Investing in private equity: Don't expect to beat liquid markets unless you're doing something different

Summary

Based on industry research, and decades of aggregate experience across Avida's senior team, we're unconvinced that simply allocating to private equity or 'productive finance' will deliver better outcomes for pension savers.  Outperformance is available, but only if a scheme does something different.  We describe five different governance models, comparing their relative comparative advantages.  We lay out key characteristics which in our view will be most likely to deliver successful outcomes.

Background 

Late last year the DWP published a research paper entitled 'Pension Fund Investing and the UK Economy'.  This didn't get much publicity, which is a shame because it's a well-argued and important paper.

It looked at the impact of private equity and infrastructure investing on DC outcomes.  Just the sort of investment the UK government (HMG) is keen to see.  And indeed the investment industry, which supports the case 'in favour'.

The analysis is sobering.  It shows that in the median case, a member would be better off, over a working lifetime, by 2%.  Not 2% pa.  2% over a lifetime.  The bullish case for asset returns showed a meagre 1% advantage.  Somewhat counter-intuitively, the outcome for a bearish case showed an improvement of 4%.

An uncomfortable conclusion for us (though the DWP spun it differently!) is that the impact of private assets exposure, as envisaged by HMG, is lost in the rounding.   

In the AVERAGE case, we agree - the case for private equity is weak.  Expecting outsize returns with the headwinds of higher debt finance costs (ie high real interest rates), whilst competing with a wall of money provided by like-minded investors, is unrealistic.

Will investment in private equity be worth it?

Searching for answers in broader academic work is inconclusive.  Some views are damning - Warren Buffet described private equity as 'simply dishonest' and 'not a fair fight'.  Others conclude that extra gross returns were generated by leverage, which then disappear into the pockets of fund managers.  Conclusion: Net returns were no better than, or even lower than the stock market.

We've sympathy with these views but note that (because the range of returns is so wide) it should be possible to beat the market, and through time, BUT ONLY IF YOU DO SOMETHING DIFFERENT TO THE BROADER MARKET.  In other words, to 'win', your scheme has to create some form of sustainable comparative advantage relative to other investors. 

This view is also based on decades of aggregate practical investing experience of Avida's senior advisers, across private equity, infrastructure, debt and real estate.

Considering different governance models

We consider five broad models of accessing private markets:

Table 1

1. Simply avoid - stick to liquid markets

2. Buy 'easy access' vehicles which invest.  Investment Trusts, REITS, LTAFs are examples

3. Buy into PE funds (fund of funds an even more expensive variant)

4. Co-investment (provide flows to big PE funds on preferential terms, essentially a partnering model)

5. Direct investment (whole or partial private ownerships, not through 3rd party funds)

Models 1, 2 and 3 require different capabilities - 2 and 3 are more complex to run, with more advisory and operational/monitoring overhead.  However, given the academic evidence and our own experience, we find it very difficult - in terms of expected economic outcomes for members - to say that any one of these three models will be better than the other.  

Models 4 and 5 are much more interesting - with an inherent advantage of lower fees, and (usually) a more hands on/selective approach.  Model 5 is most hands on and the most resource intensive, the selection and management of investee companies being in-house.

An 'ideal' model might be a hybrid of 4. and 5. enabling flexibility across different sectors.  This could be supplemented by tactical freedom to exploit, through the secondary market, dislocated pricing in the funds market evident under models 2. and 3.  Given liquidity, Model 2 could also be used for rebalancing, or flexing exposures.

For a growing scheme, with aspirations towards a best practice operating model, Model 4 could also be a stepping stone to Model 5, banking learnings, and building incrementally along the way.

What characteristics might make our 'ideal' Model differentiating? 

A winning governance model would have the following:

• Commitment to material allocations - upwards of 10pc of total assets (else why bother).

• Clarity of sectors where the scheme has a sustainable comparative investment advantage (eg expertise in tech or health is very different to infrastructure).  And clarity where it has not.

• The appointment of trained (likely professional) trustees, alongside an expert and well-resourced in-house executive team.  Access to expert, sector specific advice.

• Specialist fund managers appointed under Model 4.  Under Model 5 the fund manager is in-house.  This needs to be well resourced, well paid, and well organised, with robust buy and sell disciplines, alongside a cycle of forward planning and monitoring.

• Tactical freedom to trade secondaries either on rich (sell) or stressed (buy) valuations. 

Other operational and supplementary capabilities, for example in contractual negotiations, reconstructions/refinancings, or 'work outs' for failing investments.    Alongside successes, the best asset owners should expect failures/defaults and be ready for them.  This requires specialist, expert legal capability.  Bear in mind the failure rate of the likes of venture capital is about 30-50%. (A large range, but hopefully readers take the point - at the time of writing the catastrophic failure of Nothvolt is worth considering as a scenario).

What might this feel like to trustees or boards?

In our experience very few pension schemes have the sort of capability described above, indeed it took decades for the Canadian system to develop same.

It's perhaps worth thinking about the parallels of governance structures built up within DB schemes to deal with Liability Driven Investment, the purchase of Bulk Annuity Contracts, Longevity Hedges, or approaches to Climate Risk.  Only examples.

 At least at set up these would have likely involved greater trustee involvement, perhaps working groups, a project management framework, the engagement of specialist resource (eg interim staff), and so on.

Conclusion

Our conclusion is that private equity exposure is merited ONLY if the asset owner's investment process creates a clear and sustainable comparative advantage in the selection, management and (potentially) exit from private holdings.  

Put another way, the way a pension fund organises its affairs around private equity (or other complex, illiquid assets for that matter) has to be superior to other asset owners.  This is what unlocks the extra performance.

How can Avida help?

Avida has worked with clients to optimise their governance and operations around private assets to help create the comparative advantages we describe.  These take the learnings from very large asset owners in Canada, Australia, Europe and the UK/ 

We think the size of the prize for private equity might be around 5% pa return (net of fees/costs) over a comparable liquid index.  This number is indicated, in many studies, as the difference between upper quartile and average returns.