3. What Drives and Constrains Direct Investment?:
3.3 Direct investment today
In this section we look at broad trends in direct investing today before discussing the pros and cons of the three main models of direct investing: solo direct investing, partnerships and co-investing.
Broad trends: size, investing maturity and asset type
The ability of an asset owner to invest directly is linked to size, as larger institutions find it easier to overcome constraints; asset type, as some assets require less intense management capabilities; and investing maturity, as investors need experience to invest directly.
• Size: The biggest commitment to direct investing, in terms of investment volume and the range of direct investing models employed, tends to be seen in the largest institutions, 26 while small investors continue to delegate most of their investing. Figure 9 sets out four broad divisions by size alongside their typical approach to direct investing. However, there are many exceptions and corollaries; even among “mega investors”, the allocation to direct investing varies from a few percentage points to over 90% of the investment portfolio. The relationship between size and direct investing is driven largely by economies of scale — notably the size of investments in a particular asset class in relation to the relatively fixed costs of building internal teams—as well as the bargaining power that investors gain as they become bigger. There seems to be a particular inflection point at around $25 billion AuM. Above this size, institutions can often use their scale to gain co-investments and other services from asset managers. Rather below the $25 billion mark, institutions often cannot make a full commitment to direct investing but may still have many of the characteristics of committed direct investors: significant volumes in illiquid assets, enhanced control and governance structures to cover these assets, and a more active relationship with asset managers. The strategies adopted by this group increasingly include mandates under which the institutional team retains significant discretion over the key investment decisions but uses an asset manager to implement the investment strategy.
• Investing maturity: Direct investing requires significant experience and considerable investment in resources and support structures, so most investors initially use asset managers for any given asset class. They then begin to move parts of the investment decision-value chain in-house to improve their access to the right kind of investment, increase control over investment decisions and assure value for money (Figure 10). Investors also tend to begin direct-investing activities close to home, in markets and geographical territories that they feel they already understand, although more mature direct investors sometimes see direct investing as a way of gaining exposure to new asset classes, such as in emerging markets or in terms of asset type.
• Asset type: Assets vary considerably in terms of the knowledge and resource necessary to acquire and manage them with regard to both broad asset classes and the more precise nature of each deal. Private equity is generally considered more complicated than infrastructure and and the latter is generally considered more complicated than real estate.27Many experienced direct investors will continue to use asset managers for private equity, even if they invest directly in other assets. Moreover, within certain asset classes, there can be a range of complexity (as illustrated in Figure 11). Equity investments made in an already-operating (or “brownfield”) infrastructure asset, in a jurisdiction with well-established legal and regulatory frameworks, for example, are generally considered less risky than equity investments in the new construction (or “greenfield” development) of an infrastructure asset in a frontier market with a less predictable legal and regulatory framework. Investing in the new construction of a suburban shopping mall is likely to be of higher risk and more complex than investing in an existing Class A office building in Midtown Manhattan, New York City.
There are many exceptions to the broad trends just noted, and they offset one another to a degree. For example, some investors have a long history of investing in illiquid assets, and this maturity allows them to behave more like mega investors despite their smaller scale (e.g. the Wellcome Trust). Family offices are another common exception to the rule, with many making direct investments. To overcome their scale and staffing disadvantage, many use intermediaries and trusted advisers to perform sourcing, screening and due diligence.
At the other end of the size spectrum, some mega-sized pension funds that would seem to be natural candidates for direct investing are deterred by their mandate or institutional culture.
Even among committed direct investors, the trends lead to a selective approach to direct investing in terms of asset type. As a workshop participant observed, “direct investing is like maintaining a house: you can do certain things yourself but need help for others.”
Case Study: Canada Pension Plan Investment Board – A mega investor
The Canada Pension Plan Investment Board (CPPIB) invests the assets of the Canada Pension Plan not currently needed to pay pension, disability and survivor benefits. It was founded in 1997 as a separate entity. With C$219.1 billion (US$198.1 billion) in assets at the end of 31 March 2014, CPPIB is among the 10 largest retirement funds in the world, allowing it to make large-scale investments. It has both a very long investment time horizon and a very flexible liquidity profile since the pension plan’s contributions are expected to exceed benefits paid until 2022.28
Without a pressing need for liquidity, CPPIB can look at the total risk-adjusted returns available from investments over the longer term. As a result, CPPIB invests a significant proportion of its portfolio in illiquid assets, with C$88.5 billion (US$80 billion) in private and real estate investments as of 31 March 2014. As well as investing in illiquid assets through third parties, CPPIB has become a leading direct investor over the last decade, alongside other large Canadian pension funds, and makes many of its private investments through dedicated business units.
• Funds, Secondaries and Co-Investments, which manages more than C$45 billion in carrying value and unfunded commitments and maintains relationships with more than 80 general partners globally. FSC is a leading investor in private equity funds, engages in co-investments alongside private equity partners and is a large player in the secondary market, acquiring portfolios from other private equity owners.
• Principal Investments, which makes co-sponsorship and lead investments in private transactions globally through three business units: Direct Private Equity, Natural Resources and Private Debt.
• Infrastructure, which invests mainly in brownfield infrastructure assets in core developed markets, but is now increasing exposure to emerging markets, particularly India and in Latin America (Brazil, Peru and Colombia), as well as selective opportunities in Asia. The group is also exploring innovative structures to provide long-term capital to enable early-stage investors in such markets to release and recycle investment from maturing development projects.
These units are then supported by CPPIB’s Portfolio Value Creation team, which is actively involved in the governance and management of CPPIB’s private assets. Recently, the team launched an ESG monitoring process in support of CPPIB’s responsible investment goals.
CPPIB quickly developed its expertise in illiquid and direct investments. Its first commercial real estate fund investment took place in 2002 and its first infrastructure fund commitment was made in 2003, shortly after the organization was founded. From 2009 to 2012, CPPIB participated in the largest or second-largest private equity transactions globally.29
Direct investment models
Of today’s three direct-investing models, solo direct investing is the least common, although it is more prevalent with real estate investing than it is with investing in infrastructure and, especially, private equity. Partnerships are becoming increasingly popular, for instance, as a more standard way to access infrastructure, while private equity partnerships stand out for the diverse combinations of LPs and GPs investing jointly as partners. Co-investing, in particular, has become increasingly common as a strategy for ramping up allocations to private equity, although it is employed across illiquid asset classes. Linkages between each model and key asset management activities are highlighted in Figure 12.
Under solo direct investing, all the important steps of the investment decision and implementation are led by the in-house team, though they may outsource specific tasks to specialists such as lawyers. Solo direct investing sidesteps the need to use asset managers but requires investors to overcome many constraints and make considerable investments in building expertise and resources.
The demands of solo direct investing mean that only a minority of investors adopt the approach, and these typically focus their solo direct investing on particular asset classes where they have built up sufficient knowledge and investing capabilities. It is thus relatively rare to find institutions using solo direct investing in specialist areas such as venture capital and distressed debt.
Partnerships vary in form. An institution may partner with other institutional direct investors or with an asset manager, and partners may make an informal agreement to pursue an asset together or build a more formal multi-deal structure or platform, where expected deal flow is shared across a consortium of investors.
Partnerships mean that investors can help each other source assets and also pool some investment costs, while retaining control over the key investment decisions. However, partnering with another institution also brings considerable practical challenges because partners’ governance, decision making and communication styles are often different, e.g. when gaining internal approval to make an investment.
Some peer-to-peer networks or platforms are now emerging to help “institutionalize” the formation of investment partnerships, e.g. around particular investment themes, a process that may prove important in the future. However, a number of large institutions think that the advantages of partnerships are often outweighed by the downsides. It can require a lot of trial and error to find and develop productive partnerships. Among other factors, it can be difficult to implement a governance structure for a partnership to address what happens if an investment does not perform as expected.
Co-investment is where an asset manager running a fund allows fund investors to also invest directly in the fund’s underlying assets, without paying further asset management fees.
The institution wins the ability to make an additional large investment while also avoiding many of the costs associated with direct investment, e.g. fully developing its own direct-investment team. Co-investment gives investors more control over their investments than traditional delegated investing, such as in terms of choosing the size of their allocation to a particular opportunity.
Compared to traditional delegated investing, co-investment requires an institution to make quick decisions about investing in a specific asset, and the institution must be able to conduct its own secondary due diligence process. During the research conducted for this report, both asset owners and asset managers noted that some asset owners are not fully prepared to participate in co-investment opportunities.
Even so, surveys suggest the majority of institutional investors have co-invested in the past and are actively petitioning for co-investment rights in exchange for committing to a fund.30 Investors say this is their preferred investment approach for a number of reasons, including better returns (Figure 13) — though the belief that co-investments offer high returns is not upheld by recent academic studies.31
For asset managers, offering co-investments enables the manager to deepen relationships with LPs, attract a broader pool of potential investors and consider larger deals. Nonetheless, there are complicated dynamics which both GPs and LPs need to manage through so that both sides benefit. From a GP’s perspective, for instance there is a need to balance the preferences of those investors making the most sizeable commitments with those able to commit only a smaller amount to a fund.