Capital Cranfield professional trustee George Emmerson discusses how private markets can be tailored to meet the requirements of individual pension schemes
George Emmerson has worked in the UK pensions industry for 35 years, including ten as a professional trustee. For the other 25, he held senior investment management positions, including 16 years at Aberdeen Standard Investments as an investment director focusing on institutional business. He joined professional independent trustee firm Capital Cranfield in 2019.
Emmerson has worked with both public and private sector sponsors across defined benefit (DB) and defined contribution (DC) pension funds. He is currently a professional trustee on DB pension boards, covering eight private sector pension schemes across a variety of sectors including energy, publishing, manufacturing and media. His schemes range from small to large in size and he is chair of the investment committee of two schemes.
Before becoming a professional trustee, Emmerson spent over 25 years in institutional asset management, helping DB schemes with funding across all the main asset classes including private markets.
As a professional trustee, he is speaking in a personal capacity and his opinions do not necessarily reflect those of Capital Cranfield.
There seems to be a large amount of interest among pension schemes in private markets. Is this trend here to stay?
Most pension schemes now have a low allocation to listed equities. If you think public equities are overvalued and liquid bonds are expensive, where do you go? Private markets are the obvious place. You get much better spread and pickup, while most forms offer good diversification. If the employer and trustee board feel it’s the right decision, private markets allocations are definitely good additions to portfolios.
The big issue for private markets is the time it takes from deploying capital to a fund running its course. DB schemes are now much better funded. If they have an eye on a buy-in and then a buyout, private market funds don’t naturally sit in their portfolio.
Is there a solution to this issue? Some market participants suggest using secondaries as a core strategy, to improve liquidity and diversification.
That’s definitely one right way to do it. By the end of this year, at least one major consultancy is expected to start offering a private markets broking service, which would be innovative and help maturing DB schemes. A DB scheme may want to put money into private markets but if it is five or six years from a potential buy-in, it would not have enough time to get in and out of the investment. If it could rely on a broker service to get it out, rather than risk becoming a forced seller, it could potentially change the game in the decision-making process.
Everyone wants all the upside and benefits of private markets with the liquidity of listed markets.
George Emmerson, Capital Cranfield
It sounds like private markets could move closer to offering public-like liquidity. Could the usual secondaries discount be reduced by a broking service?
Everyone wants all the upside and benefits of private markets with the liquidity of listed markets. A broking service would be good for DB schemes – I would certainly consider a new option from a mainstream consultant firm.
But one thing’s for sure – they won’t be offering a broking service for free! There will be a discount and a brokering fee, but it might still be worth doing. Overall, you just need the sums to add up and be sure it’s right for the scheme. Just like for every investment, you’ve got to be careful the fees don’t drag down returns. It will also depend on who must pay the fees.
Can private markets work well in DC schemes?
The natural home in DC for private markets is master trusts, as they have plenty of capital to make sure it all fits in within the charge cap. The regulator prefers small DC schemes to be within a master trust. One scheme I work with had a DC section, but we moved it to a master trust at the end of last year because it was quite small.
The more master trusts grow, the more attention will focus on performance league tables. The one at the bottom may potentially face mass exits. If it’s holding private markets, could there be a liquidity problem?
I don’t think so. Private markets will never be a big enough allocation within default funds to cause liquidity issues. There’ll be plenty of other liquidity when members need to withdraw cash.
It also depends how you structure default funds and the glidepaths – private markets are perfect for those in their early 20s coming into the workforce. You can hold many vintages of private markets funds in a default fund. Master trusts should have plenty of liquidity.
The issue for me is whether DC members understand private markets. Maybe we should just call it ‘illiquid investments’, as that may make members more comfortable. In master trusts it’s the trustees’ responsibility to determine whether they enhance delivery and overall portfolio construction.
The case for private markets partially depends on capturing the illiquidity premium. Could a wave of master trust money potentially push down excess returns?
People look at the illiquidity risk premium, but I’m not sure that’s the right approach. It’s not a big issue, as the public-private spread contains all sorts of components.
Private markets returns are primarily dependent on two factors. Firstly, while cash is needed for the transaction process, holding excessive cash brings down returns from the IRR. Secondly, the main skills are in finding which bits of private markets are offering the best opportunities and understanding the impact of an exposure on the rest of the portfolio.
In a broad private markets offering, the manager can pick and choose which bits offer good returns, diversification and alternative sources of returns. As banks continue to pull back further from lending, is private lending the right way to go? Should a scheme diversify globally or focus on the UK?
In a broad private markets offering, the manager can pick and choose which bits offer good returns, diversification and alternative sources of returns.
George Emmerson, Capital Cranfield
The pension minister is advocating that pension schemes make larger allocations to private markets and is floating the idea of DB scheme investing surpluses in productive finance. Is the government’s main motivation getting pension schemes to subsidise its infrastructure plans?
I’m not going to say that! We need to be careful that we’re not overly cynical. To be honest, there’s a deal to be done there.
Can partnering with government to build infrastructure simultaneously provide adequate risk-adjusted returns to pension schemes while providing the government with a cost-effective way of financing it?
That’s an interesting question. There are discussions around the use of surplus for productive finance but the details of how it would work in practice are yet to be thrashed out. This is primarily aimed at the big master trusts and the remaining DB schemes that are open to accrual that have capital to deploy. They’re still risk takers.
Is there greater economic benefit from allowing a scheme sponsor to invest a surplus in UK productive finance than allowing it to do a buyout and invest the surplus in its own business? I’m not sure the outcome for the economy is any different, it’s just a different route.
DB scheme surpluses emerged largely due to interest rates increasing. Do you think these surpluses are somewhat illusionary? What happens if we enter a recession, and rates go back down to zero?
Any scheme that is fully hedged will be alright. But are they? No! Broadly, if a scheme is not fully funded, it’s only going to be hedged to its technical provisions (TP) level, so it’ll only have a little bit of excess. Pension funds have had a decent run with nice high yields, and we could lock in higher hedges. But we’re by no means out of the woods. There is a long tail of small pension schemes – some are in great health and some are not.
How much money could potentially be allocated to productive finance?
LGPS funds and the remaining big DB ones open to accrual, such as Railpen and the USS, are the only schemes that could meaningfully deploy capital. There is concentration risk for small schemes, so only the big guys can afford to do it or would want to do it. I don’t see smaller schemes ever running up enough surplus to do anything other than cover the cost of a buyout transactions or meet the ongoing costs of the scheme. An employer with a surplus would likely want to pay the tax and take the money back to invest it in their own company.
The government’s analysis of The Pensions Regulator (TPR) data shows approximately 75% of schemes are currently in surplus, worth £160 billion. But this is on a gilts plus 0.5 basis, which is a low dependency basis rather than a buyout basis. According to TPR data, the buyout surplus for schemes in surplus is around £100 billion.
Would there even be enough insurance market capacity for this volume of buyouts?
There would not be enough capacity among insurers for all the potential buyouts. It is a low margin business but a critical part of any deal. Maybe technology such as AI may start to help.