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Thinking About Private Equity in a Retirement Portfolio? Read This First

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A year from retirement, a medical industry executive spoke about an idea for a private equity investment that her financial advisor had mentioned. Her initial reaction was favorable: She saw a chance to get in on the ground floor of a good idea, as well as an opportunity to capitalize on her knowledge as an accomplished professional in the medical industry.

Still, while she might be able to take advantage of this potential industry-changing investment, hesitation crept in as she considered her lack of understanding about the potential risks associated with private equity investments.

Private equity’s risk profile is complex — and not for everyone. Depending on the quality and reputation of the investment sponsor or issuer, there can be challenges ranging from naturally private or “opaque” practices to higher fees and less-than-hoped-for returns.

Sophisticated investors have understood private equity trade-offs for years. Higher potential rewards typically come with higher risks and, perhaps, higher fees. An individual with exposure to 10 different investments may find that only one — or even none — turns out to be a winner.

As it is with other asset classes, the concept of diversification is critical to investing in private equity.

Still, even with these inherently higher stakes, investors have amped up their commitments to private equity from $30 billion in assets in 1995 to $4 trillion 20 years later. Over that period, private equity’s annual asset growth rate broadly surpassed traditional long-term mutual funds 28% to 10% respectively, according to the 2016 SEI Private Equity Survey.

Going Mainstream

Institutional investors have been a prime contributor to this niche asset class evolving into more of a mainstream investment. At the same time, more advisors seem to be encouraging their retirement-minded clients to take a closer look at using their own expertise in tandem with their advisor’s knowledge to seek out tomorrow’s potential private-sector winners.

Managing Director Charles Petrie of ARS Investment Management LLC is seeing growing interest in this nontraditional asset class. “Many advisors I speak with tell me their clients want to diversify their retirement portfolios with private equity,” he said. “They see it as an opportunity to pursue returns that may be above average with acceptable risk.”

Taking Ownership

Like any investment with the promise of higher return, higher risk is a part of the calculus.

“When it comes to private equity, investors and their advisors must take the time to really understand what they own,” Jeffrey Kelley, senior vice president of Equity Institutional, said recently. His firm, through Equity Trust Company, offers IRAs, qualified retirement plans and non-retirement custodial accounts for private equity and other alternatives.

While a growing number of private equity opportunities may be accessed through tax-advantaged vehicles like self-directed IRAs, Kelley added, “It’s still important for investors and advisors to undertake their own due diligence carefully.”

In Search of Transparency

Ironically, one of the category’s main attractions, exclusivity, may lead to a potential drawback: a lack of transparency.

Private equity investors may dislike finding themselves in the dark about what their investment is actually doing. With a private investment that requires no public disclosure and less regulatory transparency, private equity may lead to occasional surprises.

Some steps, though, are underway to temper the shock factor.

In 2008, national accounting standards were implemented to create a “fair value” standard, which still provided general partners with wide discretion in their calculation assumptions, the Center for Economic and Policy Research (CEPR) pointed out. “It will continue to fall to the SEC’s compliance and enforcement units to police the behavior of private equity firms and protect investor interests, as well as the retirement savings of workers.”

To help with screening and qualifying private equity choices, a wide variety of online private equity platforms and research companies have also cropped up to offer tools for evaluating and comparing investments.

Upgrading Technology

Inadequate technology to handle the complex nature of privately traded investments has contributed to inefficiencies that may result in missed opportunities and underperformance.

“Nearly all existing systems are an inefficient mixture of technologies (custom, off-the-shelf, spreadsheets, manual processes and other measures),” according to EY’s 2016 Global Private Equity Fund and Investor Survey. “With profit margins squeezed, CFOs must focus on operational excellence to achieve and maintain a competitive advantage.”

To grapple with tech inefficiencies, EY reported, CFOs have been stepping up “to make their teams more professional by retaining and developing key talent, as well as by adding and leveraging technology.” The goal: Automate many of the time-consuming manual processes to make operations more efficient and lower costs.

Thinking About Fees

High fees can be a problem, too. CEPR cited misallocated expenses charged to investors and inappropriate transaction fees from portfolio companies as two offenders.

However, help may be on the way from the Institutional Limited Partners Association (ILPA) to make sure private equity firms don’t overcharge their clients. In 2016, ILPA released a template (compliance is voluntary) to standardize fee reporting to account for the money collected from investors and portfolio companies. Separately, California introduced legislation to require private equity firms to report all fees and expenses.

CEPR also noted that “the SEC’s Office of Compliance Inspections and Examinations has done a surprisingly good job of examining the relationship between private equity funds’ general and limited partners and is expected to continue its focus on expenses and fees.”

Weighing Returns

While opaque practices and compliance shortfalls can impact an investor’s expectations, the combination of inefficient technology and high fees can lead to lackluster returns.

“The flagging performance of private equity funds relative to the stock market over the past decade has led to questions about whether the high fees investors pay to firms are warranted,” CEPR pointed out.

Still, investors remain buoyant about their return prospects. The 2017 Preqin Global Private Equity & Venture Capital Report, which tracks alternative asset trends, noted that “95% of investors (in a recent survey) believe that their private equity portfolios have met or exceeded performance expectations over the past 12 months” for the year ending June 30, 2016.

Another potential impact on return is that limited partnerships, limited liability companies and other entities that maintain an unrelated business or borrow funds to finance the acquisition of property may create an unrelated business income tax (UBIT) exposure. “When an investor incurs a net operating loss in a specific year, the loss amount can be carried back for up to two tax years or carried forward for up to 20 years.”

He added that specialized service providers like UBIT Professional can help tax-wary private equity investors and their advisors understand their tax liability.

Looking Ahead

Against the backdrop of the risk factors associated with private equity, demonstrable industry and regulatory moves do seem to be underway. These include efforts to improve fee understanding and investor education; provide more regulatory oversight; upgrade technology, and improve transparency, where possible, concerning the underlying investments.

Despite downside risks associated with private equity investments, this emerging category may well be worth exploring as part of a retirement strategy for advisors and investors willing to do the homework.

For the advisor, a familiarity with self-directed IRAs may also be helpful to pre-retirees. iCapital Network, an online private equity platform, reported in 2016 that “only one-third of RIAs offer private equity opportunities to investors, while nearly 70% of RIAs indicate that their wealthy clients are interested.”

With 20 years in financial services operations management, Kelley has experienced the administrative challenges of private equity at close hand. “Some of the questions an adviseor might want to ask a custodian before committing assets might focus on the firm’s tenure, regulatory profile, investment focus, [Better Business Bureau] accreditation and insurance coverage.”

Diversification in retirement may be more important than ever. The Great Recession of 2007-2009 took place eight years ago and many investors remember the downside consequences of holding only traditional, long-only investments. For the aging baby boomer cohort, the chance of recovering from another major downdraft may be getting slimmer. The bull market will turn eight this year; and, as Fortune’s Jen Wieczner points out, “No bull market has ever made it to its 10th birthday.”

Individuals have sunk more than 90% of their investment money into traditional stocks, bonds and mutual funds, according to “Alternatives in the Mainstream,” a report from InvestmentNews and Blackstone. Some diversification with alternatives like private equity may help buffer a retirement portfolio against downside volatility when the bull market winds down.

According to the Investment Company Institute, retirement plan assets reached $25 trillion in 2016. “A substantial portion of that amount is expected to migrate from company-sponsored ERISA and pension plans to the rollover IRA market,” Petrie concluded. For those who can tolerate its well-documented risk characteristics in exchange for its eclectic blend of specific industry and sector expertise, ground floor promise and return potential, private equity might prove a worthy diversification choice.