What do the PM and the Chancellor want us to do?
According to the FT, “In a letter to the investment industry, the Prime Minister and Chancellor Rishi Sunak said UK institutional investors needed to “seize the moment” and use their “hundreds of billions of pounds” to back assets that often carry a longer term payback such as infrastructure, which includes bridges, roads and wind farms”. So was born the Long Term Asset Fund (‘LTAF’). We should ask whether such funds will benefit the economy, the value of savings and by extension the prosperity all of citizens, or are they just milch cows designed to support political ends.
It should first be pointed out that the European Long Term Investment Fund has not been a notable success, but the terms are very restrictive, so maybe LTAF will do better.
The “hundreds of billions” in pension schemes?
While the Treasury may eye these billions hungrily as a source of finance for the infrastructure expenditure promised by the Prime Minister as part of the process of ‘levelling up’, it is worth asking whether the kind of investments envisaged are appropriate for pension funds. There needs to be greater clarity about what kind of investments are envisaged. Do they mean roads, railways, airports or ports? Or do they mean supporting entrepreneurial companies in forward looking industries?
First they need to remember that the whole structure of pension provision has undergone great changes in the last twenty years or so, with the result that most long term DB schemes that might have been dragooned into paying for infrastructure have disappeared. Perhaps, recognising this, the government has focused on DC , particularly workplace schemes and are even talking about extending take up beyond institutional and professional investors to retail investors.
DB schemes are yesterday’s pensions
A perfect storm of events has led to the destruction of defined benefit schemes in the private sector. These include the requirement to use a rate of discount to calculate liabilities based on the yield of ten year bonds (usually government securities). We all know that this has artificially increased liabilities as interest rates have fallen to historic lows and pushed more schemes into deficit. This artificial way of measuring the health of pension schemes persists despite the fact that investment returns are likely to be higher than the assumed rate of discount. This has left the majority of schemes in technical deficit. The accounting standard FRS17, which requires that the pension assets, liabilities and costs are included in the balance sheet and profit and loss account of the employer/sponsor is therefore the final killer; and so finance directors cannot wait to get shot of these accounting items.
Faced with having to show such deficits on their balance sheets most employers have chosen to switch to defined contribution schemes and to insure remaining defined benefit liabilities with specialist insurance companies on a buyout basis that absolves them of any future liabilities. Thus many private sector defined benefit (DB) pension schemes are now either closed to accrual or only have a handful of active members left and they are effectively in run-off. The insurance companies that have taken on the liabilities of run-off defined benefit schemes cannot consider any investment strategy other than the most precise asset/liability matching using top quality fixed interest securities, which would preclude investment in the kind of long term assets envisaged by our two plucky punters, Boris and Rishi. So the only significant funded defined benefit schemes that could make such investments are now in the public sector, which might be persuaded to invest more in LTAFs.
Therefore are the kind of investments envisaged in ’Big Bang’ appropriate for today’s defined contribution scheme?
Most employees in the private sector (and indeed the self-employed) are now reliant on defined contribution schemes, either group personal pensions or occupational DC schemes such as Nest and master trusts offered by insurance companies or larger asset managers, or Self-Invested Personal Pensions.
So which are the pension funds that are going to cough up the hundreds of billions of pounds? The shrinking population of defined benefit funds, mainly public sector funds, already invest in all kinds of non-listed assets. That leaves the defined contribution funds, on which clearly our two heroes have their eye. But the fees for private equity investment and infrastructure (whatever that is) tend to be high and , as trustees and custodians have pointed out require enhanced supervision. That might cause the occupational defined contribution schemes to exceed their statutory fee cap, if they were to invest significant portions of their assets into this kind of fund. So, surprise, they are asking for a raise.
Infrastructure or technology?
First of all we need to disentangle investment in infrastructure from support of high tech growth companies. They require quite different investment approaches. The challenge letter is vague on this subject:
“The United Kingdom’s economy possesses a rich pool of assets ripe for long-term investment and bolstered by a world-leading research sector, commitment to the green technologies of the future, and British entrepreneurial spirit.”
There are technical difficulties in investing in ‘infrastructure’ even as compared with private equity or venture capital.
Financing infrastructure is a complex business, since each project is likely to be a standalone investment that requires long term, usually fixed interest, finance. One of the most common – and often most efficient – financing arrangements is “project financing”, also known as “limited recourse” or “non-recourse” financing. Project financing normally takes the form of limited recourse lending to a specially created project vehicle (special purpose vehicle or “SPV”) which has the right to carry out the construction and operation of the project. It is typically used in a new build or extensive refurbishment situation and so the SPV has no existing business. The SPV will be dependent on revenue streams from the contractual arrangements and/or from tariffs from end users which will only commence once construction has been completed and the project is in operation. There are no other guarantees or sources of revenue, so it is therefore a risky enterprise. Before they agree to provide financing to the project the lenders will want to carry out an extensive due diligence on the potential viability of the project and a detailed review of whether the project risk allocation protects the project company sufficiently. This will require the management company of the LTAF to create a sizeable team with skills different from those needed to manage a portfolio of listed equities and bonds or even private equity, so the fee rate on an LTAF is likely to be high.
Valuation may also prove to be a problem, bearing in mind that DC funds operate like collective investment schemes with units priced at market values. Even if not full daily dealing open ended funds there are many events, like regular new contributions, transfers or withdrawals at retirement that will require accurate unit prices to be determined by reference to the market prices of the assets they hold, which is difficult, as Link Solutions and Woodford found, when there are no market prices and limited liquidity. Who will validate the valuations given that many LTAFs, will have conflicts of interest between them and the fund management company. It will have to be an AIFM that manages the LTAF and it may have associated activities as a promoter of alternative investments? If valuation is to be validated by the trustees or the depositaries of the LTAF, they will clearly have both to accept increased responsibilities and make additional charges.
And what about custody? It was also quite alarming to read in the NatWest Trustee’s clear and good analysis of LTAFs from a depositary/ trustees standpoint the following:
“Whilst there is an investor protection benefit in registering LTAF assets with the depositary, there are also potential legal, financial and reputational risks and operational complexities associated with their management and as such we propose that the AIF’s custodial assets be registered in the name of the LTAF or in the name of AFM acting for the LTAF, as permitted under FUND and AIFMD.”
The security of Independent custody surely relies significantly on title to the assets by the custodian/trustee, designed to prevent the fund management company pinching the assets.
Why are LTAFs needed to invest in private equity or venture capital?
If we turn to private equity and venture capital, we should ask whether it is lack of investment opportunities to take up or lack of ability (or wish) to invest in forward looking companies in technology, life sciences, or medical advances that is the barrier. There seems already to exist a vibrant ecosystem for fundraising for small and new growth companies and no apparent shortage of capital.
Defined benefit funds, now mainly public sector funds, already invest in all kinds of non-listed assets, and may or may not have the capacity to invest more. Allocation to ‘other’ assets, a category that includes real assets “was 27% in 2020” according to Mercers, the specialist consultancy firm.
Defined contribution funds seem willing to consider investing more in ‘Big Bang’ assets provided they can negotiate a cut price with private equity houses and managers of specialist funds and/or increase their fees to cover the increased cost of analysis and due diligence.
While small retail investors usually cannot access private equity directly they have several ways to participate: 1000 innovative LSE listed and AIM traded smaller companies, and many open ended funds investing in them: a number of listed infrastructure investment trusts, including the well-established £2.5 billion 3i Infrastructure Fund: venture capital trusts, well established, tax incentivized, listed funds which regularly raise new money of £500 to £750 million each year. And for more sophisticated professional investors: Enterprise Investment Schemes – tax incentivised schemes which raised nearly £2 billion in 2019/20
Nor is there a dearth of opportunities
Below the FTSE 100, which can be said to be an index of ‘old economy’ companies, there is the FTSE 250, with a capitalization of nearly £500 billion. And further down the scale there is the FTSE Small Cap index of a further 600 companies. All of these rely upon investors for new money to finance change or growth. And there is no indication that they cannot obtain it.
Below this there is the AIM market, which has been around since 1995, often the first choice for new companies in the growth sectors of technology, ecommerce and healthcare. AIM companies raised more than £5 billion of new money in 2020.
The British Venture Capital Association annual report shows that, in 2020, 44 UK-based VC funds reached their latest close, up 26% from 2019 when 35 funds closed. The total value of VC funds closed in 2020 was £4.8bn, the highest amount raised by UK VC funds in a single year. This is 39% higher than 2019, showing continued confidence in the UK VC industry
So, what’s the lads’ real intention?
If LTAFs are to work at all, there are many problems to be addressed and much greater clarity needed about their structure, operation and investment strategy before anyone will invest in them. Boris and Rishi don’t appear to have thought through the detail. So they must have a wider objective.
But given that fact that there is no shortage of investment opportunities anyway, the cynic in me suspects that what they “really, really want” is to get us to finance money-guzzling, dead end projects like HS2 and Hinkley Point, and a whole trail of government sponsored PFI disasters like the health service national IT system and the NATS fiasco that simply would not be able to raise finance from the deep pool of capital from existing private finance that I have discussed above.
As Jane Austen put it most succinctly:
“It is a truth universally acknowledged, that a single man in possession of a good fortune, must be in want of a wife.”
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