Dear CIOs: We need to talk about capital profile

Pension funds are increasingly being seen by some, as strategic national assets – the Carney speech at Davos made this explicit. Governments see them as a source of long-term investment. Businesses see them as providers of patient capital. Members count on them to generate strong retirement outcomes in an uncertain world. As these demands grow, it becomes more important to have strong frameworks to distinguish what makes sense from a policy perspective and what works from an investment perspective.

In my first IPE column, I said that incentives matter. Capital tends to move towards opportunities where the risk/return trade-off is favourable compared to comparable alternatives. Investment vehicles and market structures are important, but they are not usually enough on their own. Creating another vehicle does little if the underlying economics remain unattractive.

While I still believe that, I increasingly think there is a third consideration that receives far less attention: capital profile.

Over the past year, much of the discussion has focused on capital structures and capital incentives. Capital structure is concerned with access. Do the right vehicles, governance arrangements and investment mechanisms exist? Capital incentives are concerned with attractiveness. Are investors being offered returns that justify the risks involved and are commensurate with other opportunities?

But capital profile is different. It focuses on whether the characteristics of the capital itself are reflected in the opportunity being presented. This matters because different sources of capital have very different properties.

Investment vehicles and market structures are important, but they are not usually enough on their own

UK defined contribution (DC) pension schemes have a profile that is unusual by investment industry standards – and hits a sweet spot. Contributions arrive continuously. Assets are reinvested. The capital base often grows over time rather than shrinking. Allocation targets need to be maintained on a constantly growing capital base. In practice, this creates a pool of capital that can remain invested for very long periods and can support repeated deployment.

That is very different from finite-life private equity funds or other structures that are designed around eventual liquidation and return of capital.

When we discuss pension investment in private markets, most of the attention is given to access. We spend less time asking whether pension capital itself has characteristics that should influence how opportunities are structured and priced. That question becomes particularly relevant in the debate around productive finance in the UK.

A great deal of effort is currently being directed towards improving investment structures. New vehicles are being launched, partnerships formed and barriers removed. All of that is helpful. There is also significant attention on improving incentives. Better project pipelines, removal of project blockers like planning and grid connections, red tape that add to cost and uncertainty, these should all support greater investment. However, what is often missing is a discussion about whether the terms offered properly reflect the value of the capital being provided.

Long-duration, growing, compounding capital is valuable. Yet in our conversations with managers, opportunities are often presented through standard structures that were not designed with this type of investor in mind.

When managers start by considering where this particular form of capital best fits, rather than simply placing it into existing products, the conversation tends to change. Better economics can emerge for pension schemes and their members. For example, this may lead to a greater focus on open-ended, and blended structures that weigh more toward co-investment, direct deals and follow-on capital alongside primary fund investments. In other cases, it may mean recognising that certain segments of private markets are simply a less natural fit. 

Not every opportunity suits every type of capital – in some cases, asset scale and growth can work against the opportunity if there are specific capacity constraints, for example.

Equally, the existence of patient capital does not justify accepting weak returns. Pension schemes remain fiduciaries first and foremost. For that reason, capital structure, capital incentives and capital profile should be viewed together:

• Structures determine whether investment can happen.
• Incentives determine whether it should happen.
• Profile helps determine whether a particular investor is naturally well-suited to own the asset. 

In practice, many of the difficulties that arise in long-term investment stem from one or more of these elements being out of alignment, and in my experience of looking at private markets opportunities in the UK currently, it’s rare for all three to align. On the other hand, where managers have recognised capital profile and leant into it through structure and terms, they have been more successful.

Looking at proposals through this lens may be useful over the coming years. The question is not simply whether a vehicle exists or whether expected returns look attractive. It is also whether the characteristics of the investor’s capital match the characteristics of the opportunity. This could be the missing piece in understanding why some opportunities attract capital while others do not.

The conclusion for those looking to make investment opportunities attractive to capital should be clear – recognise the capital profile in the structure being offered. In infrastructure this might mean blended co-investment sleeves alongside fund investments run as open-ended vehicles. In venture capital or growth equity this might mean a target model which majors on follow-on and growth equity and a smaller allocation to primary funds or capacity-limited strategies.

Dan Mikulskis, chief investment officer of People’s Partnership