Pondering DC Plan Access to Private Equity

An ever-greater proportion of the wealth being generated by the U.S. and global economies is locked away in private equity markets.

Charlie Nelson, CEO of retirement and employee benefits for Voya, recently spoke with PLANADVISER about his appointment to the board of the Defined Contribution Alternatives Association.

Asked why he has decided to work with the nonprofit organization that provides education about the benefits of including alternative investments within a defined contribution (DC) plan framework, he said the topic has been both a personal interest and one that Voya shares. Simply put, Nelson says, an ever-greater proportion of the wealth being generated by the U.S. and global economies is locked away in private equity markets, which, by design, are accessible only by the wealthy. This fact is often overlooked by individual investors and even otherwise financially savvy advisory professionals who have seen the strong growth in the value of the publicly traded equity markets over the last several decades.

The overall growth has masked the fact that there are only about half the number of publicly owned companies available to trade today than there were 20 or 30 years ago. Because the markets have grown by leaps and bounds while the number of companies being traded has halved, this, by definition, means risk is more concentrated in publicly traded portfolios.

This week, Bob Browne, chief investment officer for Northern Trust Asset Management, also addressed the topic. He admitted the “shrinking” of the public markets is not a phenomenon that he has thoroughly analyzed, but it’s “certainly an interesting subject and one that deserves further consideration.”

Echoing some of Nelson’s comments, Browne says he wonders whether the changing character of companies going through initial public offerings (IPOs) is perhaps even more important than the drop in the total number of IPOs occurring. This is to say that many companies going through IPOs today are doing so later in their startup lifecycle, meaning a lot of the early and most significant growth of what are now major public companies is not accessible by main street investors. He points to the example of WeWork, noting how companies that delivered great returns for private investors can, later in their lifecycle, be rebuffed by the public markets. 

Browne says the current system governing the private equity offerings was put in place by the U.S. Securities and Exchange Commission (SEC) to help ensure less wealthy investors do not take excessive risk in complex private markets and do not invest unknowingly in highly illiquid or otherwise restrictive securities. This goal makes sense, Nelson and Browne agree, but at the same time, it is important to acknowledge the difference between DC plan investors, who benefit from fiduciary oversight, and individual retail investors.

How Big Is the PE Opportunity?

The newly published J.P. Morgan 2020 Global Alternatives Outlook shows demand for the above-public market returns needed to reach institutional investors’ overall return targets remains robust. Investors with the means are rebalancing out of appreciating public equity holdings and into private equity to maintain strategic allocations, explains Larry Unrein, portfolio manager and global head of the private equity group.

“For investors with experience and specialized skills, opportunities can be found,” Unrein says. “The world economy is still growing, albeit modestly in the U.S., Europe and Japan, and at a declining, though relatively healthy, rate in China as markets seemingly continue to outperform initial forecasts. While the private equity market is competitive, the smaller end of the market continues to offer opportunities for disciplined investors, and value can be realized through the creation of unique platforms or investment in companies that may have return-enhancing synergies with existing portfolio companies.”

J.P. Morgan analysts argue the pace of technological change and innovation is accelerating globally, and this will continue to be a major source of opportunity for private equity investors.

“While corporate finance deals are increasingly competitive, we still see attractive opportunities in firms with revenues of $10 million to $100 million,” J.P. Morgan finds. “These investments tend to stay below the radar and be less leveraged, with less inflated valuations than more prominent mega deals. … Outside the U.S., our focus is on opportunities in Europe. On the venture capital/growth side, the U.S. remains our primary focus, while the high growth areas of China and, selectively, India represent additional areas of opportunity. … Realistically, innovation is far more likely to emerge from smaller, lesser known, private enterprises than from large, visible, public companies—making high growth opportunities difficult to find.”

Zooming in, J.P. Morgan projects that e-commerce, cybersecurity and software as a service (SaaS) are a few areas of “tremendous promise.”

“That said, it is incredibly difficult to see the world as entrepreneurs do; conventional wisdom often dismisses tremendous opportunity as business as usual or even irrelevant. Think Amazon, for example, debuting as an online bookseller (at least, viewed through a traditional lens) and now a multi-faceted, dynamic company valued at well over $800 billion,” Unrein says. “Of course, not all companies fare as well in the public market. Some may perceive the recent short-term performance of several high profile company IPOs as representative of a broadly difficult and unattractive public market.”

According to J.P. Morgan’s analysis, venture-backed IPOs over the past 10 years have performed well, up 25% in the first 12 months following their IPOs.

“How then, can investors separate the winners from the losers? The key is having access to unique new economy opportunities and the specialized skills and experience to assess the long-term potential of innovative startups and their management teams,” Unrein says. “Investors also need to be diversified and consider their own risk-return objectives: Getting in on the ground floor can be very lucrative, while allocating to some later-stage investments may provide attractive returns with less risk.”