In the US, pension funds contribute almost two-thirds (65%) of the capital in the VC market. By contrast, they provide just 12% of the funding in the UK VC market. Soon, there will be £1tn worth of assets under management in defined contribution (DC) pensions, if just 3% of that was allocated to venture capital then that would be £30bn. This would have a transformative impact on the UK’s startup ecosystem.
It is understandable then that the Government is, and has been for a while, keen to understand why British pension funds invest less in venture capital than their US counterparts and to change it.
One key barrier is the 0.75% cap on fees for workplace pensions. In my report Unlocking Growth, I noted that this poses problems for the traditional VC model.
“Venture Capital funds typically charge a 2% management fee and take a 20% share of the uplift when the fund closes. Unlike traditional investments in stock markets, VCs invest smaller amounts and take a hands-on approach.”
A higher cap would help solve this problem. Alternatively, regulators could treat carry (the 20%) differently to other performance changes.
At the Budget, Rishi Sunak announced a consultation on changes to the cap on pension charges. While it seem highly unlikely that the cap will be raised altogether (the DWP ruled this out in January) a range of options are on the table according to the FTAdviser:
“One such measure would allow schemes to “smooth the incurrence” of performance fees, which are often payable on illiquid investments, over five years.
The use of a “rolling average” would allow schemes to exceed the 0.75 per cent charge cap occasionally through good performance without being penalised.”
For instance, a VC fund that saw three or four of its investments exit through lucrative IPOs in a single year might see fees spike and exceed the cap. A rolling average would make this less likely. However, it still might be insufficient as the FT notes:
“But this might not solve the issue of performance fees for private equity, which tend to be lumpy and concentrated in the years when portfolio company investments are harvested.”
However, not everyone is in favour of a greater share of pension investment going to private equity. The Pensions and Life Savings Association downplayed the idea, arguing that a 5% allocation to VC would effectively double the costs of a typical pension portfolio.
It’s right to try to limit pension fees and protect savers, but having some exposure to VC is in the interests of most savers.
An Oliver Wyman analysis commissioned by the British Business Bank found “the asset class has delivered an average return net of fees of 7% points a year higher than that seen in public equity markets.” There’s also a diversification argument. VC exposes people to sectors that are underrepresented in public markets. As the investments have only a weak correlation to listed equities, it has the benefit of reducing volatility.
That’s why it was welcome to read that Nest, who manage autoenrollment pensions, intends to allocate 5% of its funds to private equity. They believe that private equity will accept a deal where they pay lower fees in return for a large guaranteed stream of capital.
The challenge, as noted in the British Business Bank report, will be creating new vehicles that spread risks across multiple funds. But the prize for savers and the UK economy as a whole from a step-change in VC investment is too large to pass up.