In today’s increasingly sophisticated investment environment, one might have expected that a niche asset class such as private equity would play an increasingly important role in pension fund portfolios.
But in fact, the use of private equity by UK pension funds lags well behind that of their counterparts abroad.
According to the 2003 Goldman Sachs International and Russell Investment Group report on alternative investing by tax-exempt institutions, UK pension funds have an average 3.6% of assets invested in private equity. This is the lowest of all the regions covered by the report. The highest percentage – 7.5% – is held by North American funds. Australian funds hold 5%, while 4.2% of pension fund portfolios in continental Europe are invested in the asset class.
But are UK pension funds increasing their allocation to private equity? It is difficult to find out, because some of the money from UK pension funds is invested directly in the sector, while the rest goes in via funds of funds.
The problem is illustrated by figures from the British Venture Capital Association, which break down funds for private equity by source.
In 2001, new money coming into private equity from UK pension funds totalled £1.6bn (e2.4bn). The following year, this had fallen to £800m, and remained at that level during 2003. However, while the total money coming in through funds of funds during 2002 was a mere £300m, this figure had leapt to just over £1bn the following year.
John Mackie, chief executive of BVCA, says: “Of that total, some is from pension funds, some from insurance companies and some from wealthy individuals. Nevertheless, although the individual breakdown is not available,the anecdotal evidence is that UK pension funds are either entering this asset class for the
first time, or increasing their exposure to it.”
However, given the emphasis placed on private equity by the Myners Review, the current level of interest shown by UK pension funds three years later seems somewhat disappointing. The report’s overall aim was to suggest ways to enable decision-making by institutions to become more effective. As part of this, it also looked at private equity, setting the agenda for increased investment.
But according to Kerrin Rosenberg, associate at Hewitt Bacon & Woodrow, the changes have not kick-started the hoped-for amount of interest from the institutions.
He says: “We hoped the Myners Report would be a catalyst for more interest.” However, he points out that many pension funds have spent the past three years thinking about higher-level risk and return, and he says it is a perfect time to put those ideas into practice. “So we will find more pension funds going into private equity, the main reason being the hope of a higher return,” he says.
Mackie, however, is not too disappointed about the after-effects of Myners. He says: “What Myners said was that pension funds and their trustees should look at private equity as an asset class, but he was not saying they should invest in it. They might decide not to invest, but at least they have to think about it.”
In spite of Myners, however, Stephan Breban, senior investment consultant at Watson Wyatt, says other legislative changes have had a negative influence on private equity investing. “Both FRS 17 and the Pension Act have stimulated a move to valuation methods which are more focused on market values,” he says. “This has meant pension fund trustees becoming a lot more aware of risk, when they are exposed to greater risk because of market volatility.”
According to Breban, governance within the firm’s clients has been improving and this will help. He says: “Good governance is a much more positive influence in getting pension funds to invest in private equity, rather than simply saying they should be in it.”
For example, a common complaint of trustees has been that private equity takes so much work to understand that they would rather ignore it. Some boards of trustees at Watson Wyatt clients have now delegated specific areas of investment and monitoring work to investment committees made up of two or three people. These are able to spend time getting to grips with the complexities of private equity – something that would be impracticable for the main board as a whole.
Breban says: “We are now just beginning to see the fruits of this initiative coming through. We expect a significant movement from our clients into private equity in the next two years.” Although private equity does take a heavy toll in administrative terms, Breban says that most trustees exaggerate the burden. Furthermore, he says they often invest too small
a percentage in this asset class.
“Many trustees have only got 1% invested in private equity, with perhaps a further 1% committed,” he says. “But if the asset outperforms the quoted market by say 15%, it has little impact on the bottom line. You need to invest about 5% of your assets in order to see a difference.”
Phil Chesters, European partner, Mercer Investment Consultants, says that private equity is still more for the bigger funds. “Investors are getting more interested, but it tends to be people who’ve already got an allocation there,” he says. “The difficulty for smaller funds is that they are locked in for 10 or 15 years. Furthermore, there are not the vehicles available to access private equity through defined contribution schemes, which has become of growing importance. But small schemes can still use the fund of funds route for private equity investing.”
However, a big disincentive for UK pension funds – regardless of size – is the relatively high cost of fees for private equity investing. “A 5% private holding in a portfolio pays more in fees than the other 95%,” says Rosenberg. “But our view is that the average private equity manager net of his fees – at 5 or 6% – is still producing about the same return as a quoted stock.”
Mackie, however, is more bullish. “It is generally accepted that private equity outperforms comparable asset classes such as the FTSE 100 and WM universes,” he says. “Over the long term, the average outperformance is between 500 and 600 basis points.”
Meanwhile, a 2003 survey from AltAssets Research/BVCA suggests that UK institutional investors expect to increase allocations to private equity. Responses from 32 institutions with £10.5bn of private equity commitments indicated that their strategic allocation would rise from just over 3% to just under 4% of their portfolios, within two years of the date of the survey.