UK defined benefit funds have long been allocating to what is broadly termed ‘alternative’ assets. According to the Pension Protection Fund’s Purple Book, UK private sector DB funds invested on average 15 per cent of portfolios in alternatives such as real estate and private equity.
Consultants and asset managers have championed the benefits of illiquid holdings for many years, especially since the financial crisis pushed banks away from riskier lending markets, opening up an opportunity for long-term investors in the various forms of private debt and credit.
In Australia, arguably the most advanced defined contribution (DC) market, allocations to illiquid assets can reach as high as 30 to 40 per cent of investment portfolios. In the UK DC space, however, allocations to illiquid assets are nowhere near this.
Leading the way in DC allocations to private debt is the National Employment Savings Trust (Nest). This year it announced three investments into the asset class through partnerships with BlackRock, Amundi and BNP Paribas Asset Management, managing infrastructure debt, real estate debt, and diversified private credit respectively.
Nest, which now runs more than £8bn, plans to allocate roughly 5 to 7 per cent of its default funds to the mandates, for now, meaning combined inflows of at least £500m in the first 12months of operation. The master trust has clear sight of the managers’ deal pipeline, ensuring it can put cash to work efficiently. BNP Paribas Asset Management has also constructed a “sleeve” of liquid alternatives to ensure money is not sitting in cash unnecessarily.
The funds are open-ended and available to other pension fund investors – albeit at the manager’s discretion – meaning that, in theory, other master trusts could join the private debt push.
However, a major factor holding back allocations to illiquid asset classes is the requirement for most contract-based DC schemes to have daily dealing on their investment platforms. While there are a wide range of direct property funds available on a daily dealing basis, other illiquid asset classes are less accessible in this format.
BNP Paribas Asset Management head of sales for the UK and Ireland Phil Dawes argues that monthly dealing should be sufficient for most DC schemes, given that member contributions are usually paid on a monthly basis. In addition, cashflow-positive DC schemes can use monthly inflows to manage any liquidity demands rather than be forced sellers of illiquid assets.
“The remaining issue is the reluctance of some platform providers to open their platforms to illiquid funds with monthly pricing and monthly dealing,” Dawes says. “Some platforms can accommodate such funds, but there are providers with sizeable market shares whose systems are just not aligned to investing in illiquids. This will only change if asset managers, asset owners and investment consultants pressure the platform providers to introduce the flexibility required.”
In December 2018 the Financial Conduct Authority launched a consultation on potential amendments to the rules requiring daily dealing for some DC platforms. No changes have been finalised yet, but Dawes says this work, coupled with the Treasury’s focus on “patient capital” and long-term investing, could lead to some positive developments.
Other DC plans are entering private markets within the constraints of the daily-dealing fund universe. For smaller schemes without the scale of major master trusts, multi-asset or fund-of-funds structures can offer a way into the illiquid space.
“For private debt, it might be in the form of a multi-asset credit manager, or an absolute return bond manager that goes across the spectrum,” says Aon investment principal Chris Inman. “They’ll do listed and unlisted depending on the attractiveness of the opportunity set and the objectives that were set.”
The Woodford effect
Any discussion of illiquid assets over the past few months has invariably included mention of Woodford Asset Management. Founded by renowned UK equities investor Neil Woodford, the firm shut first its flagship fund and then its entire operation after it became unable to meet investor redemptions due to high exposure to illiquid small companies.
For DC investors and scheme trustees, the episode – and similar problems faced by GAM and H2O Asset Management this year – should carry lessons regarding due diligence processes.
“As an adviser, we need to make sure that our clients understand what it means that the fund might be gated,” says Redington head of DC Lydia Fearn. “We always say, if you don’t understand the asset class then don’t go into it. You need to make sure you are comfortable, and I would hope that the Woodford issue just raises that point around making sure you understand what you’re going into and why.”
As Inman highlights, gating can affect any regulated fund: UK property funds closed their doors to investor redemptions in the months following the EU membership referendum in 2016.
“In DC, we say funds are daily priced and daily dealt, but anything can become illiquid – anything can have a haircut any day of the week,” Inman says. “It isn’t necessarily that illiquids are bad, or that you shouldn’t be going into real estate or infrastructure. You just have to be very clear about what you’re trying to achieve, understand what you’re investing in, and make sure that operational due diligence is done. Then when these situations arrive, it is not going to be a surprise – you will have a plan.”
Eyes wide open
Aside from isolated – if high-profile – issues, it is clear there are plenty of opportunities in illiquid assets for those willing to understand these areas of the investment universe.
Private equity continues to grow, with $5.8trn (£4.5trn) invested in the asset class, according to consultancy firm McKinsey. The number of privately held companies in the US doubled between 2006 and 2017, while the number of listed US companies fell by more than 15 per cent in the same period, McKinsey reports.
Investors should be wary of some riskier areas, Inman warns. The consultancy has engaged with the British Business Bank on its push for more venture capital investment from institutions, but Inman says it is unlikely that DC funds will be willing to take this type of risk.
“Venture is high risk,” he says “Of 100 names maybe one of them – if you’re lucky – will come through and actually make you money. For a DC investor paying those fees with what is required in terms of the asset commitment to that space, it’s not something that’s going to happen in the short term.”
Whether it is private equity, debt, infrastructure or another illiquid asset class DC funds are exploring, trustees must ensure they have sufficient budget, both in terms of fees and governance.
Fearn explains: “We’ve seen a lot of passive investment in DC. The illiquid side of it really has to be actively managed; there has to be somebody who knows what they’re doing, and clearly fees will be associated with that. The trustees have to go in with eyes wide open.
“It’s for trustees and governance committees to get comfortable that the manager is on top of that, and that the member will be paying more because of it.”
PRIVATE MARKETS AND PENSION FREEDOMS
With pension freedoms fully embedded in the UK’s retirement landscape, providers are working on how to construct suitable drawdown products. According to consultants, some forms of illiquid assets could be part of a diversified income- producing portfolio.
Sam Gervaise-Jones, Bfinance’s head of consulting for the UK and Ireland, says: “Pre pensions freedoms, you were looking at the majority of your DC provision being oriented to growth, and only in the final few years having shifting towards more fixed income or cash-type instruments.
“I think that will change post-freedoms. You’re not necessarily working towards that one date. The appetite for enhanced yielding assets such as private debt will be there post retirement.” He highlights shorter-dated debt instruments with lifespans of three, five or seven years as most likely to fit well in a drawdown fund.