DC pension funds are being offered a growing range of private markets options, which have the potential to significantly enhance returns and diversification. So what factors do they need to consider when making a selection?
UK defined contribution (DC) pension funds are poised to become major investors in private markets, with a surge of products and alternative approaches appearing in the market.
The launch of long-term asset funds (LTAF), which combine illiquid assets with liquidity management tools, continues apace with 31 authorised or approved by the FCA. This growth is surely set to continue, with Carne Group finding last November that 82% of UK asset managers are considering launches.
In March alone, Aegon and M&G entered the LTAF sector and Schroders added its sixth fund. In February, master trust Nest – with approximately £48 billion AuM – took a 10% ownership stake in private markets manager IFM and predicted its £8 billion allocation will expand to £30 billion by 2030.
Joe Condy, investment consultant, Quantum Advisory, says: “Some DC schemes, usually larger in size, are beginning to supplement public markets with an allocation to private markets – which will be less liquid and more complex but can further enhance and diversify returns and risk for members.”
Gerald Wellesley, client director and at professional trustee firm Vidett, says: “It makes sense for master trusts to diversify as a lot of the investable market is now in private hands. I have largely been impressed with the progress and traction that’s taking place in LTAF products. Based on what we’re seeing, the structures are very good and working out well.”
I have largely been impressed with the progress and traction that’s taking place in LTAF products… the structures are very good and working out well.
Gerald Wellesley, Vidett
Market development
Most FCA approved LTAFs are diversified across several private markets categories, with some managers offering a split between equity and credit products. As more new products appear, DC schemes need to assess their priorities and be able to discriminate between offerings.
“I am sceptical when the industry hurtles in one direction. Commercial master trusts are driven by fashion, as solutions need the blessing of consultants to be chosen by the next employer,” says Wellesley, who notes that if a master trust doesn’t have an LTAF it’s unlikely to make a sponsor shortlist.
“I worry some master trusts are in this just because they have to be. If so, how much value they will be providing?” says Wellesley. “It’s healthy to have different approaches out there, as one might be seen to be working better than others.”
While there has been significant product development in private markets, further development is still needed, according to Condy. “LTAFs are still in their infancy and are being adapted in response to investor feedback, including concerns around liquidity.
“Providers are taking different approaches to liquidity management, including allocating funds to listed assets. The challenge of scale also remains – smaller schemes can’t access the products directly and investment platforms still face administrative challenges around funds not being daily priced or traded. Therefore, much of the investment into private markets remains by larger schemes.”
At this early stage, managers appear to be limiting specialisation to foster scale within their funds. “To negotiate effectively and achieve diversification, you need reasonable scale,” says James Monk, investment director of FutureWise at Fidelity.
Some more targeted products have started to appear, such as Schroders’ Climate + LTAF, and the product market is expected to rapidly develop.
James Monk, Fidelity
To negotiate effectively and achieve diversification, you need reasonable scale.
Liquidity buffers
DC schemes ultimately remain responsible for ensuring liquidity, whether at the scheme level or mandating a LTAF manager to do so within a fund.
Trustees need to be cognisant of how liquidity is created. LTAFs are combined private-public markets vehicles that may contain 20% (legally up to 50%) in liquid assets to facilitate potential withdrawals.
Within an LTAF, the provider manages liquidity for the trustees. “For many schemes, this would ease their governance burden. But it has limitations. In an ideal world, I would like to see providers offer true private markets and let the larger DC schemes properly deal with the governance, have the resources and structure to enable exposure to illiquid vehicles and manage them within the default fund themselves.”
The liquidity buffer exposure may not match the trustees’ preferences; for example, they may want to invest it in passive funds or achieve greater diversification than offered by a tech-dominated global cap fund. “You may want to control it, but it is taken out of your hands,” says Winterfrost.
This control includes sustainability considerations. “They’ll probably have a green tilt – but can you tailor climate risk management? Stewardship is a priority for all my schemes, but they care about different things. I suspect most LTFAs will do the same thing – they’ll aim for wide appeal to create scale,” she says.
Wellesley adds: “I don’t like the regulator’s push towards homogenisation. If master trusts just buy the same things off-the-shelf, they would end up owning the same assets. A healthy dynamic would encourage providers to develop propositions that play to their strengths and offer different things to different people. A copycat approach would not be a good trend.”
DC pension schemes beyond a certain size may not need a liquidity buffer and instead invest in funds entirely containing illiquid assets. Winterfrost says: “Some providers are thinking about offering DC schemes bespoke portfolios of illiquid assets. I know one is looking at a fund-of-one approach, which would be feasible for multi-billion-pound DC schemes and enable them to target the asset classes and sustainability themes they want.”
Liquidity concerns
DC trustees needs to consider how much the illiquidity of private markets matters to their scheme. Problems typically only come to the fore during periods of acute market or commercial stress. “The studies I’ve seen have suggested that liquidity can be managed for foreseeable circumstances – but, of course, the world is not very foreseeable at the moment,” says Wellesley.
Scheme sponsors may periodically retender arrangements in search of better value, potentially resulting in the loss of a major client. A more serious concern is the master trust running into trouble. Poor performance could lead to multiple employers leaving in short order. “A master trust that falls to the bottom of the league table could be amber-flagged in its value for money assessment, which could effectively end its life,” she says.
Wellesley adds: “If there was a snowball effect out of the market, you could have a real liquidity problem. But for a reputable provider to fall headlong down a league table and experience a mass exodus, basically a run on the bank, there would have to have been pretty major governance failings. I think it’s a very low-risk event.”
Fidelity’s Monk says: “LTAFs are designed to deal with the liquidity needs of DC, while protecting the private asset portfolio. The LTAFs regulation is a good starting point, offering a safe gateway for investors to access a diversified range of private assets – but we’ve also done a lot of due diligence and scenario testing on the design of our LTAF and underlying investments.”
Natalie Winterfrost, The Law Debenture
If too many LTAFs tick the UK productive finance box, the wave of money chasing opportunities would quickly erode any premium.
Productive finance
The Mansion House Reforms encourage DC funds towards productive investment with two key arguments: providing better member outcomes and channelling capital to support the UK economy, including in infrastructure. Only the former is clearly in investors’ interests.
“The talk about LTAFs came around at the same time as the productive finance and ‘levelling up’ agendas, so it would be naive not to assume that gaining access to DC money was not part of the agenda,” says Winterfrost. “If too many LTAFs tick the UK productive finance box, the wave of money chasing opportunities would quickly erode any premium.”
The strictest interpretation of fiduciary duty is to maximise members’ risk-adjusted returns. “If so, we should not concern ourselves with a UK bias,” says Winterfrost. “However, if you think about the members’ welfare, retiring into a healthy economy with good tax revenues and public services is in their interests. But is that the role of trustees?”
DC schemes need to decide how to respond to the Mansion House compact, says Quantum Advisory’s Condy. “DC schemes should assess investments on the attractiveness and merits of an opportunity. While there is a social argument, mandating UK investments may result in sub-optimal investment allocations that produce lower returns, which is not in members’ interests, particularly with adequacy concerns.”
Adds Wellesley: “I feel very strongly that a lot of stuff the government’s doing in the hope that more is invested in the UK is totally misguided. We just need to make sure that good investments are accessible by pension funds, not trying to restructure the industry in the hope more money will flow into corporate UK.
“There’re a lot of potential investment opportunities in the UK. What’s not clear is that these are being structured in a way to make them investable and competitive for DC.”
Performance
DC schemes need to keep in mind the original driver for overcoming potential obstacles – potentially higher returns and enhanced diversification.
Wellesley says it is a good time to be getting into private markets, private equity in particular, as managers are currently willing to do deals to attract investment. “Some attractive deals have been cut,” he says. “If they produce 6-8% while equity markets are flat, trustees would be happy.”
Private equity funds have a return profile that is likely to be unfamiliar to DC schemes, with returns weighted towards the end of the investment period. “The way to deal with the J-curve effect is to phase in investment over many vintages and build up your exposure using some secondaries as well as primary allocations,” says Winterfrost. “You can still build up meaningful allocations, although it would slow the process.”
What constitutes a meaningful allocation is also a consideration. Monk asks: “Would allocating 2.5% materially impact member outcomes?”
Lexington Partners suggests DC schemes hold secondaries funds as a core private markets exposure due to them offering greater diversification and earlier dispersion, which alleviates illiquidity.
Philip Smelt, managing director, Lexington Partners, says: “We are in a far better position coming in later than the LP that went into the original fund. We’ve got a nice advantage. We bring all the information together and reset the valuations of assets, building that into the price we pay.”
Adds Condy: “Secondaries potentially provide an opportunity to reduce the time it takes to enter and exit private markets. While costs savings could be achieved, supply and demand will be an additional factor when determining the price.”
Accommodating fees
Master trusts have the scale to accommodate reasonable fees. “It’s a blended solution, so the fees are not insurmountable. But in a competitive market where master trusts look roughly the same, pricing remains a high-profile consideration and can seal a win,” says Wellesley.
Platforms with large distribution channels are in a position to negotiate lower fees. “Nonetheless, it naturally carries a fee increase,” says Monk. “We are talking to our DC clients about why private assets are more expensive and why a value-first approach with strong due diligence drives better outcomes than focusing on cost.”
The DC industry has not yet fully moved toward value for money, he says. “Some clients and providers still focus on implementation costs. Huge swathes of the DC market won’t accept performance fees, but this restricts them from the quality end of private equity. For us, the ability to accept performance fees was non-negotiable, to bring down the barrier to the best GPs.”
He adds that there is definitely a shift towards value. “With regulatory support, there’s been a lot of positive steps. We clearly put our stake in the ground by including private assets in our default strategy. We’re offering a single default and increased our fees, but it represents very good value,” he says.
LTAF managers can potentially use internal GP capabilities, external GPs or a combination. “An internal manager would have to offer at least comparable value to external managers,” says Wellesley. “And you need to be sure a conflict hadn’t affected the value proposition for the member – that’s the trustee’s core role. Ask them, which bits are you outsourcing? Trustees must be hyper diligent and would need to put their foot down.”
Monk notes that manager selection is particularly important in private markets because the distribution of outcomes is “about five times larger” than in public markets. Fidelity has therefore opted for an open architecture approach that focuses on due diligence across a diversified array of GPs.
“In private markets, there’s a lot more bifurcation between the best and the worst managers,” says Wellesley. “Every master trust thinks it will get world-class, best-of-breed managers. This might lead to increasing cost pressure emerging among the best performing managers.”
Monk says approaching private markets from the perspective of building an ideal diversified private asset portfolio, compared to an approach that prioritises the DC operating model, leads providers to very different solutions.
From a DC facilitation perspective, Monk acknowledges that it is slightly preferable to offer open-ended fund access to private markets, as it provides greater liquidity and flexibility.
He says: “[But with this approach] the challenge is that DC provides a regular flow of money and private markets don’t offer a consistent volume of deals year-on-year. This means it would be very challenging to find a way of maintaining quality if that is your focus.”
However, this approach is favoured by some, including Wellesley: “I’m a fan of open-ended funds, or evergreen funds, that can provide a more consistent investment experience and are easier to manage. More managers are coming up with open-ended structures.”
Case study: Fidelity Diversified Markets LTAF
Fidelity’s UK DC pensions platform has AuM of approximately £50 billion. This includes its £18 billion default strategy FutureWise, a single target-date default strategy for all clients looking to delegate their investment governance.
It has started to introduce its in-house LTAF into FutureWise. Over the next three years it is targeting 15% exposure for members who are further than 20 years from retirement, which then reduces between 20 and 10 years from retirement.
The Fidelity LTAF has an open architecture approach, focusing on “a robust due diligence process to select managers across the whole market for greater diversification and stronger potential risk-adjusted returns,” says Monk.
The vast majority of its exposures are to external GPs, complemented by internal capabilities. “It’s important to find a way to enable access to the widest possible range of strategies, which includes closed-ended strategies, so that we can find those with the strongest track record,” he says.
Monk adds the multi-GP approach provides more focused exposure and enables access to specific boutique GPs with a strong sector skillsets.
“We are carefully educating the market on why we did it this way. We created the right infrastructure and made sure all scenarios have been considered robustly. The regulatory and operational barriers have been broken down for DC. We’re already there, we can start to do it now.”