Private equity is increasingly finding its way into 401(k) plans, promising higher returns for retirement savers. However, understanding the performance of these investments can be surprisingly complex, even for seasoned investors. This isn’t just about jargon; the methods used to report private equity returns can be opaque and misleading, making it difficult for the average person to make informed decisions.
The industry often touts impressive internal rates of return (IRR), sometimes exceeding 30%. But IRR isn’t a simple measure of annual yield like a government bond. It’s a formula that can be manipulated to highlight certain behaviors, such as early dividend payouts or the sale of successful companies, potentially exaggerating the actual returns. Experts warn that this can lead to a significant disconnect between the reported IRR and the actual value realized by investors.
Alternative metrics exist, such as the Public Market Equivalent (PME), which attempts to compare private returns to public market benchmarks. However, PME calculations are often complex and require specialized knowledge, placing them out of reach for most individual 401(k) investors. Another metric, distribution to paid-in capital (DPI), represents the actual cash returned on investment. While helpful, DPI only reflects past performance and doesn’t capture unrealized gains.
Further complicating matters is the challenge of comparing private equity returns to traditional market indexes. Private equity firms often benchmark their performance against underperforming indices, creating a misleadingly positive comparison. Studies show that a significant portion of private equity funds fail to outperform the S&P 500 over time.
Even getting the necessary data to make these comparisons can be difficult. Private fund valuations rely on “mark-to-market” appraisals, which involve estimating the value of unsold assets by comparing them to similar assets that have been sold. This process is often described as operating largely on an honor system, with limited independent auditing. Furthermore, these appraisals tend to smooth out market volatility, making it difficult to accurately compare private equity performance to the more volatile public markets.
Fortunately, 401(k) investors aren’t completely on their own. Plan sponsors and administrators have a fiduciary duty to act in the best interests of plan participants. They are responsible for carefully evaluating private equity investment options before including them in a plan. Moreover, private equity is unlikely to represent a significant portion of a typical 401(k), often comprising only 5% to 10% of a larger managed fund, reducing the overall impact of any individual private equity investment’s performance.
While the promise of higher returns from private equity is enticing, it’s crucial to be aware of the complexities involved in evaluating their actual performance. Understanding the limitations of commonly used metrics and the potential for manipulation is essential for making informed investment decisions in your retirement plan.
