Diversifying the investor base has been a priority for many private fund sponsors in recent years and, as we have written previously , European policymakers have been keen to help. Although the EU's Retail Investment Strategy may make things more complicated, and the UK's Consumer Duty has already enhanced the regulatory burden on firms targeting individual investors, other recent reforms are more helpful.
In particular, amendments to the legal framework for the European Long Term Investment Fund (ELTIF), which offers a pan-EU retail passport for qualifying funds, are already having an impact. And the European Commission's expected adoption of revised implementing rules seems likely to confirm that ELTIFs can, in effect, be open-ended – fixing one of the main design faults in the 2015 rulebook.
In the UK, the initial focus of its relatively new Long-Term Asset Fund structure, or LTAF, has been on the defined contribution (or DC) pensions market, although in time it should also facilitate access to some individual investors. Even though it is a large and easily identifiable pool of capital, the DC market is still a tough nut to crack for private funds. The LTAF is undoubtedly an important step forward, but uptake among private markets firms has so far been slow.
Probably the main reason for the LTAF's slow start is that the costs for sponsors do not currently match the opportunity set, especially when those sponsors are focused on wealth management platforms – seen as a bigger opportunity to access high net worth individuals in Europe (including the UK) and the Asia Pacific region.
The costs are considerable. For example, a sponsor launching an LTAF needs to be authorised in the UK to manage an authorised fund – a licence that most alternative asset managers do not currently need and, therefore, do not have. (Indeed, post-Brexit, many UK managers do not have a UK fund management licence at all, having swapped it for a licence in Luxembourg or Ireland.) Getting such a licence would be a very significant investment of time and money.
There is an alternative approach: to use a third party manager which does have such a licence, and some LTAFs use that model. However, it adds a layer of fees, and it will be necessary to demonstrate to the UK regulator, the FCA, that the third-party manager has sufficient expertise in private markets. The FCA will interrogate that carefully, especially after the failure of the Woodford Equity Income Fund in 2019, which employed an external manager.
Although some LTAFs have already been launched (and an important announcement by WTW this week indicates that more are to come), there are other off-putting features for mainstream private markets participants, meaning that uptake will continue to be limited and slow. The LTAF alone will not be enough for the government to hit the target it set last year: for 5% of DC default funds to be invested in unlisted equities by 2030. Other options need to be looked at – both to increase demand for LTAFs, which will shift the cost/benefit analysis, and to facilitate investment in traditional limited partnership structures.
In February, the BVCA's Pensions and Private Capital Technical Expert Group – which exists to identify the problems for DC schemes that want to invest in private capital and suggest solutions – published a comprehensive report , written by PwC, identifying the main roadblocks.
One structural problem has been that the dominant model for DC schemes is to use a bundled solution provided by a life insurance company (known as a "life platform"). The DC scheme invests in unit-linked insurance policies, the returns from which are derived from (predominantly) daily dealing investments. This insurance wrapper can be cost-effective for smaller schemes and facilitates very frequent information on the valuation of the underlying assets, which is important for the scheme.
The rules that determine what can be included in the underlying reference portfolio of a unit-linked policy, referred to as the "permitted links" rules, do allow for the inclusion of certain non-daily dealing investments including, on satisfaction of certain conditions, the LTAF. However, there is a high degree of uncertainty about whether other semi-liquid and/or private capital vehicles can be included in the unit linked policies, even if they have very similar investment terms to an LTAF.
Further work needs to be done to allow a wider range of semi-liquid products to access DC schemes through a life platform. Although not the only model – the alternative is to use a bank to act as custodian and fund administrator – the life platform is frequently used, and here to stay. DC schemes using a life platform should have access to a wide range of alternative asset managers and strategies. More changes to the permitted links rules are therefore needed – for example, to permit investment in ELTIFs.
Separately, it is helpful that the government is committed to consolidation of DC schemes, because larger schemes will have the scale necessary to address some of the challenges. It seems very likely that a future Labour government, if elected later this year, would remain committed to that objective.
But there are also a number of commercial barriers for DC trustees that will be equally important to address.
Concerns over liquidity and valuation need to be overcome, but there are active dialogues on those topics. The issues are certainly surmountable and, to some extent, based on misunderstandings. But fee structures will be more tricky. DC allocators remain reluctant to accept the typical private capital fee model, notwithstanding recent changes to the charge cap rules which have cleared the regulatory obstacle. The investments that are currently being made by DC schemes, often with managers branching out from long-only investments, are generally not on terms that established alternative asset managers typically target. More work on bridging this gap will be key.
The rewards for DC pension fund investors could be significant – the UK government certainly thinks so, and the influx of patient capital from new sources could also help meet Europe's growth and productivity challenges. But the obstacles are numerous and complex. The industry's concerted efforts to address them are vital.
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