Three Local Government Pension Scheme pools tell Room151 about their investments in illiquid assets, and the impact of the government’s Edinburgh Reforms on venture and growth capital in the UK.
Could the Local Government Pension Scheme (LGPS) play a bigger part in boosting the UK economy? The current government certainly thinks so, having called on LGPS funds to invest up to 5% of their assets in infrastructure projects that support local areas – to “unlock £16bn in new investment”.
Pressure is likely to increase through the government’s “Edinburgh Reforms”. In a parliamentary statement on the reforms on 9 December 2022, chancellor Jeremy Hunt promised two consultations this year – one was expected (on asset pooling), but one was not (on investing in illiquid assets).
According to Hunt’s statement, the government will “consult on requiring LGPS funds to ensure they are considering investment opportunities in illiquid assets such as venture and growth capital, as part of a diversified investment strategy”.
The statement is carefully worded – the use of “considering” and “part of a diversified investment strategy” will allow funds some wriggle room. But the direction of travel is clear, and was reinforced in the March Budget, with the “Red Book” discussing how investments in illiquid assets could “unlock some of the £364bn of LGPS assets into longterm productive assets”.
To test the mood, Room151 approached three LGPS pools – Border to Coast Pensions Partnership, London CIV and LGPS Central. We asked about government influence on LGPS investments, the definition of illiquid assets, the current approach of the pools to illiquid assets and the likely future direction.
Is it a good idea for the government to require pools to consider investing in illiquid assets?
Gordon Ross, chief investment officer, LGPS Central
Pension funds and pools should hold a diversified portfolio of investments aligned with their strategic objectives, including an allocation towards longer-term, illiquid assets. Illiquid assets play a crucial role in generating positive financial returns for pension schemes and offer access to opportunities not available in liquid markets.
Illiquid assets provide less volatility in short term valuations and the ability to influence long-term strategies for the benefit of longterm investors.
Government input may be helpful to those that haven’t yet embraced illiquid instruments in their strategic asset allocations. Ultimately, the decision to invest in illiquid assets should be made based on the individual circumstances and the aligned objectives, dictated by strategic asset allocations of a pension fund and its pool.
Jason Fletcher, chief investment officer, London CIV
Is it right for central government to be telling LGPS funds what to do? I’d question that on a number of levels.
We have 97 different local authorities, all of which have a different set of circumstances. Some of them might be 50% in private markets, or illiquids if you want to call them that. Some of them might be 10%. The answer will be very different for each LGPS fund. If both LGPS funds are being told they should invest more in private markets, then that’s plain wrong.
I’m fine with guidance, but if it’s a requirement from central government to invest more in UK “illiquids”, then this is something we have to be a bit careful with.
How would you define illiquid assets – what should be included beyond venture and growth capital?
Gordon Ross
Illiquid assets, such as private credit, equity, infrastructure, timber, agriculture, and property, require capital to be locked up for several years. Venture and growth capital, although relatively small in private markets, require patient capital to help them grow, making experienced buyout operators necessary.
Infrastructure equity investing and private credit are also essential for satisfying a diversity of risk appetites. Property and infrastructure have relatively low price volatility, are long-term investments in established and highly viable assets, and benefit from contracts often linked to levels of inflation making them attractive as inflation hedges. Private credit can offer both lending safety and lending viability if carefully chosen funds are selected.
These assets offer the potential for higher returns over the long term, albeit with some additional risks and hence require a higher level of due diligence expertise and management.
Jason Fletcher
I see the word “illiquid” as a factor rather than an asset class. My definition would be “private markets”.
Ultimately, the decision to invest in illiquid assets should be made based on the individual circumstances and the aligned objectives, dictated by strategic asset allocations of a pension fund and its pool.
Gordon Ross, LGPS Central
Our private markets programme is already providing exposure to a range of investment opportunities less easily accessed through public markets.
Ian Sandiford, Border to Coast Pensions Partnership
Venture capital tends to focus on small start-up investments, expensive, high expected return and high risk. Growth capital is really private equity or investments in private markets, not quite so expensive and with lower expected returns and risk.
London CIV invests in infrastructure, renewables, property, property leases, UK housing and private debt for our clients. I don’t know whether you can define any of those as growth, but who’s to say what growth is – it’s another factor if you like.
Ian Sandiford, head of private markets, Border to Coast Pensions Partnership
Within a general definition, we would include private equity (including buy out and special situations) and, in addition to the venture and growth capital referenced above, infrastructure and broader real assets, private credit, private real estate and hedge funds (noting that hedge funds do not form part of our current investment strategies).
How much has your pool invested in venture and growth capital (and illiquid assets more generally)?
Gordon Ross
The LGPS Central pool has committed to its first and second private equity primary partnerships. The 2018 vintage is committing £150m to upper mid-market and larger funds, while the 2021 vintage has £365m of capital and focuses on growth and small buyouts, committing at least £100m to UK technology and technology-enabled companies. In total, LGPS Central has raised over £4.2bn across three private market asset classes for its partner funds.
Jason Fletcher
We have a number of investments that cover venture and growth capital, but we don’t define them that way.
Ian Sandiford
Our partner funds had committed £9.7bn to our private markets programme by the end of December 2022, of which £8bn has been committed to underlying funds and co-investments. Within this, £2.4bn has been raised for our private equity programme, with around £600m committed to venture capital and growth strategies.
Are there any examples of successful investments your pool has made in venture and growth capital?
Gordon Ross
LGPS Central’s private equity portfolio includes successful investments in IVC Evidensia and Advent Life Sciences Fund I and II. The latter’s investment, a UK venture prospect, used capital to create a new company that subsequently spun out a new entity, which has developed a first-in-class therapy for the treatment of menopausal symptoms.
The investment is currently valued at 18.4x Multiple on Invested Capital (MOIC) with a 62% Internal Rate of Return (IRR).
Jason Fletcher
We have launched five different funds in private markets, which we would define as illiquids: two infrastructure funds, one of which is focused on renewables; a private debt fund; the London Fund (which invests in infrastructure, property and private capital); and a real estate long income fund with £2.3bn of client commitments.
We’re also about to launch a UK housing fund that will focus on affordable housing and already has support from Lambeth Pension Fund.
Ian Sandiford
We launched our private markets programme in 2019, although most commitments have been made from 2020 onwards. To date we have launched private equity, infrastructure and private credit strategies, with a multiasset Climate Opportunities strategy launched in 2022.
Given the relative immaturity of the programme, it is still too early to be considering successful exits from the venture capital and growth commitments.
Nonetheless, the programme is already providing exposure to a range of investment opportunities less easily accessed through public markets. These include innovative, fast-growing businesses focused on software, communications, next generation networks, fintech, life sciences and late-stage development pharmaceuticals, accessed via a range of specialist funds and managers.
What percentage of your investments are in illiquid assets and are you planning to increase this?
Gordon Ross
The trend of investing in private markets has been growing in importance for pension funds and is expected to continue. The LGPS Central pool has not set any targets for investments in illiquid assets, but our underlying partner funds are increasing their allocations to private markets, as part of their strategic asset allocation, as it remains a growth area for investment.
One of our pension funds plans to take a recommendation to its pension committee proposing its first ever allocation to private equity in March, as part of its strategy to increase its exposure to illiquid assets.
Jason Fletcher
Ten percent of London CIV’s pooled assets are in private markets and we/our clients will likely be investing more in private markets going forward.
Following the LDI crisis in September, many private pension funds were forced sellers. This means that many private market opportunities are becoming available in the secondary market.
Following the LDI crisis in September, many private pension funds were forced sellers. This means that many private market opportunities are becoming available in the secondary market
Jason Fletcher, London CIV
Ian Sandiford
Ultimately this is a decision of our partner funds, but they have around £60bn of assets, and have (to date) committed around £10bn to private market strategies offered by Border to Coast and also have legacy private market portfolios.
A number of our partner funds had well established private market programmes prior to pooling, but for others pooling has presented an opportunity to invest into these more complex asset classes for the first time. While each partner fund’s position is different, at present the direction of travel appears to be an increasing exposure to private market investment as a percentage of overall assets.
Are illiquid assets a useful hedge against inflation?
Gordon Ross
While not perfect, investing in infrastructure projects can be a useful hedge against inflation, as many projects have prices linked to the Consumer Price Index (CPI) and have inflation-linked uplifts. The direct lending sector has started offering inflation-linked products, such as inflation-linked investment grade UK infrastructure debt. Infrastructure investment provides a useful hedge against inflation as contracts have inflation-linked uplifts. As a result, it is becoming increasingly popular for this purpose.
Jason Fletcher
It’s not to do whether investments are public or private, it’s about the underlying investments you make. So if you are investing in a power station that gets paid CPI+ for the energy it produces, then that gives you some inflation protection. If you invest in a property that has a CPI uplift to the rent, then it gives you some inflation protection.
The fact that power stations/property are illiquid, or liquid, makes no odds whatsoever.
Matching inflation right now is very challenging. If you have a target of inflation plus 2%, that’s a 12% return. Best of luck with that. But if you’d said a target of inflation plus 2% over the next 10 years, yes, we can find some investments to do that. And when you look in the long run, historically the best match
for inflation has been listed liquid equities.
Ian Sandiford
It is largely asset-dependent. Illiquidity in and of itself is not a hedge against inflation. Infrastructure can offer inflation-linked revenue models, as experienced with some operational infrastructure assets including (but not limited to) some renewable energy assets, which can provide a degree of protection against inflation, or a positive correlation with inflation, but this is unlikely to be a perfect hedge and is asset specific.
Contractual arrangements for any asset need to be assessed to determine the degree of inflation linkage and whether this flows through to earnings or is absorbed by inflation-linked input costs. It will also depend on the level and nature of leverage arrangements on any asset.
Private debt is typically structured as “floating rate”, which can provide a hedge against inflation, while private real estate could also be structured with inflation-linked, upward-only rent reviews.
What are the dangers in investing too heavily in illiquid assets?
Gordon Ross
It is important to avoid over-committing to illiquid asset classes as the committed capital may not be immediately required for investment, and investors must ensure that they can fund any commitments made to illiquid assets. Typically, committed capital for illiquid asset classes can take up to five years to be drawn down, and it is crucial to have the ability to meet these drawdowns without resorting to fire sales (usually from liquid asset allocations held by the fund). Failure to meet funding obligations can result in being declared a defaulting investor.
It is essential to understand that not all illiquid assets have the same characteristics, often reflecting a spectrum of liquidity.
Gordon Ross, LGPS Central
Distributions from illiquid asset classes are also uncertain and should not be relied upon for cash flows to fund outstanding or new commitments. It is essential to understand that not all illiquid assets have the same characteristics, often reflecting a spectrum of liquidity. The cost of investing should also be considered, as it has the potential to negate the liquidity premium associated with these assets.
Jason Fletcher
The LDI [liability-driven investing] crisis in September is a perfect example.
A sufficient level of liquidity is required by pension funds. And that’s not necessarily cash. It’s near assets. It could be equities. It could be bonds, it could be all kinds of things, but you need to have sufficient liquidity to cover you in bad times.
You need to think medium term on this. You can’t sit there with 20% in liquid assets, sell 10% to meet next year, and then 10% the following year, and then suddenly be left with 100% in private markets that you can’t sell when you need to.
And anyone who suggests borrowing money to get around that problem, just say no, it’s usually a bad idea.
Ian Sandiford
The degree of “danger” will depend on an investor’s liquidity requirements. You have to be committed for longer periods and, by definition, investors do not have the ability to easily access cash locked up in an asset, and any liquidity may be at a meaningful discount to carrying value.
Equally, it is generally a more complicated asset class to navigate given the nature of the sectors and other considerations such as legal structures. So the more heavily invested you are, the more resource you might need to commit to the ongoing management of the investments.
