‘Insourcers’ Score One Against ‘Outsourcers’

807208_kangaroo_signThe 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.

This post originally appeared on the Oxford SWF Project website.