Defined benefit pension plans, which have long accounted for a significant majority of schemes in the UK, Canada and many other large markets, have been a great source of capital for private equity firms.
As a population ages, the way retirement is funded has had to change. According to Global Pensions Assets Study 2016 by advisory firm Willis Towers Watson, defined contribution plans now account for more than half of all pension assets globally, having grown at more than twice the pace of their defined benefit counterparts.
Private equity funds want to take advantage of this growing pool of capital. Equally, DC pension holders and their sponsors could do with the boost that alternatives bring. According to a 2017 report by investment firm Partners Group, the growth of assets in DC plans lags DB by 0.6 percent to 1.4 percent per year. The firm suggests that contrasting allocations to alternatives – an average of 2 percent for DC versus 17 percent DB – is a significant reason.
Not worth the wait
The characteristics of DC schemes make them much less able to invest in private equity than their DB counterparts. Unlike DB schemes, where members’ pension pots are shielded from economic forces, investors in DC schemes are at the mercy of the market. They value the ability to dynamically rebalance their portfolios and are less keen to have money locked away for years at a time. In tandem with the desire for liquidity, defined contribution members expect to be able to see what their holdings are worth on a daily basis, not quarterly or half-yearly.
The other sticking point is fees. The US and Australia have strict fee transparency rules. In the UK there is a regulatory charge cap of 0.75 percent on the fees and expenses that a DC pensioner can shoulder. Many tried and trusted fee structures, such as double-layered fund of funds fees, invariably exceed this limit, creating the need for more creative, low-cost alternatives.
The challenges for private equity firms wanting to access the DC market are plenty.
“For the DC market private equity funds need to be able to provide a unitised fund that almost feels like a mutual fund, where you have subscriptions, redemptions, a daily price, liquidity and where you can be fully invested from day one,” one general partner told Private Equity International.
A number of ways to overcome such challenges have emerged. Loosely speaking, the liquidity issue has been dealt with by including an allocation to assets such as cash, syndicated loans, and listed PE and infrastructure. These vehicles are gated and those gates actively employed to control the flow of liquidity.
“You can’t let more than a certain percentage of people out or they will use up all the liquid content and whoever wants to redeem next year is stuck,” says one GP with a DC offering. “There is a duty to enact those gates whenever they are triggered.”
In terms of constructing the illiquid part of the portfolio, firms such as Partners Group, one of the earliest adopters of DC private equity products, take hundreds of small direct positions. This creates fund of funds-like diversification but without the double layer of fees that can get a firm in trouble with the regulator.
As an example, its most recent offering for the UK market, the Generations Fund, launched in 2016, gives DC pension holders exposure to private equity, private debt, private infrastructure and private real estate through a liquid structure with daily price reporting. The aim is to combine returns-generating private investments with a yield-generating credit portfolio, with liquidity coming from exposure to listed private assets.
Its underlying portfolio includes a significant allocation to return-seeking private markets asset classes, complimented by an allocation to a yield-seeking credit portfolio. Liquidity is facilitated via an allocation to diversified listed private markets. The fund is designed to be included as a performance driver within a professionally-managed DC plan, for example as part of a corporate pension scheme’s default fund in the growth accumulation phase.
The question of daily pricing has been tackled in various ways. One firm starts by altering the valuations of its holdings in line with an index of comparable public companies. CFOs typically publish their company valuations at the end of the month or the quarter. If an unusual event happens before publication, whether good or bad, the GP in question will simply call the company and ask them how the event is likely to affect their end-of-month valuation. It will then alter the next day’s valuation accordingly.
“There’s always going to be minor differences [between their valuation and the CFO’s at quarter-end], but that’s not a big issue,” says a GP active in the DC market. “A lot of liquid investments, like emerging market bonds, are largely based on estimates.”
Most firms have a cap on performance- and management fees in order to keep them within regulatory limits. Pantheon, for example, uses performance-based pricing. A performance fee is only accrued when the private part of the portfolio beats the S&P 500 and it is paid out over eight quarters, so fees can be clawed back if the fund’s performance goes south.
Other firms have fixed caps on their performance and management fees. This can be frustrating, the GP having to forego fees even if the fund performs extremely well. But it gives pension scheme managers a fixed number they can use in their cost calculation models.
DC private equity products have some downsides compared with traditional private equity. The liquid portion has a dillutive effect, which acts as a drag on returns. According to another GP active in the DC market, annual returns of 15 percent to 20 percent are unlikely, with low double digits a more realistic expectation. But with DC schemes in desperate need of a boost, those sorts of numbers are not to be sniffed at.