Viewpoint: Gilts crisis won’t undermine attractions of private markets for long-term investors

There has been a lot of talk about how the gilts crisis could make long-term investors, including pension funds, think twice before investing in illiquid private markets – and the potential impact of that on environmental and social-related strategies. But the pensions market has dynamics which mean that illiquid assets can be highly appropriate, because they provide superior financial returns alongside diversification whilst also addressing the significant sustainability and levelling up agendas increasingly targeted.

After being forced to meet soaring cash margin calls driven by liability-driven investment (LDI) hedges, access to liquidity became critical for Defined Benefit (DB) pension funds. They’ve had their fingers badly burned, and it’s easy to blame the lack of liquidity as a contributor to the short-term drama. However, private assets were simply continuing to perform in line with their targets, it was the geared LDI strategies that catalysed the issues.

Defined contribution (DC) funds and Local Government Pension Schemes (LGPS) are unlikely to sacrifice the illiquidity discount or inflation-linked long-term returns available from investment in private markets.

Many of the government’s ambitions to reboot growth in the UK economy require solutions which private assets are well equipped and prepared to provide in a timely manner.

The government pressure on pension schemes in recent years to invest in UK assets is not going to stop. The scale of assets invested in DC funds is expected to double by 2030 and the government knows they have the potential to spur economic growth and create long-term prosperity. The push is continuing under the new Prime Minister.

The Department for Work and Pensions (DWP) recently reiterated that enabling pension schemes to take advantage of long-term illiquid investment is one of the government’s key priorities:

“It remains a priority for government to find ways to facilitate greater diversification in investment by UK institutional investors, particularly through investment in less liquid assets because of their potential to deliver higher long-term returns to savers as part of a diversified investment portfolio.”

This announcement came as part of a consultation on removing performance fees from the charge cap, to make it easier for DC schemes to invest in private markets and illiquid assets. It also proposed compelling schemes with more than £100mn in assets to explain their illiquid investments policies so trustees can properly consider a wider range of investment opportunities.

Earlier in 2022, the Department for Levelling Up, Housing and Communities published its white paper on levelling up, which asked LGPS funds to set out plans for investing up to 5% of their £350bn of assets under management (AUM) to local and regional projects. At present only 2.4% of the total value of LGPS AUM is allocated to the real economy, of which 1% is invested in the UK.

UK pension funds stand out in an international context as investing significantly less in private markets than their peers around the world. The latest global pensions asset survey of pensions notes that only 7% of UK pension assets are diverted to other assets, like infrastructure, venture capital and real estate. The average amongst countries with large pension assets is 19%. If the UK could attain that level, with assets worth £3.4trn, it would unlock £406bn for other assets.

The Policy Exchange recently noted if the LGPS alone invested its collective assets to the average of the ten largest Canadian pension funds, this would result in £35bn invested in UK infrastructure.

There are already encouraging signs. Industry data shows that alternatives have consistently attracted more than half of all expressions of interest from LGPS funds during the past three quarters. Illiquid alternatives – namely infrastructure, private debt, private equity, and property – have been the most sought-after alternative sub-asset classes.

During the Gilts crisis, the Pensions Regulator stressed that trustees need to maintain a long-term perspective when reviewing recent market volatility and performance. This is sensible advice. The long-term structural shifts in the investment industry are driven by investor appetite for financial returns, ESG and a political will to attract the funding necessary to level up and to move to net zero.

The Bank of England noted that the root cause of the Gilts crisis was simple – poorly managed leverage.

We should not let this undermine a commitment to long-term superior investment returns and a sustainable future.