Removing liquidity restrictions would enable DC funds to capitalise on the potentially higher and safer returns that DB schemes have benefitted from, says Patrick Marshall.
To understand the fundamental change in investor attitudes to private market investing over the last 10 years, you need only look at the changes to allocations to alternative assets for asset owners.
In 1997, alternative investments accounted for 4% of the total asset allocation by global pension schemes in the seven largest markets. Today, alternatives account for 25% of the same pool, according to Willis Towers Watson's Global Pension Assets Study 2018.
This is a clear demonstration that global asset owners have rethought their approach to investment in favour of private over public markets.
This change is as pronounced in the private debt universe.
The McKinsey Global Private Markets Review 2019 found that in the five years to 2018, 766 private debt funds raised $509bn (£406bn) for both European and US strategies.
The drivers behind this growth are complex. Since the financial crisis, the debt markets have fundamentally changed as traditional lenders reduced the amount of debt they provided on the back of higher capital requirements and more constrained balance sheets.
This allowed alternative lenders to access the market, especially for providing financing to small- and medium-sized enterprises, which were previously almost entirely reliant on banks for funding.
This retreat, combined with the fact firms still need debt in the same quantity, has led to the growth of the private debt market, which means the source of capital has changed from bank balance sheets to the global institutional investor community.
Global asset owners are drawn to this growth area because of the diversification benefits and the stable, long-term yield that the asset class has the potential to deliver with often bond-like risk profiles.
The popularity of investments such as private debt is on the rise for investors looking for yield in a low-yield environment, while being a low-volatility asset with generally stable, lowly-correlated returns.
But this long-term investment horizon and strong yield and risk-return profile means this asset class has a number of attractive qualities for UK defined contribution (DC) pension funds as well as for defined benefit (DB) pension schemes.
A report from the All-Party Parliamentary Group on Alternative Investment Management, published
The structural shift towards private investments is here to stay. Companies are increasingly turning their backs on the public market in favour of raising capital from private equity and debt providers at the start of the year, found the predicted returns of a diversified growth portfolio containing a mixture of private markets, including debt funds, as well as public asset classes were 1.8% higher than a more traditional 60/40 equity bond split. The level of volatility is also markedly lower.
The report also explored some of the barriers to higher allocation to private investments.
One of the key identified issues holding funds back, particularly DC schemes, was the perceived requirement of daily liquidity. The relentless focus on daily dealing has prevented many from taking a genuine ‘patient capital' approach.
However, this report was shortly followed by the launch of a consultation by the Department for Work and Pensions (DWP) considering how to remove some of these barriers, such as the liquidity restrictions, for UK DC pension schemes and direct some of the £60bn they collectively hold into alternative illiquid assets such as private debt.
We welcome the consultation from the DWP and the considerations into how to open up the alternative illiquid lending space to UK DC pension schemes. DB schemes have long benefitted from the ability to invest in illiquid assets, while DC funds currently have limited choice outside of public market strategies.
The structural shift towards private investments is here to stay. Companies are increasingly turning their backs on the public market in favour of raising capital from private equity and debt providers.
By removing some of the restrictions on DC schemes, such as the liquidity requirements, UK DC pension funds could begin to capitalise on the potentially higher and safer returns that come with a diversified portfolio of private markets investments, including private debt.
Patrick Marshall is head of private debt and collateralised loan obligations at Hermes Investment Management
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