3. What Drives and Constrains Direct Investment?:
3.2 Investor constraints
Developing a successful direct investing programme requires a change of philosophy for many institutions and a commitment to a different governance process, mindset, tools and ability to manage new risks. While there is a spectrum of complexity — for instance, co-investing alongside an established external manager is more complex than running a large-scale international solo investment programme — asset owners face a similar set of challenges as existing or potential direct investors.21
Constraints fall into four main categories: mandate and investment beliefs, investment resources and capabilities, ability to manage new risks, and external market factors.
Mandate and investment beliefs
The institution’s mandate and beliefs can prevent it from adopting a direct investing strategy or make such a strategy difficult to develop:
• Mandate: Some institutions, including very large ones, are blocked from direct investing by their mandate, which requires using external managers.
• Beliefs: To build a direct-investing programme, institutions need to believe that illiquid assets will continue to offer long-term returns and leverage the unique strengths of the institution; and, they need to believe in the effectiveness of direct investing, for example in terms of delivering higher returns, more control or better value for money.
Investment resources and capabilities
Institutions that have the mandate and beliefs to undertake direct investing still need to have the right investment processes, staffing models and risk management as well as back-office infrastructure. Having each presupposes that an institution has sufficient scale and a governance framework which supports the allocation of resources to building internal capabilities.
• Scale: Many organizations feel they are simply too small for direct investing to be a realistic option. As discussed in sub-section 3.3, the keenest direct investors tend to be large institutions with more than $50 billion in assets under management (AuM) and a diversified portfolio, though there are many exceptions to this rule.
• Governance: As institutions become more involved in direct investing, they need to adapt investment management, governance, responsible investment guidelines and oversight mechanisms to adequately control their direct investments, e.g. in terms of additional board responsibilities, new staff capabilities, processes and infrastructure. Most of all, the board/trustees and internal investment team need to build a common understanding of objectives, financial and non-financial expectations, and potential outcomes. The board’s responsibilities for risk management need to be delegated clearly, and important elements of how teams are organized and resourced will need to be determined.
• Investment capabilities: Successful direct investing requires new and highly tailored investment processes. Developing the right investment analysis and decision-making steps, in an institution where no similar skills and experience exist, is a huge challenge, most often achieved through the hiring experienced staff. There are also new challenges which must be managed, such as balancing the need to make a long-term commitment to direct investing against retaining the flexibility to use external managers and avoiding making investments in a specific asset class (if no good opportunities are available) simply because staff have been hired to do so.
• Investing talent and compensation: Direct-investing teams can be sizeable, and experienced personnel, paid higher salaries than before, are usually required. However, institutions are often constrained on the pay they can offer because they are part of a government entity, or because they are open to public scrutiny and may be attacked if pay seems too generous or performance is worse than expected.22 Rather than focusing on pay, some institutions make themselves attractive by giving high-flyers the chance to return from a global financial centre to their home geography, offering additional responsibilities and emphasizing their different organizational and investing cultures. That said, recent regulation aimed at controlling pay in the banking industry, for example European Union regulation to cap bonuses, has made it easier for nonbank institutions to offer competitive compensation, while the restructuring of the banking industry since 2007 has increased the pool of talent available to institutions. Nevertheless, institutions need to be aware that bringing investment decisions in-house may not fully avoid the principal/agent challenges associated with using external managers; the compensation of in-house decision-makers needs to align their interests with those of the institution over the long term.
• Operational capabilities and risk management: Direct investing requires significant investment in new analytical and risk-management tools across a range of asset classes, for example to identify concentration risks at both the individual investment and portfolio levels.23 Some institutions are putting in place multi-asset-class applications and associated processes to manage risk across a range of directly and indirectly invested illiquid assets (as well as traditional and other alternative products).24 Direct investing also requires significant investments in policies, protocols and back-office personnel.
A recent study of 19 pension funds found that for each front-office employee added by a direct investor, between one and two governance, operations and support staff were required.25
Ability to manage new risks
Institutions adopting a direct-investment approach will need to manage additional risks which, traditionally, were mitigated or managed primarily by an asset manager:
• Performance risk: The more committed an institution is to a direct-investment strategy, the more exposed it is to being criticized for underperforming relative to its externally defined peer group. When investments are made in third-party funds, both the board and management are somewhat insulated from lacklustre investment results, as blame can be placed on the intermediary. In contrast, when a board and management team decide to pursue direct investing, they are infinitely more exposed to criticism from policy-makers, the press or the beneficiaries of an institution when that approach does not appear to be effective.
• Operational and market risks: Direct investing requires significant operational asset management capabilities, which are not easily grown from scratch. Beyond the day-to-day operational capabilities noted previously, institutions need to work out how they will deal with significant operational events which might include issues such as investment blow ups, wars or fraud, without the guidance and resources of an experienced asset manager.
• Reputational risks: Direct investment involves taking respo sibility for investment decisions. In particular, direct investing means that institutions can be publicly accountable for each investment decision and its relationship with their broader activities. An asset owner, for instance, could acquire a company whose subsidiaries include organizations that clash with the new owner’s publicly stated ethical principles. Another instance would be when a government entity makes public decisions, such as the awarding of a contract or of mineral exploration rights to a company in which its pension funds also owns a stake.
External market factors
Other factors may limit an institution’s ability to invest directly:
• Legal and tax: In addition to the standard investment-related legal and tax risks, direct investors face unique challenges. When multiple parties are involved in a direct investment, it is vital to ensure that ownership, governance and decision-making rights match investors’ asset-management, liquidity and exit strategies. Deals also need to be structured carefully to minimize cross-border and inter-company tax liabilities. Cross-border investors, for instance, may be taxed at higher levels relative to domestic investors, depending on the investment-related tax framework and the nature of the investment. Different types of entities also have different requirements, e.g. sovereign wealth funds structuring investments to maintain sovereign tax exemption. Regulations vary significantly from country to country, so considerable complexity must be managed.
• Regulatory and political: Two main considerations apply here. First, the regulatory environment associated with the end investment must be sufficiently reliable, transparent and attractive enough to permit investment. This issue is particularly acute in directly regulated infrastructure sectors where regulatory uncertainty, for instance, can limit investor interest. Second, policymakers must be willing to permit direct investment. Large-scale deals involving assets that are perceived as strategic may require multiple layers of approvals to enable execution.
• Liquidity: Even when investing in liquid assets, investors will need to take a view on the long-term liquidity of assets and their exit strategies. This challenge is magnified in illiquid asset classes. Developments to standardize and package emerging alternatives such as infrastructure debt, and thus create a liquid market, make a material difference to assets’ attractiveness.