Private investors have been investing in real assets for a very long time. Agriculture, real estate, infrastructure and even shipping investments have been common for 1,000 years or more. In fact, the term “carried interest” can be traced back hundreds of years to a time when investors backed ship’s captains to go out and acquire goods and would then compensate the captains with an “interest” in whatever they managed to “carry” back to their home port.
Take the Stone Bridge, which was the first permanent bridge across the Danube, as an example of an early real asset investment. It was sponsored by merchants from Regensburg and financed by local bankers in the 1100s. The idea was to boost commercial activity in Regensburg via a more solid and permanent bridge than the existing wooden bridge, which is why it was privately financed. The stone bridge was, by all accounts, a big success: It was quickly paid off by bridge tolls and is still being maintained and used to cross the river today.
We often talk about these so-called real assets as if they are niche or exotic. If anything, agriculture, real estate, timberland, infrastructure, shipping and the like are more traditional than stocks and bonds. The truth is, there’s nothing alternative about real assets; this is the way we as a society have been investing for millennia. In my view, real assets are akin to organic food — or, as your grandparents called it, food.
And, like organic food, investors can get some meaningful health benefits for their portfolios by putting some real assets back into their diet — especially if they can swap them for the more processed abstractions most investors are asked to consume by Wall Street. In theory, real assets can provide downside protection, inflation hedging, uncorrelated returns and, in some cases, monopolistic characteristics that can help long-term investors achieve their return objectives.
For me, however, the appeal of real assets has less to do with the unique characteristics of the assets (which I do recognize are appealing) and more to do with the competitive advantages that the “giants” tend to enjoy over the real asset market (which most people do not, in fact, appreciate). As I see it, real assets offer a rare opportunity for long-term, deep-pocketed, often public investors to outcompete private investors for assets that are themselves long term, capital intensive and often public in nature. As I will explain, I think this advantage offers a unique opportunity for asset owners to change the way they operate. Anyway, I can see several reasons why giants can outperform the broader market in the domain of real assets:
Time. Most real assets have return profiles that can extend for decades, which can be a problem for a third-party manager. It isn’t necessarily a problem, however, for those giants with intergenerational objectives, such as family offices, sovereign wealth funds, endowments and even pensions.
Scale. Most real assets demand large check sizes, especially infrastructure, agriculture and timberland, which can be problematic for third-party investors. But investment size is a relatively small problem for the community of giants. In fact, a bigger check size is often a feature, as many are looking for places to park huge sums of money.
Liquidity. Most managers are generally concerned with the liquidity of assets, especially as funds near the end of their lives. But this is less of a concern for a fund that would gladly hold an investment for the life of the asset.
Social Acceptance. There is mounting pressure on state and local governments to find innovative sources of finance for their projects, which forces elected leaders to cultivate socially acceptable financing solutions. According to some research we are doing at the Global Projects Center at Stanford, the public is more apt to view giants as being more socially beneficial than are generic for-profit fund managers.
Government Protections. Most real asset investors are nervous about regulation and policy changes affecting their assets. But a government may treat a peer governmental investor differently from a generic private investor. One of my colleagues often jokes that if you’re going to invest in emerging-markets infrastructure, you should form a syndicate with the local military pension fund, as no government will risk a coup by appropriating the assets through policy changes. In that joke is an important truth: Certain categories of investors inevitably receive special treatment from public agencies. (Though, let’s be honest, there are clear exceptions to this rule.)
Privileged Access. Public investors can more easily interface with governments, especially their own, on deals. Clearly, investors have to be wary of so-called bridges to nowhere, but with appropriate governance mechanisms, this shouldn’t be a problem. In Australia the Queensland government decided to convey a motorway to its local pension fund. In the Netherlands the Dutch government created a customized financial mechanism so that its pension funds could finance a transportation project. In Canada the Quebec government is proposing to convey ownership of two transit lines to its local pension funds.
With these many advantages over the broader market, is it any wonder that third-party service providers want the community of giants to think of these real assets as “alternative”? The layers of investment intermediation simply don’t pencil out for many real assets. As I’ve noted in the past (here, here, here, here and here), a variety of constraints are preventing giants from taking up their theoretical place of prominence in the market for real assets. And as I argued in a recent paper with my colleague Rajiv Sharma, the frustration among the giants has little to do with the underlying assets. Rather, it relates to the suboptimal access points and governance structures that tend to intermediate institutional investors from the assets they are trying to invest in. And so, any conversation about real assets is inevitably a conversation about access and implementation.
All of this raises the question of how giants might access real assets so as to render them appealing. Dutch pension fund PGGM, as an example, has had a remarkable transformation in its infrastructure portfolio after it decided in 2008 to shift from external to internal teams. It went from being unhappy with a half-billion euro external exposure to being very happy with a €5 billion internal exposure. CalSTRS has decided to seed a new manager and look for other LPs to come alongside. Some giants are even leveraging their own direct-investment skills to become financial intermediaries in their own right, accepting asset management mandates from peer funds. Just this week the Queensland Investment Corp. announced it has raised more than A$1 billion for an infrastructure fund, while TIAA-CREF announced it had raised $3 billion for its farmland vehicle (which was $500 million more than it was looking for). Inevitably, we’re going to see lots of giants working together in new and innovative ways to realign these long-term assets with their own long-term strategy. (Note that this is part of the collaborative model of long-term investing that we have been researching at Stanford.)
Let me end with some deep thoughts: I’ve already said that I think the asset management industry has been rigged in favor of the asset managers because of the politics of pension funds. But even with the tables tilted in favor of the managers, real assets remain one of the rare areas in which asset owners can still outperform on a direct basis. And, putting all my cards on the table, I think it’s healthy for our asset owners to begin thinking in these competitive terms, i.e., thinking about where they can actually bypass asset managers and generate higher returns. Professionalism, I think, begins with a mind-set; believing you can outperform the market is the first step in actually doing so. It leads to better resourcing and, ultimately, better talent. Before you know it, there’s a virtuous cycle playing in the favor of the giants. All it takes is some giants to recognize the one area in which they can clearly outperform and should rethink their access point. In my view, real assets are this area. And as such, they offer a foot in the professionalization door — a way to get back to first principles and develop much-needed internal competencies. Today these competencies can be used in real assets. In the future the competencies can be applied to some less traditional assets, such as equities and bonds.
