Travers Smith’s Alternative Insights: UK Pensions And Private Capital Funds – Employee Benefits & Compensation

Diversifying the investor base has been a priority for many
private fund sponsors in recent years and, as we have written previously , European
policymakers have been keen to help. Although the EU’s Retail Investment Strategy may make
things more complicated, and the UK’s Consumer Duty has already enhanced
the regulatory burden on firms targeting individual investors,
other recent reforms are more helpful.

In particular, amendments to the legal framework for the
European Long Term Investment Fund (ELTIF), which offers a pan-EU
retail passport for qualifying funds, are already having an impact.
And the European Commission’s expected adoption of revised
implementing rules seems likely to confirm that ELTIFs can, in
effect, be open-ended – fixing one of the main design faults
in the 2015 rulebook.

In the UK, the initial focus of its relatively new Long-Term
Asset Fund structure, or LTAF, has been on the defined contribution
(or DC) pensions market, although in time it should also facilitate
access to some individual investors. Even though it is a large and
easily identifiable pool of capital, the DC market is still a tough
nut to crack for private funds. The LTAF is undoubtedly an
important step forward, but uptake among private markets firms has
so far been slow.

Probably the main reason for the LTAF’s slow start is that
the costs for sponsors do not currently match the opportunity set,
especially when those sponsors are focused on wealth management
platforms – seen as a bigger opportunity to access high net
worth individuals in Europe (including the UK) and the Asia Pacific
region.

The costs are considerable. For example, a sponsor launching an
LTAF needs to be authorised in the UK to manage an authorised fund
– a licence that most alternative asset managers do not
currently need and, therefore, do not have. (Indeed, post-Brexit,
many UK managers do not have a UK fund management licence at all,
having swapped it for a licence in Luxembourg or Ireland.) Getting
such a licence would be a very significant investment of time and
money.

There is an alternative approach: to use a third party manager
which does have such a licence, and some LTAFs use that model.
However, it adds a layer of fees, and it will be necessary to
demonstrate to the UK regulator, the FCA, that the third-party
manager has sufficient expertise in private markets. The FCA will
interrogate that carefully, especially after the failure of the
Woodford Equity Income Fund in 2019, which employed an external
manager.

Although some LTAFs have already been launched (and an important announcement by WTW this week
indicates that more are to come), there are other off-putting
features for mainstream private markets participants, meaning that
uptake will continue to be limited and slow. The LTAF alone will
not be enough for the government to hit the target it set last
year: for 5% of DC default funds to be invested in unlisted
equities by 2030. Other options need to be looked at – both
to increase demand for LTAFs, which will shift the cost/benefit
analysis, and to facilitate investment in traditional limited
partnership structures.

In February, the BVCA’s Pensions and Private Capital Technical Expert
Group – which exists to identify the problems for DC
schemes that want to invest in private capital and suggest
solutions – published a comprehensive report , written by PwC,
identifying the main roadblocks.

One structural problem has been that the dominant model for DC
schemes is to use a bundled solution provided by a life insurance
company (known as a “life platform”). The DC scheme
invests in unit-linked insurance policies, the returns from which
are derived from (predominantly) daily dealing investments. This
insurance wrapper can be cost-effective for smaller schemes and
facilitates very frequent information on the valuation of the
underlying assets, which is important for the scheme.

The rules that determine what can be included in the underlying
reference portfolio of a unit-linked policy, referred to as the
“permitted links” rules, do allow for the inclusion of
certain non-daily dealing investments including, on satisfaction of
certain conditions, the LTAF. However, there is a high degree of
uncertainty about whether other semi-liquid and/or private capital
vehicles can be included in the unit linked policies, even if they
have very similar investment terms to an LTAF.

Further work needs to be done to allow a wider range of
semi-liquid products to access DC schemes through a life platform.
Although not the only model – the alternative is to use a
bank to act as custodian and fund administrator – the life
platform is frequently used, and here to stay. DC schemes using a
life platform should have access to a wide range of alternative
asset managers and strategies. More changes to the permitted links
rules are therefore needed – for example, to permit
investment in ELTIFs.

Separately, it is helpful that the government is committed to
consolidation of DC schemes, because larger schemes will have the
scale necessary to address some of the challenges. It seems very
likely that a future Labour government, if elected later this year,
would remain committed to that objective.

But there are also a number of commercial barriers for DC
trustees that will be equally important to address.

Concerns over liquidity and valuation need to be overcome, but
there are active dialogues on those topics. The issues are
certainly surmountable and, to some extent, based on
misunderstandings. But fee structures will be more tricky. DC
allocators remain reluctant to accept the typical private capital
fee model, notwithstanding recent changes to the charge cap rules
which have cleared the regulatory obstacle. The investments that
are currently being made by DC schemes, often with managers
branching out from long-only investments, are generally not on
terms that established alternative asset managers typically target.
More work on bridging this gap will be key.

The rewards for DC pension fund investors could be significant
– the UK government certainly thinks so, and the influx of
patient capital from new sources could also help meet Europe’s
growth and productivity challenges. But the obstacles are numerous
and complex. The industry’s concerted efforts to address them
are vital.

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guide to the subject matter. Specialist advice should be sought
about your specific circumstances.