Iain Campbell, head of LGPS Investment at Hymans Robertson examines the case for greater allocations to private equity.
When Jeremy Hunt announced in his 2024 Spring budget that LGPS pensions funds would ideally need to show that they have at least 10% of assets in private equity, it caused a stir! Primarily because it was veering into dictating to funds how to set their asset allocation.
Private equity is an asset class that has historically offered relatively high returns, and investment in this area could help the government achieve its goal of growing the UK economy. However, funds are able to make investments here already, but the majority choose not to go as high as 10% because of its relatively high-risk nature. Somewhat helpfully, the government stopped short of stating the assets need to be UK based. With that in mind it’s a useful exercise to consider the private equity class as a whole. Looking at how the UK compares to other markets along with the main risks and implications for LGPS funds.
Compared to others, such as the European or US markets, the UK private equity market is not as large but, what it lacks comparatively in size, it makes up in the variety of sectors it offers exposure to. The fact that it also offers investors the chance to invest in businesses that are at a mix of maturation points could help funds to manage some of the other risks that come with investing in the class.
Typically, UK-based equity funds fall into two categories. One is focused on venture capital and start-ups and the other covers medium and large companies that are either publicly or privately owned and typically looking to grow, i.e. growth funds. Most of the businesses that the venture capital funds tend to invest in in the UK are innovative start-ups in IT, financial services, business services and healthcare sectors.
Growth funds don’t tend to be sector specific but do largely concentrate on small and medium buyouts in the UK. Some of these funds do focus on particular regions in the UK which could be useful when it comes to impact investing considerations or when looking to ensure diversification.
No matter which part of the world a private equity asset sits there are some considerations that must be made across the board. Manager selection risk is a key consideration. There is academic evidence to suggest that median returns from private equity funds are no better than from listed markets. Instead, it’s the choice in manager that has the biggest impact, with the manager’s strategic skill often being the difference between achieving returns of 3-5% pa and not.
In addition, there is the issue of vintage year risk which funds are already familiar with. This refers to the impact of making investments during a year when the market just hasn’t been doing that well. This can happen because private equity capital investments are made over a single period in each market cycle, but it can be mitigated against with care. There are of course other risks that need to be carefully considered, these include operational and tax and environmental risk.
The LGPS is well known for maintaining a long-term view and the majority of funds are leaders when it comes to responsible investment and managing their climate risk. Potentially, investing in private equity has implications for funds’ ability to easily meet their reporting obligations. It could offer many a way to meet their impact investing goals however, LGPS funds may find that they have to request customised reports from managers to ensure that they’re able to meet their reporting needs.
If funds meet this 10% ambition, it shouldn’t significantly change things for the worse. It will however increase the level of illiquidity in LGPS investment portfolios as private equity funds, for the most part, are illiquid. This has the potential to increase risk around cashflow, but there are tactics that can be used to manage this issue.
Overall, despite private equity being a higher-risk form of equity investment compared to listed equity, which the LGPS is more familiar with, it is an allocation that can be complementary to a listed equity allocation, as it provides exposure to different sectors of the economy. There is even a likely possibility that private equity allocation will act to enhance the return profile of LGPS funds’ portfolios and provide additional opportunities for diversification.
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