The private fund industry wants access to include their funds in 401(k) plans. A discussion of the merits of private fund investments is not a subject for lawyers, but instead is for investment experts. However, there are legal issues under ERISA that impact the inclusion of those investments in participant-directed plans. This article discusses some of those legal issues.

While the SEC may—and apparently will—reduce the thresholds for “retail investors” (which includes plan participants) to access private funds, that is for the future. Even then, the SEC may reduce the thresholds, but not eliminate them; in that case, standalone private fund investments would probably not be included in the core lineup of 401(k) plans, since not all participants would be eligible to invest in those options.

As a result, this article focuses on private funds as parts of portfolio investments, for example, target date funds, balanced funds and managed accounts.

In 2020, the Trump DOL issued an information letter with its views on the inclusion of private funds in portfolio investments: “Your inquiry involves the use of private equity investments within professionally managed asset allocation funds that are designated investment alternatives for participant-directed individual account plans.”

To be clear that the DOL guidance was not about standalone private funds, the letter went on: “In no case would the private equity component of the asset allocation fund be available as a vehicle for direct investment by plan participants and beneficiaries on a stand-alone basis.” A footnote to that sentence explained: “This letter does not address any fiduciary or other ERISA issues that would be involved in a defined contribution plan allowing individual participants to invest their accounts directly in private equity investments. Such direct investments in private equity investments present distinct legal and operational issues for fiduciaries of ERISA-covered individual account plans.”

With that out of the way, the DOL went on to conclude: “The Department believes that a plan fiduciary of an individual account plan may offer an asset allocation fund with a private equity component of the type you describe in a manner consistent with the requirements of Title I of ERISA.”

In other words, it is not inherently imprudent for a participant-directed plan to offer private funds as a part of a professionally managed portfolio.

The DOL went on to note, though:

“As compared to typical public market investments available in individual account plans, private equity investments tend to involve more complex organizational structures and investment strategies, longer time horizons, and more complex, and typically, higher fees. A typical private equity investment is structured to reflect the longer-term nature of the commitments required to achieve the investment’s objectives. The typical structures also allow the vehicle’s investment professionals to guide the management and operations of the portfolio companies in which the vehicle invests to maximize the returns for investors over a multiyear period during which investors’ ability to redeem or sell to obtain a return of capital may be limited. As compared to public market investments, private equity investments are subject to different regulatory disclosure requirements, oversight, and controls. In addition, valuation of private equity investments is more complex because private equity investments often have no easily observed market value, and there is often an element of judgment involved in valuing each of the portfolio companies prior to their sale by the investment fund or other liquidity event (e.g., initial public offering).”

Viewed through a legal lens, that means that there are factors that fiduciaries need to evaluate when considering offering private funds in portfolio investments, such as managed accounts or TDFs, in a participant-directed plans.

Before discussing that evaluation, I should point out that in 2021 the Biden DOL issued a Supplemental Statement about the 2020 Information Letter. The Supplemental Statement did not fundamentally change the 2020 guidance, but added a few comments:

• The Department stated that, as with any designated investment alternative, the plan fiduciary must consider whether the fiduciary has the skills, knowledge, and experience to make the required determinations or whether the plan fiduciary needs to seek assistance from a qualified investment manager or other investment professional.
• A plan-level fiduciary that has experience evaluating PE investments in a defined benefit pension plan to diversify investment risk may be suited to analyze these investments for a participant-directed individual account plan, particularly with the assistance of a qualified fiduciary investment adviser. The Department cautions against application of the Information Letter outside of that context. Except in this minority of situations, plan-level fiduciaries of small, individual account plans are not likely suited to evaluate the use of PE investments in designated investment alternatives in individual account plans.”

When combining the discussion of considerations in the 2020 Letter and the admonitions in the 2021 Supplemental Statement, the message is that the use of private funds in portfolios is a fiduciary decision which must be made prudently. ERISA’s prudent person rule is that fiduciaries must act:

“…with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims;…”

For our purposes, the key words are “familiar with such matters.” In other words, plan fiduciaries must be familiar with the selection and monitoring of private funds, or they must engage knowledgeable advisers to help them with the analysis. In short, “competence” is required.

Since, in many—if not most, cases, plan fiduciaries will not be competent to evaluate the material factors to be considered in the selection and monitoring of private funds, they will need to engage advisers who are competent in that area. The DOL Letter and Statement list a number of the factors to be considered in the evaluation, such as, higher management fees, valuation, lack of transparency, liquidity, time horizon, and complexity. Advisers will need to demonstrate that they competent to do that, that is, to determine whether it is in the best interest of the plan to include private funds in the portfolio (and how much to allocate to those funds) and to determine whether the particular private fund is prudent for that purpose.

I was recently involved as a consultant in a dispute involving a claim by the primary plan fiduciaries that a plan adviser (a 3(38) investment manager) breached its ERISA fiduciary duties in selecting alternative investments, including private funds, for a plan. The attorney for the fiduciaries asserted, among other things, that the adviser lacked the education and experience needed to prudently evaluate the private funds.

With that in mind, imagine yourself being interrogated about your qualifications, education and experience on selecting private funds in an investment portfolio for a retirement plan. The key is that the answers indicate that the selection and allocation decisions were based on substantive knowledge and experience. That knowledge can be a combination of your experience and your firm’s.

Concluding Thoughts

In my view, the DOL properly said that ERISA does not preclude the use of private funds from portfolios in participant-directed plans.

If a plan’s fiduciaries or their advisers engage in a prudent and knowledgeable process to select private funds as a part of a managed portfolio and to determine the allocation to those funds, ERISA’s fiduciary standards can be satisfied. For risk management, advisers should be prepared to show meaningful education and experience in the selection and monitoring of private funds.

The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Faegre Drinker.