Receive free Pension updates
We will send you a myFT Daily Digest email rounding up the latest Pensions news every morning.
The writer is a former global head of asset allocation at a fund manager
The goals of the pension reforms outlined last week by UK chancellor Jeremy Hunt are quite noble – they are to increase productivity and pension savings.
The reforms seek to do that with an agreement among several major financial services firms to allocate at least 5 percent of their defined contribution default fund client assets to unlisted equities by 2030. .
But his big idea rests on a couple of key assumptions. First, that the lack of equity capital prevents unlisted high-growth companies from developing. And secondly, unlisted equities provide higher returns than their public market counterparts.
The evidence for the first claim is circumstantial. When it comes to venture capital the UK is no minnow. KPMG estimates that last year almost $35bn in deals were done in the UK – more than the total done in France and Germany combined. But when it comes to late-stage deals worth more than $100mn, New Financial’s analysis found that fundraising is dominated by international VCs. In a global market for growth companies, capital is available. It’s not very British. That being said, it is not difficult to say that the cost of international due diligence has increased the UK growth company’s cost of capital by a margin.
In addition, the UK appears to have trouble scaling up unlisted companies. British Patient Capital – a subsidiary of the state-owned British Business Bank – reports that while deal sizes are comparable to US and UK start-ups in their first round of funding, in the fifth and sixth that round the deal sizes in America are about three times bigger. than their British counterparts. It’s not clear if the problem is the availability of capital, but a cheaper cost of funds wouldn’t hurt.
The evidence for private equity generating superior returns to public equity appears at first glance to be on firmer ground. The overwhelming consensus from capital market analysts of international investment managers is that private equity is the highest return asset class in the long run. For example, BlackRock projects private equity to outperform US stocks by more than 3 percent a year over the long term; Morgan Stanley expects 4.6 percent a year and JPMorgan Asset Management 2 percent.
Part of the stated methodological rationale for expecting private equity outperformance is the extreme risk of asset class liquidity. You don’t get your money when you want it. Such deterioration must have a cost, forecasters estimate, and they project this cost as a higher expected return. The illiquidity premia is easier to assume than to measure.
In the context of extraordinary recent private equity performance, this can be forgiven. But if returns are flattered by 15-year cheap debt, then the assumptions of investment managers will prove to be extrapolative rather than predictable in a new age of higher yields. bonds. However, large investors such as the Wellcome Trust have achieved excellent returns over the past decade.
When measured over longer periods, returns on high-growth private equity strategies are more diverse. Even large and sophisticated investors like Calpers have seen VC portfolio returns average less than 1 percent a year over a 20-year period. And, unsurprisingly, academic studies have found almost universally that returns from private equity do not beat the public markets, after fees. Professor Ludovic Phalippou of the Saïd Business School calls the industry a billionaire factory, where billionaires are fund managers rather than entrepreneurs.
But upon inspection of the fine print, the government’s cost analysis does not rely on heroic predictions of returns. In fact, they plan that the defined pension contribution pots will be slightly smaller if they make the transition from public to private equity, once compensation is taken into account. The payout is huge, with a 5 per cent private equity allocation more than doubling their cumulative total paid out over 30 years on the median projection from £10,700 to £22,500 per pension saver.
That said, Hunt has been forced to rely on a further forecast in which private equity firms charge UK pension managers just half their base rate to clear his “golden rule” of securing the best which are possible consequences for pension savers.
The desire of the chancellor to help solve two difficult problems – the difficulty that companies scale up from start-up to the list, and low future defined contribution pension returns – should be applauded. If he can force private equity fees to a level where the asset class outperforms the public markets even in a higher yield environment he will break third.