Investment thinking has typically focused on how much you can make and how quickly. For institutional investors, however, there’s much more to it than this. To achieve success, fund managers must understand the importance of ‘utility’ in investors’ decision-making.
Matching fund managers with institutional investors and building bridges between investment value and investor outcome requires, above all else, a thorough understanding of investor needs and how they think about portfolio construction. And it begins with one key question: What is the investor’s ‘utility’ in a manager’s investment offering? In the following article, we’ll consider this question from an investment perspective and more broadly.
Utility: A different measure of investment value
Institutional investors tend not to use peers or market benchmarks to judge their success. Rather, success is measured by the ability of each investment in a portfolio to meet the requirements of the asset pool. More concretely, it’s the long- or short-term probability to deliver the cashflows owed to pensioners or through insurance pay-outs; the expenditure requirements of foundations or endowments and their real (or otherwise) capital preservation whilst doing so; the diversification benefits from each investment; and the timeframe. Indeed, there is no point delivering a consistent 15% IRR in 10 years if the asset pool is being dissolved.
An illustrative question for those not familiar with this mindset: Why would anyone buy government bonds that lock in a negative real return over 20 years? Well, if you are hedging 20-year liabilities, the negative return is arguably a reasonable cost for that hedge. And remember that you don’t need to hold to maturity – you can actively manage but with an entirely different investment mentality.
In the minds of pension and insurance CIOs, investment decision-making goes beyond immediate financial returns and is much more about what characteristics an additional investment brings to the existing portfolio, how it helps the thousands of clients that each pool looks after and what the target outcomes look like.
A pension or insurance fund may look at two investments – the first offering modest, regular coupons each quarter for five years; the second offering a significant MOIC on exit after that five-year period – whilst accounting for liabilities to their clients. Some investors would immediately consider the second investment as more attractive, due to the higher return over the same period. But pension or insurance providers, as well as other institutions, don’t have the luxury or flexibility to forego returns in the short-term for a better long-term payoff. Consistent cash flows are often paramount in determining the suitability of investments and meeting liabilities.
Success comes when a manager recognises the importance of utility to such investors, that returns are not as important as alignment of outcomes and, in particular, how their investment approach can be used to solve a problem that other strategies cannot. Investment portfolio construction is a bit like building a house – it’s the totality, not just the genius of the carpenter or kitchen fitter, that matters.
Utility: More than just a number
In today’s market, investors are not just fund-takers; they come with a list of requirements that demand a client solution.
There’s a need to understand the distribution landscape, the different client channels, within which utility takes many forms.
In some cases, utility is driven by regulatory requirements (such as efficient capital treatment under Solvency II, or governance under AIFMD) or tax considerations (such as transparency of a fund vehicle for tax-exempt investors). In other cases, it’s founded in the need to demonstrate a sustainable impact from an ESG perspective, in order to align with principles of stewardship.
Arguably, certain established – and currently thriving – asset classes have their foundations in utility. Private credit has witnessed phenomenal growth in the wake of the the global financial crisis, largely due to bank retrenchment following the application of strict risk capital ratios under Basel III and soon Basel IV. The ability of institutions to apply capital in meeting the needs of borrowers in private markets (whilst achieving stable, long-term income and attractive risk-adjusted returns) has delivered a solution to the growing finance gap.
But we also need to look at changing trends and requirements in particular client channels, such as the wealth segment, which is today regarded as the new frontier and opportunity for many private market managers. For years, the needs of wealth investors have been met through a balance of traditional investments with carefully defined capital appreciation and/or income objectives. However, with the generational transfer of wealth that is taking place globally, the market is experiencing seismic changes, not just in what investors want but also how they want it delivered.
There is a clear theme of wealth management clients demanding greater access to alternatives in a quest for higher returns, diverting capital from traditional equity and fixed income into private markets.
Digital marketplaces and alternative investment solutions are leading this process of democratisation, and fund domiciles are innovating with new structures – such as the Luxembourg ELTIF and UK LTAF – that seek to accommodate (but offer suitable levels of protection for) retail investment in alternative assets.
Technology-driven hyper-personalisation will be essential to engage with and address the evolving expectations of high-potential millennial investors of the future. And these investors will be motivated not just by economic outputs but by their personal values, which will need to be addressed in a more holistic proposition, with impact considerations at the centre.
Firms will need to grapple with adoption of crypto currencies (whether they’re a believer or not), direct equity co-investments, gaming, VR – all in response to this new consumer’s needs, personal interests and, of course, view of ‘utility’.
About Reframe Capital
Reframe Capital is an investment solutions business that supports the growth plans of alternative managers and investors with a suite of advisory and execution services – from business and operational strategy, product development, management and governance to market intelligence, distribution and fundraising. Through a unique range of expertise, tools and resources, the business is able to partner with GPs and LPs in providing direction, driving enterprise value, facilitating growth and overcoming many of the challenges faced by the industry today, supported by a valuable affiliate and service provider network.
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