Institutional investors making a portfolio allocation to private equity or other alternative assets typically fill the allocation by evaluating fund managers and subscribing capital to selected funds, typically locked in for 10 years. Most LPs also seek preferential co-investment rights, which allow them to invest alongside the main fund.
While it saves on at least some of the management fees and carried interest it would pay in a traditional fund, all of the functions that would be performed by the GP (and, thus, the associated costs) must now be undertaken by the LP – basically, finding, evaluating, acquiring, improving and divesting from companies and projects. The aspiring direct investor will therefore need an in-house investment team comparable to a private equity fund manager.
Attracting and holding on to the right talent is possibly the single biggest challenge for direct investors. The institutions that have succeeded at building high calibre deal teams have generally done it slowly and methodically, starting with separate accounts that are externally-managed or advised, increasing their involvement in co-investments and club deals, and eventually adding specialised capabilities – deal sourcing, valuation, M&A negotiation, operational management. Some of the work can be outsourced to external consulting or advisory firms, but that comes at a cost, which somewhat undermines the ostensible reason for in-house fund management.
The LP also needs to control a large capital base in order to make a direct investment program worthwhile. Otherwise, the size of deals that it can conceivably do is unlikely to justify the costs of hiring and resourcing a management team. This is one reason why it has tended to be the biggest players – major public pension funds like Canada’s CPPIB and sovereign wealth funds like GIC of Singapore – which have blazed the direct investing trail.
Direct investors need deep pockets to meet the substantial operating expenses of a GP-style deal team. The effort and cost of due diligence and valuation are particularly hard to digest when the process does not end in an acquisition, as is frequently the case when investigating and filtering targets. During a typical 5-year investment period, the average GP can expect to review hundreds of potential opportunities. Only a small fraction will ever get to completion. In-house teams also need scale to be cost-effective, whereas many smaller institutions don’t make big enough private equity allocations to make a direct investment program viable.
Governance structures can influence a program’s viability. For instance, pension fund trustees aren’t necessarily geared up to compete with GPs. They may be wary of authorising the substantial up-front outlays needed to hire people away from investment banks or private equity firms, and then back them in the asset markets, with no certainty that future returns will be big enough to justify the time, energy and money invested.
Once a direct acquisition is made, the LP has to fulfil the GP’s role of monitoring its investment and working directly with on-the-ground management to improve performance. Team members with suitable sector-or-region-specific managerial expertise are often crucial to making a success of the supervisory role. Even if it only takes a minority stake, the direct investor would still want (and then need to exercise) customary minority shareholder rights.
A traditional fund is effectively a diversified investment program, and it is the overall return from its selection of funds and GPs on which an LP’s portfolio management team are usually judged internally. In a fund setup, the LPs are largely insulated from reputational and concentration risk if a portfolio company crashes and burns. With direct investing, however, those risks are borne by LPs.
On the upside, direct investments give the investor complete autonomy over the selection of investments and timing of exits, while keeping all of the net profits generated. Direct investors are not locked into a traditional fund’s fixed life cycle, so they can invest for the very long term – what some have labelled “patient capital” – which may be better suited to certain asset classes, like infrastructure. Because they are in control of portfolio construction, direct investors can try to more effectively match assets with long-term liabilities – for example, long-term, income-generating assets like motorway services, logistics and care homes.
Cognisant of institutional investors’ appetite for alternative assets, GPs are coming up with new products catering to investor preferences. Major firms already operate separately managed accounts for their biggest investors. Run independently of the main fund, these can offer some of the benefits of direct investing, without requiring the investor to build its own deal team. Some GPs have also set up permanent capital vehicles and long-life funds with the aim of deploying “patient capital” themselves. Institutional investors can also get exposure to the fund management business itself, by acquiring stakes in listed firms, like KKR.
Big institutional investors who can make an economic case for developing a competitive direct investment program may ultimately spread their exposure to alternatives among conventional funds, GP-led co-investments and direct investing. Other institutions would do better by focusing on fund manager evaluation and negotiating the best possible terms on their allocations.