The focus of this report is on direct investing by institutional investors in illiquid assets, most notably private equity, real estate and infrastructure. Direct investing is not new. Since the late 19th century, some institutions have directly invested in illiquid assets such as real estate. However, interest in direct investing has grown in the wake of the financial crisis, as institutions have searched for ways to increase long-term returns and diversify their portfolios.
In this report, direct investing is defined as investing in which the future asset owner makes the decision to take part in a specific investment, e.g. to invest in a toll road directly as opposed to investing in a fund which invests in a toll road.
The three main ways (models) in which asset owners invest directly are: independently (“solo”), in partnership with other asset owners or an asset manager, or through co-investments.
- Solo direct investing offers the most discretion but is the most demanding model, requiring significant time and resources.
- Partnership direct investing with other asset owners or an asset manager allows investors to share tasks and responsibilities.
- Co-investing with an asset manager alongside a traditional fund investment is the most popular and least demanding model.
The financial crisis of 2007-2009 shook investor confidence, disrupted some long-term investments and strained the flow of information between asset owners and their asset managers. In the aftermath of the crisis, volatile and uncertain returns from traditional investments have encouraged investors to increase allocations to illiquid assets. Indeed, the potential for improved returns, greater control and increased value for money have led many of them to explore the extent to which they could make these investments directly.
Direct investing is often framed around the question of cost. While some large institutions think they can run sophisticated direct-investing teams for similar or lower costs than those incurred when using external managers, very few say their direct-investing programme is primarily a cost-avoidance tactic once indirect costs are taken into account.
There are however key constraints on the adoption of direct investing, above all size and governance. An institution needs to be large enough to afford the cost of the staffing and supporting structure needed for making direct investments and have a governance framework robust enough to manage the downside risks of direct investing, e.g. around investment performance and reputation management.
The report features three broad trends in direct investing today, in terms of size, investing maturity and asset type. The greatest commitment to direct investing, including solo direct investing, is seen amongst the largest investors (those with over $50 billion in assets). Institutions closer to $25 billion in assets tend to rely more on co-investing, while smaller institutions with under $5 billion in assets typically use asset managers for all of their investing. Alongside size, investing maturity is important because most institutions (other than life insurers) begin by investing through asset managers and then move parts of the investment process in-house for selected assets as they gain expertise. Asset type is also important because the complexity of investing varies by both broad asset class (e.g. real estate compared to private equity) and type of deal (e.g. mature infrastructure versus to-be-built infrastructure).
Based on estimates of total institutional assets under management and allocations to illiquid assets by sector, and then filtering for size of institutions, governance structures and motivation to invest directly, we estimate that there are approximately $700 billion of directly invested institutional assets. However the report also concludes that the most important switching by institutions into direct investing has already happened. While there may be growth in the supply side, for example, in public infrastructure funding requirements, this does not drive an increase in capacity for direct investing per se.
This means that although direct investing will grow steadily in absolute terms, it is not expected to become the dominant institutional model. Institutions that manage almost all their assets internally will remain exceptional. However, institutions with more flexible long-term mandates such as multi-generational sovereign wealth funds may shift further towards direct investing. Overall, however, direct investing is expected to grow only slightly ahead of overall institutional asset growth over the near to medium term. More broadly, the evolution in direct investing is also likely to influence approaches to delegated investing in illiquid investments.
In terms of direct-investing models, co-investment will likely remain the most popular model of direct investing in private equity. However, each asset class is likely to develop distinct structures that allow investors to select a specific level of involvement in each deal. Partnerships in various forms are expected to become more common, and may increasingly focus on particular investment styles, regions and asset classes.
There is strong evidence that direct investment is here to stay. However, institutions looking to invest directly must consider whether they have the commitment and scale to overcome the constraints, including whether they can implement the governance structures required to be successful. They should make an honest assessment of whether (and where) direct investing plays to their strengths. Meanwhile, asset managers need to consider how to position themselves in the investment value chain in an era that will favour well-defined positioning – whether to be a large-scale generalist, a specialist focused on particular asset types or a service provider to direct investors.
Direct investing also has wider implications for the global economy because it encourages institutions to invest for the long term and, as such, has potentially important stabilizing and counter-cyclical effects on capital markets. Direct investment may also be an important source of capital in particular sectors such as infrastructure. Many of the largest direct investors seek to invest outside the country in which they are based. In turn, policy-makers looking to attract direct investments in companies, infrastructure and real estate need to evaluate and potentially enhance their frameworks for enabling cross-border investments. It is recommended that they distinguish between ownership of an asset and control; that they develop an investment environment and capital market conducive to direct investing; and, when assessing specific direct investments, that they focus on the transaction’s economic substance. This discussion is complemented with additional recommendations on attracting capital for infrastructure.