Private Equity is eyeing up your pension fund, is there reason to be nervous?

Matthew Hayes.

Matthew Hayes Managing Director

November 4th, 2022

In May 2022, the UK’s biggest workplace pension scheme, The National Employment Savings Trust (NEST), became one of the first UK defined contribution (DC) schemes to invest into private equity and venture capital, employing UK-based firm Schroders to invest £1.5bn into the industry by 2025. NEST, which represents approximately a third of the UK workforce and has total of £24bn worth of assets, revealed that’s its target long term is to make sure around 5% of its portfolio invested in private equity.

This milestone shift has a huge impact on both the private equity houses and entrepreneurial business owners. The influx of cash that private equity funds will have available from the pension funds will enable further investment into developing businesses. From the business owner standpoint, funding and investment maybe be more accessible and with private equities profitable returns, it is expected that there will be a growth within this market sector despite the incoming 2023 recession.

In todays sustained low-yield economy, investors are regularly switching to private markets for larger potential returns. However, in the UK, a substantial group of investors have been reluctant or restricted to delve into the potential of private equity investment. Investment into private equity by pension funds is widely accepted in many countries worldwide. For example, 85% of public pension funds in the US invest in private equity [1]. On the other hand, in the UK, a combination of regulatory pressure and risk-averse thinking means that pension funds are more unwilling to consider private equity.

Opinions about private capital in the UK have often been acrimonious and there has been residual concern over their use within pension funds. The typically conservative UK has been slower to adopt the change in attitudes compared to its entrepreneurial US counterpart. Despite being proven across the globe that private equity investments are performing very well, often outperforming other public market asset classes. According to Hamilton Lane’s 2022 market overview report, private assets have outperformed the public markets for decades and the recent years have been no different.

As inflation rises, it’s becoming increasingly crucial for pension funds and their managers to consider investments with higher returns. The potential returns on private equity investment are strong and historic performance states private equity has an average return of 11% over the last 20 years [2].  A report from the American Investment Council found that US public pension funds generated more than 12% annualised return from their private equity investments, net of fees, between 2010 and 2020. This made private equity the best-returning asset class for public pension portfolios within the US in the period. The UK market’s volatility may result in pushing pension funds further into private equity purely looking for better ROI.

With the need to improve ROI, pension funds may have to turn their backs on long-standing successful companies which have struggled during recent times. For example, Brexit, COVID-19 and recent market trends have caused the Rolls Royce stock price to fall by 77% in just 4 years. Prestigious and safe British brands are turning into the risky investments whereas the continuing performance of private equity is developing into the safest choice for profitable returns.

Due to the success of the private equity markets, the UK Government have been exploring regulatory options to facilitate the use of private market investments. In September 2021, a report by the Productive Finance Working Group named “A Roadmap for Increasing Productive Finance Investment” made a number of recommendations that would permit UK DC schemes to benefit from long-term private investment opportunities. The Group, co-chaired by the Bank of England, Financial Conduct Authority and UK Treasury, concluded that DC schemes, trade bodies and consultants should consider how expanding investment in less liquid assets could produce better long-term value. The FCA also recently given permission for a new category of funds to be created. The Long-Term Asset Fund (LTAF) is designed to invest efficiently in long-term, illiquid assets.

During October 2021, the Pensions and Lifetime Savings Association (PLSA) launched a Made Simple Guide on LTAF’s which aims to explain the advantages of diversifying your portfolio by investing in private markets. The guide promotes a focus on long-term net returns, rather than initial fees. 

Private equity is not the only available private markets that a pension maybe invested into. The enterprise investment scheme (EIS), venture capital trusts (VCT) and the seed enterprise investment scheme (SEIS) provide the opportunity to invest in small, AIM-quoted or unquoted trading companies and have certain legislative features in common. As small companies are more likely to fail and AIM-stocks can be more volatile than their larger counterparts, generous tax reliefs are offered in view of the commensurate higher risk. Despite the risk, according to the Department for Digital, Culture, Media & Sport, 29 UK companies became unicorns in 2021. Unicorn status is given to start ups that reach a $1 billion valuation. Some examples of VCT, EIS and SEIS unicorns include Zoopla and Gousto.

A VCT is a company listed on the London Stock Exchange. They are like investment trusts and usually invest in less than 100 young and small private or AIM-quoted companies. Rather than investing into individual companies, the investor will acquire shares in the trust accessing the entire portfolio. An EIS fund would concentrate on similar companies but usually with less diversification and sometimes at an even earlier-stage. The SEIS was introduced from 6 April 2012 to encourage investment in new start-up companies within the UK economy. As a result, SEIS funds focus on even smaller, younger and therefore riskier companies than EIS and VCTs. The upcoming changes in legislation may cause these types of funds to be more heavily invested into, providing more capital to start-ups to create more unicorns.

Hypothetically, there are advantages for everyone if UK pension schemes begin to invest in private markets and private equity. Pension schemes could potentially benefit from better returns, and the value creation generated could provide the UK economy and entrepreneurial industries with a lift. The only perceived downside is the slightly higher risk involved in a private equity investment. However, many of the biggest private equity deals in of late in the UK have started due to overseas private equity houses or firms who source their investment capital from overseas. This indicates that the UK is accommodating deals but not gaining from them. Therefore, much of the realised value of these deals is being transferred to the deal origination point. A partnership between pension schemes and private equity, facilitated by the Government, could be a beneficial relationship which will assist in fuelling UK economic growth in a post pandemic world.

In the past, a major barrier to entry for pension funds has been the fees, both management and performance. DC schemes’ have a 0.75% charge cap of funds under management and this cap restricts the capability of DC schemes to invest in illiquid assets. Performance fees which are paid to private equity fund managers if they provide positive results, are currently included within the cap. However, The Department for Work and Pensions is currently determining how to prevent performance fees from being held under the charge cap, in a move aimed at encouraging DC money into private equity investments and private markets. NEST was able to circumvent the cap as its arrangement involves no performance fees and Schroders stated it would be taking a flat percentage of the assets under management.

It appears that pension providers investing into private markets is a trend that is here to stay, especially as the government is scoping possible legislation changes to enable the process to be made easier. Former Chancellor Kwasi Kwarteng’s ‘mini budget’ during September had indicated that there will be reforms that will permit further pension funds to invest in alternative assets such as private equity. Partnered with firms showcasing their intent to provide more capital into the private equity market and LTAF’s being created, private markets are set to become a staple pension investment.  This is not to say that it is a bad idea as private equity does provide higher returns but combined with higher risk. However, with the inflation rate soaring during 2022, it puts pressure on the pension providers to increase returns which may be a driving force into the use of the private markets. The US pension schemes act as a case study for the UK market as it hopes to emulate the same success in order to satisfy the higher returns that are required.

However, the chaos that ensued post mini budget affected the private equity market and the pension funds. The collapse of government bonds, which had to be saved by the Bank of England almost resulted in the bankruptcy of multiple pension funds around the UK.

Although not at risk for immediate insolvency, the reduction in asset price such as Government bonds caused investment institutions such as Goldman Sachs and BlackRock to ask for more collateral to cover their contracts with pensions funds. Collectively, UK pension funds have £1.8 trillion in assets which could result in up to £550 billion in extra collateral. Legal & General, one of the UK’s largest pension and insurance firms, was one of the first to pass on collateral calls to its pension funds clients.

There are speculative reports of European pension funds and funds from further afield being put off from investing into UK-centric private equity funds due to the state of the market. However, due to the recent plunge in Sterling and the almost parity between Dollar and Sterling, American private equity and pension funds may cast their eyes to the UK market to spot ‘bargains’ which usually may not have been an option due to the exchange rates. A surge in exchange rates could cause investment into the UK market to be extremely lucrative. Especially as if the Pound Sterling recovers to January’s 2022 rate of 1.35 Dollars to the Pound for example.

Although there are large parts of the recent budget that was composed in an attempt to increase the likelihood of pension funds investing into private equity, all of these policies will be irrelevant if the economic plan as a whole dissuades investors from investing in the asset class completely. 

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