Seismic tremors have been emanating from the UK over the past couple of weeks that are already having repercussions for private equity. How did we get here?
It started with outgoing Chancellor Kwasi Kwarteng announcing a so-called mini-budget that would cut the top tax rate on the highest earners to stimulate the country’s slowing economy. Markets voted with their feet, selling the pound and government bonds, or gilts, over fears more debt would have to be issued to cover the lost tax revenue. Bond sell-offs equal higher yields. Higher yields equal higher borrowing costs and that requires deeper spending cuts and higher taxes.
But the shoe that has been first to drop is the UK’s massive pensions fund industry, the largest in Europe by assets. Over the past decade these pensions have leaned heavily into a strategy known as Liability Driven Investment (LDI). LDI uses derivatives to hedge against any movements in interest rates and inflation, which for the decade following the global financial crisis were essentially non-existent.
As rates rise, as they are now, the value of derivates held in LDI portfolios falls. Add to that the mini-budget reaction and spike in yields and UK pensions have for the past fortnight been scrambling to find collateral amid a mass margin call. That prompted the sale of liquid assets, namely, you guessed it, gilts, sending yields higher. The more gilts that were sold, the higher that yields soared, the more collateral pensions had to put up.
The Bank of England had little choice but to step in and stop the death spiral, acting as the buyer of last resort of government bonds. The bank’s governor Andrew Bailey warned last week that pensions had three days, up to last Friday, to offload the remaining gilts necessary to raise this cash before the central bank would call time on the emergency measure.
On Friday, Kwarteng was summarily dismissed.
The PE puzzle piece
Where does PE figure in all of this? The fire sale in the UK has not been isolated to gilts. Pensions are seeking to offload what they can to top up their cash buffers, including corporate bonds, equities and illiquid assets such as private equity.
The Bank of England is only backstopping long-dated gilts, not other assets. PE fund interests are now beginning to enter the secondaries market. This may not be a short-term response either. Just as the denominator effect has seen institutional investors de facto over-allocated to private equity, by selling down fixed income and equities, pensions may find themselves heavy on PE in the medium term too.
This selldown in liquid assets also means that it is unlikely that UK pension funds will be queuing up to commit to new fundraisings. We’ll have to see how this plays out and whether it will remain a uniquely UK trauma.
While it’s true that British pensions have been the biggest adopters of LDI, exposing themselves to leverage risk, they’re not the only ones. The pensions industry is also huge in the Netherlands – more than three times the size of its economy no less. It has also been big on LDI, as to a lesser extent have German, Irish and Danish schemes.
Unlike UK pensions, Dutch pensions liabilities are tied to EURIBOR – the average rate at which a large panel of European banks borrow. This benefits from diversification. Even if the Dutch government were to spring a surprise budget full of tax cuts on markets, it wouldn’t move the needle. However, as Rabobank noted last week, EURIBOR has been making a sustained move up over the past six months and this is increasing pressure on pensions in the country to increase their cash holdings to manage their margin positions.
This pressure in the system potentially means less PE investment by pension funds in Europe as liquidity becomes a bigger priority than at any time in recent memory.
Investors must keep their wits about them. As JP Morgan CEO Jamie Dimon said last week: “There are going to be other surprises.”