Together At Last: DC Schemes and Private Assets

Tipping point in sight as rising demand for private market instruments meets rapid innovation of supply.

It has been possible for DC schemes to give their members access to private markets for a number of years now. Yet allocations to private assets are, in aggregate, negligeable despite the well-documented boost to returns, diversification and downside protection that they can offer.

The reasons for the reluctance are numerous, but include a reticence on the part of trustees, who tend to be cautious on new asset classes in general and on illiquid asset classes in particular.

Price is also an issue. Private assets require considerable expertise and governance, so fees tend to be higher than for the management of listed assets. With fee caps in UK DC schemes’ default portfolios set at 75bps, but the competitive consolidating market trading at around 25bps, private market fees have been seen as a difficult fit with DC.

Scheme consolidation calls for wider asset range

But times, as they say, are a-changing. There is an improving momentum on the demand side, as schemes consolidate and create ever bigger pools of assets that can invest at scale to create more diversification and better net returns for the members. This creates an attractive cash-flow that may well bring down fees and makes private assets, in particular, more affordable.

“From perhaps 5,000 single trust DC schemes, we are now moving to the consolidation endgame, which will be perhaps 10-20 large DC master trusts, plus a small handful of very substantial individual company schemes,” says Nick Groom, head of DC strategy and sales at Natixis Investment Managers (Natixis IM).

This endgame, Groom notes, is the natural evolution of a process that began with the advent of auto-enrolment in 2012 and the conversion over many years of DB schemes to single trust DC schemes.

These dynamics, which have been playing out for many years, have created massive pools of pension cash which requires a wide range of assets to deliver the returns pension savers need.

“Private markets, with their diversification and performance benefits, will be a sizeable and growing part of the mix required by long-term savers,” says Groom.

As schemes get more comfortable with private assets, they will enjoy the benefits of an asset class which has low correlation with other assets, is less volatile than comparable listed assets and in which managers often have more direct control than they have over publicly-traded securities.

Regulatory and political momentum

Demand is also being stimulated by government measures, which are increasingly encouraging the adoption of private market assets, with the dual aim of boosting economic growth and improving private pension outcomes.

A key objective of The Mansion House Compact, a non-legally binding initiative launched in late 2023, is for DC default funds to allocate at least 5% of their assets to unlisted securities by 2030. Currently just 0.5% of UK DC pension assets are invested in unlisted UK securities.

The initiative was announced as part of Chancellor, Jeremy Hunt’s, first Mansion House speech, with estimates that his proposed reforms could increase a typical earner’s retirement income by over £1,000 a year. The Compact was signed by many of the UK’s largest DC scheme providers.

In addition, the government has changed the rules on DC schemes to permit the use of performance fees, which now do not form part of the fee cap. Although there have been many detractors, these fees may be necessary to ensure that the underlying quality of the investments are not compromised by asking a traditional global approach to change the way it gets paid for the sake of the UK DC market; important, but still quite small in a global sense.

Another initiative, by the FCA, has created Long Term Asset Funds (LTAFs), which are designed to provide easier, simpler access for DC investors to long-term private markets investments. Groom notes investors can allocate to private markets without using LTAFs, but the new structures represent another welcome access point. “All initiatives to move the needle are helpful,” he says.

Supply side innovation

Supply side innovation is also creating momentum for the inclusion of private assets in DC portfolios. For one, Natixis Investment Managers are innovating to reduce the fee burden for private market strategies.

This includes the flexible use of origination fees in private credit whereby instead of reinvesting the origination fees which are a transaction cost, members receive a much lower ongoing fee.

Meanwhile, investment firms with a range of private equity offerings can offer lower fee entry point to private equity assets. An example is via co-investment funds, which tend to have much lower fees than primary funds. If co-investments can be combined with private equity secondaries, the lower fees can be paired with higher liquidity (since secondary assets are closer to their maturity dates). “Put simply, shorter durations equal increased liquidity,” notes Groom.

Other innovative solutions include allocations to emerging private asset managers, which may be every bit as skilled as experienced operators, but can be accessed at a substantially lower price point given their more limited track records.

DC-friendly investments

Nowhere is innovation for DC schemes clearer than in a strategy developed by two Natixis IM affiliates, who joined forces to build low-cost, low-governance exposure to private debt.

Some of the assets are allocated to European private debt managed by MV Credit, while the rest are invested in liquid multi-asset credit portfolios, managed by Loomis Sayles & Co.

Unlike allocations to pureplay private debt strategies, the MV Credit/Loomis Sayles solution can put investors’ capital to work from Day One. Initially, investor money can be allocated to the liquid Loomis Sayles portfolio, where it can be deployed rapidly. In the meantime, MV Credit identifies private market investment opportunities to enhance strategy returns. As these opportunities materialise, Loomis Sayles divests some of the assets and the proceeds are used to buy private debt managed by MV Credit.

The process is repeated until all of an investor’s assets reach the target allocation. When the concept was launched in early 2021, the split of assets was targeted to be 50:50. But for clients who can manage liquidity at portfolio level, the initial percentage invested in private assets can range from 50% to 100%.

Groom says: “Even with 100% private debt, the strategy still has DC-positive attributes in that it is evergreen, the price point is viable, there is daily pricing although uses a stale price, and investors can trade in and out during regular trading windows.”

The allocation to private credit is particularly accretive to performance in turbulent times. The approach proved its worth during volatility in public markets in 2022. While correlation between public assets moved towards one, private fixed income markets continued to track steadily upwards, says Groom.

“As long as the due diligence process is right, private loans from companies will rarely default. MV Credit selects strong companies in defensive sectors with stable and predictable cash flows to ensure interest payment on their loans. Volatility in public markets is virtually irrelevant to them.”

Schemes and platforms changing their mindsets

The mindset at schemes and platforms is morphing into concrete action. Natixis IM’s public/private debt solution, for one, has already found its way into a large number of DC scheme defaults.

“The tipping point is right here,” says Groom. “Trustees are losing their inhibitions and are realising that the real risk is not embracing private markets. The Mansion House Compact spells this out in plain, unambiguous language.”

Rather than trying to shoehorn investments into structures where DC members can view the value of their retirement funds 24/7 online, the penny has dropped that members don’t need or want this kind of visibility. “If you’re talking about a 30-40-year investment why do you need daily pricing and liquidity?” asks Groom.

Liquidity is increasingly being managed at a higher level, allowing movements of cash and allocations to listed and now unlisted assets. “Regulators, government, pension schemes and platforms must all continue to evolve and innovate to ensure more schemes and the members they serve, will benefit from these attractive private assets,” Groom adds.

Published in April 2024