The Next PE Gold Rush?

For private equity, it’s the year 34 DB. That’s 34 years after a change to America’s employee-benefit rules allowed defined-benefit pension plans to invest in private partnerships, including buyout funds. The torrent of money flowing from those plans is one of the main reasons private equity has become a $3 trillion business.

Yet for a variety of reasons, defined-benefit funds—heavily regulated retirement plans that guarantee a fixed payout to members—are now under financial pressure, and their ability to continue as private equity’s ‘Sugar Daddy’ is in doubt.

In the meantime, the fashion-forward cousins of DB plans, defined-contribution pensions (DC), are exploding in popularity. And these pools of capital have nary a penny invested with private equity. That reality is sure to change, in no small part because DC plans will increasingly want private equity and private equity will increasingly want DC money.  The mutual attraction could spell an era of growth for the alternative asset classes that will dwarf anything we’ve seen to date.

Like a typical brokerage account, defined-contribution retirement plans are managed by individual account holders, and often receive matching contributions from employers. There’s no guarantee of a payout. But with defined-benefit plans increasingly viewed as relics from the “Age of Entitlement,” the self-directed plans are no doubt the retirement systems of the future. According to a study by McKinsey, total defined-contribution assets under management are expected to reach as much as $8.5 trillion by 2015. That’s three times larger than the assets controlled by defined-benefit plans. To put the numbers in perspective, a 10 percent allocation of that money to private equity—$850 billion—is 26 percent more than was raised during private equity’s biggest-ever fundraising year in 2008, according to Preqin.

However, the “individual” nature of the DC plans makes it difficult to add private equity to their asset mixes. Indeed, the constraints separating DC from PE have mostly been “mechanical,” as one fundraising veteran explained it to me. Defined-benefit plans can draw on stable and centralized pools of capital, making it easier to commit to long-term investment partnerships like private equity funds. Recent market swoons notwithstanding, a well-run DB plan can afford to tie up big chunks of its capital base in long-term bets with the expectation that those illiquid investments will ultimately outperform and support future liabilities. By contrast, DC plans, with their millions of separate account owners, face liquidity and pricing hurdles. It’s hard to commit $100 million to a fund when the underlying capital for that commitment is formed dollar by dollar throughout the entire life of the fund.

One of the big trends among DC plans is the move toward lower-fee, passive investment options—a trend that does not favor the relatively fee-intensive private equity model. But, according to McKinsey, an equally important counter-trend is the move among some plan sponsors toward more “paternalistic” offerings that include education resources and “DB-like” investment assets. A DC fund the claims to offer the institutional-quality asset mix of a DB fund would necessarily include exposure to private equity.

In order to crack the DC code, a manager would need to set up a mechanism to accurately price daily inflows and outflows of capital in a way that fairly accounts for the illiquid private assets. This would require substantial back-office infrastructure. Creating a way for these individual account holders to participate in long-term, illiquid, private investment pools is challenging, but the opportunity is too great to ignore.

If private equity performs over the next five years the way market participants hope (and it better, or we’re all in trouble), there will be an even clearer demand from retirement-account owners for access to alternative-investment products. At the same time, with the slow atrophy of defined benefit plans, private equity and other fund managers will face a critical need to raise capital from other sources. Can the structural engineers of Wall Street crack the DC code and find a way to connect millions of individual account-holders with long-term investment partnerships? My bet: Yes.

Follow David Snow on Twitter @SnowsNotes