3. What Drives and Constrains Direct Investment?:
3.1 Investment drivers
Institutions pursue direct investments for three main reasons: to improve returns while managing risks, strengthen control over the life of the investment, and to improve value and alignment with the institution’s interests.
Direct investing allows asset owners to tailor their portfolios more specifically to their needs and take advantage of their long-term horizon.
Direct investing allows them to select specific types of investment to meet fundamental macro-investment requirements (e.g. they may be able to hedge long-term inflation by investing directly in toll roads or similar infrastructure). Direct strategies also allow an institution to innovate and to tailor each transaction structure to its micro-investment needs (e.g. in terms of the guarantees offered or the investor’s place in the capital structure). Institutions may also use direct investments to explore nascent products before they are widely offered by asset managers. Examples include investments in emerging asset classes such as underwriting catastrophe bonds or infrastructure debt.
Direct investing allows institutions to invest in assets which, generally speaking, do not fit into the traditional asset manager model. If, for instance, an asset owner wanted to hold an infrastructure asset for 30-50 years, or potentially own a company indefinitely, this would not be possible with a traditional fund structure.
Direct investing provides an institution with more control over its portfolio, as it lessens dependency on fund managers for when to sell an asset. It also reduces the likelihood that the limited partner (LP) base of a fund is comprised of institutions which do not share a similar investment time horizon or liquidity profile.
Investing directly gives an institution control over its own destiny. It can choose to stay invested in an asset that meets its needs, whereas a fund manager, in contrast, may be forced to sell if the life of a specific fund is coming to a close. Moreover, investing directly increases an investment’s transparency within the context of the institution’s overall portfolio. It is much easier to assess the value, risk and liquidity of a specific asset when it is owned directly, assuming that the operational infrastructure is in place to manage such functions.
During the financial crisis of 2007-2009, many asset owners found they lacked control over their investments when fellow investors had liquidity challenges that led them to sell their stakes in a fund or seek redemptions.16
Value and Alignment
Institutions are keen to get good value for their money, and a number of the largest and most established institutions believe they can run sophisticated direct-investing teams for similar or lower costs than those incurred when using external managers.17 However, very few institutions say their direct-investing programme is principally a cost-avoidance tactic once indirect costs are taken into account, particularly good quality support functions and reductions in operational flexibility.
The costs of running a direct-investing programme can vary significantly, depending on the model adopted and the type of assets. As a general rule, a solo direct-investing approach is more expensive to set up and run than partnership investing, which is more expensive than co-investing. In terms of asset types, within each type of direct-investment strategy, private equity deals are generally more complex and costly than infrastructure and real estate deals. The key to a successful direct-investing programme is the combination of the right direct investing model for each asset type: for example, a solo infrastructure direct-investing programme is likely to be more expensive to manage internally than a private equity co-investing programme, and core real estate solo direct investing in a local market is potentially less expensive than partnership investing in emerging-market brownfield infrastructure.
The relative cost of delegated investing is clearly also a factor. Since the financial crisis, the threat of substitution by direct investing, together with cyclical factors, has helped push down the fees associated with investing in third-party funds (Figure 8, for example, highlights data related to buyout funds). Even so, what matters most is the overall value for money. Thus, funds with a strong track record can remain attractive despite charging higher fees. In turn, many fund investors have been focused on more intensive due diligence to identify top performers and consolidate their list of providers.
Costs aside, operational flexibility is a factor. By removing layers between an asset owner and an underlying asset, an institution reduces the complexities and costs introduced through additional intermediaries. However, it is more difficult to bench an internal team than to fire an asset manager if the institution’s investment strategy or the broader investment environment changes. It can be difficult for an asset owner to be sure that an external asset manager’s decision-making process is aligned as closely as possible with the interests of the asset owner (the discussion that follows on principal/agent challenges elaborates on this ).18 Nonetheless, for most institutions, outsourcing at least some portion of their asset management to an external fund manager is the only practical approach given the structural constraints many asset owners face (detail for which is provided in the following subsection on investor constraints).
Principal /agent challenges occur wherever a principal employs an agent to perform a task and is not able to directly supervise or measure the agent’s activities. The challenge is therefore to ensure that the agent has the right incentives to act in the principal’s best interests at all times. This becomes complex in asset management because there are multiple layers of principals and agents involved in any investment decision, creating opportunities for misalignment of interests.19 There has been extensive academic research and policy-related discussion on this topic.20 Highlighted here are some challenges specific to direct investment, in contrast to those related to traditional long-only investments.
Long-only investment fund
In a traditional long-only investment fund, principal/agent challenges are minimized by defining a clear investment mandate, publishing detailed performance information on a regular basis and providing incentives for the asset management firm and portfolio manager to ensure their interests are aligned with the beneficial owner. While this approach is generally satisfactory, it is not perfect. For instance, poorly structured incentives can make it attractive for fund managers to either take excessive risks or hug benchmarks to influence their compensation. In addition, there may be knock-on effects as investment managers put pressure on management of the companies they have invested in to meet short-term performance targets.
Illiquid closed-end fund
Management of illiquid investments using a closed-end fund structure is similar in principle but introduces some additional complications, for example:
Since investments are illiquid, a clear and realistic framework for valuation is required, including how and when gains and losses should be realized.
• Performance measurement
Performance cannot easily be marked-to-market or compared with peers, so investors use hurdle rates, carry structures and other incentives to align general partner (GP) compensation with realised performance.
Investments may be highly complex, so more time must be spent to ensure investors understand investment and operational decisions including the knock-on effects of decisions concering cost allocation between the GP and LPs.
Greater potential for conflicts of interest exist, some of which may be discussed in offering documents, such as whether funds will be closed once gaining a certain scale.
Principal / agent challenges and direct investing
Despite bringing asset management in-house, direct investing does not automatically address all these issues. While problems of cost sharing are not relevant for solo direct investors, investors using partnerships still face the same challenges as when using an external manager. Aligning compensation schemes with long-term time horizons can be even harder for an asset owner since it can be difficult to provide compensation in the near-term while encouraging long-term thinking, especially when the investment life of some investments can be unlimited and compensation cannot be linked to the realized value of an investment. In addition, it becomes an even greater challenge to ensure that senior management and the board spend sufficient time understanding their institution’s direct investing programme at the appropriate level of detail. Reducing an intermediary layer helps to overcome the principal/agent challenge, but places significant additional responsibilities on those governing a fund.