Over the past few years, there has been a growing chorus of institutional investors voicing their frustration with the misalignment of interests and high fees associated with third party mandates. Given the sub-par performance of many third party funds over the past decade, it’s easy to understand why investors are frustrated. But I’m less interested in the complaining and performance than I am in the changing behavior of institutional investors in response to these lackluster performances ... because a lot is changing.
Indeed, the frustration of many LPs seems to have kicked off a trend to (try to) bring assets in-house. In effect, institutional investors, tired of costly outsourcing, are attempting to determine and assure their own destiny by taking end-to-end control over the investment of certain components of their portfolios. It’s everywhere I turn; funds are trying to create internal markets for services that can replace or at least compete with the external markets.
But while I’m sympathetic to the plight and frustration of many of these would-be-in-sourcers, there is a problem: It’s incredibly hard to be a successful direct investor. The governance and management hurdles are extremely high. And given that governance and management standards are in question at many pensions and sovereigns, this means that some funds will be successful with their in-house programs, and others most certainly will not.
But, dear readers, this is where things start to get really interesting. (Reader: Way to bury the lead, Ashby. Me: Take your Ritalin and read on!)
Some of the more successful ‘direct institutional investors’ are now accepting (or considering accepting) asset management mandates from peers. That’s right, public pension and sovereign funds are, today, managing money for other public pensions and sovereign funds. Why?
Here’s an analogy: Certain institutional investors have spent the time, money and resources to build the investment equivalent of a sports car. Remarkably, this sports car can compete with the private sector’s sports car and, perhaps, even beat the private sector in certain illiquid and long-term assets, such as infrastructure, timberland, real estate, agriculture and some private equity investments. However, after building this sports car – which was really expensive by the way – the public investors have come to realize that they may not have enough gas to keep it running (or at least running efficiently). So these investors have decided to go out and find other investors (with plenty of gas money) who might like to ride in their sports car with them. As such, the investors with the sports cars take on a few additional passengers to make sure there’s enough gas in the tank. That’s the idea, and everybody is happy driving along in the sports car.
Confused? Sorry. How about two real world examples of this evolution from LP to GP to clarify:
OMERS: In 2009, the Ontario Municipal Employers Retirement System was given legislative authority to set up a new entity, OMERS Investment Management, that would explicitly manage assets on behalf of “eligible clients” (which includes other institutional investors, domestic and foreign). The fund has a strategic vision to progressively move assets from external fund managers to internal investment teams with a goal to have 90 percent of total assets directly managed by the end of 2012. In order to achieve this, OMERS has decided that it must expand its capital base to keep its internal programs resourced and staffed.
QIC: The Queensland Investment Corporation‘s first non-governmental client was signed up in 1996, and its first foreign client was accepted in 2002. The fund was originally set up in 1989 as a government owned corporation, but it has since grown to have roughly 90 clients with over $60 billion in AUM. Similar to OMERS, QIC manages most of its assets in house.
So I think you understand the motivation for why LPs would transition into GPs. But the more pressing question is perhaps why a pension would give its money over to another pension to manage? Fair point. While this may not make sense for all asset classes, it surely would make sense for some of the long-term, illiquid assets where it can be extremely rare to find a third party fund for which the interests of the GP and LP are fully aligned. And yet, one pension giving another pension money would seem to get pretty darn close to a full alignment of interests (time horizon, liabilities, etc.). Moreover, the motivation of the funds taking on third party money does not seem to be (at least explicitly) fee revenue. Rather, the funds seem to want to scale their operations in order to manage a growing percentage of assets in house (which requires having enough assets to warrant the internal costs and to be able to participate in large transactions). As such, scale (not fees) seems to be the primary motivator, which means LPs in these vehicles will probably receive considerable value for money.
It’s all very interesting – and rather compelling – but I wouldn’t be doing my job if I didn’t flag up a few areas of concern. For example, public investors are embedded in the political geography of the sponsoring authority, which could create some problems, or at least risks, with respect to long-term operations and strategy. With a third party asset manager in the private sector, you know they’re there to make money. That’s why they exist! And that’s comforting. With a public investor, they’re there to serve the sponsor’s needs (e.g., pay pensions or manage government wealth). Would the sponsor’s needs change after an election? Probably not. But it is possible.
Anyway, I’ll be really fascinated to see how all this develops over the coming years. The breadth of the systems and services offered by the “platform entity” may be robust beyond what a private entity could evolve because the platform entity gets to solve a much broader range of issues and they can then offer those solutions back to their client funds at a discount...making it better for all. This is definitely a space we need to watch...
