4. How Will Direct Investing Develop in the Future?:
4.2 Variation around the expected scenario
The following are important factors which could lead to outcomes other than the expected scenario:
• The size of the asset pool available for direct investment
• The constraints faced by direct investors
• Investors’ motivation for direct investment
Specific trends that could impact each of these – either positively or negatively – include economic factors, such as global economic growth rates; changes in institutional risk appetite; new regulation; and the future experience of direct investors. Important interlinkages are summarized in Figure 18. The motivation of institutions to adopt direct investing, for instance, could be undercut by a major blow up of a direct investing strategy, which in turn might prompt tougher regulatory constraints. As this example implies, while the various influences might occur in isolation, it is more likely that they will have a major impact on direct investing to the extent they are interconnected.
Two potential multi-factor scenarios follow – one on the upside, the other on the downside.
Potential upside scenario
In this scenario, direct-investing programmes at major institutions deliver a run of strong returns over the next 10 years while avoiding blow ups, demonstrating that institutions have developed the right culture and governance to manage direct investing.
At the same time, asset-owner returns are vigorously discussed in the press and by politicians, leading to pressure to publish detailed information on the amounts they are charged by external managers.
In parallel, policy-makers create frameworks that increase opportunities for asset owners to invest directly in long-term assets such as infrastructure. A tipping point is reached as the industry comes to believe that:
• Institutions have the collective experience, culture and governance to run large-scale direct investing programmes
• Core investments are too important to delegate, given political and cost pressures
• Direct investing can deliver steady performance and should form a major allocation within any diversified investment portfolio
• Roles within direct-investment programmes are well paid and attractive, enabling recruitment and retention of talented personnel
Under this scenario, the starting point of the size threshold for who can be a direct investor decreases. In turn, over the next 5-10 years, most institutions with over $25 billion in AuM embark on a significant direct-investing programme, albeit focused on a particular geography or asset class. In aggregate, the growth of direct investing increases by about 3-5% per year over underlying asset growth, and direct investing becomes a significant part of the investment industry.
Potential downside scenario
Following multiple failures and disappointments over the next three to five years, the industry recognizes that maintaining a top-class direct-investing team is difficult to get right. Under this scenario, market volatility and regular leadership changes lead institutions to make regular and significant shifts in their asset allocation. Lack of a consistent strategy and related implementation challenges lead direct-investing teams to underperform relative to external managers.
Chief Investment Officers (CIOs) of major asset owners take the view that direct investing is risky, as any underperformance is immediately blamed on their teams, since few have succeeded in educating the broader organization about the nature of direct investing and in building the governance mechanisms needed to work through periods of market tension. Some CIOs gradually wind down their direct investing programmes, while the more successful direct-investing teams are spun off to form independent boutiques, or sold to asset managers along with an asset management contract.
In parallel, following a strong listed asset performance, investment flows toward more liquid asset classes, reducing the impetus for direct investing.
Five to ten years from now, only institutions with over $50 billion in AuM will continue to develop direct investing capabilities, usually focusing on one or two key asset classes such as real estate. Direct investing grows by roughly 2-4% per year below the underlying growth in institutional assets.
These additional scenarios are presented to highlight how some of the variables driving the growth in direct investing are related. Other factors, such as a severe market crisis with specific asset classes or in general, could negatively impact those direct investors unable to withstand performance volatility, while providing potential investment opportunities for those who can. The extent to which individual asset owners or asset managers will be positioned to benefit from this trend will depend on the extent to which they address it directly.