CNBC: What else do investors need to know?
Handy: Having the exceptional funds is so important. It's not a panacea. You don't automatically get great returns.
CNBC: Initially, private equity is being marketed for target-date funds. So that means investors who use a target-date fund as the basis of their 401(k) portfolio could end up with 5 percent or 10 percent of their 401(k) holdings in private equity. Do those numbers strike you as high or low?
Handy: Theoretically, the amount in private equity should be larger early on and taper off over time as they get closer to retirement age. Five percent to 10 percent does not sound large. [Because the private equity funds are contained within a target-date fund], the individual investor will only be able to do due diligence on the types of funds that are permitted, as the actual fund investments will change over time. ... I would also think that there probably would need to be some gates placed on withdrawals from the funds if there is an illiquid piece. It just will get messy. I would far prefer for people to make their own choices about private equity with funds outside of their primary retirement funds.
CNBC: Can an investor predict which private equity funds will do well?
Handy: You look for managers who stuck to their knitting and have a track record. Then you have a fighting chance of doing well. There's no golden key. There's no substitute for hard work of finding the good funds.
(Read more: What a whistleblower has to say about private equity)
CNBC: What about the fees?
Handy: The fees are so high, so you have to earn a high return. A 2 & 20 is typical (a 2 percent annual fee on an investment, plus a 20 percent share of profits at the fund's end date).
In a lower-return environment, it's really hard for the funds. The private equity firms are looking for places to sell their funds where people are not so discriminating, and (the investors) will be willing to accept just a 1 percent higher return above the fees and the public markets.
Average investors might not be really understanding the risks involved: the risk of having their money locked up, the potential higher risk of the underlying investment and the lack of transparency and regulation. They're not demanding the higher returns to compensate them for those risks. Of course, the price at which something is purchased also is a determinant of the risk involved. Buy it cheap enough and the risk of loss generally goes down.
To me, private equity is much more about taking a greater risk. It's not always—sometimes you have a fund with safe underlying investment—but I don't know how you lump all the funds together and put them into a target-date fund or include it as an asset class in a typical portfolio. It's a definitional problem.
The investment management industry, and the financial industry in general, are always inventive.
(Read more: Advisors: The super-rich still love private equity)
CNBC: You're saying that it's impossible to create a risk/return profile of private equity as an asset class, because there is so much variation between the assets that are actually contained in different funds.
Handy: Yes. I suspect that the definitions of permissible investments will be so broad that it will be difficult to reach a conclusion about what will be the investment universe.
CNBC: What is the upside for individual investors?
Handy: One good thing about private equity is that it is illiquid.
Most people are most hurt by following the herd. They almost always sell at the wrong time and buy at the wrong time.
Private equity is great because you just can't do it. The money is locked up.
I'm not saying this couldn't be good for a sophisticated investor, someone willing to look at a particular fund to see what's inside it and whether it fits their needs.
CNBC: What's the definition of sophisticated?
Handy: Familiar with the markets, has done some good work on risk tolerance; they have to be familiar with nomenclature. It's someone working in the business or who has a good working knowledge of how private equity works.
—By Elizabeth MacBride, Special to CNBC.com