Can pension funds afford to invest in private equity?

As pointed out by many experts private equity is a niche and expensive asset, but champions of PE claim that if managed correctly it has the capacity for greater returns and in turn enrich more retirement incomes.

Private equity is a way of unlocking investments in companies that have potential to grow, and is has been targeted by the current government as an area where pension funds 'could do more', to the tune of £75bn a year.

Private equity, is both specialised and research heavy and this is reflected in its cost.

Hurdle rates, committed capital and more

Nick Groom, head of UK DC strategy and sales at Natixis Investment Managers, explained that good quality European and global private equity managers charge a 200bps annual management fees as well as carry/performance fees of 20 per cent over what is known as a hurdle rate.

Barry Jones, chief investment officer at Isio, said there were other fees over and above these if the manager performs any duties in-house that would typically be serviced by the holding company. 

He said: "The annual management charge can be on committed capital, drawn capital, and net asset value of the underlying holdings."

Jones said the committed capital approach has fallen out of favour over recent times and typically drawn capital is used on direct private equity and net asset value on fund of fund structures. "The annual management charge is typically around 1.5 per cent on each approach."

Performance fees operate over a hurdle rate, this means the manager gets zero performance fee until the fund has achieved an internal rate of return (IRR) over a set level – and for private equity mandates this is typically seven to eight per cent per year.

He added: "The PE manager typically is rewarded with a 20 per cent performance fee with an agreed catch up rate – there are various approaches to the catch up and the typical sharing of the performance beyond the hurdle is 75:25, between the PE manager and institutional investor, until the IRR is shared 80:20 for a 20 per cent performance fee.

"In summary, most PE fees are now 1.5 per cent AMC and 20 per cent performance fee, which equates to around 2.25 per cent to 2.75 per cent per cent per year all in fee for PE mandates hitting their targets."

Such fees do have the potential to breach trustees fee caps although Nigel Bolton, pensions partner at national law firm Bevan Brittan, said the government has enacted relaxations which would allow for smoothing of these costs over a period of up to five years and excludes the costs of holding physical assets.

Getting private equity bargains

Private equity costs are high, but not as steep as they have been.

“Private equity managers have been regularly managing pension scheme money since around 2005. At first, pensions schemes paid the ‘brochure price’ of to per cent annual management charge and 20 per cent performance fee, but as mandates became widespread and competitive, trustees and their advisors pushed the private equity world into a 1.5 per cent AMC and 20 per cent performance fee model for top-end PE firms."

As Jones added, scale does matter when agreeing fees and PE firms will typically reduce the 1.5 per cent AMC as some of their fixed costs spread further on larger mandates.

“There is a lot of work that goes into building a PE portfolio that is not required in public equity investing, so expecting listed equity portfolio management type fees is not something we believe is attainable.

"Examples of these higher costs include in depth due diligence, the legal costs of purchases and sales of holdings, partners sitting on the boards of owned companies and reporting.

There is therefore limited scope for material further negotiations to reduce fees beyond around 0.2-0.4% of AMC before it is no longer commercially attractive for the PE firm."

Isio predicted that the current 1.5 per cent AMC and 20 per cent performance fee for top PE houses might get squeezed to 1.2 per cent and 20 per cent if there was consolidated large scale push into PE, "but no further,” added Jones.

Private equity value

Groom also pointed the value of fees in driving quality PE.

"The performance fees we believe are important, as most of the value is driven later in the asset’s duration, and gives alignment of interest throughout to all parties."

He also sees PE managers looking to shave costs although "there will be some reticence from quality overseas private equity managers to reduce fees, given they can ply their trade elsewhere in the world at the full fees".

A well-run, single trust DC pension schemes can certainly afford to invest in private equity, argues Groom. Master trusts maybe not so much. "Master trusts are exceedingly cost conscious given value for money, as well being in a race to bottom on fees to win the consolidation battle of 30 plus schemes down to 10 in the next five years."

Groom argues that some of the more tech-heavy schemes may be able to absorb some of the increased fees associated with PE. "Smart Pension for example, which is a fintech at the core, is able to spend more on investment as its administration is more efficient when compared to those that use older legacy platforms."

This tech may, along with other innovations, help PE managers sell themselves to schemes.

"For some there is room to find a small investment in private equity, although even then we need to be innovative in the way we as asset managers present this, with some co-investment alongside the primary investments as well as the possible use of secondaries."

Private equity unmet needs and 'being told where to invest'

It is not just cost that may limit the Chancellor's ambitions, and this is also where PE managers may need to get smarter, initiatives such as the evolution of long term asset funds (LTAFs) may help the industry construct well-diversified, sector-based PE solutions, said Groom.

"The issue will potentially be that most schemes would prefer not to be told where to invest their precious assets, and will be more inclined for geographical diversification rather than just in the UK."

Groom admitted that there was an "unmet need in the UK pensions market for a UK focused PE fund" so managers which have capabilities in PE will be looking to build something specific for the UK market.

"Given some market momentum from this recent initiative combined with the regulatory push for less liquid assets and the ambition for the LTAF regime to overcome all liquidity hurdles, we may see a more accessible market for PE. Also when consolidation bottoms out, higher fees should become more common place and therefore allow more access and opportunity for less liquid assets as a whole."

'Too expensive'

Nigel Bolton, pensions partner at national law firm Bevan Brittan said private equity would only be accessible to the very largest DC schemes.

"Only they will be able to take the risk on the high fees and uncertain outcome of PE investing. This will be an asset class for the few, not the many."

"Fees will only come down if significant investment from the pensions sector occurs. This theory underpins the Chancellor's Mansion house view that PE can still represent good value for members. It remains to be seen if costs will fall in practice.