Relentlessly Reluctant

When the UK's Myners Report came out back in 2001, encouraging pension funds to consider a fuller range of investments, many GPs hoped Europe's pension fund industry would move allocations en masse into private equity

Such hopes have not been entirely without substance. More corporate and public pension funds – especially larger schemes and those based in the UK – have entered the asset class in the last few years. Some schemes, such as ATP in Denmark and the British Airways and Coal Pension Fund schemes in the UK, are now very substantial investors. In addition, pension funds outstripped banks as the main source of European private equity capital in 2005 for the first time since 2001, providing 24.8 percent of new funds raised compared to 17.6 percent provided by banks, according to EVCA data, compiled by Thomson Financial and PricewaterhouseCoopers (see table 1, p. 71).

“A lot more pension funds have entered the market in the last three years – especially smaller schemes and public plans such as local authorities. UK and Dutch schemes are leading the way though – it is still early days for many European plans,” says Andrew Lebus, managing partner at London-based private equity fund manager Pantheon Ventures.

Funds of funds have always enjoyed heavy contributions from pension schemes as they offer broad exposure for relatively small minimum commitments and alleviate single manager risk. Even so, they have seen a marked rise in commitments. Most schemes – particularly the smaller ones – are currently entering the market this way. “Funds of funds are having a great time raising money from pension funds at the moment. Private equity is a huge job to manage and most schemes looking to enter the asset class are going that route,” says Sharon Jebb, partner at London-based buyout firm Duke Street Capital.

However, GPs other than funds of funds have also seen a significant rise in pension fund investment. “European pension funds account for 19 percent of our latest fund and the amount they invested is 37 percent more than in our 2002 fund,” says Tom Lamb, co-head of Barclays Private Equity.

Yet although the number of schemes investing in private equity has risen, a great many still invest nothing in the asset class, sticking almost exclusively to public shares and bonds instead.

Many market professionals have been disappointed at the rate at which pension funds have entered private equity in Europe to date. “After the Myners Report, we thought there would be tons of pension fund money coming into private equity. But although interest is definitely increasing, a great many schemes are still not investing at all,” reflects Duke Street's Jebb.

According to Mercer Investment Consulting, although 19.4 percent of European pension funds worth over £500 million invest in private equity, the overall average is just 5.5 percent of European pension funds, including 5.9 percent of UK funds and 4.3 percent of Continental European and Irish funds (see chart 1, p. 72).

Not only are most European schemes investing nothing at all, but those that do invest usually only allocate a tiny amount to private equity. Although a few schemes invest substantial sums – ATP, for example, allocates up to 10 percent of its portfolio to private equity – most plans only allocate 2 to 3 percent (see chart 2, p.72). In the US, by comparison, many schemes invest between 7 to 10 percent of their portfolios in private equity.

This seeming reluctance to invest comes despite the superior returns that the best GPs and funds of funds can offer, with the top quartile widely acknowledged to outperform public markets by some distance. “We have found that from 1980 to 1995, average private equity returns are the same as in the public markets. But the top quartile firms' returns are substantially higher and they are more likely to repeat their success than the public markets,” says Bjarne Graven Larsen, chairman of ATP Private Equity Partners, the private equity arm of ATP.

With so many pension schemes struggling with vast deficits and in urgent need of higher yielding investments, the apparent unwillingness to invest is somewhat mystifying for many private equity professionals.

TABLE 1: PENSIONS OVERTAKE BANKSThe table shows that private equity has become more attractive for pension funds to approximately the same degree that it has become less attractive for banks. Between 2004 and 2005, pension funds increased their share of private equity funding in Europe from 19.3 percent of the total to 24.8 percent. Over the same period, the share accounted for by banks fell from 21.7 percent to 17.6 percent.

Funds Raised 2001 2002 2003 2004 2005 Total
in x 1,000 Amount Amount Amount Amount Amount 2001-2005
private equity raised by type of investor
Corporate Investors 2,209,361 1,896,480 1,204,650 1,645,983 3,443,715 10,400,189
Private Individuals 2,506,270 1,571,277 804,174 1,778,467 4,055,446 10,715,634
Government Agencies 2,281,976 2,893,517 1,727,465 1,442,338 6,694,020 15,039,316
Banks 9,189,290 6,844,903 5,435,518 5,090,882 11,890,449 38,451,042
Pension Funds 10,230,796 4,252,567 4,922,155 4,534,191 16,816,652 40,756,361
Insurance Companies 4,700,316 3,588,358 2,214,314 2,812,114 7,534,702 20,849,804
Fund of Funds 4,645,037 3,412,783 4,153,695 3,163,840 8,854,157 24,229,512
Academic Institutions 823,484 428,325 384,843 345,866 1,720,273 3,702,791
Capital Markets 198,244 38,086 85,209 506,324 842,991 1,670,854
Others/Not Available 1,425,084 1,109,611 4,378,672 2,165,811 5,851,051 14,930,229
Subtotal New Funds Raised 38,209,858 26,035,908 25,310,697 23,485,817 67,703,456 180,745,736
Realised Capital Gains 1,802,115 1,496,618 1,709,059 3,965,398 4,067,389 13,040,579
Total Funds Raised 40,011,974 27,532,526 27,019,756 27,451,215 71,770,845 193,786,316
private equity raised by type of investor % % % % % %
Corporate Investors 5.8 7.3 4.8 7.0 5.1 5.8
Private Individuals 6.6 6.0 3.2 7.6 6.0 5.9
Government Agencies 6.0 11.1 6.8 6.1 9.9 8.3
Banks 24.0 26.3 21.5 21.7 17.6 21.3
Pension Funds 26.8 16.3 19.4 19.3 24.8 22.5
Insurance Companies 12.3 13.8 8.7 12.0 11.1 11.5
Fund of Funds 12.2 13.1 16.4 13.5 13.1 13.4
Academic Institutions 2.2 1.6 1.5 1.5 2.5 2.0
Capital Markets 0.5 0.1 0.3 2.2 1.3 0.9
Others/Not Available 3.7 4.3 17.3 9.2 8.6 8.3
Subtotal New Funds Raised 100.0 100.0 100.0 100.0 100.0 100.0

Even when a pension fund has decided to invest, there are further difficulties. These include structural impediments, such as the length of time it takes to build up a quality private equity portfolio to the desired allocation limit. Building a big stake rapidly increases risk, so schemes need to invest gradually across different funds and vintages. “It takes five to nine years to build up a portfolio of private equity assets,” says Sanjay Mistry, head of European Private Equity Research, Mercer Investment Consulting.

It also takes GPs years to invest committed funds, as they only draw down when they need to. As private equity does not automatically re-invest, GPs will also be returning money to schemes from exits at the same time. This keeps the amount committed by pension funds lower than many would like. As a result, even the most enthusiastic schemes often have only a fraction of their committed allocation actually invested. “Although we decided four years ago to invest up to 10 percent of our portfolio in private equity and have already committed 5 percent, at present we only have around 2 percent actually invested,” says ATP's Graven Larsen.

Another problem is difficulty in accessing the best performers, due to intense competition from other investors. Indeed, many market experts say the issue is not so much that pension funds do not want to invest in private equity today, but simply that they cannot gain entry into their funds of choice. As the range of returns is so broad, it is critical to get into the right fund and, with many schemes aiming only for the top quartile, access has become a critical constraint.

Given the various obstacles, some professionals do not expect any further increase in investment from pension funds in the foreseeable future. “I see most pension funds moving further into bonds than into private equity. It takes a huge effort to get into a new asset class and many schemes are overburdened with new regulations now, such as solvency and accounting rules. Many trustees do not have time to learn new tricks,” says Trevor Cook, executive director of the European Pension Fund Investment Forum.

Yet other market experts say pension fund investment will keep rising. “I think the number of schemes investing will rise and also the average allocation will increase from 2 percent today to 4 to 5 percent in the next five years,” says Mistry.

This belief is driven principally by the industry's urgent need to diversify to achieve the returns required to cover their deficits. Pension funds are acutely aware of the need to implement strategies that will produce these returns and recognise that they will be hard to achieve through conventional equities.

Also, the fact that some major fund managers, such as Hermes, plus several key investment consultants, such as Watson Wyatt, have thrown their weight behind alternative investments will have a big impact going forward. Several influential gatekeepers are now advising schemes to take substantial sums of cash out of public equities to put into other asset classes, including private equity.

Investment will be further boosted by the fact that it is much easier now for small and mid-sized schemes to invest. The minimum investment in many funds of funds is under €1 million now, while shares in Pantheon's PIP cost just £7.60 apiece in early June. This has opened up the asset class to far more pension funds.

Professionals also point out that trustees are learning that many of the perceived barriers no longer apply. For example, concerns about liquidity can be mitigated by investing through listed investment trusts. Meanwhile, the significant growth of the secondaries market in the last five years is a huge boost to liquidity. LPs can now easily trade out of their positions.

For some specialists, the longer-term nature of private equity is actually a bonus. “Pension funds have to deliver long-term returns, not short-term ones. As a long-term investment, private equity is a well suited component of a pension fund's portfolio,” says the BVCA's Linthwaite. Equally, some schemes positively welcome lower liquidity if returns are right. “We like illiquid assets if they can give us a premium. We have enough liquidity for our requirements from the public assets in our portfolio,” says ATP's Graven Larsen.

Meanwhile, fears about falling returns can be countered by building up positions slowly and spreading risk through different vintages. Perception of risk can also be flawed, as in reality private equity can actually reduce portfolio risk. Although private equity tracks the public markets, it is a steadier asset class. Pension fund deficits can widen steeply after a stock market fall, while exposure to private equity can import less volatility. The recent equities correction and subsequent widening in deficits has brought this point home to many schemes.

Yet the level of pension fund investment will also depend greatly on GPs' ability to adapt strategically following the industry's move from defined benefit (final salary) to defined contribution schemes.

Defined contribution schemes require far greater liquidity from their underlying assets, as they are transferred from employer to employer. KKR and Apollo have already recognised the need to address this and the requirements of other private investors, with their respective May and June listings of publicly traded funds on Euronext. Other GPs, including TPG, Blackstone and Carlyle, are tipped to follow suit, while more listed fund of funds vehicles, such as Pantheon's PIP, are expected to emerge.

With deficits providing such a strong incentive, the consensus is that pension funds' investment in private equity will continue to rise gradually over the next five to 10 years. Give the various obstacles, however, this rise could be less rapid than that in some other alternative investments.

While no-one expects a sudden influx, there have been some very encouraging developments recently. In the last two months, several major schemes have indicated a significant push into private equity. Hermes, which manages BT's mammoth pension fund (the UK's largest), and USS, the UK's second biggest pension fund, are both rumoured to be planning movements of large sums from the stock market into alternative investments. In France, the FRR pension reserve scheme is looking to hire fund of funds managers for a debut €1.5 billion private equity programme, while the Irish National Pension Reserve Fund has announced plans to invest €1 billion by 2009.

Significantly, schemes that have already made the mental and physical leap into private equity are extremely bullish about their industry's eventual investment level. “Ten years from now, European pension funds will be investing as much in private equity as their US counterparts,” says ATP's Graven Larsen. If such a milestone is indeed reached, it will be a seminal moment: both in terms of the maturation of European private equity and the attitude of the region's pension funds toward the asset class.