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I was programmed early in life to regard all gambling establishments as dens of wolves, which rather reduces my enjoyment of spending time in them.
Nevertheless, one night, many decades ago, I found myself in a Stakis casino in Edinburgh — in those days, stockbrokers went where their clients wanted to go, especially after dinner. To make things more weird, my client, who ran a large life and pension fund, assured me he had a system which could beat the house at roulette. Even in my highly relaxed state, I then knew that things might well go from weird to bonkers.
I was looking for a route out, so sat at a blackjack table. The croupier removed me for being too drunk after I tried to take the irrational step of splitting two tens into separate hands. It was an act of kindness from Stakis that I will not forget. I left my client to his probability defying quest.
I’ve been thinking about that evening since hearing the government has forcefully persuaded pension funds to invest in private equity. Seventeen have signed what is called the Mansion House accord, promising to put at least 10 per cent of the defined contribution default funds into PE vehicles, half of them in the UK, investing £25bn.
Various questions arise.
First, why is this allocation only being made for default funds? Some might suggest that these funds are the ones where the beneficiaries have no say in how their money is invested. Presumably, if these investment companies thought that private equity was a great place to invest, they would have had this allocation anyway. So what has changed? If they are now raising their PE allocation, will they explain to the beneficiaries how this is in their interest, especially as fees on this allocation are likely to be a multiple of those on other investments, such as tracker funds and bonds?
Second, why is only half of the PE allocated to the UK? And who will keep an eye on whether the UK allocation actually ends up invested in the UK? Say a fund buys units in a UK-based PE fund. That fund might invest outside the UK, or in UK-incorporated companies which then invest in their overseas plants, or UK companies which receive the extra funds and leave them in their bank account.
“Investing in the UK” is a good intention, but the practicalities are complex. The same issue might well arise trying to get Isa investors to “invest in the UK”. That is clear comparing two large UK-listed stocks. Tesco is a company mainly operating in the UK but Rio, the mining company, does very little mining here. Both are “British” companies. Would we want investment rules to differentiate between the two?
Private equity funds not only have higher fees than many other funds but also generally do not allow investors to sell their holdings at short notice. When the investment sun is shining, this lack of liquidity can seem a minor issue, but when markets become volatile major issues can arise. Say you allocate 10 per cent to private equity, 20 per cent to bonds and 70 per cent to equities then a 2008-type market comes along and your equities halve. Your PE allocation has then risen to 15 per cent. Also, if there are any redemptions in the fund you can only sell the bonds and equities as the PE fund is closed, making this unbalancing worse.
What’s wrong with these funds investing more in listed UK equities? After all, there are many who think UK equities look modestly valued by international standards. When investing in listed shares, I believe that I am on a fairly level playing field against other potential shareholders. We have roughly the same information, but may analyse it differently, leading one to buy and another to sell.
In my experience, investing in private equity is like entering that Edinburgh casino — it can feel like entering a wolf den. The bankers who ask you to fund the company have much more information that you, the investor, and the management team may have angles about which neither banker nor investor are aware. You meet intensively for a period to arrange the private finance of a business and then are joined at the hip, unable to sell for many years after. I’ll stick with listed stocks myself.
Lastly, the expression goes “the road to hell is paved with good intentions”. Unfortunately, government actions often have unintended consequences. Announcing a compact which requires a large number of funds to buy into a limited PE market creates two unintended risks. The first is that anyone with any junk to sell will dress it up as a UK PE deal, expecting hungry buyers. The second is that existing PE investors will find this wave of cash drives down current investment returns, leading them to invest less in the UK.
Any move to mandate funds to invest in the UK — the so-called Treasury backstop — is likely to scare off more funds than it is able to corral. Even suggesting such a mandate shows that important people lack understanding of how markets work. This is a classic example of how the unintended consequences of government actions often outweigh the action itself, whatever the “good intentions”.
Simon Edelsten is a fund manager at Goshawk Asset Management
