In recent years, several high-profile LPs have begun investing in illiquid assets directly, with many others announcing similar intent. Some have suggested this could represent a long-term threat to GPs, or even the industry as a whole.
The World Economic Forum, in collaboration with consultancy Oliver Wyman, has been researching this trend to try and help LPs with their decision-making. This is not about whether GPs or LPs make better investors; there’s plenty of academic literature on that debate (which is probably best summarised as: “it depends”) . Here, the focus is on the practical considerations involved when setting up a direct investment programme.
ATTRACTIONS OF GOING IT ALONE
Our research found that institutional investors see four major advantages in direct investments.
- It helps LPs to tailor risk-return profiles: LPs can directly assess correlation with their existing portfolio. They can also opportunistically choose assets with a long-term outlook beyond a fund’s lifespan.
- It improves control: LPs remember the financial crisis, where liquidity needs dictated by the denominator effect turned many intermediaries into forced sellers.
- It improves value and alignment: Co-investments in particular are a good way to reduce fees (although most LPs stress that direct investing is not a pure cost avoidance measure; in-house teams are not cheap, and LPs emphasise the benefits from close GP relationships).
- It allows LPs to leverage their unique strengths: Certain LPs might have quicker access to capital, exclusive local networks or privileged views on an asset class (e.g. a medical foundation on healthcare)
WHY IT PAYS TO BE CAUTIOUS
However, before rushing into ‘going it alone’, LPs need to consider a number of constraints – each of which has the potential to derail a direct investing programme. These fall into two major categories.
The first category concerns investment resources and capabilities. Many LPs have very lean structures, and a credible in-house team will skew operational overhead towards relatively small parts of their portfolio (a recent survey suggested that for each deal team member, direct investing requires between 1.5 and 2 supporting staff).
As the fixed cost needs to be amortised over a substantial number of deals, a certain minimum portfolio size is necessary – the keenest direct investors are LPs with assets in excess of $50 billion.
Governance can also be an issue, since a direct in-house team marks a significant departure for many LPs. The board/trustees need to have corresponding expertise, vocabulary and risk management capability – which will often mean attracting board members with new expertise.
Direct teams will need experienced hires, often from GPs – with a commensurate price tag. Some institutions mitigate this by offering other benefits, such as relocation from a financial centre to an employee’s home geography, offering additional responsibilities or emphasising a specific aspect of their investment culture. But in most cases, compensation will be a key constraint.
Equally, the culture of a ‘hot shot’ direct investing team might not sit well with the rest of the organisation, creating challenges for which there are no easy answers.
The second category relates to the LP’s external environment. In particular, an LP’s legal and tax constraints can become critical at a deal level, dramatically increasing complexity relative to a one-off GP master agreement. Regulatory and political considerations will also be magnified, particularly in assets perceived as strategic; local policy-makers might feel more tempted to interfere where there is no GP creating an arms-length relationship.
Direct investing creates reputational risk that can expose and constrain LPs in very significant ways. Beyond the higher visibility of a public LP to pressure groups, consider a scenario where a trade union pension fund co-invests in a toll bridge where the other partners want to curtail unionised labor for cost reasons, for example. Again, there are no easy answers.
What’s more, the LP ‘owns’ performance risk in direct investments, and will need to think about appropriate benchmarks for the in-house team, as well as mitigating eventual non-performance. To address this, many direct investors still maintain intermediated investment pools.
Given the extensive range of constraints, it is no surprise that direct investing is currently pursued by the largest and most sophisticated LPs. It is worth noting (both in principle and when comparing financial performance) that the majority of ‘direct’ deals today – even by pioneers like CPPIB –are co-investments. Setting up full ‘solo’ in-house capabilities will likely remain confined to the largest LPs, or those with a very specific niche capability.
That said, a lot of innovation can be expected in the more collaborative strategies (co-investing, partnership) where the partner is either another LP or, traditionally, a GP. While not completely eliminating all constraints, they mitigate at least some of them. A large number of LPs in the $5 billion to $50 billion AUM bracket might experiment with those models in the future.
Finally, both medium-sized LPs and those with less than $5 billion of assets are likely to evolve their delegated investing models. Using ‘going direct’ as a negotiation alternative, they will crystallise some of the benefits into the delegated approach. One obvious example of this is shifting from traditional close-ended funds to separately-managed accounts or even evergreen funds.
IMPLICATIONS FOR THE INDUSTRY
WEF estimates suggest that some $700 billion of assets currently fall in the ‘direct’ category; that’s a significant pool, but it’s only about 20 percent of today’s private equity assets. For this to grow substantially, a large number of investors would have to change their beliefs or governance models – something that is unlikely to happen overnight.
More likely, direct investing will grow broadly in line with overall allocations to illiquid assets, with no need to contemplate the demise of GPs in the foreseeable future.
However, these trends do obviously put some pressure on GPs. This evolution of models will force them to be more flexible in their offering to LPs – a trend with which everyone who is raising funds today will be familiar. Coupled with research showing reduced persistence of returns (i.e., follow-on funds from a top-quartile firm are not necessarily top-quartile), this will drive GPs into articulating their value proposition in highly tailored terms, far beyond the historic focus on headline returns.
Some will try to avoid this tailoring (with its obvious costs) and look for less demanding capital sources, such as retail flows – although those will have their own regulatory requirements, with associated costs. Platform providers are also likely to gain importance, driven by the demands of LPs for collaborative strategies, the desire of GPs to stay cost-effective, and regulatory demands such as AIFMD.
While it might be tempting to interpret the move towards direct investing as a battle between GPs and LPs, we believe this misses the point. We are witnessing the maturing of an investment ecosystem, with participants seeking to optimise their interactions on specific strategies. Winning models will express this collaboration and complementarity. Upside will be created as assets find better-matched owners, and both intermediaries and capital providers express their relative strengths.
In our view, the major risk lies in players rushing into strategies while ignoring their constraints; this would lead to failed deals, impaired assets and unintended collateral damage.
Michael Drexler is a Senior Director at the World Economic Forum based in New York, where he oversees the community of institutional and private investors.