Pension funds are the largest single investor group in private equity. But their numbers are largely limited to the large state and municipal funds that promise to pay public sector workers a fixed amount on retirement – defined benefit. Absent are the large corporate pension plans that take a fixed percentage of workers’ salaries – defined contribution – but make no guarantees about payouts.
However, the position in private equity funds does not reflect the rapidly changing pension trend. Defined contribution (DC) schemes now represent 46.7 percent of the total $32.9 trillion of pension assets in the top six pension savings markets, according to consultant Towers Watson. In the US, which accounts for 61 percent of all pension assets globally, DC plans have already overtaken defined benefit (DB). Other large markets like the UK are following the same inexorable pattern.
“We believed that we needed to get in front of that change. If private equity makes sense in a DB plan it has to make sense in a DC plan,” said Kevin Albert, head of business development and client services at private equity funds group Pantheon, which started courting DC plan managers towards the end of 2013.
Others including Swiss firm Partners Group, Goldman Sachs Asset Management, The Carlyle Group and KRR are all reportedly eyeing the market because the need is clearly there. DC plans generated annualised returns of 5.8 percent between 1997 and 2011, while their DB counterpart returned 7.2 percent according to Toronto-based CEM Benchmarking. But getting private equity into the mix means dreaming up new structures that suit specific demands, such as liquidity and daily valuations, as well as the need to get capital invested quickly.
“The objective of these corporates is to shift the financial responsibility on to the individual, who will have to pick either their own fund selections or the default option,” said one firm creating DC products. “Asset managers are looking to come up with suitable solutions for those options.”
Savers in DC schemes like to be able to move their retirement funds from one savings option to another when they choose, which means products should allow redemptions and show daily valuations for ease of comparison. Not hallmarks of private equity or infrastructure, but not insurmountable problems. Tailored products that contain a sufficient slug of listed equity – like an exchange-traded fund – and use S&P 500 figures as a basis for proxy valuations help.
The other issue is investing money quickly and on equal terms for all. Savers who move their money into the option after three years shouldn’t benefit from lower fees and higher returns than people who invested at the start when returns were negative. This is where the secondary market can come in.
“The approach we are taking is to seed with a secondary portfolio, as this allows the DC plan participants to be invested from day one,” Nik Morandi, partner at Pantheon said.
A $100 million commitment from a corporation could become a $100 million purchase of a maturing secondaries portfolio, including a portion of unfunded commitments. Capital held for unfunded commitments in liquid securities can also provide the buffer for potential redemptions. When money flows back from investments, it can be deployed into primary fund investments, co-investments or more secondaries – creating an evergreen fund that can grow with appreciating assets and new savers’ money.
In time, DC schemes could actively use the secondaries market to manage their portfolios. What’s more, they could look in slightly different niches for deals than secondaries funds. They could swallow slightly more mature portfolios, or elect for an early secondary over a new primary commitment, Morandi explained.
Pantheon has tested a structure for corporate pension schemes and expects to have two clients on board in the second half of the year. It is focusing its efforts on the US, where it sees about 150 corporations with pension schemes larger than $1 billion. A pipeline of other corporate pension plans could follow.
Not all markets are the same, so one solution does not work globally. In the UK, for instance, a cap on the number of underlying funds makes it all but impossible to incorporate sprawling secondaries portfolios. Still, the DC movement will only grow.
In its latest barometer, Coller Capital said 88 percent of investors surveyed expected DC pension schemes to be an investor in private equity within five years, and almost one in five think they will be significant players.
“If projections about the market shift and future growth prove right, there is certainly more business than Pantheon alone could handle. And I would suspect in short order we wouldn’t be the only firm in the DC market,” Pantheon’s Albert said.
Reporting by Simon Meads