Pension funds have always been a staple provider of capital to the private equity industry, particularly in the US, where public plans have deep pools of capital. After all, private equity, with its long-term investment horizons, seems well suited to investors that need to cover payments far into the future. Yet European pension funds have often proceeded with caution. If they have allocated any money at all to private equity, it has usually been in the 1% to 2% category.
Pension funds were the largest contributor to European private equity funds last year, according to EVCA figures. They accounted for 25% of funds raised in 2005, or €16.8bn, up markedly from €4.5bn in 2004. Some of this capital will have come from European pension funds. But a large portion of it will be from the large US state pension funds, which have been looking increasingly to the European market. They also have the in-house expertise to make investment decisions, and are able to write large cheques and therefore gain access to the funds they want to be in.
Part of European pension funds’ reticence about private equity is down to their immaturity. Many are still relatively new and finding their feet. The UK pension plans have generally been around rather longer than their continental cousins and so came earlier to the private equity party, although their allocations have historically been around 2% mark or below.
But is this all about to change? Faced with an ageing population and a low interest environment, pension funds are looking beyond some of the more obvious investment choices, such as bonds and public equities, towards alternatives as a means of boosting overall returns – and private equity could well be one of the main beneficiaries. We’ve seen several public statements from European pension funds over the last year or so about either increasing their allocations or starting private equity programmes.
The UK’s largest retirement fund, the BT pension scheme has recently announced that it is to switch a third of its UK equity holdings into alternatives, in the process raising its private equity allocation from 2% to 5% or around £1.8bn. The second largest UK pension fund, the Universities Superannuation Scheme, is also believed to be considering something similar, by shifting £6bn from equities into alternatives. This follows an asset-liability study that advised that between 20% and 30% of the fund should be allocated to alternatives. Quite whether the fund would countenance such a shift remains to be seen – no-one at USS was available for comment.
And it’s not just the UK that’s seeing increases. The National Pensions Reserve Fund in Ireland decided two years ago to invest 4% to private equity, but it planned to increase its allocation to 8% over five years. Last year, it already had 18% invested in alternatives. In France, the state pension reserve fund has recently decided to allocate 6%, or €1.5bn, to private equity. And in the Netherlands, ABP and PGGM committed a further €11bn at the end of last year to private equity through their manager, AlpInvest. This brings their total to a staggering €30bn, making AlpInvest the largest private equity investor in the world by some margin.
The story of allocation increases is similar elsewhere. “Across Europe, we’re seeing more and more pension funds interested in private equity,” says Hannah Tobin, vice-president at HarbourVest. “If they haven’t already got an allocation, they are starting at between 3% and 5%. Those that already invest are nudging allocations up from around 2% to 5%.”
It’s a trend noted by Adveq managing partner Peter Laib, too. “We are seeing some new market entrants with significant allocations, but there aren’t many of these,” he says. “What we are seeing is pension funds that have been in the market for a few years either doubling or tripling their allocations to private equity. In the UK, allocations are highest, but in German-speaking regions and France, things are picking up. We’re even seeing an increased interest among pension funds in Southern Europe.”
Confidence in private equity’s ability to generate good returns is clearly behind this shift. And this has been bolstered by the positive experience of the last few years. “If you entered the market in 2001 or so and you didn’t have prior relationships, you were forced into investing in the mid-market and large buyout funds and in the secondaries funds,” says Laib. “These investors almost couldn’t go wrong because of the returns we’ve seen over the last few years from these funds. Indeed, these funds are showing stellar returns after only four or five years – and that’s almost unheard of.”
Indeed, some believe that the increases in allocations are a direct result of the excellent returns made over recent years by buyout houses. “We are somewhere on the way to the top of the cycle or we’re already there,” says Ralph Aerni, chief investment officer at SCM. “We’re seeing pension funds increase their allocations, many of those that have put their programmes on hold have now made them active again and some are extending their commitment budgets. Many pension funds and other investors enter the market when we are at the top or near and I think that’s what we are seeing.”
And, just as in the last boom, there may well be some that regret their decision to enter the market, says Aerni. “I don’t know when we will reach the top – many thought we had in 2005, but we’ve had another excellent year since then,” he says. “We may even see a plateau. But there is a risk that the market crashes. And if that happens, there will be a big problem because the prices being paid by many of the buyout houses are so high.”
Yet many believe that pension funds these days have a more long-term view of the asset class. Laib is one. “Returns will come back to more normal levels. There is no doubt about that,” he says. “We’ll see fewer recapitalisations as the debt markets become less hot and M&A activity, which has been another driver of returns, will slow down. But returns have been north of 30% in many instances and I don’t think there are many pension fund investors that expect this to continue. Most believe they will be able to achieve double digit-plus returns from private equity.”
Rod Selkirk is another. He is chief executive of Hermes Private Equity, which manages the private equity allocation of the BT pension fund and chairman of the BVCA. “BTPS’s decision to increase its allocation is not based on the good recent performance of the asset class,” he says. “Clearly, it’s helped, but the case we put together was based on other factors, such as the fact that corporate governance is better in private equity-backed companies than public ones because the shareholder is sitting on the board, that private equity can attract top quality management teams, that you can make improvements to the businesses you back because you generally have a controlling shareholding, etc. Its decision is based on the fact that over the long term, private equity has delivered good returns and that the factors mentioned mean that it will continue to do so in the future.”
BTPS’s private equity strategy, in common with many other pension funds, is to invest largely in buyout funds. It will also invest in some venture capital funds, mainly those located on the West Coast of the US as “that’s where most venture opportunities are”, says Selkirk, and in infrastructure. Unusually, though, it also invests directly in companies – one of the reasons Selkirk, with his 20 years of experience at Bridgepoint and 3i, was brought in. Hermes has also recently hired former CalPERS chief investment officer Mark Anson as its chief executive. With heavyweights such as this running the Hermes investment programme, it’s clear that it is serious about investing in alternatives (it also now has a 5% allocation to hedge funds).
As the largest UK pension fund, some see BTPS’s decision to increase its exposure to alternatives as a move that may influence other smaller schemes to do the same. But others say this is simply wishful thinking. Guy Fraser-Sampson, a 20-year veteran of the private equity industry and author of Multi Asset Class Investment Strategy, believes pension funds in Europe have a prejudice against the asset class. “Private equity has comfortably outperformed every other asset class and yet is still less than 1% of UK pension plan assets,” he says. “The situation in Europe is not much better. What is it that makes private equity inappropriate for use in Europe? Logically, every pension fund should allocate 25% to private equity.”
Even those that are upping their allocations are doing so too gingerly, he adds. “Those that are increasing are doing so to around 5%. That is not a meaningful allocation and will not make a substantial enough difference to the fund’s overall performance to be worth it. You’d do better not to do it at all than to allocate 5%.”
His view is that, had UK pension funds invested 20% or more to private equity over the last 10 to 15 years, as many US pension funds have done, they would not be facing the funding crisis we’re seeing at the moment. He believes many aren’t looking enough to the longer term. “The argument often given for not allocating to private equity or not doing so beyond a small percentage is resources,” says Fraser-Sampson. “Yet, if you allocated 25% to private equity you could afford and justify private equity expertise. If you just have a 2% or 3% allocation, you’ll probably end up investing in large global funds of funds, which means you’ll have very little European exposure outside the large buyout funds – it’s a kind of commoditisation of private equity returns.”
Yet building up a sizeable private equity portfolio takes time. “Getting our commitments up to 5% is part of a larger exercise,” explains Selkirk. “Part of that involves re-allocating the pension fund’s portfolio into alternatives in general. We’ve gone from 2% to 5% and you can’t build up that exposure overnight – you have to build your team and you have to go through rigorous manager selection. Some might say that we aren’t allocating enough, but there are others who might say that 5% in private equity and 5% in hedge funds is quite an aggressive strategy.”
The problem of building up an allocation is also exacerbated by current fund raising conditions. With so much capital destined for private equity, many of the funds that have been raised in recent times have been over-subscribed and general partners forced to cut back or even refuse investor commitments.
If demand continues, buyout fund sizes, already much larger than they have been historically, are likely to increase further. “We could well see fund sizes of over €20bn during the next fund raising cycle,” says Laib.
This should make it easier for pension funds to deploy their increased allocations. But will we see the kind of 10%-plus allocations in Europe that are commonplace in the US? Unlikely. Just 4% of Continental European and Irish pension funds and 6% of UK pension funds have an allocation to private equity, according to the 2006 Asset Allocation Survey by Mercer Investment Consulting. Most of these have allocations of below 3%. In the UK, “interest in private equity is anticipated to increase, but not dramatically so”, the survey says. In Continental Europe, the story is even less encouraging. It says: “Exposure to private equity is unlikely to grow substantially, with only limited additional interest.”
“The market is much more mature in the US and that’s why pension funds there have high allocations – some outliers have 20% plus, but most are in the 7% to 10% range,” says Tobin. “Europe is likely to see a slow and steady increase towards US levels, although many will not reach them.” Laib agrees: “It would take a long time for European pension funds to catch up with those in the US. The maximum level we’d forecast over the medium to long term in Europe would be 5%.”
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