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Institutional Investors today

Direct investing rethinks operations

The confluence of current financial conditions and increased market competition is driving many of our sovereign wealth and pension fund clients to seek a new range of strategic, direct investments. We see this movement for several reasons:

  • The sustained low interest rates we’ve seen for the past decade show no sign of rising anytime soon. More institutional investors are looking beyond bonds and other fixed income offerings to other asset classes that can deliver better long-term returns.
  • Some underperforming funds are now willing to place their bets on riskier, potentially higher-return prospects to help them make up lost ground.
  • Some funds that moved early into alternatives have amassed the scale, skills and capital they need to make even bigger bets in complex, longer -term infrastructure projects that are beyond the means of smaller players.

As these forces spur funds to rethink investment strategies, we see a general trend towards increased direct investments into assets that require increased internal management expertise, including real estate, infrastructure and private assets of all types, including equity and credit.

For instance, many investors have turned to ever increasing activities in credit markets, taking up some slack from commercial banks hit by regulations restricting their capacity to lend, but also replacing the steady returns that once came from bond yields. Such yield has been replaced in part by similarly reliable returns on loans to businesses (e.g., for real estate and infrastructure), consumers (e.g., for automobiles) and, increasingly, other investors.

For success, these ambitious investment strategies need additional operational support from across the fund’s organization

Front office: As an initial matter, investors need to bring in dealmakers with the skills and knowledge (and commercial relationships) to identify investment prospects and negotiate the right participation, whether through acquisition, co-venture or partnership. While this may seem obvious the importance of attracting skilled dealmakers cannot be overstated.

Many of the most sophisticated institutional investors successfully attract talent from the big banks and private equity funds, but that has not always been the case. Organizations must first develop a positive reputation in the marketplace projecting adequate commitment, sophistication and resources to their investment platform. After a fund’s reputation is established for successfully handling complex investments the ability to attract talent increases drastically. But there is clearly a “chicken or an egg” type challenge to be overcome.

Recently, we’ve seen high-profile hires go the other way, with banks recruiting talent from institutional investors — a sure sign that the market recognizes the expertise and skills which can be developed within leading institutional investors.

Middle office: Of course, upskilling the front office talent is not enough. Once the deal is closed, a middle office with new skills is needed to connect with the dealmakers so the fund can integrate and operationalize the investment. For complex, direct investments, the middle office needs complementary management skills in areas like risk profiling, strategic asset allocation, and strategy development and implementation. New capabilities are also required to monitor and review the risk and performance of portfolio assets, and to access, correlate and analyze data on returns, volatility and other measures.

Governance of the portfolio assets is another key. When a fund takes on a majority controlling interest in a company, the fund needs to provide active stewardship, for example, by taking a seat on the company’s board or other governance responsibilities.

Back office: Complex investments come with a broader spectrum of legal, tax, accounting, reporting and regulatory issues as well. Back office functions need to be upgraded to meet these new demands. As these requirements are increasingly digitalized, enabling technologies can help ensure regulatory compliance. At the same time, enhanced financial and treasury capabilities can facilitate a new range of strategic arrangements.

Even when the fund outsources functions like tax compliance, internal expertise is still needed to ensure third-party service providers are meeting their obligations.

For large institutional investors, building practical management capabilities, dealing with new risks and shifting the culture can’t happen all at once

As described, an organization needs to have in place the right skill sets and commitment to successfully embark upon a direct investment program. Moving too fast can cause internal upsets, harm investments, reduce returns and even damage the fund’s reputation. From what we have seen, those who are meeting the most success with direct investments have taken a measured approach and expand their programs over years.

This means deciding what level of direct participation in assets and how much additional risk the organization can manage today, and understanding the targeted build for the future. Rather than diving into the deep end of complex, long-term infrastructure projects, an investor may prefer to test the waters by focusing on one or two specific asset classes and/or participate as a monitory interest in a consortium deal.

With each investment success, the fund can build its reputation in the market and add to the confidence in its front, middle and back office capabilities, and move up the ladder rung by rung toward more elite opportunities. As experiences build, funds learn from their peers through co-investing, strategic partnerships and other collaborative deals. Many sophisticated funds are willing to share leading practices and lessons learned with their investment partners.

Ultimately, a successful direct investment program comes down to planning and patience. Direct investors must be in a position to insource important decision making and management. Culturally, direct investors must also be able to stand by their decisions and are directly accountable for successes and failures. And that requires investment and confidence that the fund’s capabilities are suitably primed for purpose as its portfolio of investments grow more complex.

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