Click here for printer friendly page

In it for the long haul

The results of a recent competition to design a 20-year pension fund mandate contained some good news for the private equity industry. But much will have to change if the winning entry is to provide a blueprint for responsible, long-term investing.

Imagine for a moment that you knew little or nothing about pension funds. The only source of information you have is an archive of news stories dating back, say, two years, plus a general outline of the way in which many pension funds appoint managers and review their investment decisions. What conclusion would you reach? My guess is that you would be hard-pressed to understand quite what a long-term business the vast majority of pension funds are meant to be.

Recent dips in the stock markets have evidently affected the short-term performance of many pension funds and it is understandable that the majority of those managing the assets will be in shock as a result. Many will be using their quarterly assessment meetings to compare the performance of their fund managers with that of others. They'll also be looking to change some of those managers at the end of their typical three-year mandate. All this is standard practice.

But if you put this behaviour (and many of the headlines about negative performance) into the right context, much of it seems absurd. Investing the assets of a pension fund is meant to be an exercise in ensuring that future liabilities are covered. Those liabilities may stretch out as far as 60 years or more. The performance of a fund over a quarterly - or even three-yearly - basis is probably largely irrelevant.

It was with this in mind that the UK's Universities Superannuation Scheme (USS) and Hewitt Bacon & Woodrow launched a competition for fund managers and individuals to design a 20-year mandate for a notional E30bn pension fund. Entitled ‘Managing Pension Fund Assets as if the Long Term Really Did Matter', the contest sought to ‘stimulate new thinking and innovation in the pension fund industry', according to USS chief investment officer Peter Moon.

Those paying attention will have realised by now that, as a long-term investment, private equity is a perfect asset class for this type of mandate. And indeed, the winning entry, submitted by Henderson Global Investors, contained a large allocation to private equity. In fact, Henderson split the fund into a $25bn ‘core' portfolio, comprising 50 per cent in equities, 20 per cent each in bonds and property and ten per cent to private equity. The remaining E5bn went into an ‘added value portfolio'. This high percentage to private equity should come as little surprise. The asset class can only be approached over the long term - most traditional limited partnerships have a ten-year lifespan, the first four or so years of which, the funds are likely to be in negative territory.

Committing to a mandate such as this would undoubtedly require a change in thinking among pension funds. Henderson's entry explains that success depended on the fund not being subject to the usual benchmarking. ‘It will not be appropriate to make comparisons with the returns achieved by other funds, with the performance of other fund managers or with standard benchmark returns,' it says. Quarterly assessment would have to go, too. And the client(s) would have to take on Henderson for a minimum of ten years. Henderson, for its part, would take no performance fee for the first five years of the mandate. ‘You must give us a longer term mandate than is current practice,' says the proposal. ‘You must forego the chance to comment on performance every quarter…You must steel yourselves for periods when this fund will underperform funds managed on the traditional model - perhaps significantly.' This is a radical departure from current practice among pension funds.

What is interesting, however, is that much of it will sound familiar to any investor in private equity funds - no standard benchmarking, commitment for at least ten years, short-term underperformance, etc. If pension funds (and other investors) can become more used to thinking along these lines, then in theory the private equity industry should benefit.

But general partners needn't start uncorking the champagne and waiting for the money to roll in just yet. Pension funds may need to rethink the way they operate for this type of mandate to succeed, but then so would private equity funds because the competition had another aspect to it. Entrants had to take the impact on the social and economic environment into consideration. The thinking behind this is that there is little point in creating a truly long-term investment programme if you don't consider the long-term impact your investments are having on the wider world, on the environment in which the pension fund members' children will grow up.

Part of Henderson's imaginary private equity allocation would go to large infrastructure projects or ‘nation-building', as David Bull, the person responsible for drafting the private equity section, puts it. The money would be invested in Private Finance Initiative-type schemes. The social benefits from this come from building hospitals, schools, roads and railways. ‘In the long term, it is expected that opportunities will emerge in many countries to achieve attractive long-term stable returns from the provision of infrastructure whilst improving the quality of life, fostering economic development and improving the environment,' says the document.

What is harder to gauge, however, is how that socially responsible element can apply to more traditional private equity investing, such as buy-outs and venture capital, which would make up the other part of Henderson's allocation. In some respects, as Bull points out, venture capital does fulfil part of the criteria in that it is widely recognised to be a force for economic growth and job creation. A similar claim could be made for the buy-out end, too, although to a lesser extent.

But the concept of sustainability and socially responsible investing goes further than this and it's an area that few firms consider when managing their portfolio companies. True, the increase in the number of companies providing environmental due diligence services to the private equity industry bears testament to a greater understanding of reputational and other risks involved in investing in companies that do not follow ‘responsible' practices. But private equity fund management as an industry is way behind its public equities counterpart in its thinking. Few managers even consider the social or environmental impact of the actions of the companies they invest with once they have made the commitment. Even fewer would be content to have any constraints imposed on them by their investors as to how they should conduct themselves and their business. Any attempt even to talk to many private equity managers about this area is met with a large yawn (I should know - I've tried).

Boring it may be, but the truth is that socially responsible investing is creeping up many investors' agendas and it won't be long before they start applying similar principles to their private equity investments that many currently apply to their public equities portfolios. In some ways, private equity is an ideal conduit for these considerations. Unlike in public equities, private equity funds generally hold a significant shareholding in their portfolio companies, usually with a board seat, and so are well positioned to influence their future direction. It's a point acknowledged by the Henderson submission. ‘Our overall approach to managing the investments will be to ensure that we set high standards of corporate social responsibility through an active involvement in investee companies, to include board representation where appropriate,' it says. ‘Our investment decision making will be guided by the investment committee's views on investments, in particular sectors or regions, or individual businesses demonstrating unsustainable practices.'

There could also be a potential upside for both private equity funds and, ultimately, their investors. Now that listed companies are subject to rankings, such as the FT's ethical index, FTSE4Good, shareholders are paying much closer attention to socially responsible investing. ‘Listed companies' behaviour is reflected in their share price these days,' says Bull. ‘If you are a private equity firm that has played an active role in ensuring that a portfolio company has been run along ethical lines, you are likely to find that increasingly, this will be reflected in the exit price, especially if you are selling the company via IPO or to a listed company.'

That may sound a little implausible now, but there is no doubt that things are moving this way. The fact that the competition was launched in the first place, with the support of a consultant and a handful of pension funds (including PGGM and the New York City Employees Retirement System) and that it received 88 entries bears testament to this. It seems that some pension funds are starting to look at the way they conduct their business and are seeking alternatives to the short-term approach many of them currently take. And, while this could well bear fruit for the private equity industry, it too must think long and hard about the way in which it manages ethical considerations in its portfolio companies if it is to take advantage of the opportunity.

For further information on the competition, please click here.