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Institutional investor profile: Stephen Lowe, Investment Consultant, Railways Pension Trustee Company

Lowe on the complications of private equity investing, on the downward pressure on fees, on being a contrarian investor and on the promise held by Asia.

Based in London, the Railways Pension Trustee Company manages the investments for the pension schemes of 150 railway companies in the UK. It started investing in private equity in the late 1980s before the railways were privatised. At the time, it invested solely through Cinven. Following privatisation, the trustee formalised its private equity programme and in 1999 decided to increase its allocation to an average of roughly 3.25 per cent of assets. It now invests mainly via funds of funds and through segregated accounts, although it does make some direct fund investments. Lowe joined Railpen in 2001 and has previously worked at Warburg, Gartmore and UBS.

What are your return expectations from private equity?
‘We take the view that at the very minimum, we must be able to get a return, net of all costs, of five per cent above that we'd get from public equities. If we can't achieve that, we shouldn't be in private equity. There is too much idiosyncratic risk and there is too much liquidity risk. We can't rebalance back to targets easily in the way that we can in bonds or equities or even property.'

How will your allocation to private equity change in the future?
‘We are in the process of reviewing our overall allocations at the moment. This is quite a complicated procedure because there are around 90 different sections to the scheme involving 150 employers. As a result, we don't have one overall, central allocation to any asset class. Each has a slightly different profile and so requires different allocations. By far the largest, for example, is the pensioner section of the fund. That is very mature and it is quite likely that over time, the allocation for that large portion of the total scheme is almost bound to diverge quite substantially from the policy of 70 or 80 of the other sections.

‘In addition to this, because of the very poor performance of assets in the last few years and because of some other demographic trends and other liability-related factors, the risk tolerance of some of the sections of the scheme may well diverge significantly as well.

‘But to put a figure on it, the average amount invested in private across the sections stands at around 3.25 per cent of total assets.

‘The other point about this is that I think that having a target allocation is pretty meaningless in private equity. You have to predict what market levels will be for the assets that you have got years in advance in order to be at all confident of what your allocation will be. That is something you really can't predict with any accuracy. A bull market may be around the corner, for example, or we could be in a Japanese-style long-term bear market. In six or seven years' time, the impact of that overall equity/bond big picture means that the projected weight of private equity can vary enormously - somewhere between three and 15 per cent. That's a pretty wide variance.

‘What people don't necessarily understand about private equity is that your drawdowns tend to take place perhaps more slowly than expected and the anticipated level of realisations, which in a public equity portfolio would be something in the region of three or four years on average, could extend out to ten years or may never happen at all. All this doesn't mean that you can't have a target allocation, but when we are going out to talk to clients about private equity, we prefer to refer to it as a proportion of the total equity portfolio and to give them an indicative range, which is quite wide.'

Why do you include private equity in your overall equities portfolio?
‘We like to think of private equity as part of public equities. We do have a few clients who think of it as a diversifier, as a separate asset class. But we feel that you shouldn't be in private equity unless you are at least willing to take equity risk because in the long run, the correlation between public and private equities is very high, even if there is a short time lag involved.

‘We also take the view that in the possibility of a very long bear market, the private equity allocation may be higher than it was expected to be. This means that clients have to think hard about what their worst-case tolerance for private equity would be. If, for example, you have a closed scheme in ten years' time their maturity is quite different from open schemes because there are no new members being admitted. They cannot afford to have a high proportion of their assets locked up in illiquid assets like private equity.'

What type of investments do you tend to look for?
‘We very rarely make individual fund investments, although we do still continue to invest in Cinven. When we took the decision to diversify away from investing solely through them, we came to the conclusion that we simply did not have the resources to make GP selections for the vast majority of our portfolio. We have less than one full person devoted to private equity. As a result, we invest mainly through manager of manager arrangements, such as funds of funds or segregated mandates.

‘Cinven is still by far the largest manager for us in terms of assets managed and this is likely to continue. We have eight other managers, of which seven are funds of funds.

‘We do also look at secondaries investments within funds of funds. We examine this type of transaction as a point of expertise among the managers that we meet. Secondaries seem to play an important role in the flexibility of a programme. They can often provide early distributions to slightly offset the drag of the J-curve effect. One or two managers have demonstrated that they have been able to use secondaries successfully as an important component of the returns and also as a way of smoothing the returns profile over the life of the fund.'

How do you look to diversify your private equity investments?
‘It is quite a difficult call for us, but we do have a view on where our assets should be invested. We look at it by stage and geography. But the question is whether our view is correct or appropriate. There is nothing very scientific about it. The industry has grown up to be very US-centric, so the standard global mandate is naturally very US-oriented. Admittedly, the market has developed quite substantially in Europe over recent years. Why there should be a domestic bias in private equity, I don't really understand. I can't see why US institutions have a bias toward US funds and I equally can't understand the logic of European institutions having a European bias in their portfolio, especially if they are investing through manager of manager arrangements. It makes more sense if they are investing directly in funds, however.

‘So we seek to invest across a broad section of US and European private equity and we are not looking to change that.

‘I will say, though, that we are a lot more interested in Asia than we used to be. There is no particularly strong reason to exclude the region now. There probably was a few years ago because we felt that there was too much excitement about its prospects for growth. That was dangerous because Asia's growth prospects, as we now know, weren't that good. There were a lot of young managers in a very poorly developed industry looking after private equity-type mandates. There is evidence now of some survivors in Asian private equity. I also think that, with very large economies that are not entirely dysfunctional, and with capital markets that ought to function in the same way as in Europe and the US, there is a very real prospect for growth in Asia. The other point, of course, is that it is not very fashionable to be investing in Asia, yet there are some very good funds coming out of the region now. There is the potential for a good supply and demand balance there. We therefore wouldn't be very comfortable ignoring Asia.'

So do you see yourselves as a contrarian investor?
‘I'm not sure that we are contrarian investors because that implies some kind of short-term view on the market - something you can't have in private equity. But I do believe that there is a very good theoretical reason why there should be an inverse relationship between ex ante willingness of money to get in and ex post returns on the money that goes into a market. It looks as though that pattern has been repeated again in the late 1990s early-stage technology boom. I think that it is still a pretty good principle to start from.'

What do you look for in a fund of funds?
‘Fund of funds selection is the easy part. You look at fairly similar types of judgment that you would in selecting an equities or bond manager - you just have to lengthen the timescales a little. So we'll look at the professionalism of their approach, their resources, their commitment to their business, their longevity. Do they have the right incentives to keep working for you in the future?

‘There is a reasonable choice of fairly experienced people who know the industry pretty well and seem to have the right incentives to work for the client with the same provisos that one would make about GPs - they are, one the whole, very well paid people with a very sizeable management fee cushion and there is something of a danger that you end up committing large amounts of money to people who do not have to work particularly hard to make a very nice living. That applies equally to funds of funds and GPs. Both have to keep raising funds about every three years to assure the future of their business at its current level or better. That should impose some kind of discipline on the managers. We have to rely on their need to keep showing their existing and potential clients that they are doing a decent job. The problem is that you can't assess GPs or fund of funds managers over that three-year cycle because they have really only committed their last fund and you have no idea how those investments have gone. It will take at least another three to four years before you can accurately assess the performance.'

How do US funds of funds compare with those in Europe?
‘There is a difference between the two. The fund of funds industry in the US is clearly more developed. The marketing pitch looks more credible, especially because it is based on much more data than is available in Europe and so there is more statistical validity in some of the statements made. Often the firms are larger and therefore can dedicate resources to professional marketing. While I wouldn't suggest that the professionalism is purely in appearance, I would caution against those who believe that because they look slicker they are necessarily better than their European counterparts.'

What is the biggest lesson you have learned?
‘I think the biggest difficulty, and therefore the hardest thing to learn, dealing with the uncertainty of cash flows in private equity. This is especially hard when you have to consider the way in which this relates to the liabilities of a pension fund. These are inversely related. A bad outcome in private equity is unfortunately coincident with a bad outcome for a pension fund's liability profile. This tends to be related to bond yields dropping and confidence in the equity markets falling. Risk tolerance of a pension fund can quite often drop like a stone at exactly the same time as the illiquidity of a private equity portfolio is at its most severe because funds are unable to exit.'

What irritates you about private equity?
‘The main irritation is that it is galling to see quite so much of your capital going out in fees. The value lost to institutions from the slow drawdowns over the last three years is painfully high. It has accentuated the J-curve quite considerably for investors. At the same time, we have been paying high management fees. That hurts.

‘The Myners Review in the UK had such a strong focus on commission-based fees in equities and bonds. But I do wonder whether the emphasis on unbundling those commissions was entirely fair when you consider how tiny these are when compared with fees - and I'm talking not just about management fees, but also transaction fees, legal fees, administration fees, plus all the other costs that aren't even itemised - in private equity. I think that will adjust very slowly. It will have to. It is not reasonable to expect much above five per cent net returns above public markets over the long term. If the average return hovers around 13 per cent, then can you really afford to lose more than two per cent in fees? If the industry wants to be a serious competitor for institutional funds, it will have to put a lot of emphasis on expense control.

‘The real downward pressure on fees will come four or five years from now when it becomes apparent that some of the perceived leaders among GPs and fund of fund managers can no longer show stellar results. At the moment, we are still in the situation where people believe they have to be with who they perceive to be the best. The demand for the best GP and fund of fund manager successor funds is very high. But if people start to see less stability and some of the best GPs find that they have less persistency that they thought in terms of good returns, then there will be more scepticism about accepting current fee levels and maybe even the 20 per cent carried interest.'

What is the biggest issue in the market?
‘I would say that fees are the biggest issue, as I have described. I don't think disclosure or transparency are necessarily as big an issue. That's not to say that we are relaxed about receiving accurate data and reporting, but they are not a huge problem for us. We accept that the only thing that really matters in private equity is the exit. In the interim, it's all a question of marking to market.

‘But from our perspective, because we have many different clients, it would be nice to be able to trade interests between them on an interim basis. If the industry could say that valuations were uniform across the industry and we were confident of the reliability of those valuations, then we could rebalance our clients' holdings. But, realistically, it's tough to argue, especially with an early-stage investment, that it can be valued in any other way than subjectively. This could be more of an issue in defined contributions schemes. There is a very limited amount of products out there for DC schemes. Our DC scheme, for example, doesn't have a private equity allocation and we would like to offer that to the members.'

How do you think that the market will change in the future?
‘There will be a lot of pressure on the infrastructure overall. We got to a point where there were too many people working in the industry - not just GPs, but everyone in the industry. That overhead has to decline. That will be a long and painful process.'

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