Private Equity – BVCA steps up pension fund crusade

The British Venture Capital Association (BVCA) is engaged in a continuing crusade to convince domestic pension funds of the potential benefits of venture and private equity investment. A new research report, UK Venture Capital and Private Equity as an Asset Class for Institutional Investors, undertaken by Dr Oliver Burgel of the London Business School (LBS), could prove a valuable weapon in the association’s battle to eliminate certain misconceptions that deter pension funds – and other institutions – from investing in funds managed by its members. The National Association of Pension Funds (NAPF), which like the BVCA is trying to ascertain exactly why some of its members are so resolutely set against venture and private equity investment, encouraged the preparation of the report.

The report provides detailed analysis of the private equity fund-raising and investment process and examines the characteristics of unquoted investment with regard to returns, risk and cash flow implications, with the aim of enabling institutional investors accurately to assess the suitability of the asset class.

Most of the report’s key findings do little more than confirm messages the BVCA has repeatedly sought to publicise in recent years: that cumulative UK private equity returns have outperformed all principal domestic comparators; that the actual risk of investing in unquoted equity funds is much less than investors perceive, and that a suitably diversified portfolio virtually eliminates the chance of a capital loss; and that the asset class is also less illiquid than investors generally believe, with recent funds taking as little as two years to generate positive cash flows.

The pension funds have undoubtedly heard all this before. The value of the report in this respect is twofold: it was independently compiled; and it incorporates a detailed and lucid exposition of performance measurement, risk and cash flow analysis methodologies as applied to venture capital and private equity.

The report’s findings regarding the convergence of interim and definitive internal rates of return (IRRs) may be particularly helpful in persuading pension funds of the validity of the interim IRR as a measure. A definitive performance evaluation is only possible once an individual fund is wound up. It is therefore critical to determine the reliability of mature funds interim IRRs in relation to final IRRs. Dr Burgel found that interim IRRs tend to approach final IRRs over time in a J-curve’, with substantial changes in performance being very unlikely after seven or eight years; interim IRRs after ten years were on average only 40 basis points lower than the final IRR. However, the report emphasises that this finding should be treated with caution, since full convergence analysis could only be carried on 23 of the 188 funds in the sample base.

The survey also highlights the fact that many more recent funds, i.e., vehicles raised in the 1990s, have produced positive IRRs (and cash flows) after as little as two years, whereas the funds in the convergence analysis sample took an average of five years to show a positive return.

According to the report, the Minimum Funding Requirement (MFR), often cited as a factor that militates against venture and private equity by pension funds, “presents more of a psychological barrier to trustees … than an actual significant depletion in a fund’s liquidity”. A private equity investment will have a small adverse impact on a pension fund’s MFR position but, as the report highlights, this is only experienced by first-time investors. Nevertheless, the LBS adds is voice to those of the BVCA and the NAPF in recommending that the MFR be reviewed in the light of its “potentially harmful effect on allocation decisions and pension fund performance”.

Although net returns are the accepted performance benchmark, private equity firm’s fees and remuneration structures constitute another potential psychological stumbling block for trustees considering the asset class. The LBS’s point of view here makes interesting reading: “From an investor’s point of view, the decision whether or not to invest in this asset class should not depend on the level of rewards for the venture capitalists, but on careful analysis of whether the expected net returns justify the level of risk and the necessary investment in management-picking skills.” Indeed.

Few in the private equity industry would disagree that the greatest concentration of management-picking skills’ is found among experienced fund-of-fund managers. Such groups will unquestionably welcome Dr Burgel’s own convergence with BVCA recommendations that only pension funds with assets of more than GBP100 million should consider direct limited partnership investments. For smaller pensions, the only way to achieve an acceptable level of diversification without allocating a disproportionate percentage of assets to private equity is to consider investing via a fund-of-funds. This will be music to Westport Private Equity’s ears in particular, as it markets its DTI-sponsored UK High Technology Fund, intended to encourage domestic institutions to channel more money into venture funds.

Nevertheless, the report also identifies the double layer of fees in gatekeeper structures as a drawback of this investment route. For a pension fund already sceptical regarding private equity fees and remuneration structures, this could prove an insuperable psychological barrier. Similarly, Dr Burgel’s wholly realistic recommendation that pension fund managers should be prepared to make higher nominal fund allocations in order to achieve their target exposure, may fail to convince risk-averse trustees.

The BVCA is clearly very satisfied with the LBS report’s positive stance on the potential benefits of venture and private equity investment for UK pension funds. Edmund Truell, chairman of the BVCA investor relations committee, reminds UK institutions that they are missing out by decreasing their commitments to unquoted equity funds.

“We hope that the London Business School report will lead UK institutions to review their concerns about our industry, to correct any misconceptions and to work with us for the benefit of their investors”, says Truell.

Dr Ann Robinson, director general of the NAPF, says the association “would certainly encourage pension scheme trustees to discuss with their advisers the merits of this asset class in the context of their scheme”.