Innovation Masking Saturation?

The recent paper examining Canadian pension funds' attempts to capture upstream value reveals a troubling undercurrent in institutional investing that deserves deeper scrutiny. The very premise, that pension funds need to vertically integrate and move up the value chain to generate returns, serves as an inadvertent admission of serious problems in the private market space.

Consider what this strategy implicitly acknowledges: If pension funds must now become developers, operators, and direct investors to generate acceptable returns, this suggests the traditional private equity and real estate fund model has become oversaturated and inefficient. The paper's emphasis on "reducing fee drag" and capturing "upstream value" reads as a tacit admission that the conventional private investment approach no longer delivers sufficient value to justify its fee structure.

The paper's most glaring weakness lies in its predominantly qualitative approach. While it extensively details the mechanisms of various direct investments, it notably fails to provide rigorous quantitative evidence demonstrating superior risk-adjusted returns from this strategy. This methodological limitation is particularly concerning given the increased operational and concentration risks these funds are assuming. The authors acknowledge this limitation, stating "because our analysis of those transactions is based on qualitative interviews, we are not quantifying their performance."

This absence of hard performance data raises serious questions:

• Are these complex direct investments actually generating better risk-adjusted returns than simpler, more diversified approaches?
• How do the total costs of building internal capabilities and assuming operational risks compare to traditional investment approaches when fully accounted for?
• Does the pursuit of "upstream value" simply replace external management fees with potentially higher internal operational costs and risks?

The paper's focus on "value creation" through operational involvement might be masking a more fundamental issue: the diminishing returns in private markets as institutional capital has flooded these spaces. When pension funds feel compelled to become real estate developers or agricultural operators to generate returns, it suggests they're engaging in increasingly complex and risky strategies to justify their private market allocations.

Furthermore, the paper's treatment of risk management appears insufficient given the magnitude of concentration risk these funds are assuming. While it acknowledges various risks, it doesn't adequately address how these massive, illiquid positions could perform during severe market stress scenarios. The 2008 financial crisis demonstrated how seemingly uncorrelated private market investments can exhibit surprising correlations during systemic stress events.

The move towards direct investing might be better understood as a defensive reaction to deteriorating returns in traditional private market investments rather than a genuine innovation in pension fund management. This interpretation would explain why funds are willing to assume substantial operational complexities and concentration risks—they may see no alternative for generating their required returns through conventional approaches.

This raises broader concerns about the private markets industry as a whole. If sophisticated institutional investors are essentially admitting that traditional private market investing no longer offers sufficient value, this has profound implications for smaller institutions and retail investors who lack the scale to pursue similar direct investment strategies.

Rather than celebrating these funds' moves towards direct investing, perhaps we should view it as a warning sign about the state of private markets and question whether the continuing push to increase private market allocations serves investors' best interests.