The Next Frontier: Building Strategic Partnerships in Private Markets

Background

Most institutional investors have turned to private market assets as a source of superior return during the long phase of low/negative interest rates. Private equity, private debt, infrastructure, and real estate is to be found in the portfolios of most large pension funds, insurance companies and sovereign wealth funds. While we agree that private market assets can make a significant positive contribution to the risk/return profile, investing in private markets pose inherent challenges which sets it apart from public market assets.

Over the past 20 years we have observed demand-driven market structures. In many cases, investors struggled to get into these funds. Outstanding sourcing power became the USP of asset managers. This constellation led not only to high fees but also to fee structures which prioritised the pecuniary interests of the asset managers above the interests of their clients, which – in turn – enabled the huge remuneration gap between the managers of public and private market assets. Extensive and complicated contracts enabled expensive lawyers to bill for long hours thus forcing institutional investors to spend a great portion of their governance budgets on private markets. We see many cases where pension funds spend 90% of their fees on 10% of their assets. Naturally, the return expectation net of fees has not always been met. Uncertain and often delayed redemption profiles have triggered liquidity shortfalls in many cases.

Are there alternative routes to investing in private markets?

The question of inhouse investments versus buying investment services from the market has become one of the most fundamental organisational decisions for large investors. In the public sphere, intense competition between service providers has lowered fees to levels where many investors feel that the operational and legal risks to ‘do-it-yourself’ now outweighs the associated cost advantage. The picture differs starkly in the private sphere: The gains of insourcing investment competence in private markets are considerable - but there are no virtues without vices.

The remuneration gap between the typical investment staff of pension funds and managers of, for example, private equity funds is often found to be too disruptive to the internal organisation. Pension funds who prioritise purpose and culture over maximising return may decide against private market investments. Other pension funds decided to operate their private market investments at an arms-length in daughter companies often joining forces with like-minded investors. This constellation enabled running highly professional investment organisations while minimising conflicts of interest.

Evaluation Framework

In our international research project, we identified several international investment platforms owned jointly either by pension funds or their sponsors which are partly also opening up to third party investments. Nevertheless, investors need to be careful in selecting these service providers. In a recent search we conducted for a client, we perhaps surprisingly concluded that our evaluation framework for the investment platform for private market assets closely resembled our ‘normal’ evaluation framework for service providers in general:

1) The most important selection criteria in our view are the strategic and organisational compatibility. This refers to the alignment of investment beliefs and ESG policies as well as a like-minded client base. Also, the service provider must be a good fit capacity wise, i.e. large enough for a large client’s investment needs; and, of course, the diversification regarding asset classes and geographic dispersion must chime with the client’s investment strategy.

2) Second ranks governance where the necessary ingredients are as follows:

• A highly qualified investment organisation based on institutional coherence.
• The ‘right’ people with the required investment knowledge and experience without undue key person risk. • A best-practice investment process centred on strong investment beliefs that are shared and supported throughout the organisation.

3) Thought leadership and innovation, which can be judged on past flagship projects and/or the planned major developments, ensures adaptability to changing markets and leading edge.

4) The lowest ranking selection criteria in our evaluation framework is – and maybe surprisingly so – investment performance and costs. In our view, a sound ‘engine compartment’ which we judge on the first three criteria ensures both good performance and sensible cost structures looking forward as past performance is no guarantee for future performance.

Chart: Evaluation Framework | SP: Service Provider, PM Private Markets

Conclusion

Investing in private markets is for the long-term. This requires building strategic partnerships not conducting a one-off transaction. Strategic and organisational compatibility, governance and thought leadership and innovation are the key criteria for selecting the “right fit”.

How Can Avida Help?

Avida has a solid track record of 20 years’ experience in selecting service providers for large and smaller pension funds throughout the Netherlands, the United Kingdom and Germany. We can help with independent advice when selecting key providers.