The launch of the UK’s long-term asset fund last year signalled one of the biggest moves yet in the government’s efforts to tempt defined contribution pension schemes into private assets, but more still needs to be done if a wall of DC capital is to start flowing into private equity.

Through the launch of the LTAF, the Financial Conduct Authority sought to create a new authorised open-end fund structure that can be invested in private markets and marketed to both DC schemes and high-net-worth investors. Both have traditionally been unwilling or unable to invest in private funds due to their long-term illiquid nature, and the LTAF allows investors to regularly redeem at a price reflecting the value of the assets held by the fund.

While the LTAF is a welcome step forward, there are still hurdles that prevent DC schemes from committing their substantial capital to private markets. Assets managed by UK DC schemes are forecast to grow to more than £1 trillion ($1.4 trillion; €1.2 trillion) in assets by 2030 as a result of automatic enrolment, from £340 billion in assets in 2015, according to the FCA.

But as well as struggling with the illiquidity challenge, most have been put off by the fees charged by private equity funds. Schemes are subject to a 0.75 percent cap on charges on assets under management and administration, and the performance fees charged by private funds have been seen as a stumbling block.

Will Normand, a partner at law firm Travers Smith, says: “There is nothing to stop DC schemes investing in funds that incur carry, but there is a general concern over paying performance fees or carry out of people’s retirement pots. There is now a consultation going on, led by the Department of Work and Pensions, to amend the charge cap, with talk about excluding ‘well-designed performance fees’, albeit the initial response to consultations does not set out a clear path forward. Notwithstanding this, the reality is there is a mindset shift needed before those working in DC schemes will get comfortable with private equity’s fees.”

A DWP survey found that two-thirds of UK DC schemes do not currently invest in illiquid assets, and the remaining third invest between 1.5 percent and 7 percent, mainly in property.

Can’t pay, won’t pay

The National Employment Savings Trust, which manages £20 billion in AUM on behalf of 10 million members, said in August that it is set to invest about £1.5 billion, or 5 percent of its assets, in growth and mid-market private equity by the end of 2024. But in an interview with the Financial Times last April, Nest’s chief investment officer Mark Fawcett said the fund “won’t pay two and 20” and argued that the level of fees charged by most private market funds will remain “too high for many DC pension schemes to access”.

“A potential barrier to the success of the long-term asset fund at the moment is where we end up on the
charge cap”
Emily Harmsworth
Linklaters

Emily Harmsworth, counsel in the investment funds practice at Linklaters, says: “There is an argument that the charge cap almost forces trustees to focus narrowly on cost rather than more broadly on value creation. If you are looking at private equity or similar asset classes, is it okay to pay a higher fee because your overall return is higher? And if you don’t invest, are you arguably limiting the returns that you can achieve for the scheme?

“A potential barrier to the success of the LTAF at the moment is where we end up on the charge cap, but that is being discussed and everyone is alive to that issue. The focus of government certainly seems to be on encouraging investment in productive finance assets and carefully removing remaining hurdles.”

Another impediment lies in the redemption terms set out in the LTAF rules, which say redemption cannot happen more frequently than ­monthly and that there will need to be a notice period for redemptions of at least 90 days. “That caught people a bit by surprise and is quite strict,” says Gavin Haran, head of policy for asset management at Macfarlanes. “It does create an additional hurdle for the platforms and pension administrators that DC schemes typically invest through, because their systems are set up for daily redemption and they will have to make quite significant changes to accommodate a 90-day notice period.”

A change of mindset

Perhaps the biggest barrier to private equity unlocking DC capital is cultural. “It is certainly the case that DC scheme trustees have a bit of an aversion to private equity and private assets, because they sense that they are quite risky, the fees are quite high, they don’t know whether the returns are going to match the costs, and they are just unfamiliar,” says Haran. “There is a bit of a cultural shift that needs to take place.”

With Nest having said publicly that it is preparing to do more in private equity, it is likely that others may follow suit. But while the LTAF is a big step forward, we should not expect a sea change.

Partners Group manages the Generations Fund, which is an open-end, commingled vehicle that provides institutional UK DC pension investors with exposure to private equity, private debt, private infrastructure and private real estate investments. Joanna Asfour, global head of consultant relations at Partners Group, says: “The LTAF will provide managers with more flexibility to allocate to private markets, but it will still take time to see meaningful flows of DC institutional investors. We have been really encouraged by the pace of change over the last nine months – all the right people are around the table in a very structured way looking to move this forward at pace.

“There are plenty of DC schemes that are thought leaders on this and feel it is their fiduciary duty to make these investment opportunities available to deliver better member outcomes. But there are also a big number in the market who will take more time to get comfortable with the asset classes and their risk/return characteristics.”

In the meantime, private equity funds will continue to look forward to tapping into a new investor base as it opens up. Normand says: “We haven’t seen any LTAFs launched yet and I suspect the first ones won’t be pure play private equity but rather funds of funds with liquid pools and other elements in them. We might then see some more specific LTAFs as time goes on. Lots of private equity firms are paying close attention to these developments because that DC pot of money is a big prize.”