Richard Tomlinson, CIO at LPPI, the asset manager for the £24bn pool Local Pensions Partnership, speaks to Room151 about the impact of the Mansion House Reforms and an increasingly challenging outlook for investing in private markets.
What do you make of the government’s push for more pension fund investment in private markets?
This is a trend we have been seeing unfold over the last ten, fifteen years, certainly in the UK, institutions had very little exposure to private markets in their portfolios. Over time, there has been a big push into asset classes such as unlisted infrastructure, direct property, private equity and credit. In many cases, this push has been driven by the perception that you get higher returns in these assets.
In my mind, that is true and untrue. Some of these assets can have very healthy return profiles when adjusted for risk. Others less so. In other words, you have got this reductive simplification that private markets equal higher returns and that is just demonstrably false.
Some private market assets can have higher returns, but the key then is to identify the driver of those returns. Is it leverage? Is it complexity? Or is it a niche asset that you can’t get any other way? Or is there a mispricing between supply and demand? Or a number of other reasons?
There are good reasons why some private markets fit into institutional portfolios. Much of the LGPS thinks carefully about the direct impact of their investments. Most of that happens in private markets because you can’t really do that in public markets, especially if you want to be more local and targeted about it.
If you then link that to the government’s pathway and their aim to direct pension fund investments away from public markets and into private markets, there are elements of that that are true and elements where we should apply a bit more nuance.
There are solid reasons why corporate defined benefit schemes do what they do and why their portfolios look like they do. That is quite different from the LGPS or other open schemes or even DC schemes. I get why the government wants to see more investment in private markets but there are lots of practicalities around it.
If we are talking about the LGPS in particular, it already has a reasonable private markets exposure. If I look at LPPI, our client funds already have exposure that would meet the 10% target now.
The government’s proposals seem to be focused on private equity. Why the focus on one private equity in particular?
When the government is saying private equity and then describing start-ups and venture capital growth companies that is a tiny slice of the private equity market, there is much more to it. If I am honest, the industry discourse, certainly in the LGPS, is very sensible and aware of this.
The general response is: “Fine we are going to put money into private equity, but that universe is very wide and we are going to think carefully about a broad range of assets.” And remember, this isn’t restricted to private equity in the UK alone, so there is a lot in there.
Should investors be concerned about rising risks in private equity or is now the time to take on more risks, given that plain vanilla bond funds are already offering returns in excess of 5%?
The change in the risk-free rates and the change in the long-term outlook for real rates have changed quite significantly over the last two years. Long term real rates have moved by hundreds of basis points, both here and in the US. That is very meaningful, and it has an impact on all asset classes.
Returns on short-term money were basically zero, now they are at five percent, that is an enormous difference. It all depends on your time frame, perspective, and risk appetite. If I think about our role as a defined benefit scheme with a strong covenant and long-dated liabilities, we don’t have levered balance sheets.
We think about this not as a single return figure but look at the returns we could be getting in a downside or upside scenario to establish a risk framework. That means we can genuinely be aligned with our investors without synthetic short-term barriers.
I am very mindful that if you are not careful, you end up being counter-cyclical the wrong way around. The night is always darkest before the dawn so when you think things are at their bleakest, it probably means all the bad news is in the price and things are about to turn around.
Are you concerned that private equity investments are becoming riskier as rates are rising?
It is a different environment from two years ago, there is no doubt about that. Getting startup funding has become much more challenging, capital suppliers have become much more discerning. If you think about the classic buyout strategies, their managers are generally deeply experienced people who understand what is going on and clearly the cost of capital has gone up.
Private equity is a slightly different ballgame. Businesses that are refinancing any time soon are going to find themselves paying a lot more for their capital. As you know, some of our managers and some of our capital is supplying that funding via private credit which then changes the dynamics of returns on capital to LP’s, realisations are now harder and less appealing. If a business was worth X a number of years back, you’re probably not going to want to sell it for less than X into an unfavourable market. So we’re seeing less cashflows back into the LP’s. It is a more challenging market and if you are going to buy anything now, you have got to be a lot more careful because the cheap leverage of yesteryear isn’t readily available.
So this is about changing opportunity sets. There are always opportunities out there but many of the easy trades have been done.
How are you responding to these challenges in your portfolio?
We are committed to our GP’s rather than trying to manage the assets ourselves. We are mindful of the sort of managers we have allocated to over the last few years, we tend to congregate in the relatively more conservative assets in all asset classes. We tend to not chase the hottest things out there. Within private equity we have very low exposure to venture capital, we see it as a much more challenging space to invest in. So we have missed some of the ups before but we have also missed some of the downside risks. Our investments tend to be a lot more focused on operational improvement rather than financial engineering. That type of approach is probably still more realistic.
How are you integrating climate solutions into your portfolio?
If we start off with the bigger picture, we have just been through an environment of easy money, if you owned property, you were doing alright, if you owned equities, you were doing alright and if you owned bonds or alternatives, you were doing fine too. That era is now over, there are going to be clear winners and losers.
I am always mindful of thematic investing; I think it is hard to get right but climate solutions are a theme that we can’t ignore.
A lot of investors now have climate solutions allocations, a lot of climate solutions funds have been launched, it is a theme where asset managers can raise money.
At LPPI, we are looking at a climate solutions offering quite seriously and the reason why we have to do that is that we have made a net zero commitment a year ago and the first update will now be provided.
While we as an asset manager are not part of the asset owner charter and don’t have to make investments in climate solutions, our client funds are part of the asset owner IIGCC and will have a commitment to investing in climate solutions and we want to work with our clients to fulfil that need.
This is an area we are looking at very carefully.
You are a member of GLIL so you do offer already access to some climate solutions?
Exactly, we own renewable energy assets which would fall under the green taxonomy, that is what we would point to already. The level of investment varies by client.
The LPFA has for example also made a net zero commitment so we are working with them to help them fulfil that.
Richard Tomlinson will speak at Room151’s Investment Forum. Further information about the event can be found below.
