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Private Markets, performance fees and the charge cap
Author Con Keating Posted on January 11, 2022 06:59
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This blog is a review of an article by Emma Duncan published in The Times on January 7th 2022, headed: “Let’s turn Covid and Brexit to our advantage” – an eminently sensible idea.

However, the way in which this is proposed to happen, by ”Making it easier for pension funds to invest in young firms would boost the flagging economy” is not a solution to this problem. The assumption here is that there is a shortage of venture capital financing, but that is challenged by the observation that the “dry powder” of the UK private equity sector amounted to £243 billion (2020). In their quarterly review, the BIS reports “dry powder” for venture capital and growth capital funds at $742 billion globally, 34% of all outstanding investments made.

My friends in Oxford tell me that they have been inundated with offers of finance – Oxford University spin-offs raised £1.4 billion last year, mainly for technology and bio-sciences ventures. As one friend put it, it feels a bit like the South Sea Company, “I feel I could almost have financed a company for carrying on an undertaking of great advantage but no one to know what it is.”[i]

After some initial comments on UK productivity, the article states “There are good reasons to think that some of the country’s capital is not as productive as it should be: in other words, we need to make our money work harder.” However, it is not the investors in an enterprise but rather its management who determine its productivity.

The article notes that there are nearly £3 trillion in pension funds. This is not an unreasonable estimate: the ONS reported DB schemes having £1.86 trillion of assets and DC schemes just £146 billion in 2019. The remaining £1 trillion of assets to the circa £2 trillion above are pensions written by insurance companies as insurance contracts, under the supervision of the Prudential Regulatory Authority.

The article continues with: “The regulations around how the (pension fund assets) can be invested are exceedingly tight, as they ought to be.” and goes on to suggest that “higher returns at little cost to safety” can be obtained. While this sentiment is enticing, the evidence for higher returns in standard finance is that higher expected returns are in part a function of increased risk (investments of identical risks and returns can have different outcomes depending on the cost of the investment). 

There is actually nothing to stop UK DB pension funds investing in private equity and many do. Indeed for local authority funds and in some large schemes, such as USS, their allocations are around 25% of their total assets. It should be noted though that little of this is in venture capital, and the reason for that is that venture capital is extremely risky and has the pay-off profile of a lottery – small numbers of very large gains and many total losses. This is recognised internationally and is evident in pension scheme allocations globally. The figure below[ii] shows the sources of funds for private equity, venture and growth capital and private credit funds.

The largest investor group for private equity and growth capital funds globally are Economic Development Agencies, not pension funds; and this contrasts markedly with private equity and private credit. Investment by pension funds in VGC funds is just 10% of the amount made into private equity and private credit funds.

It is true that the risk weightings applied under the Solvency II insurance regulations to private market securities are onerous but the low global participation of insurance companies in these markets reflects a broader concern with their liquidity and riskiness.

The article states “A second problem concerns the fees that pension-fund managers are allowed to charge, which are limited to 0.75% of a fund’s value.” This ignores the new smoothing rules which have been in effect since October 2021. If a scheme has 90% of its assets in low-risk securities at a fee of say 0.15% and 10% of its assets in VGC, it could afford to pay a fee of 6.15% on the VGC portfolio. Under a typical 2% + 20% mandate with an 8% hurdle rate, this fee would require a return in excess of 26% to the cap to be breached and for a breach to bind, the fund would need to repeat this in all of the five years over which fees may be smoothed.

As a result, pension funds are mostly invested in government bonds and shares that are traded on public markets, because those are the cheapest sorts of assets to manage.” The charge cap applies only to DC funds. It cannot be invoked to explain the de-risking of DB funds, where most pension assets sit, and the reasons for this are myriad but nothing to do with charge caps  The charge cap was introduced in April 2015 and applies only, in general, to the scheme default fund[iii] (less than £146 billion of the £3 trillion total) – prior to that date, we did not see DC funds investing in VGC funds in any meaningful way and the charge cap has been an extremely effective piece of consumer protection regulation.

The article then refers to a variety of statistics and performance claims which are highly contentious and there are significant bodies of work that challenge these figures both from academia and beyond. Readers interested in a detailed critique of claims made in support of private market investment are referred to the submission made by Iain Clacher and Con Keating in response to the DWP consultation on enabling investment in productive finance, which is in fact solely concerned with the charge cap. Copies are this are available from: https://www.longfinance.net/publications/professional-articles/response-dwp-consultation-enabling-investment-productive-finance/ .

The final aspect to mention is that the article repeats the often-cited view that private equity is long-term in nature. It isn’t and the average length of time an investment is held has only recently increased from 2 to 4 years; it is not the ten years of the investment funding commitment. Listed equity can therefore be far longer in term and has the flexibility of being liquid if needed. Moreover,  there are listed investment trusts which invest in private equity and venture capital, and so there will be some DC pension capital already invested through these vehicles.

So, while this article looks as if it is a call for our national regulatory standards for life and pensions insurance companies to be relaxed to develop the venture capital market, the evidence is that, globally, life insurance companies are only marginally involved in these market segments. However, if this were to happen, what would exempting private market securities add to the stock of available capital – if 10% of their funds is allocated? It would be just £14.6 billion added to the £243 billion of private equity “dry powder” outstanding. This allocation is of the same order as VC funding in 2020 (£13.3 billion).

In a number of places, the article presses for rapid change. We would favour a considered complete analysis and caution in this regard. Complexities abound – as we illustrated above, not even the default fund is a straightforward matter. To finish, we agree wholeheartedly about UK productivity and the issues associated with it or lack thereof, we would like to see better outcomes for scheme members, and we would like to see greater investment in the real economy, we just do not believe that the proposed method is the correct way to do it. Given that pension savings are ultimately meant to pay pensions, and for many this is in the distant future, then consequence-hasty decisions today will not be felt for decades to come.  

[i] See: https://archiveshub.jisc.ac.uk/search/archives/5d681937-db33-3c72-a726-a2f045889a49

[ii] BIS Quarterly Review December 2021

[iii]The “default fund’ is given a slightly odd meaning in the Charges and Governance Regulations:

“(1) Subject to paragraph (6), a “default arrangement” , in relation to an employer, means an arrangement which—

(a) on or after the relevant date is used by a qualifying scheme (which is a relevant scheme) in relation to one or more relevant jobholders; and

(b) satisfies one or more of the descriptions in paragraph (2).


(2) The descriptions referred to in paragraph (1) are—

(a) an arrangement under which the contributions of one or more workers are allocated to a fund or funds where those workers have not expressed a choice as to where those contributions are allocated;

(b) subject to paragraph (3), an arrangement which, on the relevant date, was an arrangement under which the contributions of 80% or more of the workers who were contributing members of the scheme on that date were allocated where those workers were required to make a choice as to where their contributions were allocated;

(c) an arrangement which first received contributions from workers after the relevant date, and under which, at any point after the relevant date, the contributions of 80% or more of workers who are contributing members of the scheme are allocated where those workers were required to make a choice as to where their contributions are allocated.”


Nearly all members of a tax approved DC occupational pension scheme will fall within (2)(a). 


Paragraphs (2)(b) and (c), pick up, in high level terms, those tax approved occupational pension schemes where the member is required to make an investment choice in the joining form as to which investment options to choose and at least 80% of the active members choose that the contributions made by them and their employer go into the investment option in question Contributions are defined to include both member and employer contributions but do not include AVCs.


With the advent of auto-enrolment there will be almost no members in investment options covered by Paragraphs (2)(b) and (c). The most likely exception could be a DB scheme for pensionable pay up to a particular level with DC contributions above that level.