aware of certain securities law issues. For example, in the Standish, Ayer & Wood no-action letter dealing with the application of Section 3(c)(1) of the Investment Company Act of 1940 (“1940 Act”), the SEC staff noted that it would not recommend enforcement action if a participant directed defined contribution plan were treated as a single beneficial owner with respect to an investment in a fund even though the plan’s participants could choose investments from a variety of investment options. Similarly, in the H.E. Butt Grocery Company no-action letter, dealing with the application of Section 3(c)(7) of the 1940 Act, the SEC found that the position taken in the Standish, Ayer & Wood no-action letter is appropriate in the context of Section 3(c)(7) because it is consistent with the Commission’s “statements regarding the treatment of defined benefit plans as qualified purchasers” and with the “purpose” of Section 3(c)(7). To avoid looking through to individual 401(k) plan participants, these no actions letters provide that (a) the investment fund would have to limit its investment in any 3(c)(1) or 3(c)(7) fund to not more than 50% of the investment fund's assets, (b) the investment fund fiduciaries and not plan participants would decide when and how much to invest in a particular 3(c)(1) or 3(c)(7) fund (subject to the 50% limit previously described) and, (c) the investment fund could not make any representation or assurance to participants that any portion of the investment fund’s assets would be invested in any particular 3(c)(1) or 3(c)(7) fund.
The DOL’s information letter and the SEC’s regulatory initiatives signal a willingness on the part of the regulators to consider creative solutions when exploring retail investor access to private equity investments. In addition, we believe that the information letter should provide a pathway for including access to private equity investments in individual account plans as part of the overall portfolio mix in diversified investment options. Given the complexities involved, private investment fund sponsors, investment managers, and ERISA plan fiduciaries should consult with ERISA and securities counsel in structuring or evaluating such options.
1 Information Letter from Louis J. Campagna to Jon W. Breyfogle (June 3, 2020). Information letters are for informational purposes only and are not binding on the DOL or any other party. ERISA Procedure 76-1, Section 11.
2 While the information letter is limited to investment funds that invest in private equity, the DOL’s analysis should apply equally to investment funds that invest in other alternative asset classes such as real estate.
3 29 CFR 2550.404c-1(d)(2)(iv) and 29 CFR 2550.404c-5(b).
5 Congressionally created office to provide a dedicated champion to smaller companies accessing critical capital to build, grow, and thrive. The Office operates pursuant to sections 4(j) and 40 of the Securities Exchange Act of 1934 (15 U.S.C. §§ 78d and 78qq), as added by the SEC Small Business Advocate Act of 2016 (P.L. 114-284) and amended by the Small Business Access to Capital after a Natural Disaster Act (title IX of division S of Public Law 115-141) (collectively, the Small Business Advocate Act).
7 Standish, Ayer & Wood, Inc. Stable Value Group Trust, SEC No-Action Letter (Dec. 28, 1995).
8 H.E. Butt Grocery Company, SEC No-Action Letter (May 18, 2001).