The outsourced CIO model has gone through an evolution due to pressure for oversight of specialist investment strategies, says Patrick Ghali of Sussex Partners.
Outsourced CIO (OCIO) models have become increasingly prevalent among institutional investors. Differing surveys estimate the amount of money managed by outsourced managers to be in the $1.2 trillion-$2.4 trillion range. (The difference in estimates can be partially explained by how some advisory firms classify their assets.)
Of that amount it is estimated that around 90% relates to US institutions and ultra-high net-worth families, with only about 10% coming from international investors.
It is easy to understand the attraction of the model, as running an internal asset management effort can be expensive, time-consuming and inefficient. Initially, institutions sought to completely outsource their asset management to a third party. Those third parties would then often use co-mingled funds or model portfolios to gain economies of scale based on the assumption that most investors were looking for very similar investment outcomes.
This also allowed OCIO providers to offer their services at very low cost.
While it is easy to see how this initial iteration of the OCIO model came about, it also left a gap in the market for institutions that didn’t fit this mould and that had much more specific needs.
Others had built existing internal resources which it made sense to keep, but which would benefit from being complemented by external specialist skills sets. This has led to the OCIO model going through an evolution. Specialists are now complementing the traditional offerings, and institutions are redefining what they are looking for from their OCIOs.
Recent investor surveys also confirm this, with 57% of organisations looking to conduct replacement searches. The desire for access to more specialist know-how and the requirement for more bespoke solutions are some of the drivers behind these re-evaluations by investors.
The necessity for specialist expertise is particularly apparent when it comes to non-traditional strategies, whether they be alternative credit, private equity, lending, venture capital, direct/co-investment or hedge funds. These strategies require specialist skill sets acquired only through experience over several market cycles.
In addition, the identification of suitable investment opportunities also tends to be less transparent, and these often come with additional requirements such as extensive operational due diligence.
As traditional investment portfolios don’t usually face these additional challenges, first-generation OCIO providers are often not fully equipped to properly advise on these.
Non-traditional investments are also not homogenous. Private equity, for example, requires a different skill set and research process to specialist credit, infrastructure or hedge funds, all of which have their own idiosyncrasies and necessitate specific networks for sourcing opportunities.
Additionally, the talent pool focused on these investments is also more limited, which means that compensation, as well as ancillary cost (such as travel), are usually also significantly higher. This makes it neither very attractive for traditional OCIO providers or for most institutional investors to commit to setting up internal efforts.
Drawing from experience across firms, it is, for example, sub-optimal for an institution to properly run a hedge fund portfolio with less than five specialists (including investment and operational analysts). This means that unless a hedge fund allocation runs into several hundred million dollars, it is very difficult to justify the staffing commitment. Even at that size, access to preferred hedge funds isn’t guaranteed, and if accessed, this will likely be without any fee/term negotiating power from allocation size.
The scarcity of non-traditional investment evaluation talent also means there is a real risk of ending up with portfolios that underperform by multiple metrics. Additionally, as firms that went through the financial crisis can attest, altering internal programs for performance/asset changes, or even firm ownership, can be very costly and time-consuming.
An outsourced solution, on the other hand, is easier to quantify from a cost/resource perspective and can also more easily be terminated or rightsized should requirements evolve. This has propelled many to look outside of their own organisations to supplement internal resources with external, specialist ‘alternative OCIO’ (AOCIO) providers.
AOCIO firms don’t tend to run their own products and usually have a completely open architecture to eliminate potential conflicts of interest. Their fee models are usually similar to those of traditional OCIO providers (management and performance fee), but they usually are able to leverage their overall assets to allow clients to benefit from preferential fees/terms with underlying managers.
This should offset their own fees to a large extent, or in an ideal scenario even save their clients money versus pure in-house efforts. Difficult-to-access opportunities, better overall terms for their clients (e.g. future capacity), being able to take advantage of idiosyncratic opportunities, and creating bespoke products to meet specific objectives should all be part of an AOCIO’s repertoire.
AOCIO’s may also be a good solution for the many investors that are not seeking to fully outsource their investments, but rather are looking for competent partners than can act as an extension of internally available resources and help to improve processes and performance. For those investors, the ideal partners do not have the appearance or functionality of competing with internal staff, but rather integrate with the existing team allowing internal capabilities to be augmented in a smart and cost-effective manner.
For investors that have some sophisticated, existing in-house resources which they wish to amplify, and seek a more bespoke approach (not just an off-the-shelf product but also access to managers, staff training, product specialists support or an external member added to their investment committee), an AOCIO may be the best solution. These solutions offer the most flexibility and targeted access to experienced specialists while being meaningfully more cost/resource-efficient versus a robust in-house effort. The evolution is likely to continue to the benefit of investors, adapting further to their changing needs. The current offerings, though, already provide more flexibility than what has been offered in the past by traditional OCIOs.
Patrick Ghali is managing partner at Sussex Partners
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