When Paul Myners, in March 2001, published his groundbreaking review of UK institutional investment that was sponsored by the government, an important part of his message to Britain's pension fund industry was: ‘get investing in private equity – now’.
At the time, public and private pension schemes in the UK had on average less than one per cent of their capital committed to the asset class. As a result, Myners argued, their constituents had been missing out on the benefits of an investment strategy that US pension schemes, with average allocations significantly over five per cent, had already been successful with for decades.
The UK's private equity industry, predictably enough, rejoiced: here was an influential investment professional telling decision-makers at the country's pension funds that their allocation of assets to bonds and public equity wasn't good enough. Paul Myners was making a point that the industry had been promoting for years (albeit for somewhat more self-interested reasons): pension fund money could no longer afford to stay out of private equity funds.
‘Could we not sue them?’
Even the most successful private equity fundraisers say that over the years they haven't made many friends in UK pension circles. (There are of course exceptions: the pension schemes of large private sector companies including Shell, British Airways, Natwest and Unilever invested meaningful quantities of capital into private equity long before the Myners report happened.)
On at least one occasion in the mid 1990s, according to one veteran, a group of disillusioned private equity practitioners sat around a table joking about whether they should in fact sponsor some pension holders to take their schemes to court for failing to make investment decisions with the holders' best interest at heart – decisions that would truly maximise the future value of their contribution by including private equity in the mix. Recounts one of these would-be sponsors: “We said we'd sue on the basis that money could have been made. All you would have had to do was to show that private equity outperformed the public markets by a meaningful margin – done.” The plan was never pursued, but the anecdote illustrates the point that, until recently, private equity managers considered the majority of UK pension plans close to impenetrable.
However, it's fair to assume that any joke about going after pension money by legal means would be lost on those who it was aimed at: the pension fund trustees. Most trustees would struggle to see the funny side, because, as they would insist, plan holders' best interest is precisely what they as the guardians of pension plans care about, and that keeping private equity out of the portfolio was not just some careless oversight on their part, but a deliberate and easily justifiable decision. For private equity, they'd tell you, isn't worth the hassle: risky, illiquid and, above all, extraordinarily expensive. By the time you are done paying management and performance fees, trustees would often declare, your constituents would have very good reason to ask what all this money is being thrown about for. To most trustees, private equity seemed a suspiciously costly asset class to participate in.
In the opposing camp you had the general partners who readily dismissed such arguments as coming from people who didn't know what they are talking about. They regarded trustees as poorly equipped to engage with the asset class, and as a result resented their influence. More tellingly, it was argued that the funds they supervised were prone to an innate conservatism and herd-like mentality that produced average (at best) performance. That conservatism may be changing though.
The question of whether trustees have the qualifications required to handle the increasingly complex investment decisions their role asks of them has been one that private equity managers have not been alone in asking. It was, in fact, one of the core issues that Myners addressed. The report found that out of a sample of 266 trustees overseeing 122 funds, 69 per cent had two days or less training for the role of fund trustee; 62 per cent of trustees had no professional qualifications in finance or investment; and 49 per cent spent three hours or less preparing for pension fund meetings. The implication was that here was a poorly equipped group of people who gave insufficient time to addressing their knowledge gaps.
It's worth reminding oneself though that trustees are intended to be laypeople, armed with a layperson's knowledge. Trustees look to receive guidance from investment consultants (aka “actuaries”) before authorising a pension's investment staff to execute the asset management strategy that has been formulated. Trustees are not investment professionals: how “investment savvy” should they be therefore?
In the UK, trustees are required to act as “prudent men” and “to conduct the business of the trust with the same care as an ordinary man of business” (this is quoted from the Goode Report of 1993 that preceded Myners on the investment industry). This was given a little bit more edge in the Trustee Act of 2000 that said a trustee must have regard to “any special knowledge or experience that it is reasonable to expect of a person acting in the course of that kind of business or profession”. This takes the prototypical UK trustee nearer to the US equivalent, where the Department of Labor Federal Regulations stipulate that a trustee must be “a prudent man acting in a like capacity and familiar with such matters in the conduct of an enterprise of a like character and with like aims.” But whereas in the US one can cast a trustee as a prudent expert, you are still left thinking that there are far too many amateur trustees – though no doubt very prudent – in the UK (and elsewhere in Europe too).
Myners demanded that this be remedied: trustees should get paid, be properly trained, receive sufficient in-house reports, delegate where necessary but, critically, be in the know about the issues at hand.
The pension funds say they have been taking the Myners recommendations very seriously. According to Reactions to the Myners principles, a survey published in March 2003 by the National Association of Pension Funds (NAPF), 94 per cent of its members now claim to comply, or work towards complying, ‘with the majority of the principles’, either as a direct result of Myner's recommendations or because of internal restructuring and a perceived need to respond to a rapidly changing – and significantly more challenging – market environment.
At the same time, private equity practitioners acknowledge that trustees' long-standing resistance to alternative investment appears to be softening. “There are more enlightened trustees out there now who have taken the initiative and the trouble to learn about private equity”, reports Jonny Maxwell, chief executive of Edinburgh-based Standard Life Investment (Private Equity), who as part of an ongoing fundraising campaign has spent a significant amount of time discussing private equity with trustees.
Maxwell also says, interestingly, that another key group of professionals involved in the pension fund investment process deserve credit: the actuaries. “Many of them have raised their game as well”, he says. Others within the industry though remain sceptical that this community has genuinely engaged with the asset class. Said one such GP: “The consultants now pay lip service to private equity but I remain unconvinced of their commitment to it. Rising public markets will see most of them flock back to a tried and tested asset mix that sees private equity on the margins at best.”
Any suggestion that the actuaries are now alive to the relevance of private equity in a client's portfolio is noteworthy because most private equity managers have been as ready to be critical of investment consultants as they have been sceptical about a pension fund's trustees. The idea that actuaries should be able to provide trustees with the necessary expertise to invest in products other than plain vanilla ones has widely been questioned. One reason for that is that an elite of only four firms – Watson Wyatt, Bacon & Woodrow, Marsh McLellan and Hymans Robertson – control most of the market, which, critics say, discourages innovation and creativity.
Another perceived problem is that consultants are hardly in a better position to seriously engage with private equity than their clients. Actuaries, like the trustees themselves, typically work on a pension's entire investment programme. Given that the portion of a plan's assets allocated to private equity, where it does exist, will be small, it is difficult for consultants to justify the extra time that private equity undoubtedly demands. Neither are they likely to be incentivised to do so, as their clients too are focused on their much larger exposure to mainstream assets.
Where consultants have been actively encouraging trustees to authorise private equity investment, the main beneficiaries have been the brand-name funds of funds (FoFs) such as Pantheon Ventures and HarbourVest Partners. There is a widespread belief in the industry that actuaries will follow the principle that doing the equivalent of “buying IBM” has never got anyone into trouble when recommending managers for alternative strategies. This unsurprisingly frustrates some stand-alone private equity funds who feel that their very specialism is held against them.
Steering clients towards the big FoF brands in the business isn't necessarily a bad thing though. It is a sensible move for smaller pensions such as the numerous local authority pension plans in the UK for example, who don't have the assets, let alone the managerial resources, to take a more ambitious approach. But larger pensions pursuing a vanilla funds of funds approach tend to attract criticism, except in cases where it is part of a first-time investor's strategy to get a foot in the door with a view to scaling up the effort at a later stage. Says a leading specialist investment adviser in London: “For large pension managers, going with the large funds of funds is fundamentally the wrong strategy. You're essentially buying over-diversified portfolios at a horrendous cost to your beneficiaries.”
This suggests that pension schemes with sufficient financial prowess need to be proactive when investing in private equity. It is worth noting that the Shell UK pension fund, one of the UK's most successful schemes investing in private equity throughout the 1990s, built a £500m fund investment programme without any actuarial help. Nick Shaw, the investment manager who ran Shell's investment portfolio until he joined the private equity operation overseen by Peter Gale at London-based asset manager Gartmore, says that Shell's trustees fully supported the private equity effort. Shaw invested just over 7 per cent of the pension's capital in the asset class. “We found that close relationships can be more effective than segregation between trustees, actuaries and investment managers”, he says.
Pension funds welcome
Shell's experience notwithstanding, actuaries are of course still immensely influential in guiding pensions' investment activities, and will remain so going forward. “It is very difficult to meet a trustee without a recommendation from a consultant,” says Colin Brown, an independent private equity placement agent.
That is why Maxwell's observation that more engagement and know-how is being shown within the actuarial profession is welcome news to the industry. It also comes at a time when investment consultants are facing mounting pressure to raise their game when advising clients. Estimates put the aggregate deficit currently nursed by UK pension investors at £100bn or more, and many commentators believe that consultants are in part to blame for the current malaise.
To be sure, private equity isn't a product that can help plug funding gaps in the short term. Programmes that are established today will take at least five years to deliver enough cash flow information, let alone returns, to assess whether a chosen strategy is actually working. Most of the larger UK pension funds, says an adviser, have now decided to devote more capital to private equity – typically between 2 and 4 per cent – but these fledgling programmes will take time to bed down and then yield.
Still, it seems clear that some trustees are in the process of changing their views about – and their pension fund's allocations to – private equity. NAPF data published in December 2002 showed that out of 100 of its members active in private equity, 13 had invested in excess of £100m, as opposed to just one member in 2001. 33 per cent of those invested in private equity had put in at least £20m, against only six per cent in 2001.
These are arguably still small numbers, but there is an encouraging upward trend. Most importantly, GPs agree that trustees have become more curious about the asset class. “Many are on a fact finding mission at the moment, and they are keen to spend time with managers,” says one, adding that this time spent is by no means a guarantee that an investment decision is going to follow. Far from it: “The shrewder trustees are spending time with managers in part to test the recommendations of their actuaries.”
GPs may be wondering why they should give their time to this sort of exercise, but there is an obvious answer. Supporting the trustees in their efforts to climb the learning curve is likely to be rewarded once this educational process is more advanced. For there is a consensus among European practitioners that pension funds, in the UK as much as in the already more evolved pension markets such as Switzerland and Scandinavia, are going to be meaningful investors in private equity going forward – significantly more meaningful, for example, than banks, who will be continue to be driven out by Basel II as well as their own questionable track records as investors in the asset class.
Pension funds are also expected to avoid some of the mistakes that banks as limited partners are considered to have made. One investment professional says this is so because the two groups follow fundamentally different investment philosophies. “Banks do relationship investment. They invest with people they like, they don't do due diligence, and they don't negotiate terms. Pensions are very different. They are required to do due diligence. It's amazing what some of the plans that we have come across have turned up when considering an investment. The industry can only benefit.”