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The recent London Business School report on UK private equity as an asset class for institutional investors made a number of important recommendations for both the industry, potential investors, and the government and regulators.
Commissioned by the BVCA, representing British venture capital and private equity companies, and supported by the National Association of Pension Funds, the report’s conclusions aimed to soothe the concerns of institutional investors, which saw their presence among providers decline during 1998.
The government has thrown its weight behind this asset class, most noticeably following a speech by prime minister Tony Blair at the BVCA Entrepreneurs’ Summit in July last year. “British pension funds invest around 1% of their money in venture capital. In the US it is nearer 5%. I can’t make pension funds invest more in venture capital, but I urge them to look at this issue, to examine whether they and other institutional investors are being too cautious when it comes to venture capital,” he said.
As the report points out, however, there is a major stumbling block to this laudable aim – the minimum funding requirement (MFR). Pension funds which invest in private equity for the first time will inevitably find their MFR position adversely affected. This despite the fact that given average allocation to this particular class the deterioration is quite small in real terms. However, trustees have a traditional dislike for asset classes which are not used as yardsticks for calculating MFR liabilities. Changing the minds of trustees who have avoided this class so far is no easy task. The report’s author, Oliver Burgel, calls upon the government to take this fact on board during the on-going review of the MFR, and encourage funds to allocate more to private equity with impunity.
The industry itself is also taken to task for its over-selling of the high short-term returns currently being enjoyed by investors. These, claims Burgel, “reflect a number of very successful years for the industry as a whole, partly due to a buoyant stock market”. These returns, he believes, are influenced by investments made between three and seven years ago. He affirms that the marketing of the asset class should focus on the long-term returns which have outperformed its main comparators, as it is unlikely that future annual levels of return of around 30% can be maintained for an extended period of time.
Turning to pension fund investors, the report has a number of key recommendations, but emphasises risk reduction through diversification. “Diversity between funds and managers is of the utmost importance,” says Burgel, “to smooth cash flows and to substantially reduce the spread of returns.”
Given the need for diversification, the report does not recommend that smaller investment funds should invest directly in this asset class unless a sufficient share of funds is allocated to provide such diversification.
Funds with an investment limit of say 5% in this asset class, should on the other hand look at investing through gatekeepers' funds of funds. These usually accept lower contributions. Alternatively such investors could commit to a selection of quoted investment trusts. Medium to larger funds should, however, make an appropriate commitment if investing in private equity, which the report suggests they have so far failed to do.
Currently the median size for a UK pension fund is £54m (e88m), the figure raised for a similarly sized private equity fund £84m, and the minimum stake considered by the latter 1% of committed capital. The report suggests that participation in 10–12 funds would be an appropriate diversification, involving an investment of between £8.4m and £10.8m, or between 15.5% and 18.7% of the pension fund’s assets. Funds, it is suggested, might also be prepared to make higher nominal fund allocations to this asset class to achieve target exposure, given that between 80–95% of investors’ committed capital is drawn down.
When it comes to managing private equity portfolios, dedicated managers with specific expertise in the asset class are recommended by the report, given that the assessment of track records and selection of investment vehicles require an expertise quite different to that found among public equity market analysts. Organisational procedures are also different in this class.
Finally, further allaying the fears of investors who have steered clear of private equity, the report points out that market liquidity has improved dramatically of late with the growth of the secondary market, thus making it possible to sell stakes in limited partnerships before the partnership is wound up. Kevin Hall

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