Daily policy initiatives by governments across the world who are desperate to avoid the worst ravages of an economic recession are fuelling a lot of the volatility in public markets with which investors are now sadly familiar. However, many pension funds have significant private market exposures through alternative investments. Those holdings are not immune to government intervention and pension funds should note the sometimes unexpected effect of policy changes.
The Pensions Regulator’s COVID 19 guidance on 27 March advised pension scheme trustees to “Review and manage specific risks which may now exist within their portfolios …eg concentrations of risk and/or exposures to deteriorating sectors/credits”.
This blog provides further detail on some emerging investment risks.
Private Equity (PE) Funds: Eligibility Criteria for Government Liquidity Packages in the UK and US
The Government’s financial support package here in the UK includes the Coronavirus Business Interruption Loan Scheme (CBILS). This is targeted at small and medium-sized enterprises (SMEs). One of the eligibility criteria for businesses wishing to benefit from this scheme is that their annual turnover does not exceed £45 million. The scheme is being administered by the state-owned British Business Bank, with accredited lenders mandated to provide the loans. As matters stand, accredited lenders are interpreting “business” to equate to a consolidated group for accounting purposes. Consequently, where PE houses hold majority ownership stakes in portfolio companies, the same approach is being applied – meaning that the annual turnover test is measured against the aggregate revenue of all such portfolio companies.
This policy is producing the same result as in the US (see below), with PE houses unable to procure access to CBILS for individual portfolio companies. However, market pressure has led to accredited lenders querying the position with the British Business Bank. Their response is awaited and it may be that further guidance is provided enabling portfolio companies to be considered on an individual basis. Beneficiary businesses also have to be UK-based. Such guidance, if given, would also therefore bring UK-based portfolio companies of non-UK PE houses within the eligibility criteria.
In the meantime, last Thursday the Government announced that it will be launching the Coronavirus Large Business Interruption Loan Scheme (CLBILS). This scheme will be launched later this month and apply to businesses with an annual turnover of between £45 million and £500 million. The exact criteria are being worked out but clearly the increased revenue thresholds will make it potentially more relevant to many portfolio companies. However, with the aggregation issue referred to above still unresolved, this may well apply to CLBILS as well and therefore limit the scheme’s benefit to portfolio companies.
Our recent blog addresses the important question, “Who’s looking out for private equity limited?”
US Private Equity Funds
Pension investors who have US related private equity holdings are also facing the effect of some arbitrary new rules by which the US Government is supporting small and medium sized enterprises in the US. The US legislative rescue package for such companies gives relief provided that the company does not employ more than 500 people. Because of the way that portfolio companies are owned by PE houses through limited partner structures this can make them ineligible for US Government support.
Actions for Pension Fund Investors
If you think that your fund may have exposure to UK or US SMEs via private equity funds, check your fund documentation and contact your investment consultants and relevant managers. If the new rules are going to prevent underlying investee companies from gaining access to government rescue packages, you may be faced with more capital calls than you might otherwise expect. The consequences of not meeting drawdowns in PE funds are almost invariably draconian: forfeiting of the investment or a significant part of it is commonplace together with penal interest rates on unpaid capital calls.
At a time when the UK’s own credit rating has been downgraded by Fitch and other sovereign nations’ debt is under massive strain, investors should be checking their credit managers’ mandates make sure inadvertent breaches are not occurring. Liability Driven Investment portfolios based on gilts and swaps tend to have high quality reporting because of the liquidity in the markets. By contrast, liquidity in corporate debt and multi-asset credit mandates, where spreads have widened, is challenged.
As a separate point for those who have invested in emerging market debt, the IMF and World Bank issued a statement requesting the leadership of the G20 Nations to request all bilateral creditors to suspend debt payments from those countries who are eligible for International Development Association assistance. There are 76 such countries who cover a quarter of the world’s population. Here is a link to the statement from the IMF/World Bank and a further link to the International Development Association (IDA) website.
Check your fund documentation and the manager’s investment restrictions. Do you have sufficiently regular data about your credit holdings and ratings? Does the manager have an obligation or merely a discretion to rebalance in the event that investment restrictions are breached and how quickly would you find out? Although most EMD mandates are unlikely to have any significant exposure to IDA markets, you may again want to confirm with your managers that there is no such exposure.
UK Real Estate
One of the many UK Government interventions in the domestic economy has been to override leasehold contracts which would otherwise allow landlords to evict tenants for non-payment of rent. Although the purpose of this legislation is to provide immediate relief to tenants, the knock-on effect to real estate investment holdings is that there will be disruption to income cash flows and therefore to yields. Data about rent defaults/voids will therefore be temporarily less trustworthy than usual.
In addition, most property funds have now imposed gating restrictions, so investors cannot sell their holdings.
Our Real Estate colleagues have put together a detailed guide setting out measures adopted in the UK and a number of other jurisdictions across Europe.
Information on the quality of portfolios is key at this point. Managers with high exposure to the retail sector will be facing the same sorts of calculations that their private equity peers will be making: where is cash flow coming from where consumer demand has been hit so fast? Investors’ ability to sell may continue to be constrained for a long time. Their corresponding liability to meet additional cash calls will very much depend on the manager’s investment strategy and how investments are structured – whether via a fund or under an investment management agreement.