Real Returns by Dan Mikulskis

Reading Time: 4 minutes

There’s never been a greater need for long-term investment to replace decaying global infrastructure and navigate serious challenges like climate change. But long-term investment programs are rife with challenges and there is no guarantee of success.

That’s the premise of an ambitious book (Patient Capital) by Harvard Business School professors Victoria Ivashina and Josh Lerner. Full of examples, comprehensively referenced and practically oriented I think there’s a lot to gain from reading this for investment professionals at any level. It’s practically oriented (although not a step by step how-to), and laced with helpful background vignettes to support informed discussions. here are some of the key takeaways.

Private markets have been growing in popularity for investors of all stripes, but particularly pension funds and institutions. Given the fact that there are substantially fewer listed firms that there were 20 years ago (in the US, there are less than half the number there were in 1996 – see chart), and more and more firms are staying private later in their journey (eg Uber) there’s a good argument that private markets allocations are needed to tap into the overall market opportunity of growing firms.

It is often assumed investors prefer liquid investments to illiquid, so the theory goes that a premium (higher returns) is needed to compensate investors for illiquidity, so illiquid assets are thought to offer an “illiquidity premium”. However it’s a huge – and erroneous- jump from that theory to suggest that every illiquid asset offers a premium or is even a good investment. There are plenty of dogs out there and history is littered with examples (which are discussed in the book). The illiquidity premium is vanishingly hard to pin down in practice, and some say that it may not exist as investors do in fact prefer illiquid assets due to the apparent smoothing of return volatility.

The oversight of illiquid, highly uncertain and long-term investment programs presents a number of challenges when the ultimate success or failure cannot really be judged for many years. One recent highly visible example of some of these challenges in the UK is the Woodford Patient Capital Trust.

The authors describe two key issues that threaten long-term patient capital investing endeavours:

1. Just because an asset is illiquid, unlisted or “long-term” in nature, is not guarantee of good returns (either viewed in isolation or compared to listed, more easily available options). Plenty of bad investments exist
2. Agency issues in 3rd party asset management are real, particularly rife in private markets, and these can soak up a lot of (sometimes all) of the potential gains from long-term investments. Specifically:
   • Managers will asset-gather to maximise income from fixed fees, and prioritise asset growth over performance [data shown in book to support this], without sharing the benefits of scale with clients
   • Managers will chase/game performance data and key metrics (eg, IRR) are easily juiced and manipulated so that everyone appears top-quartile, and engage in pro-cyclical behaviour when they know they are being evaluated on performance
   • The terms of typical partnership structures are antiquated, have hardly changed in decades (even centuries) and are not aligned to the investors and the underlying investments. The typical 8-10 year timeline is misaligned to the underlying investments, “limited partners” do not have enough control over the partnership

So, what can be done? The authors finish with 4 suggestions:

1. Governance
   • Have more specialist professionals on board
   • insulate from political influences
   • Frame board discussions around the big picture
2. Measurement
   • focus minds on the long-term returns
   • have a limited set of diverse metrics that are regularly reviewed (a dashboard)
   • focus on things that are directionally correct (be roughly right rather than risk being precisely wrong)
3. Incentives
   • Get the remuneration of key in-house team members right & don’t underestimate the need to make it a great place to work
4. Communication
   • To present as a desirable investor in a world where there is competition for the best assets and managers
   • To stakeholders to manage expectation especially through inevitable downturns

Overall a thoughtful and thoroughly researched read that I think even experienced investment professionals will take quite a lot from. It tends to lean more on vignettes than data (and the issue is you can find a story to support almost any argument), but that’s the nature of the beast in private markets. There is use of data and studies where available.

For what it’s worth I think that one of the main areas of fund innovation over the next decade will be private markets funds offered on terms (fees, time horizon, control) that are more aligned to the end investor than the classic models. Some examples already exist. There’s also interesting innovation going on at the level of the institutions that enable investing which could support some of these ideas – for example the Long Term Stock Exchange (LTSE). Here’s a brilliant podcast well worth listening to on the missionand idea behind the LTSE with it’s founder, Eric Reis.

Recent focus on the annual World Economic Forum in Davos has brought the question of sustainability front and centre of the investment landscape and this surely goes hand in hand with the priorities of patient capital. Many long-term asset owners including pension funds make the list of the 2,000 companies most influential for the UN’s Sustainable Development Goals (“SDGs”) which serves to heighten scrutiny on those responsible and emphasise the common goals of society at large and the owners of patient capital, making the question of how to successfully implement a patient capital invesment program as relevant as ever.