Traditionally, defined contribution pension funds have not made significant use of venture capital, although over the long-term these assets have tended to perform well.
A study by the British Business Bank and Oliver Wyman explored whether there is room for venture capital and growth equity within the U.K.’s DC schemes.
It found that the average 22-year-old could see a boost of seven to 12 per cent in their eventual retirement savings by including VC and growth equity assets in a DC plan’s default investment option.
The study noted that these two asset classes provide better allocation to sectors that are more represented in private markets and have low correlation to public equities. “This means that allocating to VC/[growth equity] would also improve the sector diversification of a default fund and reduce the level of volatility. The potential benefits accruing to DC scheme members from such investments are therefore expected to be significant, particularly for younger savers,” it said.
However, these asset classes are inherently risky.
To mitigate risk, these assets could be purchased through a pooled investment vehicle that would include assets from many schemes and include allocations to a broad range of these investments, the study said. A pooled fund could also potentially invest in companies directly. “Such a vehicle could be created and owned by an existing investment manager, or it could be created and jointly-owned by DC pensions schemes. There is more limited appetite for the latter option, on account of the complexity of setup and degree of expertise and infrastructure required.”
A vehicle like this would allow each fund to allocate a very small amount of their overall portfolio to the asset classes in question, while still allowing the DC plans sufficient scale to gain exposure to a broad enough variety of VC and growth equity investments, the study said. “Pooling assets to create scale would also reduce the risk of over-exposure to any single business or VC/[growth equity] fund.”
This investment vehicle could come in the form of an investment trust or an open-ended unlisted fund, the study said.
However, there remain certain challenges to adding these asset classes in the DC world. Liquidity, for example, remains a major consideration. “As several recent market examples have shown, funds invested in illiquids cannot promise to offer more liquidity than that which is available from the underlying assets. Such an unmet expectation of liquidity, which in reality cannot be provided by the asset class, has in these examples led to some negative outcomes for investors.”
To manage this, the VC/growth equity investment vehicle would only be an option for professional investors and the daily liquidity needs of an individual DC plan’s members must be managed at the default fund level, the study said.
Nevertheless, there are still illiquidity risks and a pooled investment vehicle, particularly an open-ended one, should have mechanisms to safeguard against becoming a forced seller, such as gating, the study said.
Another challenge is the significant level of fees associated with these asset classes, the study noted. “Despite this, the asset class remains attractive. This is because its strong historic performance suggests that, if sustained, the future return net of fees will still be higher than that of other asset classes, as well as bringing portfolio diversification benefits.”
As well, in the U.K. there are caps on DC fees, which may limit investments in VC and growth equity. To work around this, funds will need to establish DC-centric fee arrangements. “While this might initially constrain DC access to VC/[growth equity] funds, this study anticipates that over time, as DC pensions become a larger source of capital, an increasing number of funds will be willing to make these kinds of changes.”