It’s all anyone’s talking about right now as the dust settles on the chancellor’s Mansion House speech…
I want to try and challenge three of the accepted wisdoms here:
– That the U.K. pensions system is a big and significant investment force
– That private markets make for great investments and
– That channeling U.K. savers money into funds that bid for the equity of private companies will be the game changer everyone seems to think it will …
How significant is the U.K. pensions system really?
This matters as it appears to be a cornerstone of the chancellor’s argument here – mentioned in the second tweet.
John Stepek at Bloomberg succeeded in writing maybe the best short summary of the shape of the U.K. pensions system I’ve seen which gets almost everything right. Particularly welcome is the sensible line on why DB is investing how it is (yeah, duh, it’s about the liabilities). The upshot is that the U.K. pensions system has a lot less capacity to really invest in growth than you might think at first blush – Toby Nangle recently wrote on how the U.K. pension system might now invest only c450bn in equity assets
This is probably a fifth or less of the oft quoted multi-trillion number, but probably gives you a fairer idea of the significance of U.K. pensions. It’s not nothing, but it’s about the same as two really large global asset owners (think US or Canadian pensions).
Now sure, could they overall take a **little** more growth risk without harming anyone … probably? But DB is maturing and trying to actually pay pensions so a good amount of bonds (read: debt funding to the government and companies) just makes sense. The U.K. pension system just isn’t really as big as we’d like to think.
This is exacerbated further by the fragmentation issue – discussed further below. And as John rightly says, the only question that really matters is what gives best returns for members, and when it comes to growth investing in “fantastic new companies” this is far from the sure thing it’s often presented as (I’ll get to that).
Fragmentation
One characteristic of the U.K. pension system is fragmentation, we have a lot of small schemes and relatively few asset owners of true scale – say $30bn plus (in both DC and DB). This has a number of consequences – schemes effectively “rent” scale and capability from the asset management industry. In private markets the all-in access costs for these funds can be pretty high (easily 1.5-2% per year). So even if you can identify good assets, it’s quite possible you turn around and pay most or all or the excess returns back to the industry the way things are set up at the moment, and this is often overlooked (sounds too absurd to be true, happens all the time). It’s not enough just to identify great assets, you have to be able to access them in a way that leaves a fair chunk of the value in the hands of the members and that is far from a given.
Growth returns, what’s not to like?!
But of course those growth returns are far from a sure thing either. Research by Harvard academics showed that US private equity funds have not outperformed public markets since around 2005 (despite private equity fund companies minting a growing number of billionaires over the same period). And don’t even get me started on all the spurious ways they con you on the returns that have been achieved.
I’ve said it before and I’ll say it again – we shouldn’t put private markets on a pedestal
I do think this is a problem because the “private markets are inherently good” narrative has made it almost all the way into government policy at this point. This is because the funds industry has a very loud lobby voice and many of the arguments seem superficially convincing.
Honestly if the claims being made in the chancellor’s speech on returns and higher pensions came from a pension provider or asset manager, they’d go straight to the FCA and rightly so.
Update: this seems to be the analysis used to support the numbers in the speech. It’s not bad as things go, but seems to leave out the one crucial assumption which is what returns have been assumed for private equity and why.
Setting that aside even this analysis shows that you’re actually worse off investing in private equity at standard fees, and all the chancellor’s claims hinge on being able to access private equity at 1% and 10% fee terms which seems pretty optimistic given what’s out there in the market at the moment .
The analysis is also a little stingy on standard listed stock returns (just 3.7% real) nudging that figure up slightly might well erase all the benefits of private equity.
Is more new investment into companies really the answer?
Growth funding to UK companies seems a reasonable goal from a policy perspective but there are questions – as laid out in the Government’s 2017 Patient Capital Review[1] there are a number of investors operating in the space already. The British Growth Fund has existed since 2011 to fund U.K. startups, the British Business Bank was set up in 2014, British Patient Capital was launched in 2019. The UK Infrastructure Bank was launched in 2021. EIS and VCT schemes have been expanded to attract more capital. The worry is you add another new vehicle in and what happens is you get all these vehicles bidding against each other for deals.
The global private equity industry has around $3trn in “dry powder”[2] waiting to be deployed (last I checked they did know where London was and how to get here), and the government’s own “Venture Capital Unit” notes that 80% of the deals done in the UK last year were by overseas investors. We are operating in a globally connected capital market and it makes no sense to force UK based investors into bidding wars against overseas funds. This should be seen as a positive – the same trend that has seen UK pension funds moving away from UK assets has Canadian, Australian and US funds looking for good investments in the UK, and their capital should be welcomed – if U.K. companies are good investments for U.K. funds then they should be for overseas funds too (and that’s fine).
Are there really enough good deals and assets to support a £50bn future fund? The government’s 2017 report identified that the UK growth funding gap was perhaps £3-6bn per year, much of which is met by the expansion of the EIS program and the launch of British Patient Capital. Let’s look at some numbers: BGF deployed about £2bn over 10 years, BPC has deployed about £300m per year over 5 years. Those numbers suggest the 3-6bn per year opportunity might be an overestimate, and don’t suggest a market ready to absorb multi tens of billions of new investment capital.
I think that’s partly why when you look at the private markets funds offered by asset managers, most of the assets end up being US private equity buyouts or infrastructure, because that’s what they know how to access and where there’s scale.
And here’s another pitfall you need to worry about here – the old bait and switch. You get the sell story on growth and venture capital, then you see the fund and it’s stuffed with private debt and infrastructure. Nothing wrong with debt and infrastructure but they aren’t gonna give you VC like returns (especially with a 2% fee load).
Economist Allison Schrager is also sceptical of this as a means to promote growth:
I agree that UK pensions can probably handle a bit more risk and could invest in more equity. But I am skeptical that this is a means of growth for the whole country. The US pension experiment in private equity may still end in tears, and once we start seeing pension assets responsible for growing the economy, I fear they will be invested in government-favored growth industries, which may not deliver returns. It’s also bad risk management because, if it fails, taxpayers are doubly on the hook. But I give UK policymakers credit for making growth a priority.
Allison Schrager (link)
I would look more to ideas that have actually worked, for example the Greencoat U.K. wind investment trust is a success story in channelling private long term capital in the U.K. there are now many other similar listed investment trusts representing a pretty decent pool of permanent capital. These have the advantage of going with the grain of the listed markets rather than trying to create potentially expensive structures outside of listed markets.
[1] https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/661397/PCR_Industry_panel_response.pdf
[2] Mckinsey private markets report 2023