The pensions sector is fully embracing performance fees, with no fundamental objections among panellists at a recent Corporate Adviser round table event, looking at the challenges of incorporating private markets within DC portfolios.
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That attitude was summed up by Ben Lewis, head of investment proposition for Mercer DC Solutions.
He said: “To get access to the right asset classes within the DC world, performance fees are a necessity. It’s part of the toolkit.”
Yet all panellists were clear that managing fees within a price-capped DC pensions context brings huge challenges. Sam Murphy, head of client solutions and product at Future Growth Capital, said that you can’t approach the fees issue “in any short and easy sound bite way, because every asset class is different.”
He pointed out that there are also different valuation methodologies used. “Ultimately, you need a highly experienced team, who are ideally seeing lots of transactions and who are separate to the investment team and who can make a judgement.
“You are paying fees where there’s a higher risk/return in certain asset classes at certain times, while trying to minimise the AMC being collected, and maximise outcomes, in a structure that is appropriate.”
Fee transparency
Martyn James, director of investment at Now: Pensions said it is not about whether to use performance fees or not. It is about the operational side.
“If performance is good, the fees that you will pay will be extremely high, and if that’s baked into the headline fee that you’re reporting, that’s extremely challenging for master trusts.
“The performance fees have to be transparent. They have to be reported, so everyone can see them, but not part of the headline fee. Then when they’re charged, it’s about making sure that members that get the performance are charged the fee, and whether you can accrue them in certain way to make that fair.”
The challenge was noted that some investments might not pay off before some members have left.
James said: “It’s never going to be perfect, and some members are going to benefit and some are going to be disadvantaged. But if you’re looking at something like a default, you have to look at the overall membership. Is this good for the overall membership — and the answer we’ve agreed is probably yes.” He added if there was some unfairness that trustees and scheme providers need to look at how to mitigate it.
James Monk, Fidelity’s investment director for workplace investing, also highlighted inconsistent regulation regarding performance fees.
“Performance fees sit outside the charge cap within a master trust environment, but they don’t within a contract-based environment, and they’re still working to try and align that.
“If you’re looking to provide a scale solution, you ought to really be considering the same solution across both of those structures.”
Jo Sharples, CIO for Aon’s DC solutions, added: “It feels as if we could do more around fee disclosure, because there’s all sorts of weird, wonderful fee structures cropping up to hide things or make things go away, but the costs are still there. It will come through in the net performance. It’s about how you’re disclosing.”
“The fees can be hideously complicated. I worry we’re creating a potential monster for ourselves further down the road. But if we think about what we would like to see, we might be able to get a better, kind of transparent, consistent way that actually works for us all,” she added.
Yet while acknowledging these challenges, panellists were generally optimistic about how these might work
in practice.
Ben van den Tol, director, client solutions at CBRE says: “Master trusts are in a really fortuitous space, both with your scale today and your growth trajectory, you’re able to have those institutional discussions, and to be able to say: “All right, we’re going to pay you an AMC that is low. It’s enough to break even, it’s enough to wash your face’.
“But if you reach these hurdles and you’re over and above that, that’s when the performance fee can be triggered. That same narrative can then be expressed to the members.”
Valuation challenge
Ped Phrompechrut, chief investment officer of Future Growth Capital, discussed the adjustments required for marking to market.
“From a valuation standpoint within private markets, where there’s no regular trading at all, we end up in a world where we’re marking to fundamentals and we’re marking to a widely accepted modelling approach. As a baseline, you end up with much smoother valuation outcomes compared to listed where there’s ongoing price discovery every day through trading, albeit in thin volumes.
“In terms of how assets are marked and held, each holder of the assets should adjust the value for where they have a strong view. We don’t see a problem with assets being held at different valuations by different owners. We already see it within private equity and within venture. It’s all about ownership and conveying why that mark makes sense,”
Lushan Sun, head of cross-asset research, private markets, at Legal & General added: “We have defined benefit pension schemes in a rush to do buyouts. Lots of them are selling their private markets assets in the secondary markets. Perfectly decent, high-quality assets in sectors that a long-term investor might like. But because of the liquidity issue with the buyout, they’re willing to sell these stakes at a discount. There’s a great opportunity if you have the capital to deploy.”
She added that in infrastructure, where they may be a huge queue to invest, you may be able to pick up the asset from a secondary market seller, though perhaps selling at NAV rather than NAV minus.
“If I’m happy with the price, I transact and still get a decent long-term return, but that might not be the valuation. We often think about returns in that sense, because of the valuation, but it’s also very subjective private markets.”
Nalaka de Silva, head of private markets at Aberdeen, said that price discovery doesn’t really exist. “The managers who are managing those assets have to have robust processes to be able to articulate why the mark is the mark, whether it’s a model, whether it’s transaction value or it’s an independent valuation.”
He added that the real asset valuations for private equity can cost huge amounts of money. The DC market will have to do some policy work to sort out its own processes and procedures for transferring between schemes, which require both time and investment being put in.
Pricing of LTAFs
Aegon’s head of investment strategy Niall Aitken raised the issue of LTAFs. “You need a certain degree of confidence, if you’re to say most LTAFs in the market will be monthly or quarterly valued, but they’ll be daily priced. It creates a mechanism by which you can let those members come and go. But there still remain questions about “should you?””
He noted that there are a lot of protections where there are big market movements: “Does the LTAF manager mark differently than the marks they’re receiving from underlying fund holdings? Potentially? Then you’ve got the other fair value pricing of the insured fund level, and if it’s wrapped too? There are quite a few protections there and points people can make adjustments.”
He said that insurers do have experience of direct property investment funds in multi-asset strategies.
“We’re not getting to 20 per cent allocations overnight. This is a five-year journey. There will be wobbles along the way, because every year or two, there’s at least a 10 per cent drawdown. I’m seeing a chance to test some of those operational issues when you’re not at your target allocations.”
There was some discussion of gating, but it was felt to be less of an issue for DC pensions, than say private assets investments aimed at the retail market.
Sun said: “You need to be careful if you offer it as self-select. Most people are not trying to jump in and out of the default, so I think that gives another safety mechanism. Sharples suggested that “you would need to be really clued up to try and game this”.
Appeal of UK investments?
The demands of the Mansion House Accord especially around investing in UK private markets could be tested amid the appeal of other global markets.
Oliver Little, head of UK DC pension strategy at Neuberger Berman questioned the Accord demanding 50 per
cent UK investment.
“If you look at the UK allocation as part of the global equity index, it is about 3 per cent, so is 50 per cent of your private markets allocation, the right number?” he asked.
“I spend a lot of my time talking to the bulk annuity providers who are looking to the UK for matching adjustment eligible assets, and they’re struggling to find enough eligible assets to put money to work. Ultimately, when all of you scale up to the right size, there is going to be a similar sort of scenario where there just won’t be enough good assets in the UK to be invested in, so having the global diversification will be important.
“We should be thinking about using pension capital to facilitate the growth in the UK economy. That’s a noble cause, but it does come with a pretty heavy caveat about the number of productive assets that we can actually deploy into.”
Sun added: “The ultimate objective of any DC pension fund is to maximise the member outcomes. That for me is the ultimate target. At L&G we love investing in the UK, but we want to tilt our capital towards the assets that are attractive to generate a long-term return.
“We are not concerned about creating price bubbles, but there needs to be enough high-quality assets, with enough downside protections for us to invest in them.”
That said, she suggested the UK has some very strong sectors – real estate is broad and deep, and it is a leader in digital.
Lewis said: “We want to give managers the flexibility to buy UK deals where they are appropriate for a mandate, but we are not going to put a gun to their head. We are not going to say we need you to allocate, where you get crowding round a smaller pool of deals. The whole Mansion House Accord was contingent on there being sufficient opportunities.”
Monk made the point that the UK economy has been globalised for decades now. Any forcing of UK demand could be temporary, and “it would be much better to sort the longer-term supply dynamics so that it will also appeal to the global investor”.
Phrompechrut added: “This is about forward looking at indicators. Relative value can be assessed. The same PE deal flow in the UK at what valuation, debt levels, growth trajectory. They can see that side by side with other regions.
“Separately, the pace and the quantum of the marginal capital that is coming in and going out. There are pockets, where there might be intense competition, but we see lots of pockets that are starved of capital, because other players have left.”
Social housing was also seen as having a strong investment case, though even there, supply and regulatory challenges persisted. But infrastructure and certainly high tech and biotech growth saw unfavourable comparisons with other countries’ investment ecosystems.
Appeal of infrastructure
There was, however, support for infrastructure, not least in that it can help with engagement with members.
Van den Tol said: “A level of tangibility is so important for the member base. You can actually visit these complexes, and see the real-life difference they’re making. So, it’s almost about investing in the future for the member and, albeit the risk return trade off might be a little less attractive versus the US, that social dividend is really important. When you go to Canada, Australia orScandinavia, you can see bright and shiny infrastructure courtesy of private pools of capital. I’m almost a patriot to a degree, in terms of reinvesting back into the local community.”
However, it was felt that even here, approaches might have to change.
De Silva said: “You have to make it a place that foreign investment capital is attracted to. Mandating is perhaps the wrong answer instead of letting it naturally play out via high quality FDI capability being delivered. Then tell the stories to investors.
“But on the risk appetite, it needs to be calibrated, we are not seeing the same level of enthusiasm from UK pension funds or long-term pools of capital to say we are happy to take economic infrastructure risk relative to something else. We need to sort the supply side.”
De Silva also pointed out big challenges in other areas mentioned by Mansion House – such as high growth tech and biotech. The UK may produce a phenomenal amount of IP, but at later stages it is scooped up. He said: “The allocators have to feel comfortable with VC risk. You have to see an ecosystem. If the UK wants to see higher inflows you have to have an ecosystem delivering strong, positive returns year on year.”
Although there were reservations about these UK weightings, many remained positive this influx of money from DC would help further develop this sector.
