What will the US’s DC market look like in the near term?

Recent guidance from the US Department of Labor opens up private equity investment to 401(k) plan sponsors, but it's unlikely the market will see a flood of such capital any time soon.

Private equity’s listed giants in recent weeks highlighted near-term plans to tap the US’s defined contributions market following the June guidance from the country’s Department of Labor about the potential expansion into private markets.

On EQT‘s Q2 summary call chief executive Christian Sinding noted the firm has a “strategic initiative” working on it and is “figuring out exactly which products within EQT would fit this type of investor over the longer term”. BlackRock chief executive Larry Fink emphasised its own push into illiquid alternatives on its second quarter earnings call, adding that the retail channel presents exciting opportunities for the firm.

But will we see a multibillion-dollar inflow into private equity from DC funds in the next 12 months? The answer, according to two firms with US DC offerings, is a resounding “no”.

“The progress made in the next 12 to 24 months will be modest,” Douglas Keller, head of private wealth and defined contribution at Pantheon, told Private Equity International. “If I had to predict the future, I’m optimistic our firm and our competitors will be successful in gaining a first true DC client in 2021. But beyond that, it’s hard to tell. The interesting evolution will be how quickly the second, third, fourth and fifth DC clients come online.”

The firm’s US DC offering, Pantheon Private Equity Select Fund, is understood to be an evergreen private PE fund that invests in primary funds as well as secondaries and co-investments.

Keller noted there are subsets within the US DC market that are willing to allocate to PE more quickly than others, including those whose defined benefit plans are already “heavy users of alternatives”. However, the tricky part is predicting when these investors will start to ramp up their allocations to PE.

Two main hurdles exist: product innovation and litigation risk. The number of lawsuits targeting 401(k) sponsors – over excessive fees and over self-dealing leading to inappropriate investment options – has risen in recent years, according to a report from Boston College’s Center for Investment Research.

Roberto Cagnati, a managing director and head of portfolio and mandate solutions at Partners Group told PEI that when it comes to product innovation, liquidity and valuation are two things private markets firms need to get right. He added that it was not only a matter of providing solutions in the market, but about engaging with various stakeholders on the efficiencies of current regulation.

“I don’t know whether you need to price PE every day,” he said. “What is the value-add of putting a daily price in a private markets portfolio?”

Cagnati noted that firms in this space also need to work alongside clients and stakeholders on relaxing rules or removing some administrative barriers to benefit the market in the long term.

The future of other DC markets

Cagnati said that as a result of its early work in the large DC markets of the US, Australia and the UK, Partners Group is evaluating other markets including the Benelux region, South Korea and Japan: “They are a bit later in development, but we expect in the mid-to-long term a similar opening up of those DC markets. Once these markets get to a critical size and get the required covenants, they can then consider more complex allocations into private markets.”

He added that the size of the market is a consideration, along with the regulatory framework in the respective jurisdictions and the types of structured solutions needed. Other criteria, such as best practice on frequency of valuations and daily liquidity, will also lead to different answers on how private markets firms construct their portfolios.

“It’s a very long-term assessment,” he said. “From our perspective, to make investments, we need to ensure we have the right resources, the right seed capital structuring, as well as whether the client can generate AUM growth.

“You only really realise the potential from a new market after a number of years.”