Charlotte Moore reports on the rise of an increasingly popular set of asset classes.
Private markets have become a popular option for pension funds, as the risk-return profile and time horizons of these assets provide a good fit for many schemes’ investment goals.
This broad universe typically encompasses property, private debt and equity as well as infrastructure. It can also include more esoteric investments such as insurance-linked securities, aircraft leasing, regulatory capital relief and healthcare royalties.
The appeal of these assets is they are long-term investments which match the life cycle of pension schemes, says Alyshia Harrington-Clark, policy lead for DC at the Pensions and Lifetime Savings Association.
“Both DB and DC schemes can take advantage of the illiquidity premium of these assets,” she adds.
In addition, these asset classes typically involve direct investment in buildings, green energy and individual businesses – which can help pension schemes to use their investments to make positive impact on society, says Harrington-Clark.
Jeffrey Malluck, senior investment consultant at Aon, says: “Private markets are a good way for schemes to diversify their portfolios as they have lower correlation to public markets.”
Returns are also often better than more traditional asset classes. Katie Sims, senior investment consultant at Willis Towers Watson, says: “Typical annual premiums are around 1% to 3% higher than public market equivalents.”
Appetite for both individual asset classes and the type of capital funding structure varies, however, depending on the particular characteristics of a scheme. Closed DB schemes have been at the forefront of the use of private market assets.
Dan Mikulskis, partner at LCP, says: “These schemes have been allocating to these assets since 2015, with private debt and direct infrastructure the most popular.” There have also been smaller investments made into direct property.
The popularity of private debt has been driven both by supply and demand dynamics. In the aftermath of the global financial crisis banks started lending less so businesses needed another source of funding, such as pension schemes.
As returns on more traditional assets fell, private debt offered a better risk-return profile for schemes which were both closed and maturing. Mikulskis says: “Fees for these products have also fallen in recent years to become more aligned with institutional investor expectations.”
There has been a similar trend in infrastructure investments, with fees falling and the structure of these investment vehicles also changing to be a closer match with the requirements of pension schemes, adds Mikulskis.
Not only do these asset classes offer a good risk-return profile for pension schemes at a reasonable fee level, but they can also offer an income profile which matches liability payments.
Malluck says: “These strategies can provide inflation-linked returns, which is a good match to the benefits a scheme has to pay.”
Private markets can also be helpful for more mature schemes which need to find cash to meet liability payments, says Sims. “Private debt and secure income assets, such as real estate and infrastructure, can offer pretty stable and attractive yields,” she adds.
While the characteristics of private market assets will be a good match for a pension scheme, deciding whether particular assets are the right fit will depend on its particular characteristics.
Malluck says: “The decision to invest in a private market is driven by a pension scheme determining what they want to achieve – is it buy-out or self-sufficiency? Then they need to ascertain how far they are from that goal.”
If a scheme is less than a decade from buy-out then allocating assets to certain private markets is not a viable investment option, adds Malluck.
The investment time horizon of different assets is a major factor. Mikulskis says: “Private debt typically has a seven-year investment horizon, making it a possibility for schemes targeting buy-out in a decade.”
Malluck says: “These assets tend to pay out coupons and principal back so quickly the duration is often around four years, which makes them a good fit for schemes looking to achieve buy-out within 10 years.”
Other private asset classes like private equity and infrastructure are not viable for these schemes because of their time horizons. Malluck says: “Private equity investments typically last 10 to 12 years while infrastructure can last as long as 20 years.”
The schemes with the greatest flexibility, however, are those which either have a longer time horizon or are planning to run forever. Mikulskis says: “Open schemes like the LGPS can choose from the full gamut of options.”
Case study: Border to Coast
The Border to Coast pool provides investment strategies to its 11 local authority partner funds with a total of £46 billion in assets under management. It has had private market options on its roster since pooling was finalised in 2018.
Mark Lyon, head of internal management at Border to Coast, says: “We offer private equity, infrastructure and private credit.”
Deciding which type of private market funds to launch was the result of in-depth discussions with partner funds about their existing investments.
Lyon says: “We also asked those local authorities which had not invested in these asset classes before what they would want.” Pooling made it much easier for these smaller funds to access these asset classes, he adds.
If there is demand in the future for some of the more esoteric asset classes, then Border to Coast will offer these funds, says Lyon.
Unlike closed DB funds, as the LGPS is open it is able to consider a wider option of private market assets, including those with longer investment horizons such as private equity and infrastructure.
The pool is able to offer better options than would have been available to the individual partner funds, as it has a larger internal investment team which gives it greater expertise and broader market access.
For example, the pool not only offers the large well-known institutional buy-out managers in its private equity funds, but also smaller niche UK and US venture companies. Lyon says: “Partner funds would not have the resources to assess the value of these smaller players.”
Greater scale also makes it easier for Border to Coast to negotiate better fees than would be possible for individual partner funds. Lyon says: “We are able to generate significant fee savings through committing a certain amount of assets and we are able to remove some of the additional costs.”
For example, the pool tends not to use fund of funds, which would have been the only option available to the partner funds before Border to Coast was formed. Lyon says: “This allows us to remove a layer of fees.”
In addition, the pool is now able to undertake co-investments with other institutions: this removes a further layer of fees because the pool takes a direct stake rather than investing in a fund, says Lyon.
Case study: Nest
Like an open DB scheme, master trusts have longer-term investment horizons so have fewer restraints on their choice of private market assets. The risk-return profile of these assets makes them particularly appealing to a DC master trust.
Stephen O’Neill, head of private markets and investment proposition at Nest Corporation, says: “Private market assets such as private equity and debt provide diversification from public markets, while real estate and infrastructure allow us to expand our investment universe.”
In particular, infrastructure is defensive and counter-cyclical, which helps to dampen volatility and increase resilience against negative market events, he adds.
O’Neill says: “In theory each private market asset should deliver a premium over their public market equivalent as a compensation for illiquidity, complexity and scarcity.”
Nest currently has around 6% of the portfolio in private credit and will be allocating around a further 5% to infrastructure equity later this year. There is also around 4% in real estate, taking the overall allocation to private markets to around 15%.
O’Neill says: “We have not yet apportioned the infrastructure equity over the different phases of the target date fund.” But the foundation phase has slightly more private credit than in the growth phase while the consolidation phase has virtually none.
There is – in theory at least – a mismatch between the illiquidity of these assets and the administrative systems of many DC schemes which expect a daily valuation of assets. “Private markets are infrequently valued,” says O’Neill.
But large master trusts can overcome this because the number of people trying to take money out of their pension or switch is very small compared with the mass of people who are inert.
O’Neill says: “A more significant challenge for master trusts is the constant need to deploy ongoing contributions and to constantly rebalance the portfolio, which makes it hard to incorporate assets that are infrequently valued.”
The predictability of Nest’s cash flows and the size of the scheme make it easier for the master trust to overcome these issues, because the proportion of the portfolio invested in these illiquid assets will be much smaller than more liquid assets.
O’Neill says: “DC schemes also need the governance to be able to manage these complex asset classes.” That is not an option for small DC schemes and is easier for larger master trusts, he adds.
Scale has also played a vital role in Nest’s ability to overcome the most significant hurdle – the high fees associated with many of these asset classes.
O’Neill says: “Unless you have the same scales as a master trust like Nest, it is hard to negotiate fees down to a level which is affordable under the charge cap.”
That’s achieved by offering initial mandates of hundreds of millions rising to billions over a few years in order to pique the interest of managers sufficiently to reduce their headline fee rate level sufficiently, says O’Neill.