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More experts, please

The pressure is on for UK institutions to at least take a look at private equity. Trouble is, there isn't much information on the subject says Tony Golding. It's high time we started catching up with the US, where there is a whole army of private equity experts.

One of the main thrusts of the Myners Review was the exhortation that pension funds at least consider private equity - and other ‘alternative investments' - when making their all-important asset allocation decision. For trustees taking their first tentative steps into this area, investing in private equity raises many issues - long timescales, a lack of reliable performance data, higher risk, illiquidity, fee structure etc. Yet private equity can produce attractive returns, higher than those obtainable on the so-called mainstream assets of equities and bonds. And, perhaps, a low correlation with public equity will allow it to outperform when mainstream assets are producing lower returns.

Unfortunately, there are no definitive solutions to the trustees' issues. Worse still, we in Britain suffer from an appalling lack of information on the subject. In the wake of Myners there is plenty of heat but precious little light. No wonder trustees have difficulty in deciding whether or not private equity is a suitable asset class for them.

Above all else, pension funds need reliable and objective advice on the whole alternative assets scene. In the USA, a well-developed section of the investment consulting industry provides such a service. The UK urgently needs to develop an equivalent. Otherwise, the whole debate runs the risk of foundering in a sea of claim and counter-claim, leading to confusion and inertia.

US acceptance
How did the concept of ‘alternative assets' become so well accepted in the USA? The root cause is ERISA, the 1974 Act that rewrote the rules for the pension industry. It specifically urged funds to diversify their assets as much as possible. Alternative assets, a catch-all category for all assets outside equities and bonds, represented a group of investments that - hopefully - would perform well when conventional assets were in the doldrums, and vice-versa. (The term alternative assets covers a variety of investment activities, from private equity through hedge funds to real estate - which in the UK, of course, is a mainstream asset. Private equity includes both venture capital and buy-outs of mature companies).

Twenty years on, investing in alternative assets is an acceptable concept for US pension fund investors. This is also bound up with the ERISA-induced shift to specialist asset management. From the perspective of a plan sponsor, managers of private equity funds are just another bunch of specialists. They are on a par with managers dedicated to, say, Asian equities or domestic small companies. This is not to suggest that all US pension plans feel that they must have a commitment to alternative assets. Many smaller plans do not invest, or do so indirectly via a fund of funds. But they at least consider non-mainstream asset classes - on the basis of information rather than anecdote.

Back in Britain, while the Americans were embracing specialist management, we remained wedded to balanced management, with its built-in rigidities. None of the three elements in the balanced process - trustees, investment consultants and fund managers - have any incentive to venture outside the safe and comfortable confines of equities and bonds. Of these three parties, the investment consultants have been best placed to kick-start investment beyond the mainstream, given their undoubted influence over trustees. Yet, only recently, as the shift to specialist management gathers momentum, have they conceded that private equity and other alternative assets may have a role to play.

Imprecise alternatives
The root of the problem is that investment consultants possess a quoted securities mindset. In the UK the majority of investment consulting firms have an actuarial origin. This difference is highly significant. Actuaries are bred to quantify. They love precision. But alternative assets are riddled with imprecision. Contrast this with the US where most consultants come from an investment background. Many started life in the 1970s under the wing of a stockbroking firm (parting subsequently when the conflicts became too great).

The US investment consulting industry contains more than 200 firms compared with perhaps 30 in the UK. More to the point, it is much less concentrated. Myners calculated that the top four firms controlled at least 70 per cent of the UK investment consulting market. A Nelson survey in 1998 concluded that the four leading US investment consultants accounted for 34 per cent of the US market on the basis of numbers of clients (at a guess, the share might be 40 per cent ranked by assets advised).

Not only are there more advisory inputs in the US, there is a much greater variety of advice on offer. Contrast this with Myners' view that UK investment consultants provide advice that is ‘relatively uniform, insufficiently specialised and, in particular, poorly equipped currently to deal with alternative asset classes'. Some US consultants specialise in advising on alternative assets and nothing else. They were mostly founded in the late 1980s, often by consultants from bigger firms. For example, Pacific Corporate Group of La Jolla, California, only advises on private market investments, with a strong client base among public pension funds. Hamilton Lane Advisors, based in Pennsylvania, has 35 professionals dedicated to alternative assets. Sovereign Financial Services of Denver concentrates on private equity consulting. It also runs funds allowing small to medium-sized institutions access to a diversified portfolio.

Some investment consultants have gone as far as constructing proprietary indices for venture capital and buyouts to help measure returns over time. One such is Boston-based Cambridge Associates, a broad-based consultant that now has an office in the UK and is doing work in Europe in the alternative assets area.

All the larger consultants promote their expertise in alternative assets as part of the product line-up offered to plan sponsors. Starting in the mid 1980s, the big firms found they had to get up to speed in alternatives. Watson Wyatt's US website has a section entitled Making the Case for Alternative Assets, arguing that ‘only by expanding the opportunity set can the plan sponsor effect a meaningful change in long-run returns'. The Hewitt web site refers the visitor to ‘our Alternative Asset Research Portals' while, at the same time, emphasising that the firm approaches alternative assets from the perspective of an ‘informed sceptic'.

Sceptical they may be, but the large US consultants know there is a demand out there. Their knowledge base and approach needs to be transferred to the UK if private equity is to have a fair crack at convincing its potential client base. Hopefully, Watson Wyatt and the other US-based consultants will use their resources to meet the requirement. Bacon & Woodrow, through its proposed merger with Hewitt, will have access to alternative assets expertise. But, on top of this, a healthy advisory industry should be capable of producing a few home-grown specialists in this field, if only to act as a counterweight to the perspective offered by the multinational, multi-product firms. Let's hope it happens, and quickly.