The state of private equity and what it means for pensions

I had a drink with a manager of an LGPS fund yesterday and we discussed the Mansion House Reforms. His fund is 20% invested in private markets and like many other LGPS funds , that portion of its investment has consistently delivered high returns. We talked about the future; there was no sense of surprise that Government would have more of pensions invested in long term assets. Concepts such as levelling up, sustainable investing and productive finance are so familiar to his pool as to be business as usual.

Bu it  you read the article behind the headlines above, you might think private equity was facing a crisis of confidence.

Pension plans and wealth funds given fee discounts as deal drought makes fundraising tougher

The content of the article is rather more sober in tone, pointing to some discounting from the 2/20 fee benchmarking. The article talks of  some “co-investing” where there is a joint venture between manager and investor and some rebating, where fees that would have been paid to a fund manager are paid to a large investor such as a  pension fund.

However the deal is structured, there is some discounting reflecting a more competitive market. The shift is happening because of the laws of supply and demand.

According to the FT, for every $3 private equity firms are trying to raise, there is only $1 of investable capital. If this is true, it gives the lie to an argument that has been prevalent for some time that pensions need private markets rather more than private markets need pensions.

True, demand from UK pensions, other than from the LGPS is nascent not mature. According to Apollo, a large American PE firm, $517bn dollars was raised for private equity in the first six months. This may be 35% down on the previous year, but it is still a huge number. The “ambitious” target for Nick Lyons’ UK Growth Fund is only £50bn by 2030. So the Mansion House reforms may be bigger news to pensions than they are to private equity.

It may be that private equity firms start seeing pension funds themselves as a long term market which can be managed for profit to the benefit of investors. Private equity has been active in purchasing wealth managers and advisory networks for some time. Attracted by the long term annuity income from ad valorem advisory and discretionary management fees, many private equity firms already own rent on a substantial proportion of the individual wealth of the “high net worth”.

However, this is a market under fee pressure as could be seen by the price drops put in place by SJP in response to the implementation of the FCA’s Consumer duty. If the mark down in SJP’s publicly listed equity is matched by the private equity managers in their holdings, then future investment into the wealth management sector may be less ready.

Pension Funds  offer private equity similar characteristics to the wealth management market but have been less accessible. Until recently, the insurance market had a stranglehold on corporate defined benefit schemes with the private equity backed pension superfunds being kept at arms length through a labyrinthine approval process that has resulted in only Clara being accepted and no deals being done.

But the consultations behind the Mansion House reforms suggest that there will be easement in the regulatory landscape and indeed , new guidance for pension superfunds from TPR is expected any day.

Unlike insurers, occupational schemes, whether commercial or not for profit, can profitably invest in private equity as the means to pay pensions. It can be used as a contingent asset when held outside the pension scheme and it can be held as a long-term investment within the scheme. Private equity can even own the sponsors that secure pension schemes under last man standing arrangement.

So rather than treat pension funds as customers, private equity is likely to own pension funds as they own wealth managers, ensuring efficiencies in operations and investment that generate long term value for their shareholders.

The question that this poses is much more about fiduciary responsibility than a simple of fees. If the purpose of private equity is rival insurers for the affection of trustees looking to “exit”, then the question is “who exercises fiduciary control going forward?”. The rules governing insurance companies’ solvency and behavior are written in stone and overseen by the FCA, PRA and ultimately the Bank of England. The rules governing occupational scheme solvency and behavior are written by the DWP and implemented by the Pensions Regulator.

To date there has been a mismatch which has led to private equity largely being locked out of owning pension funds, supporting pension funds or even investing pension fund assets.

This is likely to change and we may well see that change this week. The timing looks fortuitous, pension funds may be ready for private equity at precisely the time that private equity is ready for pension funds. If this is the case, then the options for large DC schemes,  DB schemes and the new CDC arrangements, have just expanded.

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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2 Responses to The state of private equity and what it means for pensions

  1. byronmckeeby says:

    Over a drink it’s easy to say/hear from an LGPS or any other institutional investor that “that portion of its [private markets] investment has consistently delivered high returns.”

    I’d have more questions than answers at that point in any similar conversation:

    To maintain 20% invested all the time how much to do you have to commit when drawdown frequencies can vary with deal flow and other reasons? 30% or more?

    Do you trust the managers’ reporting of investment returns using gross or net IRRs? How do you manage the issues with reporting identified by Ludovic Phalippou and others? Are LGPS councillors comfortable with the level of performance-related fees, some perhaps based on commitments rather than investments earning returns?

    If maintaining a 20% weighting, are the net cash flows one-way, ie adding to capital invested over time rather than ever using at least some of the net cash inflows to pay pensions?

    How comfortable are you with private market valuations? “Consistency” of values here may imply a complacent approach to regular monitoring of underlying valuations to allow overpaying for acquisitions or holding on to some assets which may prove difficult to realise without accepting a haircut? If there is still a J curve in the pattern of returns then some values should surely be expected to decline before they may or may not then recover to deliver “high” returns.

    Sorry to spoil your drink, Henry.

  2. Eugen N says:

    I am going to spoil your drink too Henry.

    Data does not lie, private equity firms have underperformed the MSCI World Index past 2009.

    More to that, private equity presents pension schemes with additional risks for which they are not paid for: gearing, illiquidity, legal problems (which private equity firms usually become part of).

    Pension schemes should stay a mile from Private equity firms.

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