‘Insourcers’ Score One Against ‘Outsourcers’

Ashby Monk

The debate among institutional investors over whether to in-source asset management to internal teams or to outsource to external fund managers continues. And the in-sourcers may have just scored a game changer against the outsourcers. To build up your anticipation a little bit on this one, how about some background first? Here’s my take on this debate from a few weeks ago:

“I don’t personally have strong views either way. On the one hand, I can understand why a sophisticated institutional investor, such as the CPPIB, might like to bring assets in house to save on asset management fees, avoid agency issues and better align the interests of portfolio managers with the organization. On the other hand, I can also see the potential pitfalls of trying to run a sophisticated asset management operation in-house and, equally, I have genuine respect for those funds that focus their governance budget on becoming a highly sophisticated, outsourced institutional investor, e.g. the Future Fund.”

In general, the Canadians and the Australians represent the two extremes. The CPPIB has upwards of 87 percent of its assets managed in-house, while the Future Fund appears to be legally required to use external investment managers. As Paul Costello’s “Report from the General Manager” in the Future Fund’s 2009/2010 annual report explains:

“The legislation governing the Future Fund requires the use of external investment managers. While this is likely to result in higher portfolio management costs compared to organisations which elect to manage a proportion of their assets internally, it has the important advantage of keeping the focus firmly on the optimal design of the overall investment program rather than the challenge of building and supporting internal asset management teams.”

And page 38 of the annual report goes on to say:

“The governing legislation requires the use of external investment managers and this is consistent with the Board’s preference to operate a modestly sized organisation with internal resources concentrated on the key issue of determining the most efficient allocation of risk across investment markets. This is complemented by a focus on selecting the most appropriate investment partners and closely monitoring their provision of services as well as tightly managing operational risks.”

They make a good point. And it is perhaps why some have criticized the CPPIB on its aggressive move in-house. Anyway, all this is to say that the Australian Future Fund would be about as improbable a direct investor as one could find anywhere.

So now, finally, the scoop.

The Future Fund has, in the past few months, begun making… [pause for dramatic effect] …direct investments. It has invested directly in UK’s Southern Water, Australia Pacific Airports, and Gatwick Airport. And in case you don’t think these qualify as direct investments, here’s Martin Arnold in the FT about the Gatwick investment:

“The move is one of the first times that the Future Fund has made a big direct investment in a company, rather than indirectly through a private equity fund.”

This is kind of a big deal, as the champion of outsourcing is now managing some of its money in-house. For today’s match, it’s Team in-sourcing: 1, Team outsourcing: 0.

As it turns out, the Future Fund has a bit more freedom than the excerpts from the annual report above suggest. For example, the formal investment policy of the fund says:

“Roles will be undertaken internally where the Board forms the view external suppliers cannot meet the organisation’s specific needs. The quality and cost of an outsourced service are the benchmarks against which these opportunities to build internal capacity will be judged…The Act provides that, in the normal course of business, the Board must not invest fund assets unless it does so through an investment manager engaged by the Board.”

There is clearly enough wiggle room in there for the Future Fund to deploy some of its assets directly. Also, the 09/10 annual report says,

“…we’re prepared to invest through pooled funds, co-investments, separate accounts and individual investments, depending on the merits of each in the particular circumstances.”

So there you have it: The Future Fund is now a direct investor. I have three initial reactions:

1) The direct investments made by the Future Fund fit in with the Fund’s evolving investment strategy. Indeed, the Future Fund’s long-term expectation is to move towards an asset allocation with 25 percent in ‘tangible assets’. The Fund’s last quarterly update showed that the allocation was (in December) only 9.8 percent, so the Future Fund clearly has a long way to go.  We may be seeing quite a few more investments of this nature in the coming months and years.

2) These direct investments were all in infrastructure assets. Of all the asset classes out there, I’m of the view that infrastructure makes the most sense for in-sourcing. I’ve said it before:

“…a SWF investing in a private asset manager that, in turn, invests in infrastructure just seems off to me. Feel free to disabuse me of this position, but won’t the SWF be giving up its main competitive advantages by doing this (i.e. scale and time horizon)? … I feel as though SWFs have a certain strategic advantage in infrastructure investing, but, in order to leverage this, they really need to be investing directly. In turn, this requires upgrading the organization for a complex and risky endeavor. In my view, it’ll be worth it over the long-term…”

Now, I don’t mean to imply that all funds should in-source infrastructure. Let’s be clear, there are some solid arguments against in-sourcing. For example, I recently had a conversation with a third party infrastructure manager with an IRR of 22% over the past 10 years, who told me that for every one deal he did, he had to expend resources doing due diligence on 20. Can public funds expend this level of resources on “nothing”? I’m personally inclined to see this as just a search cost and part of doing business. But, I acknowledge, it would take some serious buy-in at all levels of public funds to do this and get away with it. In short, in-sourcing is only for a select few that have the talent, governance and legitimacy to do these sorts of internal programs correctly.

But if you can do it correctly…and that’s a big if…it makes sense to do it directly. Infrastructure is a natural asset class for direct investing. It’s a way of sidestepping the principal-agent and time inconsistency problems associated with third party mandates in long-term assets (I’ve referred to this as ‘the chain of fools’).

3) In my view, the Future Fund has made a wise move here. No doubt they will continue to work with third party fund managers in infrastructure, but the occasional direct investment will do them some real benefit in the long term.

4 Responses to “‘Insourcers’ Score One Against ‘Outsourcers’”

  1. 1 Will Hetherton March 29, 2011 at 7:04 pm

    Hi Ashby

    I was interested to read your post and think that the following points may be useful in clarifying the position:

    1. Our legislation is clear that investments must be made through investment managers and all investments have investment managers in place, including our investments in Gatwick, APAC and Southern Water. The way we work with our managers varies across these assets depending on the complexity of the asset management task and our internal team has the skills to contribute at that level if deemed the best use of their resource.

    2. It’s always been the case that we expected to make investments through pooled funds, co-investments, separate accounts and individual investments – and equally that we’d do so using external managers as required by the legislation. This means we have the flexibility to use the most appropriate structure to suit our portfolio and the characteristics of the opportunity. So actually there’s been no change in direction or strategy.

    3. One way to think of this is that it provides a sort of hybrid – we get the benefit of leveraging external managers and partners to identify and take advantage of opportunities, but we retain a small skilled team internally to both manage the program (including investments in pooled funds and co-investment and individual investments) as a whole and to provide specific focus, where we wish, on ensuring exposures and assets are managed in alignment with our strategy. This means that we get to invest directly into assets (as well as through pooled vehicles) without the cost and complexity of a large deal team roaming the globe for opportunities.

    4. Just to clarify, note that the extract from our Statement of Investment Policies, relating to “Roles will be undertaken internally where the Board forms the view that external suppliers cannot meet the organisation’s specific needs” doesn’t cover appointment of investment managers (who we after use, as noted above) but does relate to how we use resources in all other facets of the investment program and supporting activity. So, for example, we have built up a meaningful investment strategy team internally because we felt this is a crucial activity that is highly fund context specific and needs to be integrated into all our investment activities. It is therefore not easily outsourced. This internal build is also clearly consistent with our goal of being “a smaller, more focused organisation in which time and resources are focused on the portfolio itself rather than on ancillary activities”. In other areas, we have chosen to outsource, say, payroll services, rather than build that particular capability ourselves.

    5. Also note that the APAC and Southern Water investments weren’t made in the last few months, but in 2008.

    Trust that helps and very happy to discuss further with you.

    Kind regards


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This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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