NEST’s PE challenge to the industry

The UK defined contribution fund, NEST has added a number of new asset classes to its portfolio over the past year – including infrastructure with a focus on renewables – but the fund is still missing an allocation to private equity. CIO Mark Fawcett spoke to Amanda White about the fund’s challenge to the industry on private equity fees, its focus on climate-aware portfolios and innovative approaches to portfolio management.

From a standing start 10 years ago the UK defined contribution fund NEST has amassed £17 billion on behalf of 10 million members and has built a diversified portfolio with innovative implementation and fee structures.

This year it added infrastructure to its portfolio lineup with a focus on green energy, and built out its climate change policy to keep pace with the shift to a low carbon economy.

The missing link in the portfolio design is private equity and the fund’s CIO Mark Fawcett has set a task for the industry to come up with a fee structure for the DC fund that is more appropriate than 2 and 20.

“We struggle to pay any carried interest at all, on the terms normally set,” Fawcett says. “We have set a challenge to the industry to say we can’t pay 2 and 20. We are looking to partner with two to three private equity managers to run an evergreen portfolio for us. We are looking for low management costs and no carry, and in return they will get consistent cashflows coming forward and the opportunity to work with us. Defined benefit schemes are slowing closing around the world, the future of pension saving is DC and under UK regulation these traditional 2 and 20 structures don’t work.”

Fawcett says the issue of value is a key consideration for the fund that always puts its members’ interests first, with the average private equity fund too expensive in value terms.

“The average PE fund doesn’t represent good value. It’s fine if you’re in the top quartile maybe, but even then there is opacity around the fees that are really charged – director fees etc are not suitable for NEST and members,” he says. “We are looking for some progressive managers to step up. Everyone talks about impact investing and social purpose – working with us achieves both of those.”
The fund will be running a procurement in the coming months including a manager search. The primary focus is on the growth equity sector of private equity and is where the fund will focus its money. There is a possibility of also including some venture capital and leveraged buyouts.

It’s not the first time the fund has challenged managers to present innovative ideas. When it hired three private credit managers nearly three years ago only those managers able to adapt on fees and help shape innovative fund structures were in with a chance.

Early this month the fund added some more infrastructure managers as part of the plans to allocate 5 per cent of the portfolio to the asset class by the end of the decade.

It appointed CBRE Caledon, a diversified infrastructure fund manager and will also co-invest alongside the fund, and GLIL infrastructure the joint venture organisation between a number of major local authority pension plans. Nest will invest in the fund along with GLIL’s members, with its open-ended fund giving access to new opportunities in UK core infrastructure. GLIL’s investments to date include equity stakes in Anglian Water, Clyde Windfarm, Forth Ports, a rolling stock fleet of 65 intercity trains on the East Coast Mainline, and investments in biomass and anaerobic digestion energy generation.

In March NEST also appointed Octopus Renewables to boost investments in clean energy infrastructure. It has committed £250 million in the first year and has an ambition to get to £1 to £2 billion over 10 years.

“We don’t know our cashflows so we can’t make very long-term commitments. Infrastructure in the UK is closed ended and you have to make a commitment at the start and that doesn’t work for a DC schedule if we don’t know how big the inflows will be. We have done that in private credit as well. Once the manager has a shift in their perspective and see this is how it’s going to work and it’s not traditional, then it is all fine.”

Fawcett says all the managers they have recently appointed integrate ESG well, and are very focused on making sure the investments are sustainable.

NEST set its climate change policy in 2020, aligning its portfolio with the Paris Agreement targets.

“For us the key thing is to go at a proportionate pace, and we are working with all fund managers on how to transition and at what pace.”

The fund has already moved developed equities into climate aware portfolios with carbon tilts built in, with the volume of those tilts increased over time.

“We are aligned with 2 degrees and plan to align with 1.5 degrees. We are working out how to do that and keep the portfolio suitably diverse.”

In particular it is looking at how to increase certain sectors, technology in particular.

“No one has a clear handle on how to do it and measure 1.5 degrees, it is a work in progress with UBS our fund manager and the rest of the industry,” Fawcett says.

The next step is to transition the emerging markets equities portfolio and Northern Trust has been appointed to manage a climate-aware portfolio which also included doubling the fund’s exposure to emerging markets to 6 per cent.

The new strategy, which addresses a range of ESG risks, tracks a customised index produced in collaboration with the manager, and tilts investment in companies based on a score calculated on three key components: energy efficiency, alternative energy, and green building.

Now half of the fund’s portfolio has been transitioned into climate-aware strategies.

“Starting to invest heavily in renewables will be a big step change for us. Just divesting fossil fuels doesn’t make sense, we want to engage with big oil companies to encourage the laggards to keep pace.”

NEST hired Liz Fernando from USS last year as head of long-term investment strategy and strategic asset allocation sits under her remit.

“We wanted to make sure that SAA got enough focus particularly as the number of asset classes we use grows,” Fawcett says.

In November the fund increased its equities weighting to a slight overweight position at 60 per cent (neutral is 55 per cent) and reduced investment grade bonds.

“We went overweight once the vaccines were working and with the election of Biden, we thought it would mean more global growth,” he says.

The fund has also been reducing property since 2016 and that was reduced a bit more in 2020.

“We have been repositioning into things like logistics, but the jury is out on the office market. We don’t want to make any heroic bets at this point. Modern energy efficiency and green properties will do better than old properties, but it looks like demand for office space will be a lower growth trajectory than before.”

The fund has been building its private credit exposure, and during the pandemic Fawcett told its private credit managers “they needed to make sure they were earning the illiquidity premium”.

“Our managers were very selective about what they’ve done. We are pleased with the positions we had going into pandemic and did very well. We picked managers who were more at the core end of private credit, we didn’t want super distressed as highly risky and specialised doesn’t suit our members.”

The fund has also slightly increased high yield and emerging market debt.