UK pension funds have been criticised for failing to invest as much in private equities as their US counterparts. Stephan Breban says there’s nothing irrational about this position
When it comes to investing in private equities, unfavourable comparisons are often made between the UK and US, where it is claimed that pension funds invest in excess of 5% of their assets. But most of the surveys on which this information is based come from limited samples of highly biased groups. In particular, they are often conducted by private equity managers, who obtain their responses from those already investing in the private equity area.
In one sense this is preaching to the converted. If we look at more widely based surveys, such as the Greenwich Survey, the average US pension fund has around 2% of its assets invested in private equity. In the UK, meanwhile, there is little if any meaningful data on the subject. 1, the WM Company has recently begun to identify private equity investment in its performance data and came up with a figure of 0.3% for the total amount invested. However, only a small proportion of the clients subscribing to this service have actually gone to the trouble of identifying their private equity investments and this number almost certainly underestimates the true picture.
Many pension funds that invest in private equity will not be measured within mainstream fund manager performance. Indeed, WM estimates the real amount invested in private equities to be closer to 1.5% and I am inclined to agree with this. Having said this, the total amount invested in private equity still remains small. So why should this be?
To date, much of the marketing of private equity has been quite negative. Trustees are often criticised for failing to take the asset class seriously. But this approach is rarely successful in terms of winning them over. To do so would mean they were being irrational in not having invested in this category earlier.
Furthermore, the performance of the private equity market, as measured by WM, has only recently begun to demonstrate relatively strong returns when compared to the quoted equity market, and even here the additional returns are only just sufficient to compensate for the additional risk and reduced liquidity. It is unfair to claim that trustees were behaving irrationally when they failed to invest in private equity in the past.
Pension fund trustees will rarely invest in anything they do not understand. This is both rational and appropriate. Private equity managers are some way behind the rest of the industry in terms of performance measurement and until recently there was little in the way of reliable performance data to use. Most private equity managers quote either internal rates of return or money weighted rates of return for the performance of their various funds. Invariably this performance data is compared with a time-weighted rate of return on an index, or on pension fund performance as a whole.
This last point is of particular concern. It is wholly irrelevant to compare the performance of private equities with the performance of pension funds as a whole. The latter hold numerous asset classes that are each held for different reasons. In particular, a proportion of the assets will be held in bonds for the purpose of matching liabilities. Any comparisons should be made with the asset classes that are held for the purposes of achieving long-term high returns, namely quoted equities. Furthermore, comparisons should be made on a like for like basis. For instance, it is fairly simple to calculate an equivalent return on the money-weighted rate of an appropriate index such as the FTSE All-Share.
When private equity managers come to the market to raise capital they rarely give investors much time in which to invest. This “window of opportunity” is insufficient for a board of trustees to get together, conduct the necessary due diligence, discuss the opportunity and finally make a decision. Consequently, the only rational response is to not invest.
Private equity managers are often reluctant to discuss the issues of risk and illiquidity. This is because they are unnecessarily worried about trustees’ reaction to these two issues. However, trustees are prepared to take on board risk and illiquidity, but they need to see an appropriate level of reward. If private equity managers avoid discussing these issues with trustees, then the issues cannot be resolved. Dismissing risk with the comment “we only invest in good stocks” shows a complete lack of understanding of the subject and should raise concerns with any group of trustees.
The fee structures of most private equity arrangements have been designed with a certain type of investor in mind; those who are more interested in absolute rather than relative returns. While these fee structures are appropriate for the majority of players in the private equity market, they are more likely to reward managers for the performance of the market than for their skill. Performance of any private equity fund over its usual lifetime is likely to be highly correlated to the overall market. If the market is buoyant private equity funds should comfortably exceed the performance hurdle on any cash or nominal basis of say 7% or 8% per annum.
Consequently a fund manager can achieve a return substantially below the market and still exceed the hurdle comfortably, and still reap substantial rewards. The most commonly voiced response to this argument is that trustees should only pick the stronger managers and not the weaker ones. But if life were that simple, we would all have packed up and gone home long ago. This is one area where there is a significant mismatch between managers’ overwhelming confidence in their ability and their willingness to be paid on their ability.
The argument that performance has been particularly strong recently, and therefore trustees should invest, is unfortunately the most likely argument to work. Ironically, immediately after a period of particularly strong performance is probably the least appropriate time to invest in markets. Indeed, the recent rush of funds into private equity investment may even have artificially fuelled this performance; we have seen an increasing proportion of deals conducted between private equity managers, without the investee companies ever going to an IPO or trade sale. Pension fund trustees are aware of this increasing rush of money into the area and it does worry them. However, while this is a concern for private equity, it is potentially a larger concern for the quoted equity markets. Therefore, it may still be appropriate for trustees to take money out of quoted equity markets and place it in the private markets.
The performance of the private equity market needs to compensate investors for the illiquidity and additional risk they incur. Therefore, a long-term return substantially in excess of the quoted market is necessary to reward investors for the risks taken. If the return is not in excess of the quoted markets, it hardly seems worth the effort of investing. Again private equity managers often argue that you should not compare private equity returns with the quoted market because the private equity is a longer-term investment. But this is not an argument for not comparing private equity with quoted markets, simply an argument for not looking at performance over shorter-term periods of five years or less. For longer-term periods it is entirely appropriate to compare private equity performance with that of the quoted market.
Identifying private equity managers, investing in the funds as they come to the market, and then building and maintaining a portfolio of private equity managers is a very time consuming process. It is quite feasible for an investment board to spend more time and money managing the investments in a small proportion of their assets, say 5% in private equity, than it does investing the remaining 95% of their assets in quoted markets. Identifying managers and then monitoring them is particularly onerous.
Most UK pension fund trustees boards meet relatively infrequently and have many other investment issues apart from private equity to discuss at their meetings. Consequently they have little time to dedicate to private equity investments. In contrast, many US institutions employ full-time investment specialists whose responsibility it is to identify, monitor, appoint, and de-select all managers, including private equity managers. Consequently, their governance structure is better placed to cope with these issues. This is one area where UK pension funds could benefit a great deal by learning from US practice.
In conclusion, private equity does have a role to play in the investment structure of many UK pension funds. However, the way forward is not to accuse trustees of behaving in an irrational manner, but to address their concerns in order to present a balanced and reasoned argument in favour of private equity.
Stephan Breban is a senior investment consultant with Watson Wyatt in London