A piece of the pie
Asset managers are beginning to consider how they can operationally scale to cater to DC pensions as investors. This comes after the Productive Finance Working Group published its set of guidelines in November for DC pension schemes wanting to increase allocations in illiquids.
Until now, the presupposed risk of investing in alternative assets has deterred DC pensions, with lack of liquidity and high management fees as key blockers.
Things are, however, beginning to change, with the Group calling for a prioritisation of value over cost. According to its previous publication in 2021, ‘A roadmap for increasing productive finance investment’, low interest rates and slow economic growth have damaged the potential for higher returns under DC pensions’ current investment strategies.
As DC pensions are incentivized to delve into illiquid alternatives, fund managers will have to consider scaling up to support this new development. The challenge lies in being able to provide DC pensions with the liquidity that they require for their investors, and the operational overhead that is needed to support the endeavour.
Best of both worlds
Fund structuring is a major key in unlocking this new institutional pool of capital. Hybrid funds provide the ideal fund construction for DC pensions as they give access to both liquid and illiquid assets. This means that pension pot holders have access to private equity with the ability to carry out redemptions.
Having a solid fund structure is the key to effective liquidity management. The idea is to reduce the risk of a traditional long-term PE investment by diversifying the fund with a percentage of liquid assets and having an open ended entity providing an investor redemption capability.
Malcolm Goddard, partner at Zetland Capital and former partner and COO at Altima Partners, who specialised in hybrid funds, stresses the importance of a solid fund structure for a successful hybrid fund: “Amongst other things, you need to think about how to allocate expenses between the liquid and illiquid portion of the fund, as well as where the cash is to pay those expenses. Otherwise, you could end up in a situation where you're giving all your cash away in redemptions, but you still have operating expenses to pay in the illiquid portion.”
A successful fund structure requires GPs to manage both sides of their balance sheet. This entails having rigid redemption rules, which can be achieved by putting lock ups and gates in. Having such measures in place reduces the risk of fund suspension. Borrowing can also cover redemptions, but with that comes additional risk.
Held to account
Another aspect to consider is the triple threat of reporting accurate valuations through reliable accounting at high volumes. Series accounting is best used to keep track of valuations for hybrid funds. This method effectively provides each investor with their own mini-fund as, typically on a monthly basis, fund managers issue a new series for the new investors under a different NAV. This method strays vastly from PE’s equalisation method, which is a fiddly calculation, but it only happens every close.
The catch is that DC pensions tend to operate on a small scale and they exist in large volumes. A question fund managers need to ask themselves is whether they truly have the operational infrastructure, in-house or via an administrator, to manage this new type of investor, bringing with it a new set of accounting and valuation rules. The number of open series can become an operational minefield without a proper set up in place.
Ultimately, Goddard advises that transparency is integral for a successful implementation of a hybrid fund: “I think what’s absolutely key is to ask yourself whether you are matching the investment programme with your liability profile given the added pressure of subscriptions redemptions. Can you hand on heart return money within the fund period, given there will be redemption requests, without having to think about suspending?”