Why DC pensions should choose private equity
Across various stakeholders including governments, regulators, consultants, trustees, and investment managers there's a range of views surrounding illiquid investments and their role in fostering the productive economy. The underlying notion is that illiquid assets hold the potential to enhance overall portfolio risk-adjusted returns. However, if Defined Contribution (DC) trustees are inclined towards embracing productive finance, the question arises: where should they begin, especially if their current allocations to illiquid assets are negligible?
The disparity in illiquid allocations among European DC pension schemes signals a need for serious consideration. While some countries like Spain and Denmark boast allocations up to 5%, the UK stands at a mere 0.5%, highlighting a considerable gap. Meanwhile, DC schemes in the Netherlands allocate 7%, and in Australia, the figure soars to 20%. How can European DC schemes further align with the 'productive finance' agenda?
Private markets encompass a diverse array of opportunities spanning from venture capital and private equity to private credit, real estate, and infrastructure, among others. While not all assets within this spectrum may be deemed productive, their categorization depends on individual definitions. Nonetheless, private markets offer a wide range of risk-return profiles tailored to clients' objectives.
WTW's perspective underscores private equity (PE) as a frontrunner in this array of options. To comprehend why, it's crucial to consider the appropriate metric for success in DC investments.
The first step taken into private markets waters should match DC schemes’ core purpose and time horizons.
Generally, DC schemes need to positively impact the outcomes of greatest possible number of members, while having due consideration for wider systems and society. The key, however, is especially to understand the timeframe over which to judge this.
Most European DC pensions have long-term horizons, arguably much longer as one thinks about lifetime income and the decumulation phase. This is due to their relatively younger populations on average compared to Defined Benefit schemes.
“By investing in PE, DC schemes can make an active decision to support economic growth, job creation and innovation.”
Ben Leach | Head of Private Markets Solutions, WTW
The next half century will give rise to many risks and investment opportunities, including: climate, energy, technology, demographics and geopolitics. Private capital has a role to play in addressing some of these challenges and risks, whilst capturing investment opportunities and boosting financial returns for investors. However, in not all private markets are alike, and misunderstanding this could easily allow members to miss out on the best returns, or at worst even add to risk.
With its long-term investment horizon, Private Equity is well-suited to the objectives of most DC funds. When done well, private equity can create economic value, and contribute to the wider social and developmental objectives of many pension schemes and their members. By investing in private equity, DC schemes can make an active decision to support economic growth, job creation, and innovation to the benefit of both their members and wider society.
When an institution is investing over a long time horizon, such as most modern DC defaults with younger members, the focus should be on growth, tilted in favour of capturing long-term excess returns. It’s true, this still requires diversification and access to a broad array of opportunities to appropriately manage risk whilst providing that growth potential – but allocations need to be judged in terms of excess return.
This means that most DC funds do not simply need ‘illiquid allocations’ or ‘private market’ allocations – they need illiquid growth allocations.
Not all private markets are of this ‘excess return generating’ variety. In fact by contrast, some strategies such as secure income real estate and core infrastructure are examples that fit further towards the other end of the risk spectrum. Occasionally these can return even less overall than some more traditional bonds.
That’s not to say these other flavours of private markets aren’t valuable, or even essential to some investors. They can work well as lower-risk sources of diversification and income generation, but not as the first extra growth ingredient to boost fifty-year returns. Correctly chosen, such investments can in fact be better suited to members’ needs later in the pensions lifecycle, possibly even through into decumulation phases of a cohort. Discussions around private markets should be similarly balanced and cover the full breadth of the variety on offer. Decisions should be made having considered not just the suitable balance of private vs public markets across all parts of portfolios, but how members’ assets are invested across shorter-term ‘safety illiquids’ and longer-term illiquid growth assets.
The answer? Most DC funds have a long timeframe, younger members, and need to boost long term returns.
Private equity, particularly in the lower middle market, is a strong encapsulation of what is most commonly implied by ‘productive finance’, giving investors access to investments that make an active difference.
This model provides a number of advantages as a growth asset class. Firstly, there is an ‘activism premium’ from PE whereby managers improve their portfolio companies and assets. Secondly, such an approach allows a greater diversification of business models.
Private equity has historically performed strongly over the past two decades, with a significant outperformance this millennium – net of fees. PE on average has provided double digit returns to investors considerably outperforming all other asset classes including public equity which has returned anywhere between 6-7% depending on which index one looks at. Many will cite the favourable interest rate environment as a key driver of those returns, but notably, PE returns during wider market and economic downturns have been especially strong, with resilience throughout the global financial crisis in 2008-2009. Our own experience shows our clients private equity portfolios generating close to 5% more than their listed equity counterparts over the same period.
With the average DC scheme member having a retirement horizon extending well beyond 2070, it is crucial to consider illiquid investment strategies that can deliver sustainable returns over several decades. For many, risk adjusted returns over a 50-year horizon should be the metric for success.
Private equity aligns with this long-term perspective and can help DC schemes meet their members' retirement needs. By investing in private equity, DC schemes can capture the illiquidity premium and benefit from the value creation potential of privately owned companies.
What’s more, by choosing private equity as the first step into illiquid asset investment, DC schemes can even more actively drive sustainable economic growth, support the innovative companies of the future, and provide attractive returns for their members. Young people want to build the future, and their DC pensions should build it with them.
This article was originally published by the Investment & Pensions Europe, January 2024.
