Private equity: The waiting game


20 Jun 2022

British pension schemes are increasingly turning to private equity to combat low yields, but with dry powder at a record high, are risks building up? Mona Dohle reports


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British pension schemes are increasingly turning to private equity to combat low yields, but with dry powder at a record high, are risks building up? Mona Dohle reports

Private equity is leaving its mark on household names. The takeovers of Asda by TDR Capital in April and the $7bn (£5.7bn) acquisition of Morrisons by Clayton Dublier & Rice a month later illustrate the point.

While the number of listed firms are in decline, private equity has become increasingly popular among investors battling low yields, inflation and bumpy stock markets. Indeed, between January and October 2021, close to 6,000 private equity-backed deals worth an aggregate $603bn (£494bn) were completed globally. This is 28% higher than in the previous year, according to Preqin. The alternatives data provider predicts that the market is on track to be managing more than £12trn in assets by 2026.

For example, the AUD260bn (£147bn) AustralianSuper has allocated AUD50bn (£28bn), or 7% of its portfolio, to private equity, which will be invested during the next five years. Similarly, US pension funds have, on average, close to 9% of their assets invested, while German and Italian funds have 4.5% and 3.6%, respectively, according to Mercer.

The government would like British pension funds to play a bigger role in unlisted markets, too. It announced at the end of last year plans to review the performance cap for defined contribution funds in an attempt to bolster institutional allocations to private markets to back up its Build Back Better agenda and the transition towards a carbon neutral economy.

UK investors have historically been cautious, DB schemes allocated less than 1% to the asset class as of 2020, according to Mercer. But this is changing. Almost half (48%) of DB schemes plan to allocate more to private equity over the next five years, according to a survey conducted by Create Research and Amundi of 152 final salary schemes in 17 pension markets.

And UK investors are increasingly taking part, several large DB schemes, including LGPS pools and even master trusts, have announced commitments earlier this year. It is easy to see the appeal of private markets. In a world of real-term negative interest rates and volatile stocks, private equity has historically offered double-digit returns. Over the past five years, the internal rate of return (IRR) for private equity has been 18.8%, according to Preqin. Moreover, it is seen, rightly or wrongly, as uncorrelated to listed stocks and relatively less vulnerable to inflation risks.


But the flipside of this surge in demand is that the industry sat on a record $1.3trn (£1trn) of dry powder at the end of 2021, according to Preqin, other estimates put it as high as $1.8trn (£1.48trn), a quarter of which is held by the 25 largest firms. Simultaneously, the fundraising cycle has become much shorter, it fell by 10 months between 2013 and 2018, according to Preqin, adding to the pressure on general partners to deploy their capital effectively.

For asset owners, the challenge now is how to source the right investments, given that private equity has a wide dispersion of returns. Anna Morrison, senior director of private markets at bfinance, highlights that the rapid growth of the market has made it more challenging to source the right strategy.

Having been a limited partner (LP) in the past, she argues that periods of high levels of dry powder bring their own challenges. “The biggest issue right now is how you select where to invest, how much you are investing, how carefully you consider your portfolio and the number of managers you need to look at in a particular space is growing and growing,” Morrison adds. “And selecting the wrong manager could come with a heavy price tag. What the performance data tells us is that in private equity, there’s a massive dispersion between bottom quartile and top quartile performance returns. The biggest issue you have, in periods like this, is making sure you are supporting those managers that sit in those top quartiles,” she adds.

Law firm Dechert’s 2022 Private Equity outlook describes the market as “scorching hot” and warns that the perks of high levels of dry powder could backfire. “Being heavily armed with capital is a major boon for the global PE industry,” the report reads. “But you can have too much of a good thing. Looking forward to 2022, Covid-19 induced supply chain disruptions and emergent inflationary trends will also need to be considered.”

Different options

Buyout funds continue to remain a popular approach for many investors, accounting for 40% of all funds globally while debt and growth funds are also picking up pace, according to European Central Bank research published in 2020.

Accessing private equity has become easier over the years. “For first time investors, we are seeing two ways of coming to the market,” Morrison says. “There has been quite a shift between what you could do 10 to 15 years ago as a first time investor and what you can do now. “As a first time investor, you want to look at the lower end of the risk scale, but you also want returns. You want to diversify your portfolio, which generally means geographic diversity, vintage diversity and sector diversity as well. For that, one of the most sought after solutions tend to be fund of fund vehicles,” she adds.

But she has also seen some of his clients showing more interest in the secondary market. “We have seen that market develop quite significantly in terms of the quality of participants and the amount of money flowing into the market,” Morrison says. She believes that the secondary market has the potential to address some of the problems of the fund of fund market, particularly because it does not require them to commit their capital for a longer period of time.

“With secondaries, you are deploying your capital a lot faster and over shorter investing periods so you get diversity a lot quicker. You are also seeing a lot quicker path to breakeven costs than you would see in a traditional fund of fund structure,” she says. At the same time, return profiles in secondaries are different. “In a traditional fund of fund model you are looking at a higher multiple and in the secondaries market at a higher IRR. There is also a fee drag in secondaries. You are investing in funds that are often well underway, so the fee load is less,” she adds.

The money raised in secondaries tripled in 2020 to $87bn (£71.3bn), but the market is concentrated with $61bn (£50bn) raised by megafunds, McKinsey highlights. Another increasingly popular option for investors are co-investment strategies, which allow investors to deploy capital through a minority investment directly into a company alongside other private equity investors.

“Co-investments are featuring more and more as part of a fund of fund structure and we are also increasingly seeing the emergence of direct co-investment funds,” Morrison says. “This is interesting for investors who want to get SME exposure but do not necessarily have the in-house skills to do due diligence on their own,” she adds.


With plenty of strategies to choose from, how then are investors allocating to unlisted firms? In the DB world, pools have become a trailblazer in launching private equity funds. They benefit from a combination of scale and a relatively longer investment horizon due to the demographic of their membership, allowing them to make commitments to illiquid investments.

Examples include LGPS Central’s 2018/2019 Vintage Fund, which houses a combination of investments in primary funds and co investments. The LGPS pool has also launched another strategy, which closed to fundraising in January. The fund aims to deploy about 80% of its capital to the mid-market and below focusing on the lower end of the growth market. Portfolio managers will concentrate on sector focused funds and steer away from generalist funds, based on the premise that the former will be more effective in value creation.

Border to Coast has also been active in private markets for some time, having committed £10bn since 2019. As part of its private equity strategy, it is invested in growth, special situations and emerging market funds among others.

For Christian Dobson, private equity portfolio manager at Border to Coast, the lifecycle of the scheme plays an important part in selecting a private equity manager. He shares LGPS Central’s view that lower- and mid-level managers can offer better value creation. But for more mature funds, the ability to cash in may be the priority. “If you are approaching a position where you may need liquidity in your private markets portfolio, that may encourage you to go to the larger funds where there is a better secondary market,” Dobson says.

Similarly, Local Pensions Partnership has been invested in private equity for some time. The pool launched its private equity fund in 2017, and, as of 2021, it holds £1.6n in assets which are allocated across buyout, growth capital, special situations and distressed assets.

Turning point for DC

In contrast, DC funds have historically been cautious to invest in private markets, despite the favourable demographic of their membership and a rapid growth in assets. The fee structure and daily pricing requirements have so far been an obstacle.

For Brian Kilpatrick, chief investment officer of the HSBC UK Pension Scheme, accessing private markets for the DC side of its scheme remains a research issue. For Kilpatrick, inter-generational fairness is also a key concern because the J curve in private equity means that returns may initially be negative for a few years.

“You can imagine a situation where the J curve will have a negative impact for members who are invested in the early years but retire before the investment returns are realised. Other members are there for the lifespan of these assets and then reap the rewards at the end. So, the question is, how do you build these assets in to your portfolio whilst trying to mitigate those different return impacts on different members?” he says.

But even in DC land, things are changing rapidly. Nest, the £24bn master trust, awarded a £1.5bn private equity mandate to Schroders in May, to be deployed over the next five years. This may not seem like a large sum, compared to the amounts some DB schemes are investing.

But over the longer term, the master trust, which predicts it will have £100bn in AUM by the end of the decade, plans to allocate 5% of its rapidly growing assets to private equity. Nest’s chief investment officer, Mark Fawcett, argues that this mandate is indicative of how far DC funds have come. “Many UK workers, for the first time in their lives, will now have the chance to benefit from investing in private equity. We have never accepted that any type of investment is out-of-reach for our members. We want every tool in our toolbox to boost the risk-adjusted returns for our members.”

Just like the LGPS pools, Nest is targeting the lower end of the growth market. “What we were looking for was a manager who is looking for fast growing smaller companies who needed more capital to buy out the entrepreneurs who set it up, or just to give them more capital so they can grow. So, this is not about big LBOs, who won’t be investing in Twitter or Asda, this is to drive growth for smaller companies around the world where there are investment opportunities we just cannot get on the listed markets” Fawcett says.

He is optimistic that other DC funds will follow suit, arguing that this mandate could be a “watershed moment” for private equity to become more accessible to pension savers across the country. While Schroders did not want to name names, it confirmed that it is currently in discussions with other DC schemes for private equity mandates.

Approach with caution

Fawcett’s optimism will be music to the ears of UK policymakers hoping to bolster institutional investment in private markets. But there are good reasons to approach these assets with caution. Strong investor demand means that GPs are forced to bid high to win auctions, which could lock investors in less favourable terms.

The market vintage could play a key role in future returns, as a report conducted by the European Central Bank argues. “Market exuberance can drive over-optimistic investments that may lead to low returns in the medium term: the worst-performing vintages are those of 2005-06, prior to the onset of the global financial crisis, as they deployed most of their funds at a time when valuations were highest,” it said.

The central bank highlights that private equity investments can also have detrimental effects in financial stability. “PE-controlled companies issuing leveraged loans had been driving corporate leverage higher and investor protection lower in the US and Europe,” the ECB warns.

For Morrison, private equity still has much to offer but good research is key. “The risks when there’s a lot of dry powder out there is that there are lots of people chasing you for money, and it’s being able to get deep into that data and understand what’s a good sales pitch and what’s a good investment strategy,” she says.


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