Institutional investment offices face a growing set of operational challenges

Institutional investing is difficult. Investors are deploying trillions of pounds as fiduciaries on behalf of retirement plans, hospital systems hustling to save lives and endowments or foundations fulfilling noble missions. The fiduciary pressure, in and of itself, is extraordinary. Layer on lofty equity valuations, rates at historical extremes, longstanding economic relationships under question and an ever-expanding universe of asset classes and investment vehicles. Institutional investing teams can be hard-pressed to keep up with the technological, data, operating and investing requirements. For the structural reasons noted above, institutional investors may continue to evolve from traditional equity/fixed income portfolios to include larger allocations to non-traditional investments.

Historically low bond yields, equity multiples comparable to the internet boom and a breakdown of accepted macroeconomic relationships have all forced institutional investors to think more broadly about investments. Sophisticated investors are understandably cautious and seek ways to reduce duration, balance credit, identify more sources of return to find alpha and limit ever-expanding beta. Horizon Actuarial Services collects capital market assumptions from Wall Street strategists and plugs them into detailed asset allocation categories that roll up to groupings of 42.5% public equity, 32.5% liquid fixed income and 25% alternatives. In five years, the odds of a plan sponsor meeting a 7% return benchmark dropped from 57% to nearly 45% based on 20-year projections. Said differently, the market landscape has changed so dramatically in five years, the odds of plan sponsor success inverted from nearly 60% to missing the mark well over half of the time. As a result, many plan sponsors will need to lower their hurdle rate or assume additional risk in an effort to achieve their target returns.

Operating complexities

To navigate this fraught landscape, institutional investors have sought greater diversification including considering allocating capital across more flavours of alternative investments. In turn, greater exposure to more alternatives has come with technological, data, operational and investment complexities. Smaller investment offices do not have the scale or resources of much larger institutions. Case in point, the five largest university endowments in the U.S. enjoy investment teams of 50 or more people.¹ Most university endowments ranked 50 to 100 by size try to employ similarly diverse investment strategies but with investment teams in the single digits.

In tandem with this, these investors are adopting new techniques to gauge portfolio exposures across all asset classes (and managers) and need to consider harder-to-measure portfolio risks. Boards are increasingly considering an allocation to alternatives and, crucially, reporting that properly shows aggregate portfolio exposures by country, sector, ESG (environmental, social, and governance) tags and other groupings. They are prudently considering portfolio risks inclusive of all the assets in the portfolio. To do this requires investment in both staff and technology to handle the increased operating requirements.

One of the biggest operational challenges of a portfolio invested across more alternative asset classes is managing the data to drive total portfolio exposure reporting, performance attribution and risk analytics. Custodians provide some clarity for the liquid portion of their accounting book, but for up-to-date illiquid holdings and performance, many institutional investors receive information directly from managers. Manager updates take many forms, from PDFs that may or may not be password-protected to file transfers to investor portals, and there is no standard layout for manager reporting. Some investment offices dedicate a resource to gather reported data, but as the number of line items in the portfolio expands and manager counts and holdings increase, more investors are relying on technology to collect and aggregate data into a centralised data warehouse.

Just because the data has been collected doesn’t mean it is ready for primetime yet. Several measures must be taken to drive accurate reporting and analytics. Files need to be normalised to ensure data from disparate sources has consistent identifiers, the right data fields and uniform nomenclature for descriptive data tags. Custodian data should be reconciled against third-party pricing and valuation sources. Manager data needs to be made consistent, and all holdings need to be enriched with various tags (like country, sector, industry, ESG characteristics), so that analytics engines can roll up the information. Only then can you answer questions such as, how big are the Risk Reduction and Return Enhancement buckets for our portfolio, and what is our asset class exposure within each? What is our exposure to sectors directly impacted by a trade war with China? How might our entire portfolio react to a 200 basis point interest rate shock? If we experienced another exogenous global event — a global pandemic, a global financial crisis, a regional currency crisis — how would our portfolio hold up?

Another operational challenge for investment teams with alternatives exposure is document management and document review. These investors must manage subscription documents, limited partnership agreements and private placement memorandums for each private investment. These documents could be nuanced across the various alternative asset classes, so a generalist or an investor new to an asset class may need to seek outside opinions to appreciate context for each term. Bills can add up quickly if investors lean heavily on outside counsel, but there are ways to minimise billable hours. There are services that will do investment reviews of the terms in each document to point out what is boilerplate language, what has been customised and whether specific terms are within market. This can help investors focus how they use lawyers and keep legal bills in check.

It is crucial for a team to store documents for each investment in a centralised location so they can be easily retrieved for manager reviews, to double-check carry in the case of a liquidity event and to ensure responsiveness to requests from meticulous auditors. Investors share highly sensitive information in legal documents, so some institutional investors may use encrypted transfer and storage container for documents or other secure solutions appropriate for them.

For institutional investors who recently started or plan to start investing in private equity, it is important to create a robust document management process right away. For those already involved, it is always smart to optimise processes. Private equity investing goes through several phases, including the investment period, harvesting and extension. Typically, the first three to five years is when investors receive a series of capital calls to fund investments. The investment period phases into the harvest period, which is when the general partner (GP) works with its portfolio companies in an effort to grow their businesses and ideally exit the investment with a successful liquidity event. The harvest period lasts until the end of the initial fund term, typically 10 years. Following the harvest period, the GP usually has the right to extend the fund for two one-year periods, which affords the GP additional time to exit remaining portfolio companies and dissolve "zombie" companies.

In the midst of these dozen years, that same private equity fund may raise money for three or four additional vehicles. If the manager is performing well, the investor will likely commit capital to each. Moreover, an investor has likely spread capital commitments over multiple managers. Like gremlins, a few additional line items in an institutional portfolio multiply over time, and auditors love to ask pointed questions about “zombie” companies that have lingered on investors’ sheets for a dozen years. Failure to prepare for these requests with a sound document management process could potentially result in more serious queries, turning a routine audit into something much more complicated.

Speaking of fraud, investment committees have a fiduciary obligation to ensure thorough due diligence on outside managers in an effort to avoid Ponzi schemes or other fraudulent practices. Everyone is aware of high profile frauds and blow-ups like Madoff, Amaranth Advisors and Long-Term Capital Management. In private equity, the Abraaj Group misused investors’ funds to pay expenses and send money to some of its executives. The Alternative Investment Manager Association provides numerous DDQ modules so that investors can inform themselves on potential risks and committees can remain informed stewards of capital. Operational due diligence (ODD) for LP investments in private equity funds is catching up to more refined checklists for hedge funds. In 2018, the Institutional Limited Partners Association, which is focused on private equity, issued a revised 29-page Due Diligence Questionnaire. But, a completed DDQ is not a rubber stamp. Diligence starts here. Red flags should be probed and background checks conducted in an effort to avoid ill-fated investments. Diligence continues even after papers are signed via manager reviews and background check monitoring services.

The investment landscape has evolved. Institutional investors have a larger opportunity set of traditional and non-traditional investment vehicles and utilise a broad spectrum of asset classes as fiduciaries in an effort to achieve optimal, risk-adjusted returns. The cost to employ more sophisticated strategies is investing in operating and technological infrastructure. The choice becomes: should you build out your team and systems to customise the capabilities for your unique situation, or buy the operating scale from third-party providers that can cost-effectively offer best-of-breed capabilities to handle your most urgent requirements?

If you would like to discuss your organisation's specific challenges or to find out more about our solutions for investment offices, please contact us. 

¹ "Endowment funds of the 120 degree-granting postsecondary institutions with the largest endowments, by rank order: Fiscal year 2018", The National Center for Education Statistics.

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