Private equity managers eyeing DC plans for growth

Private equity firms are discovering a new type of client: ordinary people.

Carlyle Group LP, Blackstone Group LP and KKR & Co., which usually open their doors only to clients willing to commit at least $5 million, are lowering that threshold or offering investments directly to individuals, an effort to attract fresh cash amid lackluster fundraising. Their ultimate goal: a slice of the $3.57 trillion Americans have accumulated in their defined contribution retirement plans.

The firms are looking for ways to move down-market as a growing number of workers are pushed out of public and corporate pension funds and into defined contribution plans. While private equity funds are a staple of many large defined benefit plans, a sale to individuals poses dangers because the investments are hard to understand, can be illiquid and their fees are higher than those of traditional mutual funds, said David John, deputy director of the Retirement Security Project at the Brookings Institution, Washington.

“Should this start to take hold,” said Mr. John, “there needs to be either a licensing, a seal of approval or some level of higher oversight so people don't find that they are investing in something that really isn't suitable for their stage of life.”

Private equity firms lock up investor money for about a decade with a mandate to buy companies, improve their value and sell them with a profit. The firms use debt to finance the deals and amplify returns, typically charge an annual management fee equal to 1.5% to 2% of committed funds and keep 20% of profits from investments. That compares with expense ratios of 1.27% on average for U.S. mutual funds and 0.65% for exchange-traded funds, according to Morningstar Inc.

The biggest firms, seeking to evolve into broader asset managers because buyouts have been less profitable since the financial crisis, have added funds to invest in real estate, credit, hedge funds and other asset classes. Expanding their client base to include retirement savers has proved to be harder.

“We definitely would like to be part of 401(k) platforms,” Michael Gaviser, a managing director responsible for individual investor products at KKR, which oversees $76 billion, said in an interview in New York. “We think about it every day because there's so much demand.”

Under current U.S. regulations, private equity funds can only be sold to accredited investors, defined as individuals with a net worth of more than $1 million or annual earnings of more than $200,000, or institutions with more than $5 million in assets. Some 401(k) plans might qualify, although employers must ensure the investments offered have fees, risk, transparency and liquidity that are appropriate for plan participants.

Traditional pension funds are among the biggest investors in private equity, although they have become more selective after losses during the 2007-2009 financial crisis. Private equity funds raised $312 billion globally last year, less than half the $669 billion gathered in 2007, according to data from London-based research firm Preqin Ltd. Fundraising closed after an average of 17 months in 2012, compared with 12 months in 2007, according to Preqin.

With traditional investors reluctant to commit new money, firms are getting more serious about accessing retirement plans, which have been a reliable source of growth for traditional asset managers such as Boston-based Fidelity Investments.

Assets in defined contribution plans will grow about 6% a year to $5.03 trillion by 2016, surpassing the $4.9 trillion projected for public pension funds and widening the gap over private pension assets, according to Boston-based research firm Cerulli Associates.

KKR last year started two debt funds for individual investors. The Alternative High Yield Fund, which became available in November, is an open-end fund with a $2,500 minimum investment and the option to withdraw money daily. The Alternative Corporate Opportunities Fund is an unlisted closed-end fund with a minimum investment of $25,000 and quarterly liquidity. The funds, which will invest in assets such as high-yield bonds and bank loans, are the first pools managed by KKR that are structured like mutual funds.

KKR is close to being able to add the high-yield fund to its own 401(k) plan through Fidelity, according to a person familiar with KKR's plans. KKR views that as a step toward offering the investments to other Fidelity 401(k) plan clients, said the person, who asked not to be identified because the information isn't public. Nicole Goodnow, a spokeswoman for Fidelity, declined to comment. Fidelity is the nation's largest provider to 401(k)s.

“We're seeing a great level of interest by investment managers who have never worked in the defined contribution space to find a way for their products to fit,” said Lori Lucas, defined contribution practice leader at San Francisco-based consultant Callan Associates Inc.

Blackstone, the world's largest manager of alternative assets such as private equity, real estate and hedge funds, is seeking to develop products that would be suitable for individual investors, according to a separate person who asked not to be named because decisions on such products haven't been made yet.

Christine Anderson, a spokeswoman for New York-based Blackstone, declined to comment on the plans.

The firm last year partnered with Boston-based State Street Corp. to create an exchange-traded fund for speculative-grade loans. The fund, SPDR Blackstone/GSO Senior Loan ETF, started trading April 4 under the ticker SRLN.

Carlyle is raising a fund with New York-based investment firm Central Park Group LLC that will accept as little as $50,000 from individual investors, according to a January regulatory filing. Central Park Group will allocate money from the pool, called CPG Carlyle Private Equity Fund, to a variety of Carlyle-managed funds, with the aim of putting as much as 80% of the investors' capital in buyouts.

The minimum commitment to Carlyle's funds is typically $5 million to $20 million.

Carlyle, which is based in Washington and oversees $170 billion, expects its investment products may eventually reach defined contribution plans, said a person with knowledge of the firm's strategy.

Traditional defined benefit plans have benefited from the ability to access a wider array of asset classes, said Alan Glickstein, senior retirement consultant at Towers Watson & Co., New York. DB plans outperformed defined contribution accounts by an annual average of 93 basis points from 1995 through 2008 after adjusting for fees, according to Towers Watson's latest data.

Private equity funds returned an average of 14% from 2002 through 2012, according to Seattle-based researcher PitchBook Data Inc. U.S. stock funds gained an annualized 8.4% and bond funds rose 5% a year, according to Morningstar.

The likely entry point for private equity firms seeking access to DC plans are target-date funds, the most common default option for employees joining the plans, said Callan's Ms. Lucas.

Target-date funds could add an alternative strategy — such as a private equity, real estate or hedge funds — as part of the asset allocation with other sources of liquidity, Ms. Lucas said. Large employers increasingly are using formats such as collective trusts or creating customized versions, which are regulated differently from mutual funds and may allow for more illiquid investments such as private equity or real estate, she said.

Assets in target-date funds will more than double to $1.1 trillion by 2017, according to Cerulli.

“As that custom target-date world continues to develop, consultants are going to want to bring more sophisticated investments to their clients,” said KKR's Mr. Gaviser. “They're trying to find greater returns, but they can't access the same investments that defined benefit plans can yet.”

Sen. Tom Harkin, D-Iowa, chairman of the Senate Health, Education, Labor and Pensions Committee, is pursuing changes to 401(k) plans. Mr. Harkin has said he will introduce legislation this year that would create so-called USA Retirement Funds, blending features of pension plans and 401(k)s to improve worker outcomes.

“Because of the frequency of withdrawals, it's much harder for 401(k)s to take advantage of the types of investments that pension plans, with their long time horizons, use to diversify their holdings,” Mr. Harkin said in an e-mail, citing asset classes such as real estate and private equity.

Employers can take years deciding on 401(k) investment choices because they're liable under Department of Labor regulations as fiduciaries of such plans.

The spread of alternative assets to 401(k)s will be slow because of “the nature of the market,” said Kevin Chisholm, associate director at Cerulli.

BlackRock Inc., Fidelity, T. Rowe Price Group Inc. and Vanguard Group Inc., four of the largest providers of target-date funds in 401(k)s, said they have no imminent plans to add private equity or hedge funds.

The added cost and complexity of alternatives have kept T. Rowe Price from including them in its target-date series, said Richard Whitney, director of asset allocation at the Baltimore-based firm. Still, over time, there will be a convergence of practices seen in pension plans with those in 401(k)s, he said.

“I believe in the future non-accredited investors will ultimately be able to invest in private equity,” Carlyle co-founder David Rubenstein said in September. “It will be possible in the future where 401(k) check-off plans will be able to say, you can take a certain amount of your money a year and go into an illiquid private equity fund.” n