Finding the right path for private equity

Written By: Alexandra Noble Director Noble Associates

Private equity investment has the potential to deliver return and diversification benefits for members of the LGPS. Alexandra Noble of Noble Associates outlines the challenges and opportunities for investors

Private Equity (PE) has grown substantially in importance in today’s financial marketplace. In some circles, it has become the “fashion asset class”. But what is PE? Whilst it already figures in most LGPS funds, for some there are reservations about how important it is and how important it should be. Undoubtedly, there is considerable expertise and experience of PE in the sector, but I would venture to say that it is not universal. It is therefore my aim in this short article to provide some personal comments and observations that might better inform and prove useful in the future. In no way, can these comments be regarded as comprehensive, definitive or exhaustive on what is, a complex and constantly evolving topic. Somewhat like infrastructure, which with PE is sometimes regarded as a part of the general bucket of “alternatives”, there are many and varied opportunities which require considerable research into areas that may not be familiar.

As I have already alluded, many speak of PE as an asset class in itself. I think this is unhelpful and potentially misleading. I prefer to confine the use of the term “private equity” to any investment aimed at gaining significant, or even complete control of a company with the aim of using this strategic influence to earn a higher return – regardless of the sector, activity or asset class of that company – as opposed to activist equity which involves a substantial but minority holding in a listed/public company and putting pressure on management to influence strategy. The PE sector has developed and grown massively over recent decades, especially with the emergence of PE funds. PwC (PricewaterhouseCoopers) estimates that it could increase its assets from USD 3.6 trillion in 2013 up to USD 7.4 trillion by 2020. These are dedicated to, as the name implies, investing in assets that either are not owned publicly or that are currently publicly owned but the PE fund intends to take private. So, although the money used to fund these investments comes from private markets (such as LGPS), private equity firms not only invest in private companies but also in the “take private” acquisition of public companies in order to add value and realise shareholder value – which may be by way of a new public offering.

Pension funds have been increasing their exposure to private equity, driven largely by the higher returns of PE relative to traditional bonds and equities, along with a desire to invest in truly diversified sectors, and in some cases is the only way in which to get exposure to some sectors. eVestment predicts that this trend will continue with alternative allocations constituting as much as 20% of portfolios in the near future. In this instance it is not clear as to how this percentage is split between PE, infrastructure and private debt. In 2015, Preqin (the alternative assets industry’s source of data and intelligence) undertook research that indicated that 64% of investors considered that their private equity portfolios had met expectations, while 30% acknowledged expectations had been exceeded. The research indicated that the climate of opinion remains bullish, with 95% of investors anticipating that the returns from PE investments would outperform the returns from public markets. So in the current world of zero or negative interest rates, it is self-evident that LGPS managers will need to concern themselves with PE if they are to deliver alpha in order to meet the growing liabilities of their funds. PE has to be on your radar screen as a LGPS manager. But there are other good reasons for this. Apart from the need for local government pension schemes to reduce the direct correlation with public markets and to attain risk diversification, the longer timescale of lock-ins, typical of private equity, is an attribute which an LGPS fund is well able to accommodate given their long-term view on portfolio investments. There are various options for dealing with the specific risk management implicit in private equity investment. One option is to confine private equity allocations to a fund-of-funds (FoF = a private fund which in turn invests in other individual private equity funds). Apart from the implicit simplicity, FoFs have become attractive due to their capacity to access the best performing funds in the market, or to access highly-specialised funds, such as geographic location or type of transaction (e.g. true venture capital). But the use of FoF comes at a cost, with an additional management fee on top of those levied by the component funds. This with the lack of transparency is a significant issue particularly within the LGPS sector. Lord Myners, while giving evidence to the House of Commons Hearings on PE in June 2007 said, “Investors [in private equity] can be quite lethargic… [we] should ask why they invest in private equity with its association with aggressive capital structures, high incentives for management and a minimalist approach to governance… while adopting an entirely different approach when investing in public equity.” We should indeed! When investing directly in a specific private equity fund, the key is to secure favourable terms with the private equity managers over issues such as the fees, the distribution of the proceeds and opt-out options. The governance underpinning the private funds, namely the limited partnership (LP) agreement, is a pure contractual product in mature jurisdictions such as UK and US. No industry-wide or statutory rules apply to these agreements, and much of the investors basic rights can only be obtained and exercised by negotiation with the private equity manager. This prompted Pierre Hubbard in his 2008 paper, Pension Fund Investments in Private Equity: Implications for the Stewardship of Workers’ Capital to write: “…compared with shareholder activism in listed equity AGMs, the LP is a return to the stone age of governance.”

This somewhat ad hoc nature of the investor / private equity manager relationship explains why many pension funds seek to establish long-term relationships with certain specific private equity groups, or to create their own dedicated private equity group. Teaming up with other pension fund investors to create international “consortia” has proved successful in the US and will undoubtedly become more prevalent in the UK, especially in the light of the new pooling arrangements. In some international markets, pension schemes have pooled together and created joint private equity branches (e.g. the Dutch pension funds ABP and PGGM run a joint private equity firm, Alpinvest and similarly, IFM in Australia) and this trend would surely be appropriate in the UK LGPS. In Canada, the private equity investment vehicle of Ontario Teachers’ Pension Plan (Teachers Private Capital) has a strategic partnership with two US private equity firms, Providence Equity Partners and KKR.

I cannot stress enough the critical importance for LGPS manager and trustees having access to informed independent advice that is provided by one or more professional advisers with proven integrity. My former colleague, John Jones, who is one such adviser, put it well: “As far as local authority funds are concerned, since they are generally cash positive, private equity does offer opportunities to add value. Each pension fund should look at it based on its own position and time horizons, and decide for itself. Pension funds also need to be very clear about who is investing the money and what the managers are getting into.”

Access to informed, independent advice that is provided with integrity, is key to developing and implementing a successful, sustainable and appropriate private equity strategy, but at the present time, for whatever reason, the UK LGPS sector appears resistant to availing itself to such advice on a realistic commercial basis. My fear is that this is likely to result in tears in some quarters, as the LGPS follows the trend for PE investment on the basis of advice that may be based on serving interests other than their own, or, that there is a mistaken move towards seeking to devise regulation that will never be able to adequately mitigate the results of ill informed, or misguided management and trustee decisions, based upon the less-than-independent advice of consultants or fund managers.

I would even go further and suggest that with the appropriate informed advice, LGPS managers might consider the opportunity of impact investing provided through PE opportunities that are truly local. While in no way suggesting that the fiduciary responsibility of LGPS trustees to fulfil their obligations to their pensioners should be compromised, meeting these while also contributing to the socio-economic welfare of the community in which they are likely to live, is not an opportunity that should be summarily overlooked. As technology increasingly promotes the possibility of connected localism, I believe that what I call “relationship returns”, may well become an increasingly attractive and valued informal bonus which LGPS trustees will be able to deliver to their pensioners.