How the UK’s largest workplace pension is getting into PE

The National Employment Savings Trust (NEST), the UK’s £17.2 billion ($24.4 billion; €20 billion) workplace pension scheme, is readying its foray into private equity, roughly two years after first allocating to private credit.

NEST has earmarked up to 5 percent of its total assets under management for private equity at the beginning of next year, head of private markets Stephen O’Neill told Private Equity International.

“That would be a commitment of about £1 billion or more, which is a lot of money to force on any one manager to deploy on co-investments, so we might need to split it up,” he added.

O’Neill noted that trying to put £1 billion in the ground is “not going to happen overnight” and the move will largely depend on the fees that PE managers charge. NEST intends to take stock of its position after 24 months and see if it “can afford more or, if it has already used up all of its dry powder”, he said.

“The target allocation will depend on how much fees cost ultimately. Our appetite for the risk return features of private equity probably exceed what our budget can reasonably allow us to allocate to it. That’s true in infrastructure equity and private credit as well. So, the cheaper it is, the more we can allocate.”

O’Neill noted that the target of 5 percent is 5 percent of a sum that’s always growing. NEST takes in nearly £5 billion of new assets every year, meaning the pension is set to make additional top-ups to the commitment of about £250 million every year.

“We’re ambitious and we have a lot of money to allocate, and we’re also open to innovation. Those three things in combination mean that we weren’t going to take no for an answer,” O’Neill said.

Established in 2010, NEST is the largest defined contribution pension in the UK by number of members. Its AUM is expected to grow to £100 billion by the end of the decade, as PEI reported in January.

Prior to this move, NEST’s private markets team conducted “a huge amount” of market engagement and market warming, speaking to dozens of managers over the past 18 months, O’Neill noted. Some were less encouraged around the DC pension’s limitations on fees, while “a good quorum” was amenable to changing the fee model, he added.

Private equity’s high fees have been a major concern for some DC pensions. In an interview with the Financial Times in April, Mark Fawcett, NEST’s chief investment officer, said the fund “won’t pay two-and-20”. He added that the level of fees charged by most private market funds will remain “too high for many DC pension schemes to access”.

Getting into private markets

NEST began allocating capital to private markets in 2019 starting with private credit, “probably the easiest private market asset class to access for DC pensions”, noted O’Neill, because “it tends to be a lot cheaper than others, and while it’s illiquid, the loans tend to be shorter duration”.

Private credit made up 3.5 percent of its portfolio, according to its first quarter 2021 investment report. It has backed funds including BlackRock GBP Infrastructure Debt Fund and BNP Diversified Private Credit Fund, according to the report. It began investing in infrastructure equity this year, accounting for less than 1 percent of its assets. It has deployed capital across three mandates including most recently in Octopus Renewables Infrastructure.

“In terms of a big class of private markets, private equity is probably the hardest and the next one on the menu. And it’s the hardest in the sense that it’s the most expensive.”

“The competitive pressures and forces within the private equity industry are not quite the same as in infrastructure and credit. There’s much less downward pressure on margins because there’s so much capital and so many funds are many times oversubscribed.”

Backing ‘high-quality’ assets

The idea, according to O’Neill, is to provide capital to “platforms with a large amount of high-quality co-investment dealflow that they don’t otherwise get to transact on, either because they don’t have dry powder or because their existing clients don’t quite have the risk tolerance or the governance structures in place to transact as and when the deals go through”.

“We would say: ‘If we give you a discretionary mandate to build a portfolio of core investments for us, then you’ll have that capital to stand behind those deals. We won’t interfere in the due diligence process. We’ll just let you draw down committed capital’.”

NEST will pay managers a reasonable fee for the service which is “not remotely near the two-and-20 that one would have to pay for a commitment to a traditional blind pool fund”, he added. He declined to provide additional details on the fee model.

NEST is planning a formal procurement process by the end of August and could select one or a few managers, O’Neill said. “The precise timeline’s yet to be confirmed, but we are quite eager to strike while the iron is hot and get a manager or managers in place by the end of the year or early in the new year.”

The most likely outcome according to O’Neill is that one or more managers will set up co-investment vehicles for NEST. He noted that the pension does not want to participate in closed-end funds and would prefer to invest in the asset class via vehicles that are “a bit more bespoke structurally as well as commercially”.

Capital will be deployed via an evergreen limited partnership structure, and NEST is “fairly flexible about the legal form of the entity as long as it’s tax efficient and evergreen”.

One key requirement is that NEST wants to have “a line of sight and a certain amount of control on how income and capital gains are either re-invested or distributed”, O’Neill said.

“We don’t want our managers to fire sell assets, but we do want to have a plan for being able to redeem money at some point in the future, because it can’t be in a permanent lock up.”

What is NEST looking for?

The pension is eyeing growth equity focused GPs.

Growth managers, noted O’Neill, have the best balance of risk and reward as well as the most productive effect in terms of job creation.

“Because we’ve got a lot of money to deploy, we’ll also be prepared to have a more balanced strategy with small- and mid-cap buyouts. We could also have a very limited amount of large-cap, but we don’t want that to be a major element of the strategy.”

Managers need to have global exposure, and NEST will eventually consider backing GPs that may have a narrower geographic focus provided they “demonstrate that they’ve got a really strong calibre” in their focus markets, he added.

What’s more, NEST expects “best-in-class ESG integration throughout the strategy and full alignment with its climate risk mitigation goals”, that aim to halve its portfolio emissions by 2030.