401(k) Plans Offer a Powerful Distribution Channel for Hedge Fund Managers Willing to Tackle ERISA, Liquidity and Non-Discrimination Concerns
Hedge Fund Law Report
Traditionally, the investment options available to participants in 401(k) plans have been staid and sleepy, consisting primarily of stock and bond mutual funds, money market funds and similar products. However, since around 2005, 401(k) plan sponsors have been offering hedge funds or hedge fund strategies as alternative investment options for plan participants. Inclusion of hedge funds can benefit both sides. For participants, it can expand the range of investment and diversification opportunities. For hedge fund managers, it can offer a potentially far-reaching distribution channel and access to a large and largely untapped market. But offering hedge funds in 401(k) plans raises legal and practical issues, for both hedge fund managers and plan sponsors. On the legal side, hedge fund managers are concerned that the 401(k) plan or its participants can be construed by the Department of Labor as “benefit plan investors.” If such investors hold more than 25 percent of any class of equity interests offered by one of the manager’s funds, the manager can be subject to the Employee Retirement Income Security Act of 1974 (ERISA). Plan sponsors have to contend with non-discrimination rules, which generally require participants at different income levels in the same plan to receive the same investment options. At many companies, certain employees would qualify as “accredited investors” and “qualified purchasers,” and thus would be eligible to invest in most hedge funds, while other employees would not qualify. Plan sponsors that wish to offer hedge funds have to figure out how to do so without discriminating against the employees who would not qualify, outside of the plan, to invest in hedge funds. Plan sponsors also have to be cognizant of unrelated business taxable income issues. On the practical side, hedge fund managers and plan sponsors have to contend with potential discrepancies in the liquidity offered to plan participants and investors in the relevant hedge fund. This article explores structures and approaches being used by plan sponsors and hedge fund managers to address or mitigate the various legal and practical hurdles involved in including hedge funds or hedge fund strategies in 401(k) plans. In the course of our discussion, we offer specific strategies for addressing ERISA concerns and the liquidity mismatch between 401(k) plans and most hedge funds, and thereby provide the beginning of a roadmap for managers interested in vastly expanding the scope of their distribution into retail or quasi-retail channels.