It has been a year since Paul Myners published his review of institutional investment. So, it seems as good a time as any to step back and take a look at what its impact has been on private equity and on pension funds’ decision-making processes as far as investing in the asset class is concerned.
The review’s main remit was to recommend ways of improving the quality of investment decision-making among institutional investors, and particularly among pension fund trustees. However, it also set out to examine why UK institutions had been slow to commit to private equity.
It is worth noting here what the review’s ultimate aim was. Its aim, articulated by the government and particularly by the chancellor of the exchequer, was to improve UK competitiveness by ensuring a more cost-effective flow of investment funds to British industry. As far as private equity in particular is concerned, the government views it as one of the main drivers for creating an entrepreneurial culture and promoting economic growth. It felt that private equity was being overlooked by many institutions and in 1999, prime minister Tony Blair made a speech to a meeting of the British Venture Capital Association. He said that the UK’s pension funds were not investing as great a proportion of their funds in venture capital as similar institutions in the US were. In particular, he referred to an average of 5% of US pension funds in private equity as compared to 0.5% from the UK’s funds. This appeared to confirm suspicions that the UK suffered from an ‘equity gap’ for smaller companies, particularly in the high-tech fields, which in the US had appeared to be the drivers of the long ten-year growth record.
But the proportion of UK pension fund assets being allocated to private equity was not the Myners review’s main focus – and it contains no specific proposals to ensure that the proportion rises. Instead, its proposals are general, in the form of a set of principles for more effective, and therefore more rational, decision-making by trustees. Yet, over the long term, these principles, and the Myners Review in general may well indirectly cause an increase in institutional investment in private equity.
The fact that Myners devoted a whole chapter to private equity and the reasons for the relatively low participation among pension funds and other institutions has already started having an impact. Note that Myners was in no way advocating or recommending investing in private equity. However, he did suggest that pension funds at least consider it as an investment option and as a result it is now on many more investors’ radar screens. Trustees for pension funds that follow the Myners principles may well find that they will need to make positive decisions as to whether or not to take an exposure to private equity and if so to what degree and over what time scale.
If the Myners principles are followed by all trustee boards there can be no doubt that some will conclude that, having gone through the recommended processes, they should look more widely for investments which will deliver them good returns at an appropriate level of risk.
The Myners Principles rest on the assumption that every pension scheme is unique and that its plan sponsor has different liabilities and strengths, and therefore risk appetite. They go against the idea that a scheme’s successful investment strategy is one that others should follow. Each scheme needs to develop its own strategy. There are methods available to help in this process, such as deciding on asset allocation using an Asset Liability Model (ALM). This will first generate a range of bond/equity distributions. Trustees then need to consider assets that do not fit neatly into these two broad classes – ‘alternative’ assets. These include property, private equity and hedge funds. Each of these ‘alternatives’ has differing degrees of equity and bond characteristics. The process ensures that these types of asset are considered even if, at the end of the process, the trustees decide that they are not suitable for their particular purposes.
Consideration of an exposure to private equity will, in future, be a positive process, rather than something that can be ignored because all other funds appear to ignore it.
The Myners Review has raised awareness of private equity and ensured that institutions that follow the principles it recommends will at least consider it. But that may not automatically mean pension funds will start investing in private equity or increase their allocations. The chart shows the allocation of UK pension funds to private equity over the past five years. All things being equal, you might expect to see increased interest from the UK’s pension funds in private equity as trustee boards implement the Myners principles. But all things are never equal. There are a number of negative factors that may limit the growth of funds from the UK’s schemes to the UK private equity industry:
o First, the UK is witnessing a decline in defined benefit (DB) schemes and a move towards defined contribution schemes. For a number of reasons, including the fact that the investment risk falls entirely upon the individual, such schemes are unlikely to allocate much money to private equity.
o Second, the remaining UK DB schemes are becoming super-mature. As they do so, they are likely to move generally from equities towards bonds. Very few new DB schemes are being established to provide new inflows of money.
o Third, although there is still a general consensus among investment advisers that equities, over the long term, will out-perform bonds, many argue that it is not wise to assume the equity premium is still valid – currently rated at 2.0% or less.
o Fourth, for the past couple of years, returns from equity markets have been poor and the markets have been volatile. This brings us to the crucial point about private equity. There is no doubt that it is perceived to be more risky than quoted equity. But those who advocate it argue that the returns are good enough to justify the risks. They have been in the US over the past decade of extraordinary long and strong economic growth and rising equity markets. The returns from private equity depend crucially on the exit capacity through trade sales or IPOs. When the public markets falter, and in particular when they are depressed for a long time, where can the returns from private equity investing be made?
These are difficult times for institutional investors. Nevertheless, with some of the UK’s larger, and less mature, DB pension schemes, the impact of the Myners Review will be positive for private equity and release more funds into the market. It will arise gradually, as they do their ALM studies, and conclude that an exposure to private equity is cost-effective for their needs. This effect may be sufficient to make a real difference, for it has always been the larger funds that have supported this asset type. Smaller funds may follow the Myners principles of decision-making but conclude that passive and conservative investments are the best for them. Above all, in estimating the likely progress of the UK’s private equity markets, the Myners Review has to be seen as just one factor. It directs decision-makers towards better outcomes. But trustees will still have to take into consideration the scheme’s individual circumstances and the different investment opportunities that are currently available.
Ann Robinson is a non-executive director of Almeida Capital as well as a pension fund trustee. She was formerly the director general of the National Association of Pension Funds and a member of the Myners review team