September 16, 2016
Interviewed by: David Snow
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McKinsey: The Institutional Investor of the Future

Sacha Ghai, a senior partner at McKinsey & Company, discusses the firm’s recent survey of limited partner, and why the future looks bright for alternatives.

Sacha Ghai, a senior partner at McKinsey & Company, discusses the firm’s recent survey of limited partner, and why the future looks bright for alternatives.

McKinsey Exec: Inside the Mind of Today’s LP
With Sacha Ghai of McKinsey & Company

David Snow, Privcap:
Today, we’re joined by Sacha Ghai of McKinsey & Company. Sacha, welcome to Privcap. Thank you for being here.

Sacha Ghai, McKinsey & Company:
Thank you for having me.

Snow: Your specialty is the world of the institutional investor. You’ve recently done some research into what you believe will be the key trends in the future for these very large institutions that invest in private equity, but also in every other asset class. I’m fascinated to hear what you’ve found out about what their challenges are and what they would like to be in the future. What are some of the key challenges facing these institutional investors as they grow and evolve?

Ghai: I think it starts and probably ends right at the investment level. They’re facing significant challenges on investment performance. You’ve got persistently low interest rates. You’ve got volatile equity markets. All the while, liabilities aren’t going away. They continue to face significant challenges in terms of paying pension on the pension fund side or helping finance government budgets on the sovereign wealth funds side.

The other thing I would add is also a bit of a newer challenge—that the world is becoming more competitive. There are more institutional investors out in the marketplace hunting for good opportunities today than there were 10 years ago. And in a world where there’s a finite set of attractive investment opportunities, it becomes even more challenging for these institutional investors to navigate this environment and find opportunities that they can execute on.

Snow: One of your top findings was that institutional investors want to be more strategic as they construct their portfolios. What do you mean by that?

Ghai: Yes, that’s an important finding—if not probably the biggest finding—of our report that we recently published: we’re seeing what we call a “back-to-basics” look on institutional investing. What do we mean by that? At the end of the day, the fundamental investment decision an institutional investor has to make is how to allocate its capital across asset classes. We’re seeing increased focus on [the question], “Are we doing that the right way?”

Beyond that, we’re also seeing a lot of push around the assumptions that go into an asset allocation. Because the traditional approach is that you assume a certain set of equity market returns, fixed-income returns and private equity returns. Then, you assume a set of correlations across those returns. You put it in some sort of black-box asset optimizer and out comes your portfolio. And people are asking themselves, “Are those return assumptions accurate? Is the future going to be the same as the past? What is the outlook on private equity returns? What is the outlook on infrastructure returns? Are they correlated to equities or bonds?” [There’s] a lot more questioning around those fundamental assumptions—that’s what we mean by being more strategic. And [there are] thoughtful discussions at the management team level in these institutional investors, but also at the board level and getting board members involved.

Then, the last piece I would add…is around head count. We’re also seeing significant push on hiring more, bigger, bulkier teams at the top of the house and thinking about these issues so that they can get it right.

Snow: As these institutions (at least the ones you spoke to—largely pension funds and sovereign wealth funds) begin to bring people in house, does that mean they will necessarily allocate less to third-party managers? Or is it both?

Ghai: You’re going to see different strategies emerge. From an asset allocation perspective, I think putting more bodies at work thinking hard about asset allocation—that’s neutral in terms of whether they are going to continue to use fund managers or not. I think those are two very different functions within an institutional investor. One is how do we allocate and two is how do we invest?

Having said that, one of our other findings has been that many institutional investors are thinking about internalizing more asset management. My personal take on it is that you probably are going to see more institutional investors try to bring some investment management in-house, but I believe there will always be a big role for high-quality, high-talent fund managers who can access markets and investment opportunities that even the most sophisticated institutional investors will not be able to.

Snow: Let’s talk about the fact that, regardless of what approach an institution takes to asset allocation, we’re seeing a continued rise of illiquid long-term asset classes such as private equity, infrastructure and real estate. How does that square with the thinking that they’re having on their liabilities and the need to match these liabilities and the sometimes illiquidity problems that arise?

Ghai: You’re seeing a lot of asset allocation conversations around [the question of], “What is the liquidity profile we need in order to match the cash flow expectations on the liability side?” And one of the reasons you’ve seen infrastructure as an asset class really take off in the last five to seven years is that because while they tend to be a little less volatile than the equity markets, they also offer cash yields associated with it. It could be a toll bridge or toll road. It could be shipping ports and things like that. There’s a cash element to it that they can then use to offset liabilities and provide a good cash-flow matching while, at the same time, it’s also an asset class that also offers you big tickets. You can write half-billion-dollar checks in infrastructure and, for many institutional investors, being able to put money to work is not easy. So, I think the combination of good cash-flow matching with the ability to deploy large amounts of capital has powered a lot of these asset classes in the last few years.

Snow: Of course, a major challenge that U.S. pension funds, in particular, have is that they have caps on what they can pay their financial and investment professionals. How are they going to get around that challenge? You’ve got large institutions in Canada that actually are able to pay their investment staff near market wage or at least near Wall Street wages. How are the U.S. pension funds going to get around the issue of salary?

Ghai: It is perhaps the most important issue facing the U.S. pension fund community these days, in my opinion. I’m happy to see that there is movement afoot in various U.S. states around compensation reform. It takes the function of two main areas: one is better benchmarking and data transparency in terms of what market wages are. For many years, it was a bit of a black box and nobody knew. I think you’re seeing better data availability and pension funds using that to inform conversations around what their compensation philosophy should be.

The other thing you’re seeing is more pay for performance. This is something we think is essential if you’re having a well-performing organization. Are your employees motivated and aligned with the pensioners, with the people actually whose money you are managing? Those people—are you aligning their interests? I think you’re seeing more of that through bonuses and long-term incentive plans that is very healthy and will result in a talent culture that will be on par with what you’ve seen in other parts of the world.

Snow: Final question for you, which has to do with the future. If you could peer into, let’s say, 10 years from now, what do you think the world of the pension fund, the sovereign wealth fund and the large institutional investor will look like?

Ghai: I think you’re going to see a number of changes from where they are today. You’re going to see a great emphasis on portfolio construction. Bigger teams, more people thinking about tilts, dynamic asset allocation, alternative ways to get optimal diversification in their portfolio, risk parody, reference portfolio. You’re going to see a lot of innovation in that, and [as for] the traditional policy portfolio consultant-led model, I think you’re going to see a lot of people move away from that in the next five to 10 years.

I think you’re going to see a great allocation to alternatives and that’s good news for the fund-management community. I think people are going to recognize the value of these asset classes; they’re going to learn to deal with the liquidity issues they have and you’re going to see some of them continue to use fund managers and some of them start to do some of it themselves.

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