Managing reputational risk and alternative investment

Written by: Jordan Berger
There is a general consensus that returns from equity markets over the coming years will be materially below recent performance. As a result, institutional investors have been shifting their asset mix towards non-publicly traded asset classes including property, private equity, and infrastructure. The shift in asset mix has been in many cases quite dramatic across pension plans. For example, 57% of Canadian investment managers surveyed by Mercer believe non-traditional investment mandates will increase significantly in 2008.* For alternatives in particular, the size of the fund in question has an impact on how these asset classes can be approached. For example, no matter how large the allocation to alternatives, many institutional investors are simply too small to contemplate introducing internally managed programs and must invest through external managers. As most observers realize, the fee structure of private equity, infrastructure, and real estate funds can be very “generous,” especially when compared to public equities and fixed income. Furthermore, external managers are more difficult to monitor for a variety of reasons. These include the characteristics of the industry, where a lack of transparency is actually a competitive advantage, as well as the lack of incentives for managers to spend a great deal of time and resources on managing their relationship with investors. Here, institutional investors would do well to ensure that they have capable internal staff or external consultants that can draw on global resources to find and negotiate with suitable external managers. On the other hand, sophisticated institutional investors who seek to reduce costs and increase control by building internal staff face many challenges, especially during the initial start-up phase. The stakes are high indeed. For those institutions that try to launch a program internally and fail, their ability to re-enter the market may be compromised for years. It is a challenging situation to manage and as such the number of global top-tier private equity and infrastructure teams employed internally by pension funds numbers in the tens, rather than the hundreds. To successfully launch a program, these funds must attract experienced professionals, who bring with them long-term relationships with general partners and proprietary market knowledge and insights. To keep them, and to exploit and grow the global networks these staff can access, pension plans need robust governance systems that provide potential partners with clarity and confidence in the plan’s ability to deliver on up-front and long-term commitments. This is especially critical for alternatives where large deals can take months to bring to fruition and can involve massive due diligence and opportunity costs. Similarly, for many pension plans, clear governance structures and effective delegation of authority depends on trust; not between the plan and the external world so much as between plan boards and their staff. The nature of alternative investments, with its emphasis on attracting and retaining staff, forces boards to continually review compensation structures and the agency-principal problems these can entail. In general, the amount of time and complexity of decision-making these asset classes require can impose great stress on many, if not all, boards contemplating an allocation to alternatives. To reduce implementation risk, it is critical that boards agree on the objectives surrounding and restrictions defining their alternative investment programs. Private market professionals can be quite flexible regarding their employer/client’s requirements, as long as they are known at the beginning of the investment process. The damage caused by last-minute “surprises” at the board level can be significant. In all cases, institutional investors would do well to understand and take measures to actively manage their “reputational” capital. It is one thing to purchase, either directly or through external managers, shares in a publicly-traded company. It is another thing entirely to purchase, alone or as part of a coalition of investors, an entire company and take it private. In the former situation, controversy over corporate practices, for example, can be dealt with through a robust proxy voting policy. The institution can exercise its ownership rights in a responsible manner by responding to or initiating proxy statements. For private market investments, it is arguably not sufficient to be on the side of a small minority of angels. The acquiring investors are the controlling owner and face the potential for persistent pressure to address controversial decisions. This is surely one of the greatest ironies of these asset classes: private market transactions – which are attractive in large part because of the reduction of transparency involved – create a new category of risk for large institutional investors that are even harder to offload or ignore. In these cases, reputational risk is directly tied to potential returns – an alternative asset investment program that can not depend on a supportive and trusting board faces serious restrictions in its ability to execute transactions and, over the longer term, will have difficulty retaining professional staff. Alternative assets bring with them a level of transparency, at least in regard to ownership, that is not found in public markets, where ownership patterns are more fluid and highly diversified across both time and space. Managing the relationship between reputational risk and investment return is a critical task for any fund investing in or considering investing in alternative assets. One of the potential mechanisms for minimizing the fees paid to external managers and/or reducing the cost of investing in alternatives when internally managed is through collaborating with other institutional investors.** Indeed, leveraging the expertise of institutional investors and global networks and exploring the potential to pool assets could improve the efficiency of allocations to alternatives. Similarly, working collaboratively can help to mitigate the reputational challenges that institutions face in pursuing these asset classes.


* Mercer’s 2008 Fearless Forecast.


Mercer is a leading global provider of investment consulting services, and offers customized guidance at every stage of the investment decision, risk management and investment monitoring process. We have been dedicated to meeting the needs of clients for more than 30 years, and we work with the fiduciaries of pension funds, foundations, endowments and other investors in some 35 countries. We assist with every aspect of institutional investing (and retail portfolios in some geographies), from strategy, structure and implementation to ongoing portfolio management. We create value through our commitment to thought leadership; world-class, independent research; and top-notch consultants with local expertise.