Private Equity: Is It the Exciting New Investment Coming to Your 401(k)?

Paul Winkler: Welcome. This is “The Investor Coaching Show.” I’m Paul Winkler. We talk money and investing around here.

Our Perspective

There is plenty, plenty, plenty to talk about this week, and I’ll get to all kinds of stuff being talked about. Of course, we had the crypto bill, right? A lot of people are talking about it and thinking, What on earth does this all mean? 

What does this all mean to markets? What does it mean to investors? How does this thing work? What is it?

All those types of things. And I’ll talk a little bit about that.

One of the things that is a big deal right now, okay, so this show, for those of you that don’t know, just a real quick thing, we come from a perspective of, and this is really weird because this is almost non-existent around the country — I mean, not just locally but around the country — where you have a show that is put on by someone that doesn’t sell. Not selling annuities, not selling products, not trying to push you toward anything.

We’re just fee-only, no commissions, no nothing planners, and all degreed, and all of us have more than 20 years of experience that run the offices around Middle Tennessee. And it’s one of those things that I’m very adamant about, that they all be multi, I like lots of degrees. The more, the better. And that’s my big thing.

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It’s not only that, but also making sure that we come at things from an evidence-based academic perspective, which is kind of unusual. 

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You don’t see that very often. So that’s the idea behind that.

So when I get into these conversations and talk about these things, it’s not from I’m trying to push you toward one thing or push you toward another thing. And I get emails and I get little text messages from people.

There’s one guy who actually had this one comment about something I talked about a little bit earlier, and I was wondering what is his dog in the fight on this? He’s really, really adamant that I stop talking about something, and I’m like, oh, that makes me want to talk about it more because I’m still rebellious. May be in my 60s, but I still have that rebellious streak.

Those of you that know me know how I can be. I can be ornery that way, but it’s ornery in a good way. It’s a positive. I’m trying to take care of people, right?

Discussing 401(k)s

One of the things I want to do is I want to talk a little bit about something that is being discussed pretty significantly regarding 401(k)s. Now, if you have a 401(k) at work or 403(b), a 457 plan, the idea is deferring your compensation from one point into the future.

And the idea being “I don’t need the income today. Give me the income at some point in the future when I’ll need it more. So don’t tax me on income today if you’re using a pre-tax version.”

So what does it mean by pre-tax? It’s just, I say, “Okay, I’ve got $10,000 of gross income.”

That’s income before taxes. It’s net income after taxes, right? So if you’re in a 22% tax bracket, you save $2,200 in taxes if you don’t take the income today. Now the idea being that at some point in the future I’m going to need income more than I need that income today.

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When I get to retirement, I have a lot of income I can earn where I’m not paying any taxes because of standard deductions. 

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And due to the Big Beautiful Bill, the standard deduction has gone up, and we have a couple of other deductions or other ways to not pay taxes, $6,000 a person over age 65, which is kind of nice. I mean, you look at the amount of income that you can actually get without taxation, it’s pretty significant. I mean, really.

Then you have just a 10% tax bracket after that, and that’s what got renewed with the Big Beautiful Bill is that and a 12% bracket versus going up to a 15 and 22 and 24 versus going up to 25.

So the idea being that, hey, look, we can not pay taxes today and pay taxes at potentially lower rates. I always say potentially, just because you don’t know what the tax rules will be in the future. If we do what other countries have done, where you have a value-added tax or consumption taxes, you could actually have income taxes go down even further.

I mean, you just don’t know. But anyway, the 401(k) has been nice because you can do that, you can put off.

And then you have the Roth version. For those of you in the lower tax bracket, you’re very, very low income right now, and the likelihood is you might be in a higher income in the future. Well, that’s where you have Roth-type programs. That’s typically where that makes a whole lot of sense.

What Do You Invest In?

So what do you invest in? Well, a lot of people just do the defaults. They just go, “I don’t know what to do. Let’s just stick it in this target date fund or let’s stick it in this asset allocation fund.”

They have no clue what they’re investing in. And what they typically don’t know is that those things aren’t that well diversified. I’ve never seen one, not once, a target date fund where it has actually been really well diversified. They’re typically very, very focused on certain areas of the market.

Now what happens as time goes on, especially in the atmosphere that we’ve been in, in recent years, the atmosphere has been really, really favorable to any kind of fund that had a lot of exposure to large U.S. stocks, which is what these funds typically do.

Now, back in 2008, 2009, 2010, you couldn’t give these funds away. Nobody wanted them. And the reason was because you had 10 years, but that asset category had zero return. I mean, we’re not even talking after inflation; we’re talking zero return period, end of sentence.

Nobody wanted them, and now people want them. And that’s just the way investors are.

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When something has done poorly, they don’t want it. When something has done well, they can’t get enough of it. 

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And that is hence why investors typically get some really significantly bad results when it comes to investing. For example, at the beginning of this year, I couldn’t tell you anybody that came up to me and said, “Hey Paul, man, could I have some international small value stocks?” Because the area of the market had been underperforming in recent years.

And then you have this 30% return, and now all of a sudden people are talking about it. Some people. A lot of fund companies still don’t even have a fund that captures that asset category.

The major mutual fund companies, no, they don’t even have it. You’d think that would be something that they probably put on their radar screen, but they know you probably still aren’t paying attention unless you listen to the show.

Private Equity in 401(k)s

So one of the things that they’ve been talking about is, “Hey, well, let’s do this.” Because people a lot of times get behind on their retirement planning, and because they get behind, they want to go and stick a bunch of money in something that they think is going to just take off and hit the roof.

One of the things they’ve been talking about is private equity. I’ve been talking about that a little bit because there was this executive order to help open up 401(k)s to private markets and it was being talked about, and let me just give you a little bit of a, and let me just keep an eye on this audio because I’ve got to make sure it doesn’t get too loud for you. But anyway, just here with something that was talked about.

Andrew Ross Sorkin: I know we got to run. I’m just curious, I don’t know if you saw this story we were debating earlier in The Wall Street Journal about 401(k)s getting into private markets, whether you think that’s a good thing, these semi-liquid products, what you think that should be.

Gary Cohn: I think it’s a great thing.

PW: Of course.

GC: I think that we should give people with 401(k)s access to products that will perform well above —

PW: “Will.” You hear that?

GC: — market expectations over longer periods of time. And I think the history of private markets is that they have outperformed through the cycle.

PW: Yeah, hear that: “will outperform. They have outperformed.” I’m going to beg to differ regarding that right there.

So I’ll beg to differ in just a second. I want to just let him continue. I want you to hear the rest of his comments before I beg to differ.

GC: A 401(k) is a perfect vehicle to put something like that in because you more or less buy it, you somewhat forget about it.

ARS: Hopefully. Right.

GC: Own it and hopefully the duration is you’ll buy it when you’re 30 years old, and you can’t get the money out for another 35 years.

PW: Well, and that’s the idea behind 401(k)s, right? When you put money in, you don’t think about it. But the reality of it is people do watch, and then they do make changes.

People did want to make all kinds of changes after you had a dead decade in large U.S. stocks. They were just like, “Well, this is stupid. How am I going to get any money for retirement if most of my money’s in this thing that hasn’t made any money?”

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Then they make changes, and then the thing that they change to doesn’t do anything, and the thing they change from takes off. 

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But it’s this idea that they’re going to just set it and forget it. And this is particularly true of financial advisors. I’m going to tell you, that it’s the most undisciplined lot amongst them. I do a lot of teaching of financial advisors around the country, and I’m going to tell you, they don’t tend to be the most disciplined investors on the planet earth.

Does This Change the Marketplace?

Matter of fact, you look at cash flows, there are studies, and I have this in my book, “Confident Investing.” I actually have the S&P 500, a chart of it, and I have cash flows in and out. And you’ll see that when the market is up, the cash flows are high. When you see the market is down — the S&P 500, that is — you see that the cash flows are negative.

I mean, people take money out of it. But he’s saying, “Oh, this is really great. And I think private equity is going to be wonderful and it has such a great outperformance.” And anyway, I’ll just continue, just for a quick second.

GC: All right. So you’ve got 35 years of compounded appreciation.

ARS: Does that change the marketplace so more companies stay private or does it change the marketplace so more companies go public?

PW: Okay, so that’s a really good question. I’m going to stop it right there because he asked a really good question. If you supposedly are going to have this much greater rate of return on this investment and on private equity, if this is going to have such a great rate of return, would companies go, “I think we’re going to go public,” so that it would have a lower return?

Well, you go, “Paul, what are you talking about here?” What is the stock market? The stock market allows companies to use your money. It allows them to use your money, and they have to pay you to use your money.

Now, what do they have to pay you in? Earnings. So let’s just take this down to something you’re familiar with: interest.

Let’s say that you have this investment and you have this money that you can borrow, and you’re sitting there going, “Hey, you know what, I need to borrow some money to buy a house,” let’s say.

And you have this one market you can borrow the money from, and that one market charges interest 4% higher than the other market, let’s say. And now you’re going to sit there and go, “Well, wait a minute.” And this is public companies versus private.

But if I’m looking at that decision, I’m saying, “Well gosh, why on earth would I want to pay 4% more? That doesn’t make any sense.”

Because remember, he said that the private markets are supposed to have higher rates of return.

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I hope you’re following me here, that you are the lender, so to speak. When you own companies, you’re the one letting somebody use your money.

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And if the rate of return is going to be higher for you, that means they’ve got to pay more to use your money. And how that works with stock markets is that you get less money for every dollar of earnings you have to give away.

Will More Companies Go Private or Public?

Now, I don’t know if that was Andrew’s point in asking that question, but he seems to be a fairly intelligent guy. It probably was. So the idea being: Are we going to all of a sudden have companies that decide, “Shoot, I don’t want to be private anymore. I’m going to go public because I don’t want to pay that much”?

And it’s a really solid question when it gets down to it. Well, what was his answer?

ARS: Does that change the marketplace so more companies stay private or does it change the marketplace so more companies go public?

GC: I think at the end of the day it probably will have very little effect —

PW: What? “It’ll have little effect?” Companies won’t care how much they’re paying to use people’s money?

Okay, whatever. I mean, he’s just guessing. You don’t know.

GC: — on companies going private and companies going public. You can buy a private company and a 401(k) and have it go public and end up with shares delivered to you.

I don’t think the owner of the 401(k) cares. They actually might like it. In the beginning they bought something in private, they’d appreciated a lot, and at the end they got something very —

PW: And then there he goes again, saying it appreciated a lot. He’s assuming that it appreciated significantly in that answer.

Now, “They’re not going to care very much.” Well, there are studies on companies that become IPOs, initial public offerings.

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They go from private to public, and the studies show that they lose money in the first nine months. 

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So that’s the research, and I’ve quoted that research for 25 years on this show. Hasn’t changed.

GC: — liquid and transparent, that they could easily liquidate. They don’t have to wait for someone else to liquidate. If you tell people that would be the normal path of trajectory that you’re going to buy something private, and by the time you’re able to liquidate this 35 years later or 30 years later or 25 years later, most likely it will be a public security that you can —

ARS: I think it creates such a larger pool of money for private assets.

What Is Private Equity?

PW: There is the reality. That’s what they like. They like the idea that they could have access to more money because if you have a 401(k), let’s say, and you have a certain asset inside of a 401(k), like private equity, now what is private?

For those of you that don’t even know what the heck I’m talking about, you have public companies that are traded on Wall Street and they have to give out all their information on their earnings, their cash flows. They have to give a lot of information so you know what the heck you’re buying. That’s a public company.

Now that was the idea. That’s where we got in trouble in the Depression: People didn’t know what the heck they were buying when they bought stocks.

Now, when you have private equity, that information can be held close to the vest, hence private. So you don’t really know necessarily everything you might want to know when it comes to buying a stock, and know what to pay for it.

So that’s why we’ve never really had this situation where this stuff has been out there, ubiquitous, in 401(k)s. It’s because of this issue.

Now we’re looking at it going, “Hey, you can do this.” Or, “We’re going to let you do stuff.” And I’m not faulting anybody. Kind of the modus operandi, quite often, is buyer beware.

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But most people aren’t very aware. Most people don’t pay attention very much, or they work with financial advisors that don’t pay attention much.

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I’ve found that to be the case. So private equity, the idea behind it is that these companies are liking and really thinking this is a great idea. What if you have a 401(k) where people put money away for their retirement, and now all of a sudden we have this situation where we’re going to have an abundance of money.

Now when they have an abundance of money, I want you to think through this with me, and all of a sudden these private companies, these companies that don’t give out a lot of information about their earnings or their cash flows or anything, when there’s a lot of money available to them, what do you think will happen as far as their cost of using that money?

If you said down, you’re a thinker because that’s exactly what can happen. That’s why they would be excited. That’s why Andrew said that, which I thought was a very, very bright comment right there.

Say No to Private Equity

ARS: Which, therefore, would more likely keep them private for longer or they’d sort of hot potato.

PW: Yeah, why not?

ARS: As even a private for longer kind of scenario.

GC: Look, there’s going to be rules on private funds and private securities and how long you can keep them. I don’t think you’ll see asset managers keep private companies private for 30 years.

PW: Yeah, “I don’t think.” Again, kind of weaselly, don’t know what on earth they’re going to do. But here’s the reality: I went to Morningstar, and I looked up the data on private equity funds. So what I did is I looked at open private equity funds, because we’re talking about things that we can actually invest in.

That’s open. The idea behind that between open versus closed private equity funds.

And what I did is I ran the rate of return, and I was looking at the rates of return over the past one year, three years, five years, and 10 years. And in every single time period, the rate of return.

And what did he say about them? “Oh, greater returns, wonderful. Higher returns,” right? Versus the S&P 500 10-year return of private equity, average private equity fund under by 5.09% per year.

Now, just case in point, if you have a 2% underperformance over a 20-year period, you got 40% less money. I don’t know what 5% is. I’d have to pull out a calculator to tell you what 5% per year is. That’s pretty stinking bad, right?

You look at the five-year results versus the S&P public markets, large U.S. stocks, about almost 9% per year. Look at three-year results, 9.49% average performance under the S&P 500, and for the last 12 months, 8.66% under.

So you look at that and say, “Well, wait a minute.” And it kind of gives a little bit of credibility to Jason Zweig’s article in The Wall Street Journal, which was, I didn’t get to last week, but it’s, “You’re Invited to Wall Street’s Private Party” — private equity — “Say You’re Busy.”

And will my mind change on this? I don’t think so. I doubt it.

I don’t see that. There’s possibility that they might have some rule changes and information becomes a little bit more, maybe a little bit more visibility takes place.

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But at this point in time, I’m with Mr. Zweig from The Wall Street Journal: not excited about private equity. 

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Just say no, as far as I’m concerned, in your 401(k).

Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.