The UK private equity industry has received much press of late. The Myners Review was initially commissioned by the government to investigate the low level of institutional investment in the UK private equity industry. Despite the remit covering the wider factors distorting institutional investment decision making, a number of observations and recommendations were made regarding private equity for both defined benefit (DB) and defined contribution (DC) schemes.
One of the recommendations of the review was that trustees of DB and DC pension schemes should consider all investments, specifically including private equity. Myners touched on two of the perceived stumbling blocks of DC investment. First, the perception that investment in risky and illiquid assets is inappropriate given all investment risks are borne by members. Second, the need for regular member valuation of investments. Myners indicated that these beliefs are overstated and that some investment vehicles, such as investment trusts, could be used successfully.
An important change in the pension fund landscape is the move by pension plans from DB to DC arrangements. There has been substantial media coverage of the closure of the final salary schemes of some big UK companies and the opening of DC schemes for new members. Although the coverage has so far been more or less concentrated on the big pension schemes, evidence from the industry points to a definite trend to DC. Indeed, new developments, such as stakeholder pensions, only reinforce that view. This is further compounded with the arrival of FRS17, the new accounting standard, which is expected by many to accelerate the demise of DB arrangements.
The National Association of Pension Funds survey of 1999 indicated that 13% of schemes were DC schemes. When translated to assets under management, the percentage decreases considerably as most of these schemes are immature and only established relatively recently. Both numbers are expected to grow considerably over the next few years.
The top-level investment objectives that should apply to the provision of a DC investment arrangement is the maximisation of a member’s benefits subject to an appropriate level of risk, plus a balance between protecting financially unsophisticated members from making inappropriate investment decisions and giving flexible investment arrangements for the more financially aware to meet their needs.
Private equity can meet the objective of benefit maximisation as part of a diversified asset allocation strategy. It can act as a diversifier and be a source of non-correlated returns. Good manager selection (and it is by no means a given) provides an additional source of high absolute returns.
There are a number of investment characteristics of DC arrangements that are in stark contrast to those of DB arrangements – the investment risk borne by members, the lack of pooling of risk between members and the need for liquidity and frequent valuation of members’ holdings for transfer or information purposes. Each of these present a number of challenges to the private equity industry.
It is important to differentiate between investment risk and investment choice. Members bear the investment risk that at retirement the accumulated value of their funds will be either less than expected or insufficient to meet their requirements. There is no obligation by the employer to compensate members for poor performance of their chosen funds. This, arguably, can be taken as a reason for a more conservative investment approach to DC schemes by both trustees and members.
More often than not, the choice as to where members can invest their contributions is taken by trustees of the scheme (at least as far as occupational money purchase schemes are concerned). Evidence from surveys of DC schemes point to the fact that a number of employers offer their members little choice of funds in which to invest. Even for those schemes that offer a range of options, there often is an unwillingness of many members to make investment decisions. This is evidenced through the fact that the majority of members of a DC scheme usually take up a default option, if available, rather than select their own line-up of funds. The increasing predominance of lifestyle options as default strategy, where plain-vanilla equity/bond strategies usually prevail, points to a limited take-up for less traditional asset classes such as private equity if offered as DC options.
One of the key features of DB schemes that is lacking in DC schemes is risk-pooling between members. All else being equal, this, together with the lack of sponsor guarantee to benefits, as alluded to above, could arguably lead DC schemes trustees and members to follow a less-risky investment strategy than their DB counterparts.
One of the advantages of DC arrangements is the relative ease in transferring one’s own fund between employers. This implies that DC schemes most often invest in asset classes with transparent and clearly determinable market prices and relative liquidity. It is known to all in the private equity industry that valuation is at best conservative and at worse misleading, whereas liquidity is limited. This is compounded by the fact that the predominant vehicle for private equity investment is the limited partnership, a vehicle presenting a host of other problems.
A strong feature of DC arrangements is the need for education of members as to the characteristics of the choices and their implications in terms of risk and return. There are currently, through initiatives by the NAPF, the BVCA, private equity managers and various investment consultants, various conferences on educating pension fund trustees on the characteristics of private equity. The fruits of these initiatives could potentially lead to an increase in the adoption of private equity within a scheme’s overall strategy. For DC schemes, this should translate into an increase in the number of schemes offering private equity as an investment choice. Until the education process bears its fruits, the balance when deciding on the choice of funds for a DC scheme will be tilted towards the protection of the financially unsophisticated members. In addition, until this whole education process trickles down to the wider public in general rather than being limited to pension fund trustees, it is unlikely that the take-up will be high. Also unlikely is members being able to make truly informed investment decisions on the basis of little or no understanding of the asset class.
With the secular trend towards DC provision, it will be important for the private equity industry to develop appropriate vehicles for DC members to invest in private equity. Although the education process is under way, it will inevitably take some time to reach a wider audience. This gives time for private equity players to develop more innovative structures to tap into the DC market more efficiently than the currently predominant limited partnership vehicle.
A quoted fund of funds structure is the immediate candidate. Liquidity of these shares will be a problem but already there have been a number of such funds launched with innovative structures in place to address some of the peculiarities of private equity investment. Indeed such subtleties as partly paid shares, appointment of market makers and re-purchasing facilities for shares help reduce liquidity issues, albeit in a rather limited way.
The retail market offers an untapped source of liquidity. Current regulatory restrictions on advertising to private individuals however presents a stumbling block. Nevertheless it is encouraging to see a burgeoning venture and development capital investment trust market. This goes to show how government tax incentives can bring more focus to the asset class.
Private equity within the DC market faces tough challenges at the moment but the future offers many opportunities. It is in their interest of all parties to face up to these challenges.
Brian Lim is an investment consultant at Watson Wyatt in the UK