As consultations, regulation and initiatives such as the Mansion House Compact come thick and fast, we must begin to prioritise what is important: improving member outcomes using less liquid asset classes. While the benefits to member outcomes of including illiquids in portfolios are clear, it’s taking too long to embed illiquids into the system, with still only a handful of us that offer innovative solutions to this low-cost market. We must shift the focus away from the risk of investing in these asset classes to the risk of not investing in them.
There’s a genuine split between those that have ‘product’ and see no major barriers to doing business and those who don’t have product. For those who don’t the narrative is often that of caution, fear of the risks, unintended consequences, worries about large redemptions, and liquidity. The fetish for liquidity continues to raise its ugly head. We are fixated on it, because of outdated unit-linked policymaking. It’s time to move on and see how the benefits outweigh downsides, and consider the ways to manage the practicalities at the portfolio level.
The focus on cost is also holding the market back. Price remains on the extremely low side whilst the 30-odd master trusts that are left consolidate into neater, fewer, more secure positions of scale. However, master trusts are still reluctant to stand out from the crowd with a better investment proposition that might be a bit more expensive; a price-trap driven by the benefit consultants who continue to judge and switch employer schemes on price and not quality.
So where does that leave us in getting to a position that the Australian Super Funds enjoy with up to 40 per cent in private markets and reaping the benefits? You may have heard Aware Super deputy CIO Damien Webb at the Mansion House Summit last year confirm that he had enjoyed annualised returns of 23 per cent in his portfolio from the 6 per cent allocation to private equity over the past 5 years. What are we waiting for?
While fees are often cited as a reason for not investing in private equity, when discussing fees with our counterparts down under they are not such an issue. Pension funds pay the going rate including performance fees to get exposure to quality investments that are reaping these rewards. If the fund is growing too big, they ensure they check those fees accordingly, reducing the carry, and the waterfall mechanism ensures that managers have to wait to be paid, ensuring alignment of interest throughout.
Ask an Australian Super fund CIO whether it is worth paying for quality and the answer you will get will be in the affirmative. They know that good PE managers are different to ‘good’ stock pickers. Stock pickers can succeed through a combination of luck and rising markets – theoretically half of them should be above average, before their costs are factored in, based on the choices they make, informed or otherwise. PE managers on the other hand are good business people who know how to turn businesses around with actual profits. With PE managers you are buying into businessmen and women who know how to make real money from real businesses, not paper profits that rise and fall with the market.
Of those business folk, there is also a pecking order. The best of them aren’t easily accessed by the masses, those funds are oversubscribed like a good wine vintage, so are very unlikely to reduce their fees to let little old UK DC through the door. And only in 12 out of 20 years has the median PE fund manager been able to get returns over the hurdle rate. Good quality private equity managers with a global footprint can ply their trade anywhere in the world without compromising their fees, so you must pay to get the best.
Fortunately, substantial positive UK DC cashflows are attractive year on year, and we have a number of solutions emerging that are evergreen, which include co-investments and emerging manager programs, also using secondaries to ensure shorter durations to manage liquidity inside an LTAF alongside other illiquid asset classes for example.
The exam question is: How can I keep my fees down to remain competitive, while allocating to higher yielding illiquid asset classes?
The answer is you need to incorporate some performance fees and agree the hurdle rate at which point they will be paid which, in turn using co-investments and other ways to lower the overall fees, will mean a lower flat fee that enables the core cost of the scheme to remain competitive – only paying the additional fees if you enjoy higher than expected returns.