A Roadmap for Increasing Productive Finance Investment

Co-authors, Con Keating and Dr Iain Clacher.


A Roadmap for Increasing Productive Finance Investment

We consider here the case for investment in less liquid assets and the current DC pension scheme landscape as set out in “A Roadmap for Increasing Productive Finance Investment”. We note first that the sole element considered is the use of illiquid investments within DC pension funds. The paragraph numbers are those of the Roadmap Report – blue typeface indicates a verbatim quotation from that report.

  1. Investment in long-term, less liquid assets, managed appropriately, can help savers secure higher net returns.

We agree with this statement. However, we would note that the Roadmap Report does not address the most elementary questions surrounding liquidity: what is the price of liquidity, how might we measure that and how does it vary with security instrument structure? The failure to address these questions undermines most of the conclusions of the report. The report consistently and incorrectly refers to an “illiquidity premium” when it is in fact liquidity which has a cost.


If we are to consider investment as part of a diversified portfolio properly, we need to consider prices, returns, and their volatility, and the correlation among assets on common terms. None of the analysis presented does this adequately. Nor does it present any evidence to the contrary, and there is much out there that would challenge the underlying case being made.

  1. Pension scheme members receive regular illustrations setting out their projected investment returns under the assumption of high, medium and low returns. The gaps between these are typically material and can make the difference between a comfortable retirement for members and one that is less so. Investment in less liquid assets, such as infrastructure, private equity (PE) and venture capital (VC), as part of a diversified portfolio – and with the appropriate advice and due diligence – could support pension schemes’ ability to improve retirement outcomes for their members.

This has no evidential value beyond being a statement of the fact that higher returns should produce higher portfolio values at later dates. This of course is true of any form of investment, not simply those being promoted by this working group. Note that the utilisation of the proposed asset classes will require “appropriate advice and due diligence but there is no mention of the costs of this, which is another source of income for the financial services industry.

  1. While no investment return can be guaranteed and past performance may not be a good guide for the future, a wide range of literature illustrates how less liquid assets can outperform their more liquid, often listed, counterparts.

There is also a wide range of rigorous academic studies which challenge the existence of excess returns from the asset classes being promoted.

For example, empirical estimates by Oliver Wyman and the British Business Bank suggest that a 22 year-old new entrant to a default DC scheme with a 5% allocation to VC/ growth equity (GE) could achieve a 7%-12% increase in total retirement savings.

This is simply repetition of the earlier problem (see point 2).

This ‘illiquidity premium’ is partly a compensation for more restricted exit opportunities from such investments. And while there is no consensus on the existence and size of this premium, analysis from the Pensions Policy Institute suggests that it has varied between a 1%-7% increase in returns over the long term.

The cited PPI paper quotes other’s estimates of the return differential but it does no analysis of its own. The 7% estimate appears to be rooted in the British Business Bank / Oliver Wyman publication “The Future of Defined Contribution Pensions, Enabling Access to Venture capital and Growth Equity” The report uses the chart reproduced below to illustrate the situation.

Prior to 1980, VC and Growth Equity were really specialised craft industries which would not warrant the description ‘asset class’, and if there was any international dimension to it, it was carefully hidden. That raises concerns as to the appropriateness of the MSCI world equity index as a benchmark. In addition, prior to 1980, UK international investments were subject to the dollar premium of exchange control regulations.

According to this chart, VC/GE has never experienced an annual loss in the period since 1970, but the earlier Pitchbook chart of private equity returns shows 12 negative annual returns, and 8 which probably should be, in the much shorter period since 2002. The annual losses reported by Pitchbook are not trivially small, they lie in the range -10% to -25%. In the period since 1970, gilts have experienced losses in eleven years, which have ranged up to -10%.

The chart is of course comparing apples with pears: self-reported IRRs versus market-valued equity returns. It is also comparing average rather than median returns. If we had bought the MSCI in 1970 and held this portfolio reinvesting income, we would have achieved the 11% return cited but the VC/GE average shown does not possess this property. To achieve the 18% return shown the portfolio would have had to be rebalanced in each year, with perfect foresight, to the average portfolio of that future year. If there is even a small difference between the annual mean and median returns of the sample of funds, over this time, the chance of any investor achieving 18% is vanishingly small. Moreover, the volatility of this mean figure is irrelevant in the context of portfolio construction.

The further point to note is that these analyses are attempting to compare net returns available to investors and liquidity.  There is no mention of the committed but undrawn funds which lower the investment returns achievable by investors. The PPI study refers to a Robeco paper which makes the point: “It is however not always clear what the required extra return or diversification benefits for the illiquidity should be. Additionally, there are numerous reasons for illiquidity each with their own challenges.”

There is one indicator of the cost of illiquidity to private equity investors in the sense of the foregone return on assets sold to secondary traders when compared with the return achieved by funds. Table C1 shows the median IRRs reported for global private equity and secondaries for the vintage years 2016 – 2020. The suggested liquidity cost proxy would be the difference in returns realised. The concept is simple – that the secondary purchaser is acquiring the same assets as the fund continues to hold. It is immediately obvious that the cost of liquidity, in the sense of the experienced cost of realising an investment is highly variable and may be very large indeed.

Table C1: Median Reported IRRs

2020 2019 2018 2017 2016
Global PE % 12.37 15.20 17.73 20.00 19.10
Secondaries % 91.23 37.78 41.54 15.50 21.80

Source: Pitchbook

This is reinforced by the inter-decile ranges of reported IRRs for secondaries; these vary over this period from a low of 22% to almost 200%. One possible interpretation of this is that there is some predatory pricing in the secondary market, such as it is. At the least, it suggests that global private equity is far more volatile in reality than it is in the valuations raised by the managers of these funds.

  1. This section begins by repeating claims such as those considered and criticised earlier.

There is also some evidence on the potential increased returns from investments in private debt and infrastructure.

The evidence referred to is in fact some Aviva marketing documents. Table C2 shows the mean and median reported IRRs of 787 private debt portfolios held by UK DB pension funds over the period 2018 – 2020. These are returns reported for funds of all vintages held.

The gilt comparator is the FTSE all gilts total return index; the global bond index is the Bank of America/Merrill Lynch global bonds total return reported in sterling terms; the High Yield is the Barclays Capital Very Liquid High Yield index in sterling terms.



Table C 2: Private Debt and some fixed income comparators

Net Returns Bonds Mean Median
  Gilts 5.50 7.1
  Global 5.27 6.5
  High Yield 7.53 7.0
  Private Debt 5.39 5.63
  Fees 2.08 1.18
  Private debt 7.36 6.74

Source: ClearGlass.

It is far from obvious here that there is any advantage to private debt though there is clear evidence of the profitability of private debt to its managers. These figures are based upon drawn funds. In terms of value for money, all of the traditional debt asset classes are superior.

  1. These potential additional returns could make a material difference to the size of DC scheme members’ pension pots at retirement.

Indeed, but this statement is true of all asset classes.

  1. Allocating to less liquid assets also offers the benefits of diversification, which can help manage portfolio risk, reduce volatility and enhance returns. For example, adding less liquid assets to a hypothetical portfolio comprised of 60% stocks and 40% bonds would have increased returns and reduced volatility materially between 2004 and 2018 (Table 2.1). These benefits, in part, reflect less liquid assets tend to have a low correlation with other assets.

Allocating to any assets with heterogenous return characteristics will bring reductions in portfolio volatility, but it will only be the addition of an asset class with a higher expected return which will enhance returns. We do not know the correlations used by FS Investment Solutions in generating the table referred to, but another footnote suggests that the Oliver Wyman / British Business Bank study suggests a correlation of around 10% between global VC/GE returns and MSCI World Index returns over 1970-2016, and a correlation of around 40% between global VC returns and US equities over 1990-2018. These are highly questionable values; they are inconsistent with the cross-sectional volatility of private equity funds, and with the volatility of secondary buy-out returns shown earlier.

They are also inconsistent with the fact that private equity owned companies are on average about twice as leveraged as listed companies. This will have the effect of increasing the volatility of the value of their equity. In addition, many funds also utilise leverage in the fund, which will further multiply the volatility of holdings.

There is a further issue. The IRRs reported by private equity and other funds are on deployed, drawn, and invested capital, but the investor has committed to a larger sum and needs to hold reserves to meet further drawdown calls. This will lower the returns experienced by the investor – if 50% is undrawn and held as cash, the IRR experienced by the investor will be half that reported by the fund manager.

  1. Investment in less liquid assets can also have broader benefits, including facilitating the financing of long-term projects, such as the transition to a net zero carbon economy.

These benefits are not unique to less liquid assets, they extend to listed equity and debt.

Many less liquid investment strategies involve direct relationships with the underlying business or project, which can offer investors greater influence over environmental, social and governance (ESG) or sustainability issues by reducing agency problems.

This is again a very broad statement with no obvious evidence to support such a statement. If there is any reduction of agency problems, it is very small. Direct relationships as described are usually the exclusive province of the fund manager, not investors in a fund. Very few pension fund managers have the scale to be able to serve as the fund manager. The exception would be direct co-investments manager alongside the private equity fund manager. Furthermore, if an investor were to approach the management of an investee company, that management would know that the investor really does not have a simple market sale exit available to them. Such lobbying would likely be less effective than as a direct shareholder with the vote/exit option available.

Less liquid investment strategies often target newer industries or innovative business models, which are likely to play an important role in the growth of the economy more generally.

These of course are also the riskiest of companies; fifty percent of UK companies fail within their first five years of operation. There are also very serious issues of valuation surrounding these enterprises, which can tax even the most professional investors, as the travails of Softbank demonstrate. It is not that these businesses should not be invested in, it is a question of who should invest and at what point. Amazon notably listed on public markets very early in its existence and so there are other paths for funding for innovative and new businesses.

  1. Although there are benefits to investing in less liquid assets, they also present different risks to more liquid ones and may not be suitable for some investors. For example, by their nature, such assets typically involve liquidity risk, whereby investors may have to wait significant lengths of time to realise their investments.

There is a recurrent confusion evident in the many papers covering illiquid investments. There is illiquidity of the instrument recognising ownership of a fund and that is quite distinct from illiquidity of investments made by that fund. It is perfectly possible, for example, to have a listed and traded investment trust which owns a portfolio of entirely illiquid investments such as private equity funds and participations. Private equity and venture capital funds typically hold investments which are far shorter in term than the investment capital committed to them. The fact that an investor is ‘locked up’ for some period does not mean that the investments are held for that term.

 A large infrastructure project such as a windfarm, for example, is likely to require investors to tie up cash for many years. Conversely, the shares of many companies listed on an exchange can usually be traded frequently throughout the day.

There is again confusion. It is true that the funds invested in a windfarm may take many years to be repaid from the proceeds of operation, but it is also true that the funds invested in and by a company may take many years to be repaid by the proceeds of operations. It is the instrument recognising the claim on the company or windfarm which is the object of concern. The shares of a listed company have incurred the costs of initial listing and the maintenance of that listing to enhance the ease of their negotiability. By listing on an organised market, the shareholder has reduced the search costs of identifying a buyer when they may be looking to sell. In addition, sale in an organised market eliminates potential issues with the performance and execution of sales and exchange. This also holds true of listed debt instruments. If the windfarm is structured as a company, it can enjoy the same benefits.

One of the principal ancillary advantages of market listing is the availability of the market price for valuation. In theory at least the market price should be superior, in the sense of being more accurate on average, to other methods of valuation.

All of the proposed investment classes, private equity, venture capital, infrastructure and private debt can be accommodated as assets within a listed limited company i.e., an investment trust. This would allow the managers of those assets to continue with their existing performance-based fee structures and offer a market price valuation of those assets to pension fund investors. As noted, in Appendix B, several such closed end investment trusts already exist. The reluctance of private equity managers to use the investment trust structure may be interpreted as a reluctance to have their valuation assessments closely scrutinised.

  1. Several factors could help reduce liquidity risk. An appropriate fund structure design could help align the liquidity of the fund with that of its assets.

It is not necessary to align the liquidity of a fund with its assets and often not even desirable. Companies may make long-term illiquid investments in, for example, property, plant, and equipment but have shares which recognise the investor’s claims on those assets as liquid traded securities. By contrast, hedge funds may have portfolios of assets which are themselves liquid traded securities but choose to restrict access to those securities to facilitate the investment strategies involving those assets.

In addition, it should be recognised that even with alignment of the duration of assets and liabilities, order imbalances may arise. Liquidity is not simply a matter of speed of sale or purchase execution; it is also a question of price.

Such risks are also likely to be less material where allocations to less liquid assets are made as part of a diversified portfolio, such as within a DC scheme default arrangement, where liquidity may be sourced from other parts of the portfolio.

It is true that the liquidity of the elements of a diversified portfolio will tend to differ in ease of use, which may mitigate the likelihood of distressed sales of less liquid assets, but the sale of some of these does require the diversified portfolio’s owner to be prepared to tolerate the lesser diversified, riskier residual or resultant portfolio. Liquidity is not being sourced elsewhere in the portfolio, it is being sourced elsewhere in the markets.

Finally, as retirement investment vehicles, DC pension schemes have long investment horizons. Scheme members are unable to access their pensions until age 55, so those joining a pension scheme after leaving school or university have an investment horizon of at least 30 years. Some scheme members may also choose not to access their pension until they are significantly older, further increasing the investment horizon.

It is true that DC pension scheme may have long investment horizons but that does not imply that any or all of its investments should be contractually long-term. Such a philosophy would deny the value of the option to alter asset allocations in the event on new information coming to light.

The optimal duration of investments within this horizon is a question of the expected term premium available. It should also be noted that some ‘asset classes’ such as venture capital are poorly suited to long-term horizons. Pitchbook reports the IRR of venture capital declining from 18.5% at a five year horizon to just 8.0% at twenty years.

These sections above comprise the Roadmap report’s “…case for investment in less liquid assets”.

The report continues with a description of the current extent of use within DC schemes. It does though offer one bizarre opinion (14 below):

  1. The differing approaches to investment in less liquid assets means that many DC pension savers with similar investment needs may see potentially different outcomes for their retirement income simply because of the scheme they happen to be in, which would not be a desirable outcome.

This is incorrect. Whether or not schemes invest in less liquid assets, it is likely that the outcomes of the chosen investment strategy will produce different outcomes. If anything, the inclusion of less liquid assets is likely to increase the range of those outcomes.

The Roadmap Report and more importantly the DWP consultation consider this “case for investment” to be overwhelming and final. However,  it is a serious concern that some of the contentious aspects of private equity such as subscription lines (leverage within the fund) or continuation funds (which can defer the day of reckoning for overstated returns indefinitely) pass without any comment. Indeed, the DWP refer to the purpose of this working group in the following terms:

“The key focus of the group was to develop practical solutions that remove current barriers to investment in long-term, illiquid assets by DC schemes.”

It is notable that government has referred to this report as being “industry-led” rather than as an independent evaluation of its agenda. The final report looks like uncontroversial evidence that what is being proposed is inherently correct and can only lead to good outcomes.

However, the reality is much more complex and nuanced, and the risks of this are borne by members. While there are aspects of the ambition that most will agree with around funding the transition, better member outcomes, and so on, the fundamental issue is the method for doing so being proposed and it is far from clear that a compelling case has been made.


About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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