Private equity or bust? Why the Mansion House pension compact needs detail and circumspection

Even its greatest champions will admit private equity is a niche, expensive and complex asset. Unlisted companies are normally used to diversify a portfolio, rather than generate huge returns and private equity investors tend to be those happy, and able to afford, to take a risk and will pay a premium to do so.

Private equity is not new to pension funds, but the pressure on them to invest more heavily is.

Chancellor Jeremy Hunt singled out private and unlisted companies as the future of UK economic growth in his Mansion House speech earlier this month. The government believes the investment might of pension funds can unlock £50bn worth of investment by 2030.

Britain’s biggest defined contribution pension providers put their hats in the ring via The Mansion House Compact. The agreement, announced in the speech, is between some of the biggest names in pensions, who have committed five per cent of their funds to private equity and early-stage businesses.

The compact will cover around two-thirds of the defined contribution pensions market and was signed by Aviva; Scottish Widows, L&G, Aegon, Phoenix, Nest, Smart Pension, M&G and Mercer. 

Regulatory scrutiny 

As it stands asset managers and pension consultants are probably those most set to gain from the Mansion House plans, as pension funds scrabble to work out its implications.

Ed Wilson, investment partner at pensions advisory firm Isio, said the Chancellor’s Mansion House speech did address a number of important issues but "fell short of being a significant step forward".

Wilson said the Chancellor’s requirement for schemes to invest five per cent in unlisted equities, while "headline grabbing, lacked both rigour and ambition". 

"On one hand this suggestion was not particularly radical. Many schemes have already reached this target, with others having started work towards it before the Mansion House speech."

Wilson said not enough detail had been revealed, and that the speech itself failed to stand up to regulatory scrutiny.

"By taking a compact approach, focusing on only a small number of master trusts - albeit those in the compact do cover most scheme members - the challenge of fiduciary duties has been somewhat sidestepped with little clarity provided on what is actually meant by UK private equity investment.

 "On the other, and perhaps more surprisingly, the manner in which the information was presented at Mansion House was more simplistic than expected. Some believe it fell short of the standards that private firms are obliged to meet, and regulatory bodies such as the Financial Conduct Authority, the Advertising Standards Commission and IFoA, would have expressed serious concerns.

"This is because much of the bigger picture around the benefits of investing in unlisted equities is missing. Whilst investment in an efficient, scaled way has clear merit, the benefit lies more in diversification and access to a much larger investible universe - not in magic extra returns.

"It is important for schemes to remember that high-risk asset classes are not guaranteed, whether in the short-term or the long-term."

Private equity and fees

Wilson said this lack of scrutiny also extended to the fact that "many private equity funds charge fees that surpass the assumed annual charge on assets and a 10 per cent portion of the upside".

He added: "If these fees were adjusted to a more realistic basis, the perceived ‘gain’ largely disappears before the risk is even taken into account. Further, the narrative around private equity investments specifically targeting the UK disappears in the detail of the speech, as the funds would be allocated on a global scale."

"This is not to suggest that investing in private markets in an efficient and scaled manner is bad idea – for many investors it is an important element to their portfolio construction. However, relying on the expectation of achieving superior returns as the justification is somewhat missing the point - It’s there as a diversifier.  Ultimately, with the modest allocations discussed, there is a mismatch between investor freedoms and investing in private markets.

Private assets and pension returns

Private equity does have the potential for an expanded role in pension fund investing strategies. Evolved pension markets elsewhere have seen the assets play an important role in improving member outcomes.

Jonathan Parker, head of defined contribution at Redington, argued that globally only a relatively small proportion of companies were public and/or listed on a recognised stock exchange. 

"For example, in the US, around 80 per cent of companies with over $100m (£77m) in revenues are private, and therefore out of reach for most DC pension schemes to invest in. With more companies choosing to remain private for longer, and with DC schemes growing in size, it is important that this part of the capital markets is considered more. 

"However, as with any investment opportunity, there will be winners and losers - and probably more losers - and so due care must be given to selecting private market opportunities. 

"In addition, international evidence from other large DC markets including Australia, Canada and the Nordics (and indeed the UK’s own NEST Pension Scheme) points to private assets being able to play an important role in improving member outcomes."

Net zero and private equity

The UK's largest asset managers may be, as one anonymous industry expert said, looking forward to being able to sell in another asset to schemes, but the asset managers themselves believe private equity can help them offer schemes more value.

Tim Orton, chief investment officer at Aegon UK said asset managers were committed to providing value for pension schemes and that private equity can provide access to growth opportunities not always available in other asset classes.

He said: "While some pension schemes may view private equity with a jaded eye, there are a number of positive reasons to invest in this asset class. Additionally, private equity can help to diversify a pension scheme's portfolio and reduce its overall risk and there is lots of evidence which demonstrates private market assets can deliver stronger returns than public markets." 

"We believe it is possible to achieve both sustainability and fiduciary duty within the five per cent private equity rule and the ability to demonstrate this will be a key consideration for any trustees who make the decision to invest. It will require pension schemes to carefully consider their investment strategies and make sure that they are aligned with their long-term objectives."

ESG, sustainability goals

The nature of private equity may also benefit other mandated pension fund requirements. Orton added:"Freeing up DC schemes to invest in private assets grants many benefits in terms of ESG integration. It allows DC members to more effectively benefit from the transition to net zero, given the much greater potential to invest in growth opportunities such as renewable energy, green infrastructure and nature-based solutions.

"The opportunities for stewardship are also significantly greater in private markets, given the greater requirement for due diligence and ongoing active engagement. This is achievable in both private credit as well as private equity."

"By taking a thoughtful approach to sustainability, pension schemes can help to ensure that their investments are both financially rewarding and responsible."

Private equity - what do trustees need to know

For many schemes Hunt's announcement was old news. Nigel Bolton, pensions partner at national law firm Bevan Britta said trustees of most DC schemes do not need to do much other than understand the proposed changes including any potential risks and keep abreast of the changes as this area continues to  evolves.

"Part of that process will include getting a better understanding of whether private equity does outperform listed stocks and how this works in relation to government forecasts for this to work for scheme members."

They may want to look at schemes such as Nest, which already has 6.5 per cent of its portfolio invested in unlisted equities including private and direct infrastructure, and has plans to increase this weighting to between 10-15 per cent over the next 18 to 24 months.

Challenges ahead

But there is a major challenge for other schemes looking to up their private equity weightings, the cost.

Stephen O’Neill, head of private markets at Nest, said: "In order to invest in unlisted equities, you have to pay higher fees and I don't think the price point we have achieved with our private market managers is at this particular point replicable by many other DC schemes."

“For insurance companies, where they have made private market investments for their general account, they could potentially migrate some of those investments on a low-cost basis to their master trust offering."

“The big commercial providers with a member price point at the 75bps charge cap, while trying to minimise the cost of administration and investment - and so maximising margin - will struggle to find a business case to make a big allocation to very expensive asset classes."

"The compact will have signed up because they can do it but whether it will propagate to the wider DC market - we will have to wait and see."