Alternative investment firms need to adapt or die

Tens of millions of citizens across the world trust their futures to institutional investors. Examples include pension funds that provide retirement income and healthcare expenses, sovereign wealth funds that fund critical infrastructure, and endowments and foundations that provide educational and cultural services. Increasing costs, a global financial crisis, and poor investment returns have undermined the long-term sustainability of many institutional investors.

Many have responded by increasing their investments in alternative investments, which can help diversify portfolios and provide higher returns. Alternative investments include asset classes such as private equity buyouts, venture capital, hedge funds, infrastructure, and private debt. Overall, institutional investors have benefited, but it has come at a cost, as alternative investment funds charge fees that are typically much higher than traditional stock or bond funds.

This arrangement worked for decades, but the process of institutionalization is changing the landscape and with it how institutional investors engage with alternative investments. Four key changes enabled this shift:

• Increased scale: The amount of capital that individual institutional investors allocates to alternative investments has soared in recent years
• Experience: Alternative investments are no longer a mystery to most, as many institutional investors have 10+ years of experience investing in them
• Industry maturity: Over time, leading alternative investment firms have become large financial institutions capable of developing deep and bespoke relationships with institutional investors
• Labour market: Shifts in the labour market have enabled institutional investors to attract and retain world class investment and operational talent

These changes have led institutional investors to move beyond passively allocating capital to alternative investment firms. In recent years, many leading IIs have developed internal investment teams capable of partnering with alternative investment firms on deals or even leading their own deals. The trend is providing them with greater control over their investments and enabling them to reap the benefits of alternative investments without incurring all of the traditional costs.

They are accomplishing this by using four models in particular:

1. Separately managed accounts

The model is a blend of traditional equity or fixed income mandates and alternative investment structures. An institutional investor retains full ownership of the funds in the account and has the right to add or withdraw funds at its discretion. It pays both management and performance fees to an alternative investment firm to oversee and invest the capital, with the institutional investor retaining the ability to replace the firm at will. The result is a model that is more flexible, cost effective, and scalable than the traditional fund investment model and one that does not require developing a large internal investment team.

Notable examples of LP use: OTPP (Canada), PFZQ (Holland), Texas TRS (US)

2. Co-investing

Co-investing involves an institutional investor deploying capital alongside an alternative investment firm. The arrangement allows them to invest capital without paying management or performance fees and provides them with more control over how much capital they invest in a particular industry and geography and when they exit an investment. However, doing so requires an in-house investment team capable of analyzing the investment and working with deal partners.

Notable examples of LP use: ADIA (U.A.E.), CIC (China), CalPERS and CalSTRS (US)

3. Direct investing

Direct investing eschews working with an alternative investment firm entirely, as the institutional investor becomes the investment firm. It avoids paying fees to alternative investors entirely, but it also takes on the responsibility of developing an investment team capable of finding, analyzing, and acquiring entire companies or assets.

Notable examples of LP use: CPPIB and Caisse de depot (Canada), GIC and Temasek (Singapore)

4. Joint-ventures

Joint ventures can be between an institutional investor and an alternative investment firm or two or more institutional investors banding together. Relative to co-investing, a joint venture offers a much greater degree of permanence and flexibility and allows institutional investors them to retain control over an individual investment and the timing of its acquisition and sale. The role that the institutional investor plays can range from leading entire deals to primarily providing capital for a deal and dictates the size and sophistication of an internal investment team needed to support the JV.

Notable examples of LP use: GIC (Singapore), APG (Holland), RDIF (Russia)

Sophisticated institutional investors are leading the way in transforming how they engage with alternative investment firms. By doing so, they are paving a way for other institutional investors to follow that entails lower fees and deeper engagement with alternatives.

New investment models for institutional investors are just one important way that the alternative investment industry is changing. For more discussion of this topic and other mega trends affecting the industry and related stakeholders, we would encourage you to read the full Future of Alternative Investments report.

Author: Jason Rico Saavedra, Project Lead, Private Investors Industry, World Economic Forum

Image: A building (C) owned by Morgan Stanley’s Australian real estate unit Investa Property Group can be seen in central Sydney, Australia, July 28, 2015. REUTERS/David Gray