European Funds Comment: What is Preventing UK Defined Contribution Pension Funds From Investing in Private Equity?

18 October 2019
Issue 96

Large, sophisticated investors with long-term liabilities tend to have an allocation to private equity and venture capital.  It is not hard to understand why:  academics and investment consultants generally agree that investments in private equity and venture capital funds have consistently outperformed investments in the public markets.  Pension funds are among the most obvious candidates to invest in this asset class, given their targeted returns and liquidity requirements, and it is not surprising that last year pension funds accounted for more than 30% of all capital raised by European fund managers (according to figures published by Invest Europe in May).  

However, the UK pension fund industry is changing rapidly and dramatically and that has created a problem that needs to be fixed.  Companies are closing their “defined benefit” schemes, where employees and employers contribute to a fund that promises to deliver a pension pegged to the employee’s final salary.  Instead they are contributing to (and often are required by law to contribute to) “defined contribution” (or DC) schemes.  There are significant tax breaks for these workplace pensions, but the employer has no further obligation to the retiree.  But, for a variety of reasons, these DC schemes do not usually have an allocation to private equity and venture capital, and savers are therefore missing out on the returns available to other pension funds.

Aware of this problem, the British Business Bank (BBB) – a government-owned economic development institution – recently chaired a government funded “feasibility study”, the stated aim of which was to “create better outcomes for people saving for retirement”.  The BBB published a report detailing its findings last month – and set out policy prescriptions that should be seriously considered by the industry and by government.  If taken forward they could help to open up DC schemes to venture capital and private equity funds. 

The BBB report confirms the outperformance – after fees and expenses have been taken into account – of venture capital and growth equity funds.  It claims that a 22-year-old starting a workplace pension could boost their retirement pot by up to 12% on retirement by having a 5% allocation to the high-growth, innovative businesses backed by such funds. 

But there are both attitudinal and regulatory hurdles for those young savers.  Perhaps the most well-known is the “charge cap” for so-called “auto-enrolment” schemes.

Regulators have, rightly, sought to protect pension fund beneficiaries from “excessive fees”.  They impose a cap of 75bps for administration and investment costs across the entire portfolio for the default funds that are offered to savers.  The problem, of course, is that some investment strategies are more expensive than others.  The active ownership approach that private equity adopts costs more and commands higher fees. 

However, the BBB report suggests that the charge cap need not be an absolute hurdle: it says that a fund allocating 5% to these higher cost strategies “would not be expected to breach the charge cap under normal circumstances”.  Ironically, though, because of the alignment inherent in the “carried interest” model, the more that an investment in a venture fund contributes to a pensioner’s returns, the less attractive it is to a trustee trying to control the fund’s overall costs.  For example, if the lower cost part of the portfolio achieves net returns of around 8% p.a., as would be expected, and the venture capital allocation achieves top quartile (rather than average) performance levels, that could cause the charge cap to be breached.  Similarly, a market crash affecting “other” investments more significantly than the illiquid portion could also lead to a breach.  While savers should be focused on net returns and diversification, the structure of the charge cap can give rise to perverse incentives.

The BBB report suggests that tweaks to the way charges are calculated could mitigate that problem, which certainly feels like an issue that ought to be soluble.  They argue that, for example, carried interest could be calculated on a rolling average basis, rather than accounted for when paid.  The relevant government department, the Department for Work and Pensions, is already consulting on the way that the performance fee is assessed for charge cap purposes, so there is hope of progress there. 

The BBB report is wide-ranging and there are clearly other barriers to investment in the asset class that need to be addressed.  Among the other recommendations are innovation in fee structures by the industry, the establishment of a pre-seeded pooled investment vehicle to aid diversification and asset selection, and more reliable data on UK returns. 

Moreover, the report highlights another important attraction of private equity and venture capital funds.  As pension fund trustees – to some extent driven by regulation and the demands of their beneficiaries – increasingly focus on socially responsible investment strategies, venture capital funds will be a more attractive proposition.  Investors (LPs) can, and do, help to shape the “environmental, social and governance” (ESG) policies of their investee funds, and hold managers to account for the impact they achieve in their underlying portfolios.  In turn, venture and private equity fund managers (GPs) take significant stakes, board seats and an active approach to investment.  They have the incentives and expertise to use their influence to ensure that underlying portfolio companies take proper account of ESG risks and opportunities.  That investment approach will become increasingly popular in the years ahead.

The BBB’s report was generally welcomed by the industry.  The BVCA says that it supports the central objective of “addressing the barriers holding back DC pension savers from investing in our asset class” and welcomes “initiatives that will help to demystify what it means to invest in the asset class and enhance the understanding of the returns and costs entailed.”