The knock-on effects of the Truss government’s disastrous ‘mini-Budget’ in late 2022, which caused panic-selling of bonds by pension funds and forced the Bank of England to provide tens of billions of pounds to stabilise markets, continue to work their way slowly through the financial system.

Whereas before the upheaval most defined-benefit (DB) funds were decades from being fully funded, thanks to the unprecedented rise in interest rates during 2023 many funds are now in a position where their assets are almost enough to cover their current and future liabilities.

As a result, they are keen to offload some of their less liquid assets such as private equity, private credit and infrastructure, much sooner than expected, with a potential knock-on effect on valuations.

Investment trusts invested in private assets already trade at a significant discount to NAV (net asset value) as the tables shows and it is possible the trends discussed in this article could exacerbate this. So, this complex issue should be on investors’ radars.

AN ‘INDELIBLE MARK’

The market upheaval which followed the ‘mini-Budget’ exposed serious weaknesses in what the pensions industry calls LDI or liability-driven investment, a strategy many funds had use to manage risk.

In an article for industry publication Pensions Expert, Paul Wood, founder of legal services firm C-PAID, said the LDI crisis had left ‘an indelible mark on the pension landscape’ and brought to the fore several underlying issues that had been simmering beneath the surface for years including the need to maintain some kind of buffer or reserve to cushion against unforeseen market volatilities.

A lot of funds decided to diversify their investments away from bonds into less liquid ‘alternative’ investments like private equity, private credit and infrastructure, in theory so as to create more resilient portfolios capable of withstanding big market fluctuations.

Today, many DB funds – which promise to pay their members a fixed amount in retirement, unlike defined contribution (DC) funds where the amount paid out depends on the amount paid in and investment performance – are looking to offload these illiquid private assets due to their poor performance.

WALL OF SELLING

According to research by Bloomberg, DB funds are lining up to sell as much as £200 billion of holdings in alternative assets in the next few years rather than over the next two decades to reduce their risk profile.

However, in their haste, these funds may have to accept knock-down prices which are not only negative for their returns but negative for the wider alternatives space.

‘We are seeing prices that are genuinely below asset value. There is effectively a forced sale going on,’ says Simeon Willis, chief investment officer at actuarial and consulting firm XPS Pensions (XPS).

Another specialist quoted by Bloomberg describes being approached by dozens of funds in the last six months all looking to sell assets in the secondary market.

The endgame for many is once they are fully-funded – in other words once their assets are deemed sufficient to cover payments to current and future retirees – to sign a risk-transfer agreement with an insurance company, which will take over the assets and administer the fund from that point onward.

Transferring out allows companies and their pension trustees to access any surplus the fund may have built up and allows management to focus on running the business instead of worrying about its liabilities.

The issue is, insurers typically only want to take on schemes with low-risk assets like cash or government bonds, not risky, illiquid alternative assets. 

According to Bloomberg, based on data compiled by the Pension Protection Fund and estimates by market experts, some 5,000 pension funds managing £1.4 trillion now have between 14% and 20% of their portfolios invested in ‘hard-to-sell assets’.

Some funds are estimated to have as much as 40% of their assets in private holdings, meaning they could have to sell at a considerable discount to book value if they really wanted to do a deal with an insurer.

‘They’re still holding a lot of illiquid assets thinking they have years to get out of them, but they don’t,’ says Charlie Finch, partner at consultants Lane Clark and Peacock.

‘In most cases, you can sell illiquids on the secondary market but you’re looking at a haircut of 20%, and maybe 40%, which is painful,’ adds Finch.

WHAT DO THE EXPERTS THINK?

Given the size of the potential de-risking, Shares asked several private equity, credit and infrastructure investors for their thoughts.

Helen Steers, manager of £1.5 billion private equity investment trust Pantheon International (PIN), explained how she was approaching the situation. 

‘These dynamics have already fueled some interesting deal flow in the private equity secondaries market where we are seeing high-quality deals at attractive pricing. 

‘This is particularly the case for manager-led deals, which is where the private equity managers themselves instigate deals to provide liquidity options for the investors in their funds. This includes single-asset secondaries which tend to target our managers’ individual “trophy” companies and remain an area of focus for Pantheon International.’ 

However, says Steers, not all manager-led deals are created equal. With an increasingly large volume of deals entering the secondary market, experienced investors like Pantheon are being extremely selective regarding asset quality and manager quality as well as the alignment of interest between the manager and new investors. 

‘It is also worth noting there is a distinction between new deals and secondary market valuations — which reflect current financing conditions and risk-off sentiment — and valuations for existing portfolio companies which we have seen trading resiliently across our portfolio and for which financing pressures are less prevalent’, adds the manager.

Sadly, no-one from the private credit or infrastructure sectors was willing to go on the record.

AN £80 BILLION MARKET THIS YEAR

Anglo-American insurance group Willis Towers Watson (WTW:NASDAQ) estimates the UK DB pension market could see £80 billion in de-risking transactions this year following what it describes as ‘significant improvements in pensions scheme funding’ in 2023.

In its annual report on the sector, the firm expects £60 billion in bulk annuity deals and £20 billion in longevity swaps making 2024 the biggest year on record for pensions de-risking.

‘It’s clear that funding improvements have turbo-charged the pensions de-risking market and, from a capacity perspective, we have already seen that the insurance market is capable of scaling up to meet demand,’ says Jenny Neale, a director in WTW’s pensions transactions team.

Also, after the first ‘superfund’ transaction was cleared by the regulator last November – under which 9,600 members of the Sears Retail Pension Fund were transferred to Clara Pension Trust – WTW believes more deals this year ‘could pave the way for future momentum’ in the superfund transfer market.

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