Over the past few years, I’ve written time and time again that collaboration and cooperation among institutional investors would become increasingly common. Why? Because I believed that long-term investors, such as pensions, sovereigns, families and endowments, could fruitfully work together to bolster their returns and achieve their objectives. In large part, the economic geographer in me was convinced that the sharing of local knowledge and asymmetric information that would come from partnering with peers (not to mention access to other funds’ skill-sets, deal pipeline, and network of elites) would have real commercial value. And I still believe that. But, I have to say, I’m much more cynical than I was a few years ago.
While I remain enthusiastic about co-investment arrangements, I think there are a few major roadblocks that ‘potential partners’ will have to overcome if they are to work together on more than an ad-hoc basis. Here are three that jump to mind:
Compensation: The design of incentives has enormous influence over the behavior of individuals. So, if an institutional investor designs its incentives (i.e., its compensation system) in such a way that drives employees to think of peers as competitors instead of as partners, then collaboration will be all the more challenging. And, at the top funds in the world, that’s exactly what’s been happening; compensation is increasingly a function of how a fund or individual adds value above a market-based benchmark. Put another way, compensation is based on a fund’s performance relative to its peers. How can we expect people to collaborate if their compensation is tied explicitly to the amount by which their fund beats its peer group on an annual basis? Formalization: Try all you want to come up with Memoranda of Understanding or even (bless your soul) formal organizational structures to facilitate collaborative investing (with allocated assets and joint-investment committees), all you’ll end up doing is helping a few lawyers put their kids through college. Recall that most institutional investors are often bureaucratic to begin with, which means it can be extremely difficult to get internal approvals to launch a vehicle where one fund relies on the investment advice of another fund. But even aside from the legal challenges, these formal arrangements are an attempt to replace trust and interpersonal relationships with contracts and commitments. And that’s not easy. As such, most of the collaborative ventures I’ve seen eventually revert back to more informal arrangements (whereby each member retains absolute authority over their assets and resources) and instead focus on building trust and inter-personal relationships. Ontology: In order for meaningful collaboration to occur between two or more investors, these organizations have to have very similar world views (ontology). By this I mean to say that like-minded investors will be more apt to collaborate than those funds that see the world in different ways. It’s not all that important that they act in exactly the same way (methodology) – in fact it’s probably better if they have different skills and knowledge to round out each others’ endowments – but it is important that they agree in the way assets should be deployed in a given domain. The problem here is that it can be very challenging to identify the reasoning and motives (ontology) underpinning a fund’s actions and behavior (methodology), which makes attempts to find partners quite challenging. Again, in order to really assess whether a fund is “like-minded” requires inter-personal relationships built around mutual respect and trust; this is not something that an artificial contractual edifice can replace.
So that’s what’s limiting collaboration (beyond one-off transactions). What are the implications? I’ve got two competing thoughts:
1) Potential collaborators can keep it simple / informal and focus on ways to build trust and friendships with other investors. In this case, the ‘dating game’ at conferences and events will inevitably reveal ‘like-minded’ investors, and the co-investment opportunities will bubble up organically. 2) Potential collaborators can get together with one or more like-minded investors to launch a new vehicle. In other words, they can take an additional step to create a de-novo asset manager (with a dedicated team) that will deal with all of the issues that tend to derail collaboration. I’ve seen these types of vehicles a few times in the Middle East (e.g., Kuwait China Investment Corporation).
Anyway, I remain a fan of collaboration — it’s a useful way to extend the reach of under-resourced funds — but the hurdles above represent, in my view, enduring challenges.
