President Trump has just signed a bill that allows corporate pension plans to offer private equity products that individuals can purchase in their IRAs and 401ks. This comes at the same time as his attacks on universities appear to be causing them to become sellers of long-held private equity investments. Is there a connection? My guess is no. My surmise is that, if anything, connecting the dots that his stamp of approval on private equity purchases for you and me will reduce some pressure on education institutions would have meant he’d refuse to sign.
Private equity itself is a pretty broad term, though.
In its most basic sense, it means an ownership interest in an entity controlled by holders of common stock —and which is not publicly traded. Yes, being publicly traded makes it easier to raise capital and to compensate employees through stock options. But going public also requires that the company’s financials aren’t terrible, and that the management controls and financial statements meet a relatively high level of sophistication and accuracy. So an early stage company, or one that has steady cash flow but not a lot of near-term earnings growth sizzle, or one that needs money now to expand may find that a private placement of stock today suits its needs better than starting the process of going public, say, next year.
At the same time, it was one of the key insights of the Yale economics department in the 1970s that university endowments like theirs were natural buyers of such private stock sales. That’s because the yearly calls on their accumulated wealth were tiny, so they had no real need for near-term liquidity. This meant they could take a much longer term view in their stock purchases than the typical mutual fund, whose manager might be fired after two bad years. So both the endowment and the company raising money could arrive at a much better deal for each by agreeing to a private transaction with one another.
This worked well for decades, and was widely imitated.
Traditional pension funds, now mostly the province of government entities, have also found that private equity has allure. State-run pension funds for municipal employees (I’m not an expert here, though) are, as far as I can see, seldom fully funded. Imagine a wicked bear market comes along–think, COVID or 2007 financial crisis. Publicly-traded stocks drop through the floor. Bonds don’t do so well, either. So the underfunding that was already there looks a lot worse. Maybe the state has to raise taxes to put more money into the plan to make it solvent again. A political nightmare! But although Mr. Market rules the valuation of the S&P and NASDAQ, one could argue that private equity holdings are relatively undamaged in a situation like this. At the very least, there’s no evidence from public trading that they’ve lost any value–because there’s no public trading. No wonder state pension plans tend to have healthy doses of private equity.
Why, then, introduce private equity to individual IRAs and 401ks?
The obvious answer, I think, is that the traditional markets for private equity are saturated.
An aside: Early in my career, I was at an analyst conference for a big hotel company. The company, which had traditionally focused on big metropolitan hotels, was starting to open smaller hotels in industrial parks, and motels for the first time, too. How so? …the iron rule of marketing, the VP of marketing said: you don’t start selling chocolate ice cream until the market for vanilla is saturated. In other words, the act of selling chocolate itself reveals everything you need to know.
In the private equity case, we’re down to either strawberry or cookies and cream, whichever is #3.
Given what the Ice Cream Rule says the present situation is, I wonder if plan sponsors are going to risk offering private equity alternatives to their pension fund clients.