LONDON - Hedge fund Davidson Kempner and asset manager M&G are racing to be among the first firms to inject capital to boost Britain's 1.4 trillion pound ($1.77 trillion) pension sector, industry sources say.

In a so-called "capital-backed journey plan", investors provide a pension scheme with extra capital, in return for any investment returns above an agreed level after a set number of years.

There has only been one such deal so far, but the market is seen heating up as an alternative to a bulk annuity, which involves the transfer of a pension scheme to an insurer. "There is a lot of private capital out there that would like to deploy its capital in this market," said Derek Steeden, a director at PwC.

Britain's 5,000 defined benefit pension schemes were mostly in deficit overall following the global financial crisis. But rising interest rates in recent years mean most are now in surplus and can afford a bulk annuity, considered the gold standard in providing safety for pension schemes and removing liabilities from employers' balance sheets.

While bulk annuities have become more affordable, some employers are keen to continue to run their pension schemes themselves, which is where investor capital can help.

"Running schemes on could present an opportunity for members to receive higher benefits and companies to see a return of some of the billions of pounds of contributions they have sunk into UK pension schemes," said Simon Turner, partner at consultants Mercer.

M&G told Reuters by email that it was entering the market.

Davidson Kempner is also looking to offer such deals, according to Steeden - one of the authors of a report on capital-backed journey plans -, Turner and a third source with direct knowledge of the matter. Davidson Kempner declined to comment.

Investment firm Aspinall Capital Partners pioneered the first capital-backed deal in 2020. Aspinall's Chief Investment Officer Michael O'Connor said he was "hopeful" of doing another deal this year, and confident of deals in 2025, adding that there was "a lot of interest behind the scenes".

Pensions specialist Punter Southall is working with private equity firm Carlyle and institutional investors to provide capital to pension schemes with assets of at least 250 million pounds, Punter Southall principal Richard Jones said.

Jones said the firms' Pension Safeguard Solution had a pipeline of deals and hoped to complete "one, maybe two" this year.

Clara-Pensions, a so-called superfund which takes on pension schemes until they can buy a bulk annuity, is also looking at a capital-backed structure, Turner said. Such structures do not break the link between the employer and the pension scheme. Clara declined to comment.

Industry veteran Edi Truell's Pension SuperFund Capital has offered to put "a couple of hundred million" pounds into Thames Water's pension scheme in a capital-backed deal, Truell told Reuters. Thames Water declined to comment.

Capital-backed journey plans are not all regulated, though some may be assessed by The Pensions Regulator.

The regulator will publish guidance to trustees later this year on issues to consider when choosing such plans, a spokesperson told Reuters by email.

Sources say there is increasing demand for the deals, as pension schemes have had time to reassess funding positions following a badly executed mini-Budget in September 2022, which sparked a jump in UK government bond yields and forced pension funds to sell assets in a hurry to get cash.

($1 = 0.7895 pounds)

(Reporting by Carolyn Cohn; Additional reporting by Nell Mackenzie, editing by Sinead Cruise and Susan Fenton)