4. How Will Direct Investing Develop in the Future?:
4.1 The expected scenario
Our research indicates that the most significant switching by institutions into direct investing has already happened. In turn, the key driver for growth in direct investing is expected to be the increase in size of the pool of institutional assets over the next five years and beyond.
There will be offsetting factors as well. For instance, the pool of potential assets in which investors could invest directly is likely to increase. With infrastructure, for instance, there is a strong possibility that governments will create scalable project pipelines and improve investment frameworks, leading to increased opportunities for asset owners to invest in them. However, the constraints on direct investing at most institutions will continue to impact their ability to invest directly.
On balance, it is estimated that the net effect will be growth in directly invested assets slightly above the underlying growth in institutional assets over the near to medium term. Although direct investing would grow in absolute terms under this scenario, it is not expected to become the dominant institutional model. In response, asset managers will continue to improve and tailor their offering to institutions and, in some instances, broaden their product lines to target retail investors as well.
Market size and segment behaviour
Although we do not expect a major shift toward direct investing across institutions as a whole, there are some exceptions in terms of specific industry segments. An overview of global institutional assets under management by industry segment follows in Figure 16. We anticipate for instance, that sovereign wealth funds will likely grow in confidence and their investment capabilities will mature, increasing the likelihood that they will shift towards direct investing. Additionally, we anticipate that strong growth in insurance assets in the Asia-Pacific region, and rising allocations to illiquid assets, may support more direct investing, although the sector’s allocation to illiquid investments is currently relatively low.
• Defined benefit pensions33 in developed countries are maturing and will have to increase the amount they pay out, while the shift to defined contribution pensions continues. Many funds will find it difficult to overcome the governance and compensation restrictions that constrain them from direct investing, though the motivation to repair funding gaps may counteract this in some cases.
• Insurers are likely to invest more in illiquid assets as global wealth increases. However, their asset allocation to illiquid assets remains relatively low, and only the largest insurers have the capabilities necessary to invest directly.
• Sovereign wealth funds are likely to continue to grow quickly in terms of assets, as more countries create funds to benefit from wealth in natural resources, and increasing sophistication and experience will lead existing funds to experiment with various direct-investing models. Nevertheless, national sensitivities often constrain sovereign wealth funds from taking direct stakes in key foreign assets, and their domestic political environment can spur changes in investment strategy and appetite for direct investing.
• Family offices are likely to increase the amount they invest in illiquid assets, and while some are highly motivated to invest directly, they need to ensure that returns match the additional operational expenses of direct investments. The small size of many of these entities will prevent most from undertaking direct investing on a significant scale. However, multi-family offices are likely to have the scale to invest directly more readily.
• Endowments and foundations will likely continue to display varying appetites for direct investment; our view is that many of the leading large institutions will continue to invest through asset managers rather than developing in-house capabilities.
We anticipate the following developments in key asset classes:
• Real estate: Large institutions will continue to conduct equity-based deals in major markets. Insurance and pension funds will continue to make the majority of their investments in core real estate, while sovereign wealth funds will make a broad range of investments across the sector, but will continue to attract disproportionate attention when investing in high-profile assets in major centres. Leading institutions will build diversified portfolios of real estate assets across all real estate risk segments and geographies. For smaller institutions real estate will continue to be the gateway asset class into direct investments.
• Infrastructure: Our view is that the first wave of investment into the infrastructure asset class has already occurred, so future activity will focus as much on reinvestment following exits as on new investment flows. Based on their experiences to date, institutions have become more sophisticated and think about their allocations to infrastructure across multiple dimensions, including equity/debt, brownfield/greenfield and developed/emerging market. Large institutions will continue to focus much of their infrastructure asset allocation on brownfield developed-market equity deals, effectively as a less-correlated fixed-income substitute. At the same time, increases in institutional investment in infrastructure debt are expected, both for liability-matching purposes and to fill the gap left by banks that continue to restrict lending based on tight balance sheets. Select institutions will invest directly across the capital structure. Depending on how institutions approach opportunities for accessing infrastructure across the risk/return spectrum, some institutions will also explore riskier infrastructure developments, e.g. clean energy development projects.
• Private equity: The largest institutions are increasingly likely to develop private equity capabilities, with teams focused on developing internal capabilities to source deals more broadly. Leaders may develop in-house “value creation” teams to add value to portfolio companies, or may choose partnership and co-investment routes to obtain external value creation expertise.
Institutions such as insurers, sovereign wealth funds and a few of the largest pension funds will be able to play a far greater role in funding debt transactions directly, based on availability of lower-cost long-term funding compared with banks under current regulations. As a result, it is expected that institutions will develop partnerships with banks and investment houses to enable “renting” of their balance sheets.34
Geographically, when assessing the differences by asset class, direct investing will likely be more prominent in developed markets, with some variation by asset class since a larger proportion of institutional capital is focused on developed markets relative to emerging markets.
However, there will be some impact in areas where attractive demographics enable investments with potential for long-term growth. Real estate direct investment is likely to have a larger impact than other classes because it is more mature and straightforward relative to other asset illiquid classes, while direct investment into significant emerging and frontier market infrastructure projects will continue. In contrast, impact on emerging and frontier market private equity will be limited; here large institutions will rely on global asset managers or local specialists for advice.
The emerging alternative sector will remain largely intermediated, with the impact of direct investments confined to developed markets because these will develop the fastest and offer reasonable scale. Here the scale of the opportunity is dependent on institutions driving industry and regulatory change to overcome the sector’s challenges as highlighted in the following example concerning infrastructure debt.
Case Study: Swiss Re – Supporting infrastructure debt market development
The need for long-term funding over the next several decades is significant. For infrastructure alone, global annual spending requirements are estimated to increase from $2.6 trillion to around $4 trillion by 2030, generating a cumulative infrastructure financing need of $60 trillion through 2030. Securing the funding for this type of investment is crucial for economic growth and financial market stability and, thus of keen interest to policy-makers.
One key issue is the lack of a transparent, harmonized set of financial market instruments that would allow institutional investors to access the infrastructure asset class. Bank loans remain the predominant instrument for institutional investors investing in infrastructure. Infrastructure loans meet many institutional investor needs: regular cash flows, attractive risk-adjusted yields, and high credit quality relative to comparable loan or corporate bond classes. However, current infrastructure finance deals are complex, and the secondary market remains almost non-existent. Also, long-term investors must have the ability to make adjustments to their portfolios as required.
Swiss Re has proposed the development of a transparent, harmonised and accessible infrastructure global project bond market to increase both the supply and the liquidity of infrastructure debt as an investable asset class. Besides benefiting economic growth and financial market stability, this would help those investors oriented towards matching assets to liabilities by increasing the pool of investable longer-term assets.
Specifically, Swiss Re has proposed a joint private/public market initiative, leveraging the role of multilateral development banks (MDBs) and, in Europe, leveraging the European Union-European Investment Bank Project Bond Initiative. Elements of the Swiss Re initiative include the pooling of infrastructure projects and the setting up of insurance facilities to increase MDBs’ lending capacity. This private/public-enabled asset type would feature a set of desirable characteristics, such as a marketable infrastructure asset class, potentially lower regulatory capital charges, and best-practice standards set by the MDBs to facilitate a global passport for investments in this asset class.
In addition, the initiative would include an institutionalized risk transformation element with the (re-)insurance industry providing a facility to MDBs for risk coverage.35
Future direct-investing models
Under the expected scenario, the drivers for direct investing are strong for many institutions but their managers are held back by constraints that will not prove temporary or easy to overcome, particularly with regard to solo direct investing.
This will most likely lead to an evolution in the types of investment structures provided by asset managers, as well as to an evolution in the structures used to make direct investments.
Traditional delegated investing
The traditional model of investing via an asset manager’s fund is evolving to offer a wider range of choices that deliver some of the benefits of direct investing to investors that do not wish to develop direct investing capabilities in a particular asset class.
Two of these choices exist already as mainstream models but are likely to become even more important:
• Separately managed accounts (SMAs): SMAs have already made inroads into the asset management market because they offer institutions a way of enhancing transparency while delegating the sourcing and management of the assets to the asset manager. The manager has discretion over which assets to purchase, but SMAs offer significant control and transparency advantages over traditional fund investing; the investor can see at a glance which assets it owns, and may be able to influence the asset selection and the timing of the exit. In addition, large institutions are particularly able to negotiate relatively low fees compared with fund investments in exchange for committing large amounts of capital over the long term. SMAs are a particularly significant development in the private equity market, where many investors already say they are considering applying the approach, following the lead of the Texas Teachers’ Retirement System and New Jersey Division of Investment, which opened multibillion-dollar SMAs in late 2011.36
• Seeding asset managers: Here institutions seek out the most talented start-up fund managers and offer them the capital they need to launch new firms in return for preferential treatment. APG, for instance, has run what it calls an “IMQubator” since 2009, which “aims to incubate the next generation of investment managers.”37 The institution may gain lower fees and can steer contractual arrangements in the right direction, e.g. in terms of transparency, as well as helping funds emerge that focus on investment types and time horizons that suit its interests. The approach can help ease an institution’s reliance on established top performers, but brings new challenges in terms of spotting rising stars and renegotiating when the manager becomes established.
In addition to growth in SMAs and seeding, we expect some more limited growth in a range of models that can be seen occasionally in the market today but that may develop further over the next few years:
• Non-discretionary mandates: Unlike SMAs, non-discretionary mandates allow institutions to retain key investment decisions over each asset while outsourcing resource-intensive tasks to the asset manager such as due diligence and day-to-day asset management. The institution gains much of the control associated with direct investing while, in return for a fee, sidestep the time-consuming chores.
• Evergreen funds: These funds have no end date by which the manager needs to realize gains, unlike traditional funds, and thus are attractive to investors keen on having exposure to long-horizon assets such as infrastructure, without facing the expiration of a fund’s life. An asset manager can focus on creating value through sourcing and managing assets, however, the approach creates different complexities in terms of valuation, management continuity and managing a very long-term asset manager relationship. Evergreen funds should continue as an important but niche investing model. For example, IFM Investors is a uniquely structured asset manager with A$53 billion (US$46.3 billion) AuM as of 30 September 2014. It is owned by 30 pension funds and cites this ownership structure as enabling it to invest over the long term without conflicts of interest. Its infrastructure funds are structured as open-end funds, thus avoiding set maturity dates.
• Stakes in asset managers and asset purchases: Over the past few years, some institutions have bought stakes in asset managers as a way to improve alignment of interests, gain additional control and learn from the asset manager. More recently, some institutions have begun providing exit capital to existing funds towards the end of their life as a way of acquiring a ready-made portfolio of high-quality, long-term investments.38
Co-investing is expected to remain the most popular form of direct investing, particularly with regard to private equity. The demand for traditional co-investments is expected to continue to increase in the near to medium term, constrained by the supply of co-investment opportunities available and the extent to which LPs develop expertise and formalize processes to respond quickly to co-investment opportunities. Over the medium term, demand is likely to increase (or decrease) based on the specific investment results LPs see from their co-investing.
Alongside traditional co-investing, a greater variety of approaches, allowing institutions to tailor their involvement and level of control over their investments, have become more common and it is expected that this trend will continue. LPs, for instance, are helping to underwrite deals alongside GPs, becoming actively involved in due diligence during the development of a deal.
The evolving co-investing relationship provides positive opportunities for both sides. Asset owners gain access to a broader set of investment opportunities, reduced fees and experience in specific asset classes. Asset managers have the opportunity to deepen their relationship with their LPs, which can build trust and, ultimately, a broader relationship with the firm. But the dynamics are complicated. For instance, as noted previously, deepening a relationship with a subset of LPs having preferential access to co-investments risks impacting relationships with LPs (or potential LPs) that have less preferential access.
The need for co-investors to respond rapidly to potential opportunities is likely to increase in line with increased involvement in the process and control over their decisions. At present, 58% of GPs believe that offering co-investment rights to LPs slows the deal process.39 While this may be weighted to the views of those reticent to offer more co-investments rather than the experience of those who have a very active programme, to the extent that the deal process did slow down and the performance of the underlying fund over time were impacted, this would be worth noting.
Investment partnerships between institutions have already emerged as one way to conduct direct investing and are likely to become more common. Typical partnership arrangements are deal-specific. Considerable energy is required to align partners’ interests and iron out myriad issues given differences in scale, investment and control objectives. Thus, institutions will try to develop more lasting and “institutionalized” structures via joint ventures and platforms.
While an attempt had been made to provide reasonably precise definitions of each model, the industry uses these terms somewhat interchangeably, so the key here is the concept behind each structure.
• Joint ventures: These are permanent legal partnerships, based around a vehicle set up by asset owners with asset managers or other asset owners for the purpose of investing in deals on an ongoing basis. The use of a legally separate entity has major advantages in overcoming some institutional constraints, such as flexibility in offering the right packages to talent. Institutions will often be able to invest much larger sums through a joint venture than would be possible through an investment fund. At the same time, setting up a joint venture involves tackling a wide range of governance issues that require significant management time and attention. This structure will probably appeal to investors in the $10 billion-50 billion AuM range, but the number of joint ventures that prosper over the long term is likely to remain small.
• Platforms: Platforms can be thought of as a longer-term partnership or less-structured joint venture, where multiple investors create an “investment club” or semi-structured collaboration model to originate, execute and then manage investments. Benefits include a greater information flow to participants, access to a broader set of opportunities and the ability to compete for larger deals. Platforms differ from joint ventures in that the collaboration model is less formal, and platforms do not require participants to agree on each investment decision. Some partnership platforms already exist,40 and more may emerge to focus on particular investment styles, regions and asset classes. Examples include the transactions led by the Canada Pension Plan Investment Board to acquire and then syndicate 40% of the 407 Express Toll Route in Toronto to other institutional investors.41 We expect that this type of platform arrangement will become more common in the future.
• Asset owners investing on behalf of other asset owners: Institutions that have spent heavily to build their own direct-investment infrastructure are sometimes in a position to open up these capabilities to other investors by becoming both an operational partner and, in a sense, a special type of asset manager. OMERS and TIAA-CREF, for instance, have been active in this space. Some institutions are doing this because it leverages the largely fixed costs of their investment team, enabling them to scale up still further. Some potential client institutions see the approach as a way to access a high-quality investment team, familiar with institutional concerns, at a fair price. However, there are often substantial concerns about conflicts of interest and governance, should the “asset manager” prioritize its own interests in deals or abuse confidentiality, so safeguards need to be built in to protect the client’s interests. Moving from serving a single client to serving multiple clients can be complex and time-consuming, since almost all functions within the business are affected.
Case Study: how partnerships open emerging markets for the Caisse’s real estate arm
Ivanhoé Cambridge, the Caisse de dépôt et placement du Québec’s real estate subsidiary, has been turning to emerging markets as it seeks new opportunities outside of its traditional markets. But even for a global investor, operator and developer such as Ivanhoé Cambridge — with about one-tenth of the Caisse’s C$214.7 billion (US$201.2 billion)in net assets — it can be challenging to manage risk in emerging markets. This is why Ivanhoé Cambridge consistently teams up with a local operating company with a strong track record to develop its presence through partners that have an in-depth knowledge of the region.
Ivanhoé Cambridge made its first big platform investment in Brazil in 2006 in partnership with the Carvalho family. Their joint venture, Ancar Ivanhoe, has made $1.5 billion worth of investments so far in this market characterized by a rapidly growing middle class. Ancar Ivanhoe now owns and operates 16 shopping centres.
It also manages five additional centres owned by third parties, capitalizing on its in-house expertise to generate other sources of revenue. Ivanhoé Cambridge believes its success in this challenging market is largely attributable to its partnership model, which can provide the flexibility to invest in new projects or properties through a structure or a level of commitment that can differ from the original partnership.
Ivanhoé Cambridge has built on its Brazilian experience to gain a foothold in other growth markets. In 2013, it partnered with TPG to acquire P3 Logistic Parks for close to $1 billion. Based in Prague, P3 is an operating company that specializes in supply-chain types of warehouses in key Central and Eastern European countries. After the initial equity investment, P3 concluded a series of acquisitions in Italy, Romania, Poland and the Czech Republic, doubling the size of the company’s assets in less than one year.
Ivanhoé Cambridge also took a similar approach in Mexico. In 2014, it partnered with Denver (USA)-based Black Creek Group to invest $500 million through its MIRA platform in Mexico, targeting key Mexican cities to develop mixed-use urban communities. Black Creek and MIRA’s local team have extensive experience and a proven track record in the country’s real estate market.
The company has already committed more than $100 million to its first project in suburban Mexico City.
Response of asset managers
Since we expect the growth of direct investing to mirror that of the broader institutional market, we do not think that direct investment poses a threat to the existence of managers of illiquid assets. However, asset managers will need to further tailor their offering to institutions and demonstrate more clearly how they add value, following the lead of the largest players.
• New product and partnership offerings: KKR, Apollo Group and Blackstone, for instance, have recently offered separate accounts for significant institutional investments for key LPs wishing to leverage their multi-product offering and also benefit from lowered fee structures.
• Position in the value chain: Asset managers are now diversifying how they cover the investment value chain. For instance, some managers offer specific client propositions including discretionary and non-discretionary accounts, as well as analytics packages which can be used by asset managers, fund of fund managers and end clients.42
• Diversification: Several firms have been exploring ways to diversify their investor base, in part by attracting capital from retail investors. Carlyle, for instance, has diversified to offer its services to retail and private client investors, while Blackstone has also begun looking to attract retail investors, initially via a hedge fund of fund offering.
• Transition to permanent capital: Rather than focusing on raising capital and liquidating funds, firms such as KKR have gone public and then, recently, have hinted that they will grow their balance sheets and move towards permanently funding investment vehicles. On the one hand, this will better align interests with long-term investors, but others fear that going public will subject the firm to short-term profitability pressures.