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How does the UK government deploy large sums to promote economic growth without spending too much taxpayer money?
The answer, it seems, is simple.
Successive Conservative governments have turned to the £2.9tn in UK pension assets as one way to meet their dual commitments to fiscal responsibility and growth stimulus.
Shortly after a Sir Damon Buffini-led industry panel published proposals to encourage long-term investment in new businesses, the government last month said it wanted more pension fund support for the most innovative and “knowledge-intensive” of the UK’s start-up businesses. With the help of pension funds, it hopes to unlock more than £20bn of retail and institutional investment over the next decade.
But poor returns and early signs of investor disinterest could leave the government in a tough spot on its so-called patient capital ambitions.
The government’s response to the industry panel acknowledges that UK venture capital is locked in a vicious cycle of poor returns, which has led to lower investment and a drop in talented investment professionals, in turn depressing returns.
It hopes to reverse this by boosting capital flows to tomorrow’s unicorns, private companies valued at more than $1bn, by funding a £2.5bn Investment Fund incubated in the British Business Bank, alongside private sector fund of funds.
At the same time, it will attempt to remove barriers to pension fund investment in the asset class.
But attracting pension capital to the new funds will be tough, not least because of the returns on early-stage investments.
Median net internal rates of return for venture capital funds have declined steadily since 2011, dropping from 14 per cent to 8 per cent by 2014, according to Preqin, the data service.
And VC funds are not particularly interested in UK deals, according to AnaCap, the private equity company. The financial services specialist recently said Brexit headwinds mean it could ditch the UK as a top-tier investment destination.
Specific patient capital funds have not fared much better. Shares in Neil Woodford’s £903m Patient Capital Trust have lost about 6.59 per cent of their value in the past year, according to Morningstar, the data provider.
“I think that most pension funds would find it very hard to devote much to early stage. They lack the skill base and the returns would be very unpleasant,” says Jon Moulton, founder of Better Capital, the turnround specialist.
The VC veteran says pension funds are actually disadvantaged in comparison with retail investors in the asset class, due to tax breaks available from the Enterprise Investment Scheme and Small Enterprise Investment Scheme.
“The unpredictability of returns is not a feature that would commend itself to the actuaries,” he adds.
Private equity inflows among European pension funds is also drying up, according to MandateWire, the FT’s institutional business intelligence platform.
The number of European investors who told the site they were interested in private equity of any type fell dramatically, from 183 in the first nine months of 2016 to 43 over the same period this year.
More worryingly, the number of European investors who told the site they were interested in the asset class fell dramatically, from 183 in the first nine months of 2016 to 43 over the same period this year.
Mr Moulton says the government is trying to solve the wrong problem. “It’s not the availability of funding, it’s the desirability of funding. There aren’t enough good deals around.”
If the government does succeed in encouraging pension funds to invest in patient capital, the benefits to both investors and the country could be significant.
The UK’s defined benefit schemes, which account for the majority of pension assets, are increasingly invested in government and corporate bonds. More than half of UK quoted equity is owned by foreign investors, according to the Office for National Statistics.
Given the low yields currently available on fixed-income assets, a rethinking of pension asset allocation could help the pension funds themselves, according to Will Hutton, chairman of the Big Innovation Centre Steering Group.
“In that sense saying, ‘Let’s create an asset class in which pension funds can put some risk money’ makes sense,” he says.
However, significant barriers to investing remain. Mr Hutton says investors are “flying blind” because of inadequate accounting practices for intangible assets such as intellectual property.
Others say UK DB funds are stuck with their bond-heavy allocations, because their liabilities are linked to the long-term interest rates available on gilts.
Unfortunately, “there is not as much correlation as you would like” between gilts and patient capital assets, according to Hugh Nolan, president of the Society of Pensions Professionals and a director at Spence & Partners, the consultancy.
“DB schemes are withering on the vine, as we know, and most people have in their minds the idea of getting these things off their balance sheets as soon as they can,” adds Mr Nolan.
Without a sudden reopening of the UK’s defined benefit schemes, it is unlikely that they will be able to make significant allocations.
The government’s response to this issue is that the Pensions Regulator will “clarify guidance on how trustees can include investment in assets with long-term investment horizons, such as venture capital, infrastructure and other illiquid assets in a diverse portfolio”.
But Andrew Warwick-Thompson, who recently stepped down as executive director of regulatory policy at the Pensions Regulator, is less than optimistic about the prospect of attracting private sector pension funds.
He says the regulator’s guidelines have been recently refreshed and any updates are unlikely to make the returns available any more attractive.
“It’s not their job to promote any asset class or investment strategy, but to make sure trustees are aware of their responsibilities and take investment decisions on the basis of appropriate knowledge and advice.”
The policy has one potential lifeline: the scaling up of UK pension funds.
Multibillion-pound schemes, such as those created by the pooling of UK Local Government Pension Scheme assets, can make meaningful allocations to patient capital with as little as one per cent of their portfolios.
At the end of October, the UK had 5,794 DB schemes. In the Netherlands, one of the most advanced pensions economies, that figure is closer to 600. A similar proliferation is seen in the defined contribution schemes that are more common today, but which make up a minority of assets.
But consolidation is beginning to occur. The constituents of the UK’s Local Government Pension Scheme are combining in pools of up to £36bn. FirstGroup, the transport operator, has become the first private sector group to join one of these pools.
“For those schemes that are still open, such as LGPS, which are interested in longer-term growth potential and are less constrained by cash flow needs, it is a potentially interesting asset class,” says Mr Warwick-Thompson, now chief executive at LGPS Central.
“We are pretty good in Britain at coming up with brainwaves,” says Sir Steve Webb, director of policy at Royal London, the insurer. But does the veteran of pensions policy think the new initiative will be more successful than previous attempts? “It looks pretty challenging to me.”