It is governance, scale and expertise – not mandation – that will deliver good private market returns. And schemes must beware zombie continuation vehicles, says Professor Iain Clacher. John Greenwood hears why
The debate over private markets has become one of the defining arguments in UK DC pensions. Ministers want
schemes to channel more capital into productive assets while providers argue that illiquid investments can improve diversification and long-term returns. Yet uneasiness remains as to whether pushing assets towards these investments is the right thing to do at this point in the cycle.
For Iain Clacher, professor of pensions & finance at Leeds University, private market assets are a fantastic opportunity with potential downsides if done wrong. For trustees, independent governance committees and advisers, it is a case of targeting quality by accessing deep market expertise. And for policymakers the key is to establish a framework that distinguishes between investments that genuinely finance economic growth and those that merely provide convenient exits for existing investors.
Clacher is an academic whose work has shaped thinking on trustee governance, investment cost transparency, productive finance and CDC. He has advised the FCA and policymakers.
One of his biggest concerns is the temptation for struggling private equity managers to recycle assets into continuation vehicles or other structures. Government policy, he argues, is intended to support investment in the real economy rather than creating liquidity for incumbent fund managers. Pension money should be financing productive businesses, infrastructure and growth rather than simply changing ownership.
Convenient exit?
Clacher says: “We’ve seen a lot of private equity funds globally struggle to do exits recently. There is a reckoning due in some parts of the private markets world – private credit too has risks building up. One scenario that people talk about is that managers think they can offload what they’ve got on their books into DC and start their next fund. But Government policy wants money flowing into the real economy. It doesn’t want money going into
continuation vehicles.
“So there’s got to be a real clarity as to making sure that the money’s transferring not just from pension funds to private markets in different fund structures, but that it’s actually transferring through into the real economy as opposed to creating a convenient exit.”
The Mansion House Accord’s 5 per cent target for UK private markets would mean allocations approaching £50bn in the not-too-distant future, with the sector already at around £1 trillion and growing exponentially. So how concerned is Clacher at the Government’s attempt to force money into parts of the market it might not otherwise have gone to?
“I don’t like mandation. The Government should be creating the circumstances where there are attractive investments in the real economy. They’re obviously there – look at the foreign capital flows into the UK. There’s lots of money that comes in. That money is not coming to the UK out of the goodness of its heart. It’s coming here for good businesses and good returns.
“So the government has to find ways to enable DC schemes and pensions more broadly to invest in those projects as well as other private markets globally. An arbitrary target will have the effect of potentially pushing money to the wrong places and as a consequence over the long term savers are going to get worse returns.”
Capital life cycle
Clacher’s message for those managing private market mandates for DC schemes is targeting the right part of the growth story.
“What we have in the UK is a real lack of companies staying and growing. So even if companies scale and grow to £2bn, £3bn, they’re not actually focused then on staying in the UK and growing further in the UK. Often they’re
looking overseas to the US in particular because they then see a much deeper capital market. When you think about going from angel investor through to private through mezzanine and scaling up, that scale often comes to an end in the UK. So the problem for me isn’t that the capital comes from different places. It’s that longer term picture which is those companies then don’t scale here. They don’t grow here and ultimately then don’t list here. The government’s got to have a much more life cycle of capital approach to this rather than saying private is the way forward.”
So at what stage in the growth of new companies should pension schemes be investing members funds? Clacher says: “For me there’s a question around where pension capital should be deployed in that life cycle. Angel and early private equity investment has significant risk capital but there’s a point where it starts to not become as risky. In the UK when we talk about scale up we’re probably in the sort of £100m to £1bn, where you would access much more of that long-term patient capital with pension fund money. So when you’re doing your Series C, your Series D and you’re looking for £100m, £500m, £1bn, that’s where you would see pension fund money coming in.”
Clacher also thinks making the UK a more business-friendly environment is going to be the trigger to attracting more investment. “That’s a massive part of it. When the government’s finances are very constrained changes to things like employer NI increases seem rational. But factors like this and the regulatory burden on firms doesn’t help existing companies, it doesn’t incentivise them to grow, and for new businesses it makes it harder,” he says.
Swerve the zombies
Proponents of private market allocations look to allay fears that we are in a bad point in the cycle for some asset classes, including private credit, by pointing out that it will be possible to drive keen prices on secondaries.
Clacher foresees a wide distribution of outcomes in terms of return profile. “There are going to be secondaries you will be able to pick up cheaply and those businesses will be good investments. But I have a real concern that there’s a lot of zombie stuff out there just now. And there are definitely cycles to all of this,” he says.
He points to the period of quantitative easing, which started in 2009 following the global financial crisis, when money was cheap.
“It was very easy to go into the market back then. People were throwing money at you, even if your business was not as robust as one might expect. That’s not fully unwound yet. So there’s got to be a real detailed understanding and consideration around what is a good business in the current economic environment where interest rates are higher, capital’s much scarcer, and the return profile has changed. That is a really complicated exercise that will require serious due diligence and expertise on the part of the asset owners and fiduciaries,” he says.
Scale benefits
While he is against mandation of private market allocations, Clacher is supportive of the idea that scale should deliver better returns in the long term, because this is the only way providers can build the capacity to play in the best opportunities across the market.
Even Nest is only just getting to the point where it can make direct investments into the market, he says. Clacher thinks providers should collaborate to further build scale and access really big investments together.
“If providers don’t feel that they’ve got the skill to effectively access a particular asset class, they should explore the idea of a consortium of pension funds, whether in DC or DB, working together. If five schemes put in £4bn, then at £20bn you are at the order of capital to do a direct investment in, for example, an airport, toll bridge or other infrastructure project. Something like the IFM model would be attractive.
“If you’ve got five big funds looking at a project, they’re all doing their own due diligence. If they all decide to invest and you think the upside’s there, that’s giving a degree of assurance as to what the potential benefits are.”
Better returns?
When it comes to what has become, for the DC pensions sector, the sixty-four million dollar question of whether we should expect better returns from private markets, Clacher is measured but net positive.
“Yes and no,” says Clacher. “There are amazing private market opportunities out there, but there are a lot that are going to be lacklustre and there’s going to be some where you lose your money. We’ve got some poster child
examples of where private markets and their complexity have gone incredibly badly.
“Thames Water is always going to be held up as the reason why you shouldn’t invest in private markets. But there are also lots of successes out there that people don’t see. If you look internationally, you can see incredible success by some international pension funds. The Australian supers are a great example of where they’ve done private markets really well. There’s some really good examples in the Netherlands and Canada.
I’m a big fan of the Ontario Municipal Employers Retirement Scheme. They’ve been really successful in looking at big macro plays, creating the in-house capacity, and then deploying that capital effectively over the long term,”
he says.
Backing the right horses
So how do schemes accesss better deals? And is the past a guide to future potential returns?
Clacher says: “You can look at manager track record. There are people out there that are incredibly successful. And you can also look at the overall firm’s track record. You do have very good private equity houses where you’re buying into that experience. It’s like investing in companies in the stock market – you might not always get it right but you’ve got PE houses with track records you can be more confident in.”
Are gilts productive?
The Government is hoping that private capital, including DC assets, is going to deliver the investment in utilities that the nation desperately needs. With private markets aiming to generate much more than gilts, wouldn’t it be cheaper for the government to fund these projects themselves?
Clacher says: “There’s a question as to whether gilts are a productive investment. I’m very firmly on the camp that the Government is not the appropriate investor because they make choices that are short-term and politically expedient. Whereas pensions capital deployed in the right way is independent of government. You’re also then not funding day- to-day costs of the Government.”
Charges challenge
Private markets charges are famously high and opaque. But Clacher believes greater transparency of costs is needed across the board in pension investments. He’s a fan of ClearGlass Analytics, the research organisation set up by the late Dr Chris Sier, the transparency campaigner who died last year. Clacher believes the work done in the UK on charge transparency is causing ripples globally, causing reverberations that are ongoing.
“There’s a real lack of transparency in costs and fees and what people are paying. When we look at the data that comes out of ClearGlass research, you can see that variability. People then realise their charges are out of line with the asset class, and then trustees and asset owners are empowered to go back to the asset manager and negotiate better terms. I don’t think we’re at a point where you can say costs and fees are done. There’s some way to go, both at home and internationally,” says Clacher.
CDC future
Clacher is firmly supportive of collective DC arrangements, but argues that policy work is needed for us to make a success of it.
“CDC is arguably the future of pensions,” he says. “There could be different models of CDC and the Government’s got to be a little bit more open as to what is the underlying business model. How does it make money? How does it operate? What are the potential risks? Because you could see a uniformity creep in which would stifle
innovation. Innovation creates much more resilience than a one-size-fits-all model.”
“I’m not particularly kind about DC pensions. I describe them as glorified Isas. They’re an accumulation product. But the finance sector is incredibly innovative and very smart and if we sit down we can come up with different models that will be attractive and provide a unified solution across accumulation and decumulation.”
Time will tell whether the mandation power ever gets used. But the Pension Schemes Act’s scale measures are already driving consolidation that should give the DC sector a chance of taking advantage of better opportunities.