Private equity wants to help retirement savers earn more. Figuring out returns might break your brain.

• Funds formerly off limits to ordinary investors are being introduced to 401(k)s.

• The private equity industry says these funds can help savers generate higher returns.

• The industry’s methods for reporting those returns, however, can be opaque and hard to follow.

When selecting the 401(k) investment options offered by your employer, you likely check the performance of a particular fund before you invest.

That process could soon be put to the test, as private equity and other alternative investment assets, once closed off from the average person, are introduced into more retirement savings plans.

A few plan sponsors (2.2% as of last year) have already experimented with offering alternative assets in their plans. President Trump’s August executive order is likely to push this number higher.

The industry’s pitch is that everyday people will get the chance to invest in an asset class that has minted dozens of billionaires by gaining exposure to the private market — a massive slice of the US economy that’s largely off limits to ordinary investors. Roughly 90% of American companies over $100 million are privately held.

Private market returns, however, are opaque and complex, which could present problems for regular people trying to vet them or compare them against benchmarks.

Here are some of the challenges savers may face when trying to assess the performance of funds once reserved for pensions and other large investors.

The private equity industry’s favorite way to portray performance is with the internal rate of return, or IRR. But IRR, which can easily hit 30% or higher in industry marketing materials, is not basic yield.

“A lot of people think the internal rate of return is like the yield on a government bond,” said Jeffrey Hooke, a former industry insider who led investments for a $30 billion private sector division of the World Bank and is now an adjunct instructor at Johns Hopkins.

Instead, it’s a formula that rewards certain behaviors, like selling good companies or paying dividends early in a fund’s history, said Hooke.

IRR is easy to “game,” said Eileen Appelbaum, co-director of the Center for Economic and Policy Research.

“The IRR gives you a great big number, but the true value is nowhere near that great big number,” Appelbaum said. “As every public pension fund and every finance person knows, this is not money you can take to the bank.”

Appelbaum said the formula was created to help CFOs weigh the costs of investments, such as a new piece of machinery, within their own company, and assumes that the rate of return for one asset can be repeated year over year.

Confusing IRR for net annual return can have comical results, as shown by Ludovic Phalippou, a professor of financial economics at Oxford. In a recent paper for Investments & Wealth Review, Phalippou calculated that if the private equity portion of Yale’s endowment had a 36% annual net return since 1990, it would be worth $5 trillion. Instead, the entire endowment is worth $41 billion.

Appelbaum prefers the Public Market Equivalent, or PME, formula to compare public and private returns. Two economists developed PME in the late 1990s to address the shortcomings of IRR. There are a few different ways to calculate the number, but all try to make it easier to compare a fund’s returns to a stock market index.

However, pension funds tend to calculate this number themselves or hire a consultant to do it for them — putting it out of reach for the average investor.

The industry is adopting another metric, distribution to paid-in capital or DPI, which actually does equate to money in the bank. It is expressed as a ratio of the amount of money originally invested. A DPI of 1 means you made your money back, a DPI of 2 means you doubled it.

This is a helpful measure for cash-hungry investors, but it’s only useful after the fact. A low DPI doesn’t necessarily mean bad performance, wrote Phalippou.

“‘DPI is the new IRR’ makes for good conference banter, but it’s a silly yardstick,” Phalippou wrote to Business Insider. “You can have a DPI of exactly 0.0× and be doing great — for example, a young fund with strong unrealized gains that simply hasn’t distributed yet.”

Deciding what formula to use to judge returns is just the first step. Investors will also want to figure out how they compare to the stock market — opening up a whole new can of worms.

The S&P 500 or Dow Jones may be household names, but private equity returns are often compared to underperformers like the Russell 3000 or MSCI World Index.

“They like to use the Russell 3000 because it is a worse performer,” Hooke said.

When Hooke tested the returns of 19 large players, comparing them to the S&P 500 from 2007 to 2020, he found that fewer than half beat the market.

As an individual investor, you may not even receive enough information about the performance of the assets in a private fund to calculate things like Public Market Equivalent. You might be stuck with whatever metrics the fund and your retirement provider calculate for you.

You’ll also have to rely on the fund’s valuations of those assets. The only way to know the true value of a private asset is to sell it, but unsold assets need to be valued to calculate a fund’s performance.

This process, known as “mark to market,” tasks private equity investors with appraising the value of their private holdings. They do this by comparing their holdings to similar ones that have been sold recently in order to come up with a fair market value, similar to the process of appraising a home.

“It’s almost 100% on the honor system,” Hooke said.

Auditing firms will do a “smell test” on these valuations, said Hooke, but they can only review a small fraction of valuations themselves.

A 2024 Morningstar report highlights another problem: these calculated values are much less volatile than the public markets, known as the “appraisal-smoothing model.”

Less volatility might be a selling point for the private markets, but it also means that true comparison to the stock market is a challenge, according to Morningstar.

The good news is that a retirement saver won’t have to figure this out alone. 401(k) retirement plans aren’t a free-for-all, with individuals deciding where they’d like to park their nest egg. Instead, there are layers of professionals responsible for building, evaluating, and presenting plans to 401(k) participants, who then choose from a list of potential options.

Some of these professionals, like the employer offering the plan and the human resources teams administering it, have a fiduciary duty. This means they must make decisions based solely on the interests of those in the plan when evaluating retirement plans, at the threat of costly and embarrassing lawsuits.

Trump’s executive order makes it clear that fiduciaries will remain responsible for protecting savers, including when evaluating private fund investment options.

In other good news, industry experts tend to think that private assets will likely make up a relatively small portion of one’s 401(k). One option being tested is a private fund that occupies 5% to 10% of a larger managed plan, like a target date fund. This means that instead of having unlimited options for their retirement capital, plan participants are more likely to have just a few — or even just one private option — to break their brains when assessing performance.

Read the original article on Business Insider