A 10 per cent allocation to private markets could increase the fees of a typical default fund by 19 bps but boost annualised net returns by 67 bps, a study by Neuberger Berman finds.
The Neuberger Berman analysis modelled two hypothetical DC portfolios, one with only traditional equities, and another with an allocation to private equity, starting at 10 per cent at the outset and declining to zero at retirement, after 40 years.
The private equity version delivered both a higher return and also, in a Monte Carlo simulation, an improved range of returns. Over a 40-year saving journey the increased performance would deliver a retirement income 14.3 per cent higher, the report concludes.
The study’s return and risk assumptions are based on forward-looking estimates of index results, with fees in line with industry averages. The study assumes the use of a predominantly co-investment strategy.
The report argues that among the major sectors of private equity primaries, secondaries, and co-investments, co-investments are an appropriate fit for UK DC schemes, because of their fee-efficient and capital-efficient characteristics. It argues that while investing in primary funds can help to build a well-diversified portfolio over time, they typically incur significant fees at the LP level and can take considerable time to fully invest the committed capital. Investing via secondaries can speed up the capital deployment, but the fees are similarly high.
Oliver Little, head of UK DC strategy at Neuberger Berman says: “In both cases, the LP has little control over what goes into the portfolios. In comparison, we believe co-investments, which are direct investments into private companies made alongside a private equity manager rather than through a fund, offer significant benefits for DC schemes.
“Co-investing enables managers to be more actively involved in the investment selection and due diligence processes and have greater control of the investment decision, allowing them to start and stop investing depending on the environment. Co-investment capital is also highly valued by private equity firms and is therefore typically offered with lower management and performance fees than a traditional fund, and sometimes with no fee at all. Though all these advantages make co-investing resource-intensive compared to a primary or secondary approach, having control over investment selection enables managers to better align portfolios with scheme objectives, by targeting specific sectors or regions, for example, or balancing between growth equity and buyouts; and lower fees result in higher net returns, all else being equal.”
Tully Cheng, head of EMEA institutional solutions and insurance analytics at Neuberger Berman says: “Some master trusts seem to be going with a lower cost provider and finding perhaps the deal flow isn’t happening quicky enough, so there can be a question around the quality of the deal flow. Or [a provider] might opt for a single name private equity manager. The challenge there is that you are only getting their deals. We have 440 LP advisory committee (LPAC) seats. This means we can build a strong flow of co-invest deals in a fee-efficient way.”