At first, I didn’t believe the number in front of me.
But I checked and rechecked the calculations. The value of the company was £0.
This had never happened before. I had never valued a company at exactly nothing before. But sure as hell, the equity was completely underwater (the debt of the business was greater than it’s ‘value’ meaning no money would go to the shareholders of the business).
In a way, it didn’t make sense. The equity of a business can’t be zero – it must be worth some nominal amount. But the overall point was clear, this company was practically worthless.
On Tuesday, the excellent Jo Cumbo of the FT broke the news that the government plans to amend the regulations on how pensions schemes comply with the 0.75 per cent charge cap so that they can more easily invest in funds with performance fees. Performance fees are often associated with so-called ‘alternative assets’, such as infrastructure, and private equity.
That means investing in companies like mine above. A privately owned logistics and infrastructure business.
The government’s justification left me a little uneasy:
“We know that average annual charges for pension schemes which are subject to the charge cap are between 0.38 per cent and 0.54 per cent,” the consultation said. “It is therefore clear that trustees have scope, within the existing level of the cap at 0.75 per cent, to consider innovative investment opportunities which may attract higher charges, should they wish to. It may, however, be the case that the way compliance with the charge cap is currently determined does restrict trustees’ options.”
For once the government does seem to have its figures right!
FEE, n. A tiny word with a teeny sound, which nevertheless is the single biggest determinant of success or failure for most investors. Investors who keep fees as low as possible will, on average, earn the highest possible returns. The opposite may be true for their financial advisors, although that is still not widely understood.
So just because there is room in the fees cap doesn’t mean it should be used!
To make this clear let’s take things back to first principles.
The first is simple: Asset allocation is the biggest driver of investment performance.
How does this relate to alternative assets?
Firstly, these assets offer the possibility of excess returns due to their increased risk.
Secondly, these assets offer a diversification benefit to an investment portfolio. When the market zigs, these assets often (though not always) zag.
Thirdly, it’s often not possible to access some areas of investment through traditional public markets. For example, utilities, hospitals and roads, major public works are usually not accessible through public markets.
Together, investing in these assets offers the ability to access a potentially superior risk-adjusted return through the benefit of diversification. You can read more about this in my post about asset allocation and the ‘efficient frontier’.
Our second principle
But we have a second principle that is key:
The two things an investor can actually control are cost and levels of risk. Everything else is beyond their control.
An investor can choose where to invest their money. And therefore the fees they have to stump up. They can also choose how much of certain assets to invest in. Setting themselves up for a certain level of risk. For example, more equities generally means a higher level of risk/volatility than investing more in government bonds. But returns are not guaranteed. Those are beyond their control.
So it leaves us with the trade-off. We can potentially lower our level of risk in exchange for higher costs (performance fees).
The million-dollar question is, therefore: is it worth it?
To answer this, we really need to think carefully about what we mean by risk.
Risk is a terrible word. It is much confused. When we talk investing we are usually talking about volatility. An investment return is not guaranteed. Instead, there is a range of possible returns. Volatility is the measure of how big that range is from our expected return. You can see this in one of my favourite graphs from Howard Marks (co-founder of Oaktree Capital Management):
By investing in alternative assets like private equity, infrastructure and private credit we can potentially reduce the volatility around an expected return through the benefit of diversification.
But, whilst our volatility may be lower, we introduce ourselves to new types of risk. Here are four examples:
These investments can’t be bought and sold at whim on the market. It’s possible you may never be able to sell them.
Taking my logistics and infrastructure company above – the seller had to wait 3 months for me to value the business before they could sell their stake.
In exchange, for this ‘risk’, investors receive an ‘illiquidity premium’. Despite decades of super-smart academics trying to work out how big this premium is, nobody really knows for sure.
Because these investments aren’t actively traded on a market place, they aren’t priced every day. The best you can hope for are quarterly valuations. But even then you can have big swings in value (especially if you invest in Venezuela). This is problematic for a pension scheme in particular as they need to price their funds every day. At quarter or year-end there could be a big movement in value. That could mean some savers win big or lose out just down to unlucky timing.
Now imagine a company with even less oversight, little to no internal audit function and operating in a third-world country. And there’s little you can do about it.
My logistics and infrastructure company was in such a bad state because a few people in the business had been doing some naughty things. They had been accused of bribery and corruption by the US Government. The Department of Justice were coming down on them like a ton of bricks. The company was in line for a whopping fine that would have put it out of business.
This leads us neatly to our final risk. Reputation. Not all publicity is good publicity.
How are investors going to feel investing in countries with questionable human rights records? Or companies that do business with particular industries (forestry, oil and gas, resources)? Are members going to be happy investing alongside sovereign wealth funds from the Gulf States?
Whilst we can manage and mitigate some of the risks above through good risk management it is very difficult with these types of investments. When they go wrong, they go wrong in a big way. Take the recent terribly sad example in Brazil of the dam collapse.
So is it worth it?
I think for individual investors the answer is: no.
That’s because liquidity and valuation risks are so pervasive that the potential benefit can be significantly dwarfed by the downsides. Sure, we can access these through pooled investment funds. But the costs are staggeringly high. And save for any professional investors of high net worth individuals, the amount we can safely stash away in these investments is just too low to be worth the hassle. You’ll end up spending 90% of your time worrying about something that makes up less than 10% of your portfolio.
But can it be worth it for pension schemes? Maybe.
Large schemes with billions in assets are less vulnerable to liquidity and valuation risk. With billions in assets spread across a large diversified portfolio, the impact of these risks is mitigated. Similarly, management and reputational risks can be managed by hiring experienced staff to monitor and appraise these investments. Think risk analysts, investment strategists, communication professionals.
But those people are expensive! Just taking myself as an example. I wasn’t a big earner in the city by any means. But when I left my job I was making my way towards a six-figure salary. If I had kept doing my old job I’d probably be earning close to £100k now (after nearly 10 years experience).
The more you invest in those assets, the more of these expensive people you need. That’s more going out of the pockets of savers and into the pockets of the pension scheme’s employees and advisors.
That’s before we even talk about performance fees. Reassuringly, it looks like NEST (the government-backed DC scheme) doesn’t pay performance fees and would only do so if it fits within a tight cost budget:
At the #TUCpensions conference, Stephen O'Neill of NEST says the workplace pension scheme is NOT currently paying performance fees for its investments but would consider assets with this fee structure if it met its fee budget.
— Josephine Cumbo (@JosephineCumbo) February 5, 2019
With all that said, I think investing in alternative assets can work out well for pension schemes. But I think the following three things are vital for it to succeed:
- Just because you can invest in alternative assets doesn’t mean you should. It’s only worth it if it is cost-effective. Investing in these assets is most cost-effective when a pension scheme does not have to pay performance fees. Schemes should strongly resist the urge to pay performance fees to access these investments.
- Investing in alternative assets might mean lower volatility but that doesn’t necessarily mean lower risk. New risks such as illiquidity, valuation, management and reputational risk pop up. These need to be successfully managed. This requires certain expertise that pension schemes may not currently possess.
- It is not a good reason to invest in alternative assets to chase returns or because ‘politicians said so’. The reason to invest in these assets is to try to achieve a better risk-adjusted return through appropriate asset allocation. However, there is no guarantee of success.
All the best,
Young FI Guy
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