Asset mix changes and ad velorem fees are the irresistible forces pushing costs up. There’s no immovable object blocking their path. Pooling and transparency offer little resistance.
It’s easy to understand that, as you allocate more to higher cost assets, total costs increase. Disparities in costs means that just small movements between public and private assets create very large total cost changes, dwarfing savings from lower manager fees.
Source: CEM Benchmarking
For some time, global investors have had a seemingly insatiable appetite for higher-cost private market investments. It’s easy to see why. The 5-year average net return on global equity mandates across the global CEM universe (approx. 350 funds, £7 trillion in assets) to December 2018 was 10.1%. In the same period, Diversified Private Equity delivered an average return of 17.5% and Infrastructure 12.8%. Private assets have delivered great net returns for many funds.
With that in mind, the government’s strategy of encouraging investment in infrastructure is pushing on an open door. There’s an irony in this however, because it’s clearly going to lead to higher costs. The other irony is that pooling will fuel the overall rise in costs. Pooling provides a more efficient route to access private markets, so it is almost inevitable that funds will push for and avail themselves of those opportunities through the pools.
This is what happens globally. Larger, more sophisticated funds are viewed as more attractive investors by General Partners (GPs) and so have better access and are presented with opportunities that are simply not available to small funds. This translates into asset mix differences across funds in different size ranges - larger funds invest a higher proportion of their assets in alternatives:
Source: CEM Benchmarking
At this point, changes in asset allocation within LGPS are relatively slow. It can be expected to gain momentum however as the pools develop their propositions.
Source: CEM Benchmarking
* CEM’s LGPS universe comprises approximately 45 (typically larger) funds with combined assets of over £200 billion.
The key message is that we should switch the conversation away from cost savings and towards the eminently more achievable objectives of efficiency gains and cost effectiveness (which in my opinion is a better term here than value for money). This means stripping away the impacts of asset mix changes over time and asking:
1. Whether the funds underlying costs are reducing, and
2. If collective active management decisions are ultimately being rewarded in terms of outperformance relative to sensible strategic benchmarks.
Reducing manager fees is one way of achieving efficiency gains. This is already a priority for the LGPS funds and pools (and rightly so). If we are looking for a lever to pull that will have a more material impact though, it is in how the pools use their scale to enable the funds to implement their strategies more efficiently. This is through changes to what we call ‘implementation style’. It has two key threads:
1. Building the capability to bypass commercial fund managers and invest directly. Public markets are easier. The cost savings that should emerge tip the scales in favour of the fund, increasing the probability of success in the long-term, i.e., more net value added.
2. Minimising the cost ‘drag’ in private markets by avoiding high-cost structures like fund-of-funds. Direct GP/LP relationships are more efficient. Co-investments better still. Direct deal making is the holy grail (but a distant dream for most).
In the long term, larger funds outperform on average because they are more efficient (not necessarily lower cost). By and large, the LGPS funds and pools ‘get’ this. What we need to do is measure their success in the right way – and the right measures include efficiency gains and cost effectiveness.
John Simmonds, Client Relationship Manager, CEM Benchmarking
