Last October I wrote a paper on private assets, starting with a statement which a well-known Private Equity (“PE”) investor made in public: ‘everything is for sale’. His point was that in his view there was a large gap between stated valuations and real exit prices. My own take was more positive about valuations but recognised that the crux lay with the path of bond yields: lower yields help valuations but probably reflect lower growth and operating earnings; higher yields are trickier for valuations, but may anticipate higher operating earnings.
In the event, U.S. growth has been sustained and bond yields have come down a little, so the valuation gap has probably reduced. In this article I look more narrowly at private equity in the context of the LGPS. I conclude that at a time when many funds are de-risking by reducing equities it would be wrong to skew that further in the direction of PE, whether deliberately or not.
Let me start with the Government’s position. The recent DLUHC consultation* was clear that the Government would like to see LGPS funds investing in PE, and particularly in venture cap. It cited higher returns and the LGPS’s long term horizon. There is no reason to expect a future government to take a different path.
The LGPS is a Crown Guarantee scheme, which means that while any shortfall in paying pensions lands in the first instance on the Scheme Administrators i.e., local authorities in most cases, ultimately, responsibility sits with the Treasury. As they will bear the consequences of poor investment results, the argument is that they should have some say in the investment. In this case they want to pursue their growth and levelling up agendas by encouraging investment in start-ups and local (place-based) investments.
I have elsewhere argued that these proposals come close to encouraging LGPS Funds to contravene pension law. The other flaw in the Government’s argument is that while the Treasury has ultimate responsibility, the Scheme Administrators are first in line in the event of poor investment performance. There is no reason why their taxpayers should have to pay for poor investment decisions driven, or even mandated, by the Treasury’s wider agenda.
The idea that all that is required to kick-start growth is for the hose of institutional money to be directed towards venture cap is seductive but it is plain wrong. To learn why read Sebastian Mallaby’s ‘The Power Law’** which is a fascinating account of the growth of (largely) Silicon Valley and the creation of the mega tech companies which dominate today’s world.
He makes it clear that institutional money is just one factor in the creation of Silicon Valley as a hub of innovation and growth. Government intervention of the right kind is needed in other areas too. As an example of how not to do it, Mallaby references the European Union’s 2001 EU2 billion initiative in venture investment.*** They failed to address their burdensome labour regulations, to create IPO friendly stock markets, or to allow limited partnerships which became the standard in the U.S. and the initiative bore no fruit either.
In practice many LGPS funds have had an allocation to private equity for fifteen years or more, and they have by and large delivered the promised returns. We can argue whether this is down to leverage and low financing costs, or value genuinely added by the General Partners (“GPs”) who control the PE funds, but the returns have been OK.
These investments have been global, in practice largely in the United States, so taking advantage of the U.S.’ more propitious culture. The U.K. Government, unless it has had its ear bent even more than I suspect by the PE lobby, is presumably thinking more in terms of investment in the U.K. Otherwise there will be no benefit to its own growth or levelling up agendas.
Until some of the other required building blocks Mallaby cites are put in place, I doubt we will see the burgeoning of a U.K. equivalent to Silicon Valley. That means that neither the growth nor the returns to investors are likely to be as high as they have been in the U.S.
From a returns perspective, there are other problems too. The higher cost of finance is an obvious one, as private equity is normally geared around five to six times EBITDA. PE managers gear to this extent because of the tax break which allows companies to offset the cost of leverage against tax. But when PE managers abuse the system by leveraging in order to pay dividends (Thames Water is an example), or charging unreasonably high interest rates in order to extract money, it is not unreasonable to expect the tax break to be withdrawn or reduced, which would increase the cost of finance further.
What about valuations? Nine months after my last article on this subject, the outcome has been more benign than the market feared. However, the threat of higher bond yields remains out there – in fact, my view is that they are inevitable. And the stand-off between buyers and sellers in many long-term assets has not eased much. So at some point, quite possibly a year or two ahead, I expect there to be a second downward valuation re-set.
The change in the balance between draw-downs and distributions is also having its effect on LGPS funds. In 2021 there were considerable distributions, but since then exits have been more difficult for the reasons above, and distributions have fallen. Conversely, as we have come out of the COVID lockdowns and attractive buying opportunities have arisen, the pace of draw-downs has increased.
As LGPS funds are in many cases already cashflow negative, they have found themselves needing unexpected amounts of cash to fund draw-downs at the same time as less is coming back through distributions. Money to fund these cash shortfalls has tended to come from listed equities as they are the only major asset class remaining with real liquidity.
This combination of faster draw-downs, slower distributions, valuations which may be lagging reality and the general reductions in equities as funds de-risk, has led to established PE programmes becoming a larger weighting within equity allocations than was intended. For example, one of my clients found itself in 2023 with a near 10% weighting against a 5.5% target. It has come down since then, but remains well above target. There is little we can do about it except wait.
This highlights the importance of liquidity: in my view it is not good enough to say that pension funds are long-term and do not need liquidity. The difference between a pension fund and an endowment is that pension funds have contractual liabilities they have to meet. If they do not have cash to pay them, they have to sell whatever they can to ensure pensions are paid. In contrast endowments have the choice of not making payments.
An overly illiquid portfolio is also less flexible and makes rebalancing more difficult. Secondary markets have grown apace over the past ten years and GP-led transactions can provide some extra liquidity for investors with mature PE portfolios. But with valuations hard to strike, there is a risk that purchasers will end up overpaying.
In summary, I am concerned that the government’s “ambition” that LGPS funds should hold 10% in PE may lead to an imbalance in the investment portfolio while reducing flexibility and without delivering the higher returns needed.
* Next steps on investments – government response (Nov 2023).
** The Power Law (Penguin Books 2023).
*** ibid p396.
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