Although UK pension funds may be shunning equities because of the current unstable economic climate, private equity has not been seeing the same sort of flight. In fact, if anything, the level of commitment to the asset class is growing, according to industry participants.
The impact of the Myners Report continues to make itself felt. “As far as you can generalise about pension funds, I think you can say that there has been more serious thinking about private equity over the last few years, a clear effect of the Myners Report,” says Chris Davison, head of research at AltAssets, private equity advisers in London. “But the result is very difficult to measure.”
“Post Myners, there has generally been more receptiveness to private equity in the UK market, which has historically been quite conservative,” says Gilbert Chalk of Barings Private Equity Partnership. “The scepticism will be maintained, but there is a different mindset now. There is a balance between an emphasis on liquidity and an openness to alternative investments.”
Current market conditions can be seen as a disincentive to explore the private equity market. As pension funds move out of equities and into bonds, the amount available for new investment in private equity – which is, after all, still an equity investment even though it is less correlated — becomes limited. A liquidity crunch further tightens belts and limits pension funds’ ability to branch out. And when pension fund managers and trustees are already under pressure, they may not be prepared to attempt a new investment approach, especially one that is time-consuming and research intensive. “The economic background is not helpful – there is not really any clarity anywhere,” says Davison of AltAssets.
In addition, some areas of private equity investment have not been immune from the dismal economic environment. “The Myners report coincided with a brutal downturn in some areas of private equity, especially venture funds in the USA,” says Davison. “This is a difficult convergence for trustees to compute, so it is not easy to make the case for private equity to trustees who are risk averse at the best of times.”
However, private equity is not feeling the crunch that might have been expected. “In general you would expect private equity to go up or down in line with equities,” said Andrew Dyson, head of institutional marketing for Merrill Lynch Investment Managers. “But people are coming off a low base for private equity – they can be reducing equities but still boosting private equity.”
Davison has not seen any flight from private equity either. Rather he has noted divergent behaviour in relation to sectors. “Buy-outs look less risky, but venture capital is really suffering,” he says. Among institutional investors, banks in particular have been hard hit by the collapse of the tech bubble. So today, investors are either sticking to buy-outs – or even the boldest are outsourcing the decision-making to funds of funds or consultants.
In addition, current market conditions may be encouraging ordinarily conservative pension funds to look towards alternative investments. “If you get three years of underperformance from established markets, people start to look around,” says Ian Larkin, head of business development, UK and Ireland, for Morgan Stanley in London. The fact that private equity, in theory at least, can produce absolute returns in any environment is certainly attractive to pension funds.
If a combination of Myners and desperation have been making private equity more appealing to investors, the business environment has also been responding.
It is notable that consultants have definitely been allocating more resources to private equity research over the past 12 months, and many have set up dedicated teams to private equity. This is a sure sign that pension funds are now ready to consider investing. “Consultants need mandates – it is very expensive for them to deal with education,” says Alistair Altham, responsible for funds of funds, ex-USA, for Morgan Stanley. He makes the point that, in the realm of alternative investments, significantly more consultant resources have been devoted to private equity than to hedge funds.
In addition, the growth in funds of funds has opened a more accessible route into private equity for many investors, allowing them to achieve key diversification without having to do all the research on the ground. “If the market has changed at all, it has been through funds of funds, which have opened it up for hedge funds and private equity,” maintains Larkin of Morgan Stanley.
So there is a distinct buzz about private equity in the UK over last 12 months. But will all this talk lead to action? “My view is that in the UK pensions market, there has been a lot of talk over the last year,” says Altham. “Over the next 18 months, there will be more commitment to investment.”
Currently, only the larger of the UK pension funds have significant holdings of private equity, but it looks like the smaller funds are going to see greater activity. So far, local authorities, which often tend to be a little more adventurous and innovative, have been getting into the private equity market. “In the UK, the interest is less from corporates than from public funds like local authorities,” says Dyson of Merrill Lynch. New entrants during 2002 included the East Sussex, Enfield and Shropshire councils, and the London Borough of Newham.
The NAPF annual survey of occupational pension schemes bears this out. While in percentage terms, the overall number of schemes that invest in private equity has remained steady over the past few years, there has been a marked jump in take up by public schemes. In 2001, only 40% of public schemes responding to the survey said that they invested in venture and development capital funds — in 2002, 60% said that they did.
But even the large funds are not sleeping. At the end of January, Hermes Asset Management, which is 60% funded by the British Telecom pension fund, announced the formation of a £200m private equity fund. Previously the bulk of its venture capital investment, which amounts to some £550m, was placed through other firms. This new fund will give it a more structured approach to direct private equity investment. While Hermes will not be aggressively marketing the fund, “if any pension funds approach us, thinking that if it is good enough for BT, then it is good enough for them, we are not going to say no,” says Charlie Metcalfe, head of business development.
Up to now, those pension funds that have invested in private equity have done so at a very low level, allocating less than 5% to the asset class. However, the conventional wisdom is that you need to make an investment of at least 5% – and ideally 10% – to see any effect on the bottom line. “Typically, pension funds haven’t allocated very much to private equity,” says Larkin. “I sometimes wonder why they do it. Private equity is difficult to get into – aim for 7% investment and you’ll get 5%.”
To an extent, this low level of investment can be seen as a natural first step into a new market. “People who are coming into private equity will naturally be cautious,” says Dyson. And the NAPF survey gives an indication that allocations are on the increase (see table).