HSBC Bank (UK) Pension Scheme, the pension fund for the HSBC Group’s United Kingdom employees, has adopted a new multi-factor global equities index fund that incorporates a climate tilt.

The scheme – one of the UK’s largest corporate pension funds – has selected the fund for its equity default option worth £1.85 billion ($2.2 billion) in its defined contribution scheme. In doing so, it becomes one of the first pension funds to adopt a multi-factor investment strategy incorporating a degree of climate change protection as its default fund.

“While it is a well-performing fund, we were still mulling over what we could do to make it better,” explains chief investment officer Mark Thompson, who joined HSBC in 2011 prior to which he held senior investment roles for more than 20 years at Prudential Group’s M&G.

“The questions we had were how could we achieve a better risk adjusted return; how could we incorporate climate change protection and how could we make the ESG engagement process better given that it was a passive mandate?” he says.

The query led him to consult with colleagues at FTSE, investment consultants Redington and L&G in a process that culminated in the launch of the so-called Future World Fund.

“The four factors we picked are value, low volatility, quality and size, with the bias towards smaller not larger companies. If you look at how these factors have performed since 2000, they have all outperformed the market cap by some fair margin with a better risk-adjusted return. Between September 2001 and March 2016 the FTSE World Index was up by 7.05 per cent but our index would have been up by 9.6 per cent. The volatility of the new index also comes in lower – 14.8 per cent versus 16.3 per cent.”

Next the team introduced the climate element to the index, tipping away from exposure to carbon emissions and positively towards green revenue.

The fund, which incorporates LGIM’s Climate Impact Pledge, is also a solution to boosting ESG engagement within a passive strategy.

Six global industries are most affected by climate change, says Thompson.

“L&G will engage with these companies. If they are not putting in place strategies on how they will transition their business to a 2°C world L&G will send a clear message, voting against the chairman at the next shareholder meeting, and divesting.”

Rather than the fund engaging directly, he wants L&G to put pressure on investee companies.

“We are not set up to talk to all the companies in which we invest,” he says.

HSBC’s defined contribution beneficiaries choose their own funds, but 90 per cent opt for the default strategy. The fund will replace HSBC’s current passive global equities mandate, which is already managed by LGIM, in January 2017.

ESG is a growing priority across the whole fund where trustees have adopted a core belief that ESG is part of their fiduciary duty; a comprehensive climate change policy was adopted in June 2015.

Yet the latest ESG-focused strategy only affects the £2.6 billion ($3.2 billion) DC portion of the hybrid fund, which has the bulk of its assets in a defined benefit fund worth about £25 billion ($31 billion).

The reason ESG has taken priority in the DC scheme is that these beneficiaries are more exposed to climate risk, argues Thompson.

“Sixty per cent of our members in the DC scheme are under 40. We need to build in protection against climate change here most.”

 

DB strategy all about de-risking

In the DB scheme, investment strategy is shaped around long-term de-risking.

HSBC, an early adopter of LDI, has a liability-driven swaps program involving the use of long-dated interest rate and inflation swaps to manage funding risks.

“The fund is very well hedged and protected against falls in interest rates,” he says.

It also managed to clear a £3 billion deficit between valuations in 2008 and 2011. Since 2011 he has stepped up the de-risking pace, breaking the portfolio into matching and smaller return-seeking parts with the matching assets steadily rising ahead of slated maturity in 2025.

That said, a portion of the illiquid matching assets like property and corporate bonds sit in the return-seeking portfolio and also have long-term, matching characteristics.

It means a steadily declining role for the return-seeking portfolio. Nevertheless, Thompson notes some strategies that have done well, like the “slightly overweight” 4 per cent exposure to emerging markets.

“Emerging markets have done well; and it’s not hedged. We don’t bring it back to [pound] sterling because we like the diversity. Although, of course, I’d like to get to the place where we have no emerging market allocation at all,” he says, in another nod to his de-risking priorities.

Similarly, the fund is shrinking its current 3.4 per cent allocation to private equity.

“We are running down our private equity; it doesn’t make sense to put more in ahead of 2025,” he says.

The emerging market allocation is actively managed; equities are either in passive strategies or smart beta; global credit is a combination of active management and smart beta. Regarding fees, he says: “It’s not a race to the cheapest. It’s a race to the best value.”

Has Brexit hurt the fund?

“No. Our interest rates are hedged; we’ve got inflation and currency hedging in place; we’ve locked down our risk so that whatever happens is ok. We are in a good position.”

He doesn’t believe uncertainties regarding US climate commitments under a new Trump presidency will derail momentum on climate conscious investment either.

“The feedback from Marrakesh is, let’s do it. It’s not going to go away.”

But he won’t be drawn on any future impact of either Brexit and forthcoming European elections, or the US electoral outcome on investment returns going forward.

“I am an economist by training and am used to forecasting. But as I’ve got older I realise that forecasting is easy. It’s just getting it right that’s difficult.”

The election of Donald Trump can’t help but feel like a setback for responsible investment. “Expect the election to herald a wholesale reversal of public policies addressing how corporations and investors tackle ESG rights and risks” said Global Proxy Watch.

As proponents of responsible investment develop their response to the election, one thing remains constant — expect the topic of fiduciary duty to remain on the agenda.

In a principal agent relationship, the agent acts on behalf of the principal. Fiduciary duties exist to ensure that those who manage other people’s money, act in the interest of the principal. In its simplest form, this requires prudent investment. Fiduciary duties do not respond to one election, but an evidence-base, years in the making. At a time of political turbulence, fiduciary duties move carefully forward.

Fiduciary duty requires investors to consider all value drivers, regardless of politics or ethics. If an issue is, or could be, financially material to portfolio value, investors must have a process in place to consider it. Integrating ESG factors into investment decision-making is part of the technology of investment analysis. There is no ambiguity.

It’s why pension funds around the world have added climate change to their risk register. And even if, as Donald Trump has promised, the US withdraws from the Paris climate agreement, other countries will not. US companies cannot be valued in isolation; their stock price is not subject to US policy-making alone. So climate change must be considered. Not least, because it is already disrupting company supply chains.

In 2015, the Department of Labor introduced Bulletin 2015-01, which clarified that ESG issues should be part of the primary analysis of investment decision making. “Keep politics out of our pensions”, said a handful of fringe US commentators. But they missed the point, the Department of Labor has and did. Prudent investment decision-making is not about politics.

The PRI, UNEP FI and The Generation Foundation have contributed an extensive evidence base to the topic of fiduciary duty, including more than 200 interviews with policy makers and investors and legal reviews by 12 law firms. Our report, Fiduciary Duty in the 21st Century, was launched in New York at Morgan Stanley’s Institute for Sustainable Investing. Our research on fiduciary duties in China was launched with a foreword from the chief economist of the research bureau at the People’s Bank of China.

Since their publication, we are preparing roadmaps in eight markets, including the US, to advance fiduciary practice. The roadmaps make a series of recommendations, both policy and practice, that will allow a fiduciary to fully integrate ESG risks. To do so, it is necessary to understand barriers through the investment chain, which start with corporate disclosure.

Corporate disclosure of ESG factors is a necessary, but not sufficient, condition for prudent investment. ESG disclosure is part of a company’s narrative on supply chain security, consumer demand and future value. We recommend companies disclose ESG factors in their annual report, independently assure all financial factors, and use common performance metrics to allow for comparability by industry, portfolio and across time-series.

Our roadmaps also make recommendations on effective shareholder engagement, sometimes referred to as stewardship. Shareholder rights are assets of the pension scheme to be used and monitored by fiduciaries in the best interests of beneficiaries. Corporate engagement is a long-term instrument; benefits accrue over several years. Stewardship practices should be a source of competitive differentiation, particularly among investment managers.

On the relationship between fiduciaries and their beneficiaries, our recommendations focus on the pension fund regulator. Rather than new regulation, in most countries it is clarification of existing regulation. For example, the UK Law Commission stated that “there is no impediment to trustees taking account of environmental, social or governance factors where they are, or may be, financially material”, which should be clarified in a revision of the UK investment regulations.

In prioritising our recommendations, the PRI, UNEP FI and The Generation Foundation is mindful of political feasibility. It would be wrong to say politics doesn’t matter.

In PRI’s analysis of the French Energy Transition Law, which requires investors to report on a portfolio’s carbon emissions, the PRI identifies political leadership as one of the five necessary conditions that enabled the law’s implementation. A change of government in the Province of Alberta presents an opportunity to extend Ontario’s pensions act, which requires Ontario-registered pension funds to disclose whether ESG factors are incorporated into a pension plan’s investment policies and procedures.

So politics matters but the essence of fiduciary duty remains unchanged. Investors must consider all long-term value drivers. It is not the origin of the factor, but rather its financial materiality which is of relevance. And that includes ESG factors, regardless of the ebb and flow of politics.

 

Will Martindale is head of policy at the Principles for Responsible Investment

While many sustainable investors and environmental groups were dismayed by the recent US election results, it is important to recognise that the election of Donald Trump—and to a large extent Brexit in the UK—reflects a growing unhappiness and dissatisfaction on the part of millions of people who feel that existing financial systems, policymakers and structures are not working in their favour.

The PRI recognises that many people across the world feel left behind by globalisation and are still feeling the outcomes of the global financial crisis.

They have seen Wall Street bailed out, while they have been left with the bill, and to struggle with cuts in services, the loss of jobs and real wages in decline.

People are looking for something different, for markets and a system that works for them, not against them, which is why the PRI is undertaking work, in collaboration with our signatories, on creating a more sustainable financial system.

This work aligns closely with the PRI’s mission, which calls for it to promote a sustainable global financial system that supports long-term value creation and benefits the environment and society as a whole. It also aligns to the UN Sustainable Development Goals (SDGs) announced last year, notably, SDG1, whereby a healthy financial system can help curb income inequality.

On a practical level, convincing the President-elect that his mandate to stimulate growth and re-energise the job market by improving ageing US infrastructure would benefit from a sustainable focus is a challenge that investors groups should rise to.

No one can dispute that America’s dilapidated roadways, bridges, waterways, electricity grid, telecommunications and other essential services are desperately in need of modernisation.

The American Society of Civil Engineers has estimated that $3.6 trillion would need to be invested in US infrastructure by 2020 just to raise the country’s support systems to acceptable levels. From a commerce standpoint, America’s crumbling infrastructure is undermining its productivity and competitiveness.

A smart way for the President-elect to begin his mandate would be to invest in sustainable infrastructure projects that create jobs and use the latest technologies and innovation but do not harm the environment and are “climate proofed” for the future. The commercial reality is that, given investors are adapting to the “new normal” of a low/no return environment, marrying patient capital with long-term sustainable investing makes perfect sense.

Another opportunity is construction. Buildings are responsible for an enormous amount of global energy use, resource consumption and greenhouse gas emissions. In the US, buildings account for almost 40 per cent of national CO2 emissions and out-consume both the industrial and transportation sectors.

Trump has built his fortune as a property tycoon and investors are keenly aware that ensuring buildings are constructed to the highest environmental standards results in longer term profitability. As the demand for more sustainable building options increases, green construction is becoming increasingly profitable and desirable in commercial, industrial and residential markets. Global property developers appreciate that well-constructed and efficiently-run buildings will have reduced energy costs, attract responsible long-term investors and be able to command the highest rents.

Then there are the declining costs of clean energy and the fact that the renewable energy sector continues to be a bright spot for job creation.  According to the International Renewable Energy Association, global renewable energy employment increased by 5 per cent in 2015 to reach 8.1 million jobs.

It is through infrastructure upgrades and green property that the Trump administration may come round to the sustainability agenda by recognising the commercial realities and requirements of today’s investors.

It is also worth remembering that individual states in the US such as California—which has adopted higher emissions reductions targets than those set at the federal level—Vermont, Washington, New York, Oregon and a host of other states have strong climate policies in place, which will be independent of policies at the federal level. Climate-change related occurrences such as storm surges are expected to cause more than $500 billion in property damage in the US by the year 2100.

Before his inauguration on January 21, the President-elect has already felt pressure from businesses to stay the US course on climate change.  At COP 22, 360 businesses, including DuPont, Gap Inc, General Mills, Hewlett Packard Enterprises, Hilton, HP Inc., and Kellogg Company to name a few, urged Trump to honour the Paris climate agreement and continue to support bold action to reduce emissions.

 

China in the ascendancy on green finance

But regardless of what happens in the US, other countries are not standing still on climate policies.  During COP22, China renewed its commitment to reducing emissions and to its wider green finance agenda. Xie Zhenhua, China’s special representative for climate change, noted in a speech that climate and green investment has a vital role to play in transforming China’s economic structure.

Zhenhua further said that co-ordination is needed to attract green investment and that policymakers need to work out both economic and environmental policies. This includes promoting innovative, high-tech industries.

China’s leadership on green finance raises another issue for the US, namely, that the US will not want to get left behind and watch other countries surge ahead in green design, technology and innovation, all of which are fundamental to a dynamic economic future.

China was not the only country at COP22 to speak out on the momentum around climate initiatives.  French President Francois Hollande said the Paris Agreement “is irreversible”.

In a speech at COP22, he said: “The United States the first economy in the world, second emitter of greenhouse gases, must respect the commitments that were made.”

 

The PRI spearheads new initiatives on climate change

Amid the COP22 backdrop, it was a busy time for the PRI.  We launched new guidance, Green equity investing, at a Chinese government event and formally announced a deforestation partnership with Ceres, and supported the launch of a UN Global Compact platform to mobilise business action to support The Paris Agreement. We also participated in a Sustainable Stock Exchanges session, Fostering Green Capital Markets in the South, during which we called on exchanges to support the FSB Task Force Disclosure Framework and promote green investment.

Looking ahead, the FSB Task Force on Climate-related Financial Disclosures – of which the PRI chair is a member – will release draft recommendations on company disclosure on climate change on 14 December. Ensuring that investors have consistent and reliable data on how companies are addressing the material financial risks around climate change, is vital to making sound investment decisions.

The PRI encourages corporates and investors, both large and small, to engage the new US administration, not only because they appreciate the issues at stake, but because they can speak to the President-elect in language that he will understand.

Direct engagement is now the task at hand, so let’s focus on the opportunities to move the sustainability agenda forward.

Institutional investors are, in general, very long term in nature because the obligations they are aiming to meet are due many years or decades hence. Such institutions are natural investors in equities, expecting to benefit from relatively high returns driven by long-term corporate profit and dividend growth.

An approach focused on capturing this profit and growth by making investments with low turnover — in relatively stable portfolios of underlying companies held over long periods of time — could be described as long-horizon investing.

In practice, equity manager turnover shows that portfolios aren’t very stable and underlying companies are generally held for short periods (often less than two years).

Of course, such averages can be misleading. In this case, the averages likely disguise what can be thought of as two styles of equity investing — managers who identify share prices they think will go up (by more than the market), and managers who identify companies they believe will grow (by more than the market expects) over the long term.

For many institutional investors, the second type of manager approach (which might crudely be considered as investing rather than speculation) is more naturally aligned with their own long-term investment horizon. Critically, it is also consistent with their underlying raison d’etre – to ‘grow’ the savings pool sustainably by investing in equities. But do such long-horizon managers really exist and can they be readily identified?

The answer is undoubtedly yes. Managers which focus on buying companies for the long term do exist, though they are rarer than one might expect. Warren Buffet’s approach of buying wonderful businesses at fair prices and holding them forever is relevant here. But this brings up additional questions:

  1. Do such great businesses exist? Answer: probably yes.
  2. Are they sufficiently stable and enduring that ‘holding them forever’ (say for 10 years or more) is a viable strategy? Again, the answer is probably yes, although with less certainty than the answer to question 1. Through changing external or internal circumstances, great companies may not persist for an extended period of time (because the product they sell becomes obsolete, for example).
  3. Is holding them forever regardless of price a realistic strategy? Even the greatest company can become overvalued relative to its realistic future growth prospects. Should the manager ignore this overpricing and continue to hold the company even though it’s likely to underperform over an extended period as the overpricing corrects? Or would it be more prudent and pragmatic to take some profits and invest in other great companies that aren’t as overvalued?

The true long-horizon investor will probably agree that a) the company is held for its long-term growth not its shorter-term share price performance, and b) great companies are so thin on the ground that one would need to think very carefully about disposing of one in favour of other opportunities if the risk is that it proves impossible to buy the company back at a reasonable price (because it remains overvalued or becomes even more so).

 

Two categories of long-horizon investor

There are arguably two distinctive styles of long-horizon equity investor.

A majority of the managers would focus on those companies that are high quality with strong brands, large market shares, high barriers to entry, low operational gearing, and robust balance sheets.

Such companies should have the ability to earn higher rates of return on capital employed ad infinitum (or at least over many years). This has tended to be a successful investment strategy because the majority of other investors assume that the returns earned by these companies will eventually return to the average rate, whereas the long-term investor has confidence that these businesses will ‘beat the fade’.

The second type of long-horizon investor is almost completely different.

This type of manager buys companies that he or she expects to grow to a much greater extent than the market currently believes. These companies will already have been identified as high growth companies by the market but this type of manager believes that the market lacks the imagination or time horizon to understand how fast and for how long these businesses can actually grow.

What the two approaches have in common is a much longer time horizon than the market generally. The success of these approaches is not going to be appropriately assessed by considering the movement of share prices over short or even medium time periods, whether in absolute or benchmark-relative terms. What happens to share prices along the way is arguably just noise.

Knowing what success looks like

Measuring performance by comparing share price performance with the market average over short periods of time is likely to be fruitless at best, or misleading at worst. But we do need to find a way of measuring how the portfolio of shares is progressing – is it ‘on track’ or has it ‘gone off the rails’?

For the first ‘compounding’ group this is probably not too difficult. It should be possible to look at the whole of the portfolio and measure it as if it were a single company, looking at whether, for example, dividends had increased, return on capital employed had grown, and if the balance sheet had remained strong, with the deliberate use of a combination of measures that are naturally in tension and therefore cannot be easily manipulated either by the asset manager or the managers of the companies in the portfolio.

For the second type of manager, which invests in what might be called ‘transformational growth’ companies, the same type of measurement approach is not going to work.

Companies growing at very rapid rates are unlikely to see dividends at all or neatly corresponding returns on capital employed.

For these companies, more of a private equity approach is likely to be required. When the manager acquires shares in the company, what are his/her expectations for growth, and how do these compare with the company’s business plan?

The manager should then be prepared to report on whether the companies in the portfolio are in line with, ahead of, or behind expectations, and why.

The establishment of a monitoring process that works for both investor and manager should enrich the debate at the outset of the mandate, align investors and managers more closely, and make for a much better informed discussion about portfolio performance, ultimately leading to good long-term relationships and superior long-term performance.

Nick Sykes is director, manager research at Mercer

 

Gone are the days of managing risks and rewards at a portfolio level; investors are adopting a so-called ‘systems level thinking’, investing in line with a broader understanding of their ability to impact the world around them and to influence the shape of the future that will, in turn, impact their portfolios.

So argues a new report, Tipping Points 2016: Summary of 50 Asset Owners’ and Managers’ Approach to Investing in Global Systems from The Investment Integration Project (TIIP), and supported by the New York-based Investor Responsibility Research Centre Institute (IRRCi).

Gathering data from a diverse set of 50 asset owners and managers, with combined assets under management of $17.3 trillion, the authors find more investors are intentionally pursuing strategies that tie portfolio-level decision-making to systems level risks and opportunities.

It’s an important part of the advancement that finance appears to be taking as it contends with an evolving world, explains IRRCi executive director Jon Lukomnik.

“It has been more than a half century since Harry Markowitz popularised diversification and portfolio level investing, for which he later won a Nobel Prize,” Lukomnik says.

“Since then, capital markets around the world have changed dramatically, and the global financial crisis was a game changing wake-up call. Against this dynamic backdrop, investors are evolving and realising that global financial, environmental and social systems have major ramifications on their investments and simultaneously, their investments have deep impacts on those systems.

“The report illustrates the new policies and practices that investors are embedding into their business culture and investment strategies. We now have concrete evidence that investors are intentionally confronting global environmental, social and financial systems challenges in a way that makes financial sense,” he says.

Key catalysts behind the changing investment culture include industry-led initiatives like the UN-backed Principles of Responsible Investment, a network of more than 1500 investors working to create a sustainable financial system.

The Task Force on Climate Related Financial Disclosures, which aims for companies to voluntarily produce climate-related financial risk disclosure for the investor community, is another force of change.

The report finds investors are motivated to invest at a systems level by risk reduction and financial returns; a desire to contribute positively to society as well as public pressure and legislation.

It highlights the steps investors are taking towards systems-level investing in what it calls “on ramps”. ESG integration, prioritising long-term value creation, impact investment, exclusion or screening, the careful selection of managers and investment stewardship are typical “on ramps” that lead to a systems-level investment approach.

Pathways

The report also identifies deliberate strategies among its sampled investors to pursue big-picture strategies, counting 10 “pathways” via which investors express what it calls “intentionality”. It is through these pathways that investors bridge the gap between their daily portfolio management decision-making, to facilitate impact at a systems level.

The pathways include:

Additionality: Where investors pursue opportunities with competitive returns in markets that are currently underserved.

Diversity of Approach: Where investors consider a diverse set of system-level risks. Climate change, for example, is an area where an investor might adopt a diversity of approaches via divestment, engagement or investing in alternative energy.

Evaluation: Where investors place a financial value on environmental and societal systems. America’s biggest pension fund, California Public Employees’ Retirement System adopted the investment belief – one of 10 – that long-term value creation requires effective management of financial, physical and human capital; another belief at the fund articulates that risk is “multifaceted” including issues not measured by tracking error and volatility, like climate change, demographics and resource scarcity.

Geographic Locality: Where investors buy connected assets in the same geography. This could include endowments committed to serving communities, or investing to support local economic growth as demonstrated by Ireland’s €7.6 billion ($8.3 billion) Strategic Investment Fund. Similarly Canada’s $254.9 billion Caisse de dépôt et placement du Québec includes investment in Quebec businesses, infrastructure and public transportation in its global portfolio.

Solutions: Where investors create investment vehicles that target solutions. This is a strategy pursued by the Dutch pension fund manager PGGM when it allocated a multi-billion dollar portion of its assets to what it describes as a “solutions” or “impact” portfolio. Here the focus is on four issues where it believes it has particular expertise and can effectively address fundamental environmental and social systemic challenges – climate change, food, healthcare and water.

Successes and challenges

The report finds that investors are successfully integrating ESG into their investment strategies, along with developing investment products that target environmental and societal issues.

Similarly, respondents reported success in meeting specific goals, like reducing exposure to risk or allocating assets to a solutions-orientated portfolio.

However, challenges include the varying quality and availability of data, particularly from investee companies. The need to educate staff, clients and other stakeholders on systems-related considerations, and how to measure the true impact from ESG or other systems-level investments was also cited as a challenge.

Here the report authors highlight the need for more support for asset owners and managers in measuring and reporting on the effectiveness of their individual and collective policies at a systems level. Owners and managers would also benefit from identifying opportunities for collective action, it says.

“A lot of work is left to be done to better understand the complex relationship between systems and portfolios. But, this study demonstrates that institutional investors, whether implicitly or explicitly, understand that the world is becoming increasingly interconnected,” TIPP’s William Burckart, report co-author says.

“Previously, investors could find ways to insulate their portfolios from certain global events. Today, even seemingly “local” events can immediately and adversely affect all portfolios. Because the largest and most influential investors are recognising this trend and beginning to consider the connection between planetary systems under stress and adversely effected portfolio performance, we are looking at a potentially critical shift in the evolution of investment.”

Intentional steps towards positive impact at a systems level may still be hesitant, taken by relatively few investors, unclear, or lack consistent articulation.

But they are an important part of the evolution as finance contends with the realities of volatile financial markets, social needs and environmental instability.

The concept among asset owners that they are universal investors with responsibility for the vitality of the whole economy has taken root. And with it the knowledge that what happens at a systems level will impact the value of their portfolios.

Almost a year on from the launch of its private equity reporting template on fees, expenses and carried interest, the Washington-based Institutional Limited Partners Association (ILPA) reports “significant progress” in the template’s adoption.

The $178.6 billion New York State Common Retirement Fund (NYSCRF) has made fee disclosure via the template a condition of investment in all new private equity funds.

“We require the managers of all new commitments to use the ILPA template,” said a spokesperson for the fund, which has 7.8 per cent of assets in private equity.

“Over half of our managers are either using the ILPA template or are working to use the ILPA template.”

However, he says managers with older funds tend not to report in the ILPA format, although the Common Retirement Fund is “working with these managers to improve their reporting standards.”

ILPA’s template requires GPs flag carry fees but also capture expenses and the incentive allocation paid to managers and their affiliates.

This means investors can compare fund performance going back to inception, plus a whole range of advisory, placement and deal fees.

The idea is this data will support LPs’ internal allocation decisions, help steer their manager selection processes and will feed up into top line organisational assessments of value across the portfolio. It is the kind of transparency investors hope will help them to both negotiate better deals and level the playing field which currently lets the biggest LPs, with the best relationships, also get the best deals.

Head of private equity at the UK’s USS, Geoffrey Geiger, says the template, or equivalent disclosure, is now a condition of investment.

“We support a voluntary approach to adopting the template, the PE industry came up with its own solution to concerns around transparency on fees and we think it works well.  It is in the GPs’ and LPs’ mutual interest to use the template, and as more GPs develop the systems to comply with the template and LPs become accustomed to receiving the data, it will just become part of the process.”

“The template, or equivalent disclosure, is now a condition of investment; as we negotiate with our GPs we are using the template with GPs. We find that we get high levels of disclosure as a result, and more than what has been reported on in the industry.”

A number of leading general partners (GPs) have now also publicly backed the initiative, as well as a large and growing number of limited partners (LPs) and service providers, says the organisation that represents some 300 institutional investors in private equity.

“As the initiative builds a real head of steam with support from all corners of the asset class, we are on the cusp of meaningful change that is in the long-term best interests of all industry participants,” says Peter Freire, ILPA CEO.

The aim of the fee template is to establish more robust and consistent standards for fee and expense reporting and compliance disclosures among investors, fund managers and their advisers. The template is the industry’s own response to growing criticism of private equity fees from regulators, trustees and beneficiaries, with private equity increasingly perceived as a grey area that allows managers to charge investors and pension funds hidden and backdoor fees.

“The evidence suggests that template adoption is gaining momentum. More GPs are officially endorsing the template and even more are providing the template data unofficially by making it available to LPs that request it. On top of the GPs already offering – or gearing up to offer – the template, we have more than 100 LPs asking for it, and in many cases making it a condition of doing business,” Friere says. “This building momentum around adopting the template makes complete sense: notwithstanding near-term (and very real) implementation costs, the long-term benefits of a single, industry-wide standard for all – GPs and LPs – are self-evident.”

Private equity has always been one of the most expensive asset classes for investors. It remains to be seen whether the greater fee transparency will translate into an ability among LPs to put pressure on fees.

“It is too early to tell,” said the NYSCRF spokesman.

ILPA’s Freire agrees: “It’s too early to tell how the template’s adoption will impact what the market will bear in terms of fees. To the extent that greater transparency helps LPs in negotiating fair and reasonable fees, any such impact would likely not be apparent until late 2017 at the earliest, when detailed reporting for recent vintages becomes more widely available and the ILPA template becomes a more widespread feature in newly negotiated LPAs.”

 

A two-year transition

Due to the long-term nature of private equity funds, and the complexity surrounding the technology required to automate the production of this data, a full transition to using the template is expected to take up to two years.

Several of the endorsing GPs expect to begin producing the template data for LPs, requesting it as early as the first half of 2017, says ILPA.

Despite progress, some funds report slow progress when it comes to persuading GPs to use the template and simplify their fee structure.

“Things are improving but it is a slow process. Some of our managers have been very constructive, but not all. A common response from managers is that they don’t see other LPs asking for it, even though we find that hard to believe. I think it’s likely that we would make filling out the template a condition of future PE commitments,” says James Duberly, director, pensions investments at the UK’s £12.5 billion ($18.8 billion) BBC Pension Trust with a 5 per cent allocation to private equity.

So far 33 LP organisations have publicly endorsed the template.

The latest prominent GPs to publicly back it include Advent International, Apollo, Blackstone, CCMP, Hellman & Friedman, KKR and Silver Lake. They join The Carlyle Group and TPG.