Travers Smith's Alternative Insights: Helping UK savers access private funds

A regular briefing for the alternative asset management industry.

The benefits of investing in private funds have always been spread widely. The biggest contributors to the fund raisings of European private equity funds are pension funds and insurance companies – whose ultimate beneficiaries are millions of individual savers. When private equity funds perform well, those savers are better off. And there is plenty of evidence that, over the last two decades, European private equity has performed very well.

But the way in which individuals in the UK save for their retirement is changing rapidly, and policymakers are looking for ways to make sure that the next generation of retirees do not miss out on the return and diversification benefits that private markets have to offer. An important step forward came last week, when an industry-led, government sponsored working group issued a set of recommendations and a roadmap, which could have a significant impact on policy.

The change in savings habits is hugely important. As is well-known, workplace "defined benefit" pension schemes – where, broadly speaking, the employer makes a commitment to provide pensioners with a certain level of future income – are being rapidly replaced by workplace "defined contribution" (DC) schemes. In these DC schemes, the individual takes the investment risk, but does not usually take active investment decisions. As this graph shows, this move towards DC schemes has been dramatic: by 2030, the total assets in UK DC schemes is expected to exceed £1 trillion.

The trustees of DC schemes are responsible for putting in place the investment options and, critically, for selecting the scheme's default funds. The choice of default funds is vital because members overwhelmingly invest in these funds, rather than making an active decision to invest elsewhere. But these default funds tend to allocate far less to private equity and private credit than traditional defined benefit schemes, or than the DC schemes in some other countries.

Last week's report of the Productive Finance Working Group – jointly chaired by the Treasury, the Financial Conduct Authority (FCA) and the Bank of England – strongly endorses the case for dismantling barriers to investment by retail savers, particularly by the trustees of DC schemes. The working group points to evidence that private equity consistently outperforms the public markets and urges trustees to consider increasing allocations.

This is not only a problem for the next generation of retirees, but also for the economy. So-called "patient capital" – investment in long term, illiquid assets – has been championed by the government as a source of funding for innovative businesses and much-needed infrastructure. Policymakers are therefore keen to see more allocation to illiquid assets from DC schemes.

...Last week's report of the Productive Finance Working Group strongly endorses the case for dismantling barriers to investment by retail savers, particularly by the trustees of DC schemes...

But, as the report explains, the problem is multi-faceted. One issue is a lack of scale in many workplace DC schemes, which makes it difficult to invest the resources needed to make an allocation to a more complex asset class – and, sometimes, to reach the minimum ticket size that some private funds require. Another is said to be the lack of a suitable fund structure – although it is acknowledged that investment trusts and other vehicles are already investible by DC schemes. The UK's forthcoming new Long Term Asset Fund (or LTAF), discussed in a previous edition of Alternative Insights, is given a strong plug by the report.

However, the Productive Finance Working Group also acknowledges what is surely the main barrier to investment by DC schemes in illiquid asset classes: the fact that schemes are subject to a charge cap, limiting the charges the default funds can pay to the fund manager. This charge cap, introduced to prevent investors bearing excessive fees when investing in liquid assets, is an important protection for DC savers but is also a blunt instrument which does not fit well with the standard charging structure in the private markets. That's partly because it is often not possible to predict the total charges in advance, especially if performance-related incentives are included in the cap, as the Department for Work and Pensions (DWP) argues that they should.

This focus on fees means that DC savers may be missing out. The report argues that a focus on expected net (after fee) returns is more rational than a rigid charge cap and asks the DWP to think again – specifically, to "continue to consider how to reconcile performance remuneration (that may be associated with greater overall value for members) and the charge cap rules".

The DWP, in a statement included in the report, accepts the need to focus on value for money in a more holistic way, and the potential negative impact of a focus on costs alone. They point to a series of regulatory changes that are aimed to nudge trustees in that direction. But pressure is clearly building for them to do more, which would mean more fundamental changes to the regulation of charges in the default DC funds than is currently contemplated.

Even without any such changes to the charge cap we can expect more investment by DC schemes in private markets, and LTAF launches expected in the coming months will certainly seek to tap this increasingly important source of capital. Meanwhile, in August, the trustee of the National Employment Savings Trust (NEST), the workplace DC scheme set up by the government in 2010 and which now has 10 million members, announced that it will target an allocation of 5% to private equity by 2024 (adding to its already significant allocation to private markets) and launched a procurement process.

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