5.1 For asset owners
Institutional investors face a choice over whether to develop or expand their direct-investing capabilities and, if so, which direct-investing model to adopt. In light of the constraints noted earlier in the report, boards and management need to consider a series of critical issues associated with direct investing, in particular the following:
• Commitment: Institutions need to consider whether they are able to make a long-term commitment to direct investing on a meaningful scale in specific asset classes, particularly in the case of solo direct investing. Substantive commitments enable institutions to attract talent and build the tools, processes and culture that are essential to overcome key constraints.
A significant commitment is likely to be highly visible inside and outside the institution and grab the attention of others in the investment eco-system such as potential investees and specialized investment professionals. However, commitment has its downside. A change in asset allocation or investment viewpoint might turn the new in-house capability into an unacceptable burden. This loss of flexibility must be justified in terms of the scale of potential gains.
• Governance: Senior internal stakeholders need to build a common view about the ongoing goals and risks of the direct-investing programme, e.g. in terms of control over investment decisions, the investment time horizon, flexibility and costs. They need to be clear about how major decisions – those both routine and addressed under stress – will be made and implemented. More specifically, they will need governance processes in place to address the new risks which the institution would be taking on as a direct investor:
— Performance risks: The institution needs to consider how to react in situations where it can no longer ascribe under-performance to an asset manager, and eventually switch to another manager. Furthermore, the question of when to look for a new investment team or pull the plug altogether on a specific strategy needs to be addressed.
— Operational risks: Above all, institutions need to have a framework, from the board level down for assessing and managing operational challenges associated with in-house investment management. They need to develop the policies, procedures and controls to support this.
— Reputational risks: Under a direct-investment approach, institutions become far more exposed to the impact of public opinion as the press, lobbyists and interest groups quickly highlight perceived issues. Institutions need to be prepared to respond constructively to these challenges.
• Talent management and infrastructure: The institution needs to ensure it has the right level of operational knowledge, experience and infrastructure to deal with the challenges associated with making and managing direct investments. Institutions embarking on direct investing for the first time will likely face gaps, which they will need to identify and mend, particularly in terms of developing the talent in their internal teams, e.g. around recruitment, compensation, career development and training.
• Competitive advantage: Institutions need to make an honest assessment of how direct investing will play to their strengths relative to investing through external asset managers. For example, the institution may feel it has better access to some investment opportunities in certain markets, or it may have built up the skills to select or manage investments in particular asset types. In turn, this will help the institution to build a shared view of where external specialist service providers should be used to support or supplement the direct-investing programme. It is also worth considering the reverse point – to define where the institution’s current or prospective asset managers can add the most value.
• Communication: First, despite being long-term investors, asset owners are likely to face short-term pressures on performance. As direct investors, they will be held to account even more closely than if their assets were managed by an external party. In turn, asset owners will have to build their capabilities in communicating their near-, medium- and long-term strategy to those on whose behalf the fund is managed, the press, domestic policy-makers and the public at large. Second, institutions should engage in brand building as long-term investors through interactions with potential counterparties and governments to foster understanding of their investment priorities as well as to help generate sufficient deal flow.