Investment management costs soar as UK pension funds opt for higher allocations to private markets

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Local government pension schemes are increasingly choosing more expensive alternative investments, including private equity and infrastructure, which is raising the overall fees they pay to asset managers as pension funds seek out higher returns, diversification benefits, and lower investment risk.

One UK pension fund, Gloucestershire Pension fund, has seen its overall investment management expenses soar by 20 per cent to GBP7.8 million over the past financial year to the end of March 2020, according to data obtained via a Freedom of Information request. 

“Investment management fees for some mandates have increased as a result of moving from passive to active managers and a change in the strategic asset allocation which resulted in increased investments to alternatives, particularly private equity and infrastructure which are subject to higher fee rates,” writes the pension fund.

These include some GBP6.7 million in management fees, which increased by 26 per cent compared to the previous year. Meanwhile, performance fees rose by 4.4 per cent last year, despite a 6 per cent drop in the overall value of Gloucestershire Pension fund to GBP2.24 billion at the end of 2020’s financial year.

Another public pension fund, Devon Pension fund, has a large, and growing, allocation to alternatives, which currently make up 29.6 per cent of its portfolio. 

Over the past five years, the proportion of Devon Pension fund assets invested in alternatives has almost doubled, from only 15 per cent of assets in 2016. 

In that time, investment management expenses have also shot up by 39 per cent, reaching GBP16.5 million last year. Last year, the fund registered an investment return of -8 per cent net of fees, and closed the year at GBP4.011 billion.

High fees do not appear to have deterred public pension funds from shifting their asset allocation strategies to favour alternatives, and in particular, private markets.

“It is generally accepted that over 80 per cent of investment performance is driven by determining the investment strategy and asset allocation, rather than selecting investment managers to implement that strategy,” says another LGPS, Durham Pension fund in its annual review.

Devon Pension fund is now setting its sights on further upping its alternative allocations. 

“It is the intention to increase the allocation to private markets further over the next two years and significant further commitments have been made in 2020/21, across infrastructure, private equity and private debt,” wrote the pension fund last year. 

This will include a 6 per cent infrastructure allocation, with a “significant investment in renewable energy”. 

Pension schemes are attracted by the potential for higher returns from investing in illiquid private markets.

In particular, private equity has been the highest-returning asset class in private markets since 2006, according to a report by McKinsey, as well as consistently outperforming public markets over the past ten years. McKinsey analysis shows that private equity earned annualised returns of 14.3 per cent, compared with 13.8 per cent returns on the public equity index S&P500. 

The potential for outperformance has encouraged pension funds to allocate ever more investment capital to private equity funds.

“Private equity performed strongly in the last year delivering returns of 12.1 per cent to March 2020,” said Gloucestershire Pension fund, contrasting this to the performance of public equities, which was one of the fund’s worst-performing asset classes last year.

After a strategy review in 2020, Gloucestershire Pension fund resolved to reduce its equities and fixed income allocations within its pooled portfolio with Brunel Pension Partnership, which accounts for the majority of its investments. This will allow for higher allocations to private equity, infrastructure, private debt, and international property. 

Almost a quarter, 23 per cent, of Gloucestershire Pension fund’s pooled portfolio is now earmarked for investment in alternative assets, five percentage points up from its current allocation of 17 per cent. 

Gloucestershire Pension fund says its new asset allocation will help to “slightly” reduce investment risk, while still achieving the required returns. 

At another local government pension fund, Clwyd Pension fund, private equity was the best-performing asset class last year, generating 5.2 per cent returns in the year to 31 March.

Clwyd currently allocates 30 per cent of its portfolio toward alternative assets, including private debt, private equity, property, infrastructure, timber and agriculture., 

Information obtained via a Freedom of Information request shows these alternative investments, although a minority of the overall portfolio, are responsible for the bulk of fees paid. More than two thirds, 67 per cent, of overall investment management fees, excluding underlying fees, are generated by Clwyd’s alternative investments. 

Some academics are now sounding the alarm about private equity’s high fees. Excessive fees may even end up cancelling out the extra returns earned by investors, according to a study published last June by Ludovic Phalippou, a professor of financial economics at the University of Oxford’s Said Business School.

According to the paper, returns from private equity funds, net of fees, have been the same as those of public equity indices from 2006 through the end of 2019.

Phalippou blames a combination of “misleading performance information that was presented to investors, the fees being higher than those recorded in any other investment vehicles, and high transaction costs”, which he says lead to an outcome that is “unlikely to be positive for investors”.

“That wealth will not return to pensioners, universities, etc,” says Phalippou. “Broader society may become yet angrier at the whole PE industry and at the market system more broadly, even though most of the issues come from a subset of the PE industry, and despite the fact that PE can point to real achievements.”

A few local government pension funds, including Brent Pension fund, are already stepping away from private equity. The fund, which has a 6 per cent allocation to private equity, is currently in the process of winding down its allocation.

“Private equity will run off over time,” writes Brent Pension fund, which is planning to reallocate to diversifiers.

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Madeleine Taylor
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