After years of disappointing returns and high-profile controversies, the U.K. private equity market is once again starting to look like a tempting investment proposition.
For one, exits by PE funds have bounced back strongly following a down year in 2022-2023 when high interest rates climbed to their highest level since the 2008 financial crash.
The number of successful exits by PE funds from U.K. companies through M&A deals jumped 48%, from 120 in 2022-2023 to 177 in 2023-2024 through Nov. 1, according to data collected by advisory firm MCAM Group.
The national government is keen to get U.K. pension funds investing in domestic private markets. Rachel Reeves, the U.K.’s Chancellor of the Exchequer, has taken up the mantle of the previous Conservative government in pushing the U.K.'s defined contribution plans to invest 5% of their default funds into domestic private companies by 2030, and defined benefit funds to invest 10%.
However, the reforms stopped short of mandating investment into U.K. companies, leaving the allocation of those assets at the discretion of the pension funds themselves.
“While there is likely to be increased allocation into private equity in the near term, much of that capital may continue to be deployed outside of the U.K.,” said Alex Wolf, managing director of the primary team at HarbourVest, a private markets firm with $138 billion in assets under management as of Sep. 30.
The U.K. is still looking to bounce back from a difficult few years, which saw periods such as the economic shock of the COVID-19 pandemic, resultant issues such as persistent inflation, and a disastrous 2022 budget under then-Prime Minister Liz Truss. That budget caused a crisis in pension portfolios that utilized a liability-driven investment strategy.
At the £78 billion ($95.2 billion) Universities Superannuation Scheme, London, 50% of its private markets investments are already invested in U.K.-based assets, covering a total of £26 billion. On investing in the domestic PE sector, Ben Levenstein, head of private markets at USS, said: “The country has gone through a bit of a tough time, and the private equity market is still adjusting to that environment. As a consequence, there’s been relatively little transactions (over these years) relative to history."
“Currently, the macro levers are in a more stable position. As a consequence, we're starting to see an increase in activity levels across the private equity space,” he said.
In its results ending March 31, the USS fund noted that it had exited a number of private investments in the previous year, generally at favorable prices to where they had previously been marked in its books. However, its overall global holdings in private equity for the financial year totaled £9.7 billion, down 5.8% from £10.3 billion in 2023.
Nick Gibson, managing director at Cardano, a risk and investment specialist with £52 billion in assets under management as of Dec. 31, 2023, is also optimistic: “It is widely anticipated across the market that deal volumes will continue to increase in 2025. In the last year in the U.K., in the U.S. and across Europe, financial markets have shown good levels of resilience and borrowing costs are beginning to come down, albeit slowly. Another catalyst for M&A in our view is the improved position of U.K. defined benefit schemes — many of which have gone from being in deficit to surplus.”
The strong funding position of U.K. pension funds is difficult to deny, and in January Reeves unveiled plans to release surplus cash for sponsor firms to reinvest in areas such as private markets.
Lars Bjoergerd, managing director of MCAM, also identifies a key development from his experience that has redefined the U.K. institutional approach to private equity: in-house investment teams, such as that devised at USS.
“Previously, investment in private equity was very consultant driven. Now, larger pension funds have built up their own investment teams, and the general sophistication of the approach has increased a lot in the last 10 years,” he said.
Eyeing positives in the U.K. private equity market from further afield is Jo Taylor, president of the Ontario Teachers’ Pension Plan, Toronto. OTPP had C$255.8 billion ($187 billion) in assets as of June 30.
“A lot of the Americans at the moment are actually saying, ‘I only want to be in the U.S.,’” Taylor said in an interview with Bloomberg. “To me, that’s great news — I’ll just fill my boots in Europe.”
Taylor identified “active private markets” such as infrastructure, private equity and credit, as carrying the most investment opportunities.
However, continuing institutional interest in the U.K. private sector is still not being driven by domestic pension funds.
“In terms of corporate pensions, they have been incredibly inactive over the last two years, with various kinds of macro factors at play such as the LDI crisis. A number of those funds have either ceased investing in private equity or have transferred their private markets portfolios to asset managers,” said Laura Leyland, a partner and private equity specialist at U.K. private markets advisory firm Asante Capital Group.
A sector far from watertight
U.K. private equity may be on the mend, and institutional investors both domestically and abroad are once more looking at its potential. However, there are still pitfalls.
For one, David Hutchins head of multi-asset solutions for Europe, Middle East and Africa and senior VP at AllianceBernstein, an asset management firm with $806 billion in assets under management as of Sep. 30, still sees reluctance among institutional investors to place money into the U.K. PE sector:
“We're in a dip turn at the moment. There’s been some challenges to performance that people have seen in recent times. You've also got the changing nature of the overall asset base of DB pension plans as they move towards more bonds.”
Gathering headlines in the past year have been the high-profile controversies surrounding Thames Water, the U.K.’s largest water and wastewater services company, owned privately by a consortium of institutional investors including Ontario Municipal Employees Retirement System, Toronto, with a 31.8% share, and USS, with a 20% share.
Issues that have faced the company include fines for improper disposal of sewage, and considerations by the U.K. to make the company a public utility again and take it out of private ownership.
The USS investment was valued at £956 million in 2022, and described as being of “minimal” value in the USS annual results published in July, essentially admitting to a full write-off.
“We have spent considerable time reviewing our investment approach, what we like, what we don't like, and how we do that, as well as learning considerable lessons from the (Thames Water) experience, which we are now implementing,” said Levenstein, going on to describe the investment as “deeply disappointing.”
Fees
Worldwide, private markets are seen to be enjoying a moment of real potential. A recent report from Swiss firm Pictet Wealth Management predicted that an upcoming deregulation wave, particularly in the U.S., will create a more favorable environment for M&A and IPOs.
However, private equity traditionally comes with higher fees, and this fee issue has been a cause for concern for pension funds that may wish to avoid the impression of prioritizing bonus payouts over the needs of plan participants.
“Fees are always top of the agenda,” said Levenstein. “I don't think it matters what the return environment is. We we want as much of the benefit to flow through to our members as possible. So fees are always always the first thing that we look to negotiate,” he said.
“Ultimately, if the net returns are strong enough, I think it makes it easier for any investor to justify (higher fees),” said Bjoergerd.
“If you look at the Australian superannuation scheme market, they are very fee sensitive, so they they expect certain fee concessions, and they negotiate pretty firmly. But the flip side is that they often write very large tickets, so they’re good strategic partners,” he said.
Pension risk transfer
Solvency II is the prudential regime for insurance and reinsurance undertakings in the European Union since 2016. It remains applicable to the U.K. financial sector, although it is now subject to oversight from the country’s Prudential Regulation Authority.
How this piece of legislation impacts the U.K. pension sector is through the persistently popular trend of pension risk transfer, with the responsibility of assets offloaded from a sponsor company to an insurer. This restricts any level of appetite for PE in institutional investment, as under Solvency II, the amount of such an illiquid asset that an insurer can hold is tightly restricted, according to Hutchins.
“Before Liz Truss, there was about a 10-year plan to (pension) buyout. Private equity might still have had a role in that, but that just got reduced due to funding positions getting so much better (after gilts rebounded). Now there is a more immediate need to get ready to execute on a buyout with an insurance company, and the assets you want for that are generally liquid bonds,” said Hutchins.