Are private markets worth it – and what are managers missing?
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Much has been said about democratising private markets, and managers are in a race to launch LTAFs and reposition their offering. DB and DC schemes alike face issues with liquidity and cost. But these concerns mask the true challenge in private markets. Are managers listening to their target market – and what are they missing?
Illiquidity is a problem for DB and DC schemes alike
Research on the obstacles to cashflow-driven investing, which we conducted for abrdn in 2019, revealed a need for higher returns among DB schemes. Interestingly, two in five of those schemes would consider private credit appropriate for a cashflow matching allocation. While investment grade bonds were far more popular, private debt fared better than sub-investment grade credit – and this is likely because it can deliver cashflows, volatility protection and yield enhancement.
But despite these benefits, DB schemes preparing for buyout are either divesting from illiquid assets, or naturally running off their exposure. In 2021, 41% of these schemes had illiquid allocations over 10%, but a year later, that proportion shrunk to 24%.
In contrast, over a third of schemes aiming for self-sufficiency now invest 10-20% of their assets in illiquids, and this is double the proportion a year ago. This highlights the problem of illiquidity, leaving mainly self-sufficient schemes with longer time horizons as potential investors.
Size matters too. In fact, just under half of small DB schemes with professional trustees say they have access to both private equity and private debt investments but choose not to allocate to them. And despite the greater access to property, small schemes invest mainly via diversified growth funds (DGFs).
DC schemes can only afford very small allocations
A recent effort to improve access to illiquids has been the launch of the first long-term asset funds (LTAFs). Schroders, Aviva and other asset managers are seeking approval to launch such funds soon. However, Schroders’ LTAF comes with periodic redemptions to investors of up to 5% of total net asset value, after an initial three-year lock-up period – meaning that LTAFs are not completely liquid investments.
Additionally, research we conducted for Partners Group in 2020 revealed great interest in private equity and private debt. But despite this, most DC schemes only hold about 5-10% in private market investments, if they have such an allocation at all.
Are private markets worth it?
While private markets generally offer limited investment capacity, for DC schemes liquidity concerns are compounded by high costs. In fact, more than half of UK DC pension funds avoid private markets due to the high costs associated with such investments. Fee expectations are anchored around 1%, with a third expecting to pay just above that to access private market investments.
But our research on private debt in 2019, commissioned by M&G Investments, revealed that DB schemes face similarly high costs on average, with most paying around 100bps in management fees alone when it comes to direct lending and other specialty finance strategies.
Indeed, professional trustees point out that managers should provide ‘reasonably priced’ and ‘cost-efficient’ options, as well as do away with ‘excessive fee structures’ and ‘charge more realistic fees’.
Multi-asset funds are the path of least resistance
Cost and liquidity concerns are likely masking a bigger challenge for private markets: DC schemes question the value-add that these investments offer, an issue we first identified in 2021. A year later, the Trustee Report 2022 shows that DC schemes would rather see illiquid assets incorporated into DGFs, naming such vehicles the best way to improve access to alternative investments.
Multi-asset funds also have lower fees and greater overall levels of liquidity – and according to professional trustees, these things make a huge difference across the pensions industry:
Illiquid assets and alternative investments add cost, risk, complexity and governance. You need quite a committed board to spend time on the asset class and the managers to get the confidence. - David Fogarty, Dalriada Trustees
There are quite interesting diversified liquid alternatives that do a reasonable job of giving you a proxy to fully illiquid stuff… A lot of pension funds will be accessing these assets through DGFs which have an element of private debt and private equity. Mostly bigger funds can think about direct investments. - Alan Baker Law Debenture
What’s next for private markets managers?
Private markets managers face a challenging environment and need to adapt their offering in order to stay relevant and attract inflows. We plan in-depth research on this and other illiquid asset classes, so contact us if you’d like to become a research partner, strengthen your brand and improve your positioning across the UK institutional market.