Private markets: Illiquid dreams


7 Aug 2023

Illiquids offer the potential for better long-term outcomes but is updated regulation sufficient to accommodate change and how is the industry responding? Gill Wadsworth reports.


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Illiquids offer the potential for better long-term outcomes but is updated regulation sufficient to accommodate change and how is the industry responding? Gill Wadsworth reports.

Defined contribution (DC) pension savers could have made an extra 2% last year if they had been invested in illiquid assets. Yet these sources of additional return rarely feature in the default strategies offered to members.

Consultancy Hymans Robertson’s Master Trust Default Fund Review published in May found that historically, average returns from illiquid investment strategies “would have improved net returns for members by 1% to 2% per year over the last decade, assuming a well-diversified approach”.

The findings provide well-timed fuel for the government’s e ort to drive more investment in long-term assets that support its levelling up agenda.

The government sees pension funds as critical in providing the billions of pounds in investment needed to bolster the UK’s infrastructure, housing and green energy projects, yet the DC universe – set to be worth £1trn by the end of the decade – remains hamstrung by daily pricing requirements, cost constraints and governance burdens.

There has been significant reform to overcome these obstacles including relaxing the 0.75% charge cap imposed on work- place DC default funds, making it easier to include performance fees which are typically imposed by managers running illiquid asset strategies.

The charge cap reform preceded a decision by the Financial Conduct Authority this March to authorise the first Long-Term Asset Fund (LTAF), a move the regulator’s executive director of supervision, policy and competition, Sarah Pritchard, said, “creates an environment where investors who wish to invest in productive finance assets can more easily do so”.

Market innovation

Since then, Schroders, which was the first to launch an LTAF, has bought a second illiquid assets offering to market, along- side Aviva Investors’ Real Estate LTAF which has been seeded with £1.5bn in assets from the company’s life insurance business.

Meanwhile, in May, Blackrock received approval for a diversified alternative strategies LTAF combining multiple private market asset classes, such as infrastructure, private credit, private equity and real estate.

Duncan Hale, of private markets group Schroders Greencoat, which runs the asset manager’s second LTAF focused on renewable energy and energy transition aligned infrastructure investments, says a more amenable regulatory environment for illiquid assets in DC has been a long time coming.

“For too long DC pension scheme members have had their noses pressed up against the glass, looking in at other types of investors enjoying the benefits that come from investing in illiquid assets. [LTAFs] could only be possible due to the regulatory progress made through the LTAF regime,” Hale says.

The appetite for illiquids, at least from master trusts, is evidenced by Cushon’s 15% allocation to private markets which is on offer through its sustainable investment strategy at a fund management charge of 0.15%.

Meanwhile, the £30bn National Employment Savings Trust (Nest) invests £5bn of DC savers’ money in property, private credit, unlisted infrastructure and private equity, while Smart Pension has invested in illiquid assets since 2021.

Jesal Mistry, senior DC investment director at Legal & General Investment Management (LGIM), which only includes private market assets such as short-dated private credit in its default strategy for those who are closer to retirement, plans to extend illiquid investments to all members of its master trust.

“The natural next step is to broaden this out to the wider universe of private market opportunities throughout the entire journey within DC strategies, using the scale of the master trust structure to enable this,” Mistry says. “It is critical that we continue to do everything we can to provide our members with the best possible outcomes. We believe private markets will play an increasingly central role in DC investment portfolios at all stages of the member journey, including in the L&G Master Trust.”

Value over cost

However, wholesale moves by master trusts into illiquid assets is still hampered by a persistent focus on keeping costs low for auto-enrolled (AE) members.

The Pensions and Lifetime Saving Association (PLSA) describes the AE market as “relatively immature and highly competitive. It has consolidated rapidly and continues to do so. In a fierce market small points of price difference make a significant impact”.

This is particularly true in the master trust sector, where some providers still use fee differentiation – rather than focusing on value – to capture market share.

Mistry says: “In the past, the focus was all about driving down cost for schemes, which is an important consideration but did limit innovation in the DC market – this led to an emphasis on low-cost index funds in DC investment strategies.”

Mistry adds that there has “been a real shift in terms of the regulatory agenda” noting that the government’s Value for Money consultation which closed in March, was “all about focusing more holistically on how we define value through net of fee performance”.

“This shift will also need to happen across the market, and it is vital that value is judged more holistically to allow for any meaningful allocation to illiquids in DC strategies,” he says. Callum Stewart, head of DC investment at Hymans Robertson, calls on master trusts to re-evaluate their ability to include illiquid assets now, or risk regretting it later.

“Fast forward a decade. Would you be more comfortable having a conversation with a member about how their pension savings have been invested at low cost, or that you have delivered a superior net return regardless of the cost required to get there?” he says.

Significant hurdles

Looking further across the DC landscape, particularly to smaller schemes, the challenges of including illiquid assets becomes more acute.

What some in the industry call an “obsession” with daily pricing, which allows investors to transfer in and out of funds at will using up-to-date valuations for those assets, has turned them o illiquid assets.

But the Institute and Faculty of Actuaries says: “The vast majority of DC investors do not require daily trading, staying invested for the long term with very limited trading activity throughout their membership.”

Meanwhile new contributions coming into the scheme enable them to buy-out the units of older members.

But Sam Burden, client director at independent trustee firm Zedra, says this requires scale. “I am a proponent of investing in illiquid assets if you can get over the practical challenges, and there are a lot of hurdles to overcome. If you invest in illiquid assets you will need scale to ensure you can still meet daily trading requirements.

“At the moment it seems the master trusts are the only ones with the scale to look at this,” he adds.

And despite the advent of LTAFs, the PLSA says typical fund structures and fee models “do not accommodate DC schemes’ needs well for illiquid investing”, noting that scale in DC is delivered through platforms but these “currently offer limited choice, if any, which means these are only accessible to the much larger schemes currently slowing down take-up”.

Joe Dabrowski, deputy director of policy at the PLSA, says: “LTAFs are fairly new, and it takes a while for trustees to have a look at what’s available and make a decision about investing. We are beginning to see some of that come through the system now and more will probably come through during the year, but it’s not going to be a big bang change.”

The PLSA says that while some platforms can accommodate investment in illiquid assets, others still need to evolve their systems and processes to be able to do so. Some structures also face restrictions under the permitted links rules for unit-linked life policies.

This means more platforms evolving their systems and processes. Heather Brown, senior client solutions director at Aviva Investors, says: “I haven’t seen much movement from platforms on illiquid assets and I’ve been hearing that some are maybe better than others. But this could change quickly.”

The PLSA says it is “essential to establish a rich, and continuous pipeline of enterprises needing investment for providers to bring to market and investors to choose from.”

The association calls on the asset management industry to focus on sourcing UK opportunities and developing new investment funds and products which are appropriate to pension fund needs.

Governance burden

Given that members bear the investment risk and typically incur the fees in a DC scheme, making sure they are on board with illiquid investments is important, and that responsibility falls to trustees.

The challenge, according to Brown, is convincing them that illiquid assets will live up to outperformance expectations over cheaper passive equity strategies.

“Passive equities had a good run over the last 15 years, and they have served members well. When making the case for illiquid assets in DC, the challenge we hear is ‘where’s the evidence that we would be better off?’. There’s no crystal ball gazing,” Brown says.

This is compounded by the additional governance burden of investing in illiquid assets. “It is fair to say that illiquids require greater hands-on governance from a board of trustees,” Mistry says. “The trustees need to understand the underlying investments the scheme has exposure to, as well as the issues around liquidity and how these can be resolved.

“Asset managers” Mistry adds “have a key role to play” helping schemes understand the issues around their cashflow and investment objectives, and then providing the right blend of assets which can combine ready sources of liquidity with long-term, sustainable growth.

But so too do investment consultants not only in the education piece, but in ensuring schemes are aware of the available products, and Brown suggests provision of the latter is somewhat patchy. “A lot of [investment consultants] have come out over the last 12 months as fully supportive of the [illiquid asset] regime and structure. But what’s interesting is where they are in terms of their manager research process, because as much as they might be talking to schemes, unless they have actually done that research, then they are not in a position to recommend any funds to schemes. I think that progress is quite different across the consultant universe,” she says.

Irrespective of the theoretical benefits from including illiquid assets in DC schemes, the practical realties of doing so remain profound. Considerable advances have been made in terms of regulatory reform and product innovation, but the journey is far from over.

A concerted and combined effort from policymakers, asset managers, platforms, investment consultants, master trusts and trustees is needed if members are ever to realise the long-term potential illiquid assets can offer.


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