In Short
Given the amount of discussion surrounding LTAFs lately, we created this ‘handbook’ style article to outline some important areas to think about and watch out for when selecting an LTAF.
We believe the FCA’s new Long Term Asset Fund (LTAF) rules are a turning point for Defined Contribution (DC) schemes accessing the private markets. In turn, this could greatly benefit DC savers in the many years to come for three key reasons:
- According to some government estimates¹, nearly 40% of the UK population are not saving enough for retirement. The potential for additional returns from an LTAF can help to close that “savings gap”.
- Currently, a DC member’s risk comes predominantly from listed equities during the accumulation phase. Adding a broad range of idiosyncratic, private market investments can provide diversity to their portfolio.
- Private investments have the potential to offer enhanced sustainability benefits, either through funding world-changing technology or through trying to solve the many social and environmental challenges we face.
Nevertheless, the illiquid, long-term nature of private market investments can be a double-edged sword. Get it right and it is possible for members to enjoy the benefits we outline above. Get it wrong, however, and you can end up being invested for the long-term in a fund that is not giving you what you originally intended. The objective of this paper is to help trustees or consultants working with DC schemes who are keen to improve their understanding of private markets investing. We identify some pertinent topics, numbered below, with the ultimate goal of helping DC schemes select the LTAF provider that is right for them.
1. What’s the Purpose of Adding Private Market Exposure?
Naturally, defining what you want a private markets allocation to do is the first step. In our conversations with DC clients, there are usually two perspectives:
- Include an LTAF within the growth phase: seeking an (above) equity return coupled with additional diversification benefits. In practice, achieving this goal over the long term requires building exposure to a portfolio of private equity and/or value-add/opportunistic real asset investments.
- Include an LTAF within the consolidation and retirement phase: seeking stable cashflows in excess of bonds of equivalent credit quality, coupled with additional diversification benefits. In practice, achieving this over the long term requires exposure to core real asset and/or private credit investments.
These are two very different investment strategies across manager specialism, asset class, return target and liquidity profile. The design for both strategies needs to provide a minimum level of value for money. A growth-stage LTAF should seek a (net of all fees) return above equities to help grow a member’s pension pot as much as possible, which is particularly important given the insufficient pension saving across the UK we note above. A consolidation phase/retirement portfolio should seek a higher level of income generation with some element of inflation hedging to provide a return above bonds.
2. The Importance of Partnership & Flexibility
Picking the right provider for an LTAF is particularly important given the long-term nature of the fund structure. In our opinion, it needs to be a true partnership between the asset manager and the DC scheme. There needs to be an alignment in beliefs and trust in one another. Investing in illiquids for DC will no doubt evolve and mature as an industry. DC schemes need to be confident their LTAF provider cares about this evolution and will evolve with them. New developments should be the result of regular ongoing client dialogue and putting the needs of members first.
This is easier for larger DC schemes who can exert more influence, perhaps through investing via a fund-of-one structure where they have a set of controlling provisions. We would expect smaller schemes to invest in comingled LTAFs, perhaps also investing alongside different client types (e.g. wealth managers), and they need to be confident the manager will do the right thing by them over time.
3. Comparing Apples with Apples
Following on from the above, it is important to understand from your private markets provider what it is you are ultimately going to be owning. Some core assets can be framed as “value-add” investments and sold as being suitable for the growth phase. Using infrastructure by way of example, if you are buying an existing infrastructure asset and seeking to maintain it, we view this as a “core” asset. Building new infrastructure at scale, perhaps by doubling the output of a solar power company, would be moving into value-add. Investing in core assets has a lower expected return with correspondingly lower fees and, therefore, fits more easily within the cost constraints of DC. However, while these core investments may be appealing from a cost perspective, we feel they are unlikely to meet the typical growth phase objectives for members.
4. Return Expectations and Building “Narrow” or “Broad” Portfolios
Return expectations should always be taken with a large pinch of salt, and none more so than in the private markets. It is typical for private market providers to give return expectations that are full cycle rather than point in time. For example, a return expectation of “15%+” for private equity is typically quoted which is a full cycle estimate based on historic performance. In our view, some private market strategies will be structurally challenged in the new higher interest rate environment, which is also likely to lead to a greater dispersion between the best and worst manager performance around the mean return. It is important for trustees and their advisors to compare assumptions between different providers fairly and understand their construction. It goes without saying, but just because a manager quotes a higher return assumption doesn’t mean they can deliver that in reality.
There is likely to be a wide range of LTAFs for DC schemes to choose from. These seem to be falling into two camps regarding their portfolio makeup: narrow and broad. A narrow LTAF will invest in a single asset class, or a small set of asset classes, (e.g. infrastructure or private credit) with the intention being that a DC scheme will build up several LTAFs to create their own private market portfolio. A broad, diversified LTAF will invest across a range of asset classes and provide a single implementation route for schemes. Manager selection is different for both (see #5 below). Given these are long-term mandates coupled with the very nuanced nature of private markets, it is likely trustees and consultants will need to spend more time underwriting private market providers than they would liquid investments, across both investment and operational areas.
5. Using Third-Party Asset Managers within an LTAF
Our belief is that no single asset manager can be market-leading across the full range of asset classes the private markets have to offer. This is why at Fulcrum we have worked to create a transparent, best-in-class “open architecture” solution (i.e. a model whereby we seek to pick the best third-party specialists across a wide range of asset classes). We also believe a collection of local specialists investing in small-to-mid-market assets is the best approach to private markets investing. Why? Because the environment is less competitive, more idiosyncratic, more relationship-based and can have a wider range of exit routes than very large assets where you either need to sell to a small number of large institutions or, in the case of private equity, via an IPO. It is our aim to be the bridge between innovative asset managers and similarly-minded DC schemes that could not otherwise access these strategies.
We strongly recommend attaining a thorough understanding of a manager’s implementation approach and for DC investors to push for complete transparency within and across the portfolio, including around whether any part of the investment process is outsourced or done internally. Our own research shows that it is not always immediately obvious and conflicts may exist with internal or affiliated teams.
6. Sustainability Characteristics and Impact
The ability to genuinely influence and change what you own is one of the great benefits of private markets, both from a sustainability and return perspective. Having significant control through a large ownership stake facilitates this. With ESG and sustainability so front of mind, it should be one of the key considerations for DC scheme trustees.
Within private markets, the quantum of change and real-world impact is larger through a value-add approach. The scale of the capex and development required to meet investment objectives means real-world changes and advancements in sustainability can be made. Investments we have been considering include adding localised microgrid renewable power to buildings, improving the biodiversity and sustainability credentials of small-lot timberland, building industrial-scale smart greenhouses and constructing renewable power plants from scratch.
Core assets can still provide sustainability benefits though they have less additionality, i.e. your investment capital is typically making only marginal additional difference to passively owning and operating the asset (which, of course, is needed too).
From a sustainability and impact perspective, therefore, it is important to understand the extent of genuine value-add/change a manager will be undertaking and how intertwined that is with ESG initiatives.
7. Gaining Complete Clarity on Fees
We have always strived to be as transparent as possible on fees. One area we have historically not invested in, as a result, is externally managed investment trusts. Many of these have high (management and performance) fees that are difficult to negotiate and were (at least) historically not included in the Ongoing Charge Figure (OCF).
We have invested in the private markets for a long time and have regularly seen opaque fee practices. The most common one is to not include some (or all) of the underlying fund costs in the quoted fees. This is compounded by carried interest being particularly hard to assess and opaque – catchup rates, European vs American waterfalls and clawback clauses make these calculations more difficult, requiring intense inspection and modelling by investors.
We have also been offered (and turned down) various financially engineered “solutions” to improve “fee optics” such as the use of loan or structured notes on private market investments. Given the importance of cost disclosure for DC pension schemes, the use of these practices in LTAF products will need a heightened level of understanding and scrutiny. Often you would only discover they are being used by asking the right questions.
If a manager uses external teams for deal sourcing, it is important to explore how these teams are compensated and if this is included and reported within the transaction costs, management fees, performance fees or operational expenses. A wider assessment of the type of costs a manager can put through expenses should also be understood – we regularly have a robust dialogue with managers on the classification of costs between fund expenses and management fees.
Calculating the total costs and, therefore, value-for-money can be difficult (e.g. one manager charges a performance fee, one charges an upfront fee on invested capital and another has a flat management fee-only approach), but it is crucial to compare these approaches on a level playing field. Whichever approach is taken, the key is that it is reported transparently, fully understood and reflects the client’s wishes.
We have highlighted this non-exhaustive list of challenges to help investors avoid nasty surprises when it comes to reporting costs to members and to help manage the potential scenario of the regulator forcing transparency from asset managers who are not fully disclosing fees, as has happened in the past.
8. Balancing Liquidity with Illiquidity
Whilst the LTAF structure is well designed, it is still necessary to get as complete an understanding of the liquidity profile as possible. Trustees need to gain a high level of comfort that their LTAF’s liquidity provisions give managers enough leeway for an orderly sale of the underlying portfolio so as to meet redemption requests in the years to come. Conversely, this means not pushing managers too hard for liquidity over and above what the portfolio can deliver and where they feel comfortable.
We have learned many lessons from our long experience of managing hybrid-liquidity portfolios with the key one being that you should be very careful about leverage within illiquid portfolios, particularly those derivatives that mark-to-market on a regular basis.
9. Investment Quality
Schemes should know where they fit in the pecking order for investment deals. Being the last to get sight of a co-investment deal, after it has been offered to lots of other investors and clients, may mean these are the investments others don’t want. DC schemes should also be careful if they are investing in a round that follows where the asset manager in question has invested the bulk of their capital. We look for specialist managers who understand the strategic importance of DC and want to service that client base in the best way possible for the long term. This is a much more sustainable model with which to fuel the growth of private markets in DC for many years ahead.
Summary
We firmly believe, if done correctly, the private markets can provide great benefits to DC members. We hope the areas outlined above give food for thought and help in your discussions with potential LTAF providers. Our goal is for DC schemes to pick the provider(s) that are right for them based on a complete understanding of the strengths and weaknesses of each proposition.
Please do get in contact if you would like to discuss any of the topics raised in this article or wish to understand more about the work we have done in this area.
About the Author
David Merton
David is a Portfolio Manager within Fulcrum Alternative Solutions and is a member of the Fulcrum Alternative Solutions Investment Committee. Previously he worked as a Director at Time Partners Investment Advisory, before which he worked alongside Matthew Roberts as a Portfolio Manager at Willis Towers Watson. David holds a BSc in Chemistry from the University of Surrey. He has been a CFA charterholder since 2016.
