Lifting the lid on lift outs: Governance considerations around lift out transactions

By Rich Nuzum, CFA , Global Chief Investment Strategist

As the frequency of large, sophisticated asset owners announcing lift outs has increased, decision-making around lift-outs has evolved from “why would we do this?” to “why wouldn't we do this?”. Still, stakeholders tasked with determining whether a lift out is the right step for their investment team and assets face a complex set of governance considerations.

After a decade of experiencing the realization of reinvestment risk due to the impact of historically low interest rates on the estimated net present value of their liabilities, many defined benefit (DB) pension plans now find themselves, relatively suddenly, in an unexpected surplus position due to the extremely rapid increase in rates since 2022 – with the opportunity to lock in risk transfer deals given their newly strong funded position. An increasing number of plan sponsors have taken steps towards full buyout or de-risking of specific tranches of assets and liabilities.

Defining ‘lift outs’

For sponsors that have employed in-house investment professionals to help oversee their investment programs, a ‘lift out’, in which employment of the in-house team transfers to an implementation partner that takes on discretionary management authority for the investment program, can be a potentially attractive means of adjusting to changing objectives, requirements and/or shifts in the external operating environment.?

Decision-making around lift-outs typically requires stakeholders to weigh up a range of strategic considerations, starting with a cost benefit assessment of continuing to manage the assets in house versus delegating this responsibility to a third party, and ending with a holistic forward-looking assessment..

Lift outs are lifting off

It has been common practice for large (e.g., above $10 billion AUM) pension plan sponsors, insurers and other institutional investors to maintain in-house teams of investment professionals, either to run and oversee a portfolio of external managers, directly invest in underlying securities, or a combination of both.

There have been a series of headline transactions involving the lift out of in-house investment teams by external parties, which concurrently assume responsibility for the running and management of assets and take over employment of the in-house team on a go-forward basis.

We know from our governance work with large asset owners across markets, that for every lift out that's reached ‘lift off’, there is a larger group of asset owners that have considered the prospect and decided ‘not yet’. While the governance considerations around these transactions can be myriad and complex, in my experience asset owners that give this careful consideration, and do not move forward, are almost uniformly deciding “no, not yet”, rather than “no, not ever”.

Stakeholders typically consider what their future triggers for re-assessing a lift out would be and, ?in identifying these triggers, build a collective understanding of potential changes ahead that might warrant proceeding with a lift out in the future.

Based on our governance reviews for numerous asset owners, we see a range of factors converging to impact governance considerations around lift outs.

Drivers of lift outs

?i.??????????????? The war for talent

Over the past decade, the war for in-house investment talent – and the expertise to run both manager portfolios and manage securities and investments – has intensified. ?

Since Russia’s invasion of Ukraine, the sharp rise in the price of oil – which rose from trading in the $40s to above US$100 and remains above US$70 today – has indirectly added a new dynamic to the talent race.

The sovereign wealth fund community across countries that are major energy exporters, including but not limited to the Middle East region, has been a major beneficiary of the rise in oil prices.? These funds, as well as endowments, foundations, family offices, pension plans and other institutional investors that are benefitting indirectly from local economic strength and positive government fiscal balances, have been on a major recruitment drive for professional investment staff.

As part of this war for talent, many large asset owners are also becoming more flexible about where their staff are based, allowing greater flexibility for staff to work remote from the organization's headquarters, or opening offices in major financial hubs such as London, the New York/Greenwich/Boston corridor, or San Francisco.

?One common trigger for reconsidering whether and to what extent to compete in the war for talent is the prospective or actual retirement of a key investment leader.? Where a qualified successor is not readily available in-house, the prospect or loss of key talent can catalyze a review of whether to rehire for that role or pursue a different governance model less reliant on in-house staff.

?ii.????????????? The data, digital and technology arms race

As the pace of technological transformation across the investment management industry accelerates – our recent AI in Investment Management Survey showed that more than nine in 10 (91%) managers are deploying AI in some way across the investment process – asset owners are spending an increasing amount on data and technology in a bid to maintain competitive equity – and ideally advantage – relative to their peers.

The need for portfolio look-through capabilities at any given time has become more widely recognized following a series of market crises over the recent past.? Regardless of whether an asset owner is monitoring investments in individual publicly traded securities or investing directly in the private markets, competition for an information edge is increasing.

Even in scenarios where asset owners are “only” overseeing a group of external managers, and not investing in-house in individual securities, decision-maker stakeholders will typically request a complete and current view of exposures before taking decision in reaction to any kind of crisis.? When a crisis emerges, leaders want to know ? what do we own? While the specifics of the questions change with each crisis, the fundamental need to provide transparency on current state, before decision-makers will be comfortable moving forward with actions to mitigate risk or pursue opportunities, endures.

Having a digital, data and technology dashboard that can provide this information quickly is crucial to portfolio agility, not only enabling look-through capabilities, but also equipping investors to be opportunistic, and to maintain adherence to fundamental risk management disciplines such as rebalancing. Along with talent, the economics of technology and its knock-on impacts on portfolio management are also impacting consideration of lift outs, since a lift out can enable an asset owner to access the dashboard of their chosen implementation partner, rather than needing to maintain the investment to establish and support their own dashboard.

?iii.???????????? Operational risks can be passed on to third parties

Errors by in-house staff present economic and headline risks for the asset owner, while errors by an external manager typically result in compensation for the fund.

Headline risks should not be underestimated by asset owners.? The fallout over the recent past from the implosions of FTX and Silicon Valley Bank proved reputationally costly for a number of large investors with significant positions. Decisions taken by an in-house team can create reputational risk for their employer.

?Increasingly, asset owners are recognizing the asymmetry in downside risk bearing between continuing to run assets in-house versus a lift out (or alternative external) governance scenario.

?iv.???????????? Swimming in a bigger pond

Over the past 20 years, another major change in the external environment has been the reality that scale has afforded opportunities for the world’s largest outsourced chief investment officer (OCIO) providers to add greater value, even for relatively large asset owners. With great scale comes aggregate buying power, with asset owners standing to benefit from the economies of scale secured. ?

The technology platforms of the biggest OCIO players can be leveraged across a multitude of underlying clients and across AUM that exceed the AUM of all but a handful of the world’s very largest asset owners.? Scale also brings aggregate buying power across public market managers and can bring “first call” access to what limited capacity may be freed up across capacity constrained strategies including in private market asset classes.

Critically, there is not a competition for scale between an OCIO firm with $X in AUM and an asset owner with $Y in AUM.? Following a lift out, the OCIO provider will deploy assets equal to X plus Y, delivering a portion of the benefits of its newly increased combined scale back to the asset owner. ??Simply put, X + Y is always bigger than Y, and many aspects of institutional investment have scale economies.

?v.????????????? For DB plan sponsors specifically, the knock-on impacts of the glidepath to hibernation or risk transfer

The investment needs of DB sponsors can change as the funded status of their plan(s) improves, with a need for increased risk management precision in matching assets to liabilities, and a commensurate decline in the need for new deployment of capital to alternative investments and other growth assets.?

From our work with DB plan sponsors stepping onto a de-risking pathway, we observe two key developments commonly taking place.

The first is that plans stop making new allocations to private markets, or at least cut back on their pace of capital deployment in more illiquid areas of the market. This step is immediately recognized by internal staff previously tasked with making these commitments – who may begin to question both their job security and the impact that remaining in role might have on their own future value in the jobs market.

While investment staff may be looking to the exit, the sponsor may still need them to continue monitoring the portfolio and support return on capital deployed through the remaining term of allocations, whether that’s across direct investment, secondary market transactions or exits to create liquidity to fund a risk transfer. ??

From the moment a shift in private markets – or indeed growth allocations more broadly takes place, plans risk misalignment between their in-house staff in terms of career path attractiveness, and what the asset owner desires from them as an employer.

At this point, that war for talent we touched on earlier is no longer academic. Even if plans are willing to pay market rates, they risk losing staff managing these allocations because career prospects are seen as diminished, even if current pay remains adequate.

Do we have lift out?

Assessing all the relevant factors above gives rise to one overarching governance conclusion:? until an organization considers a lift out relative to other governance possibilities, they do not have the governance in place to consider a lift out.?

Without a formal review, DB sponsors specifically are unlikely to be well positioned to dynamically and proactively manage or mitigate the governance challenges that, in our experience, arise once a DB sponsor’s CFO or Treasurer kicks off a de-risking journey.

The person kicking off the review process to consider a lift out will vary according by organization, but in our experience, it is most often a newly appointed Investment Committee or Board Chair, CEO, CFO or Treasurer, or a matriarch or patriarch sponsoring a family office, who will question “why are we in the investment management business” – and initiate a review. ?

Once the review commences, new challenges arise. Within an organization, investment staff may have long-standing relationships with colleagues in the finance team, raising the potential for inertia bias. ?

The introduction of a third party to run a governance review or lift out tender may of course bring tailwinds in the opposite direction; one could argue that a third party brought in to assess the case for lift out is, inherently, incentivized to advise in favor.

Finally, beyond the dynamics of decision-making around lift outs, there are two key structural questions which warrant further consideration among those assessing these transactions as a next step.

First, is the recent trend for third party providers to offer a significant up-front payment to the asset owner as part of the transaction. From our perspective, this structure should set off alarm bells, as it raises questions around the source of that capital – will it ultimately be recouped through the economics of the deal on an ongoing basis through above market rates for asset management services being charged back to the asset owner? We believe that the economics of the deal need to add up over time and ultimately improve the value of the asset pool. For DB and DC sponsors specifically, where there tends to be greater formality around fiduciary duty than in some other segments, sponsors need to determine if a cash injection today would improve the security of pension promises (i.e., via an up-front payment), or whether plan participants be better served by more attractive economics realized across the lifetime of the deal (i.e., by lower ongoing fees and expenses)?

Second is the underlying structure of the services being provided. We acknowledge our own commercial bias in arguing for the benefits of open architecture.? At the same time, given that there are more than 7,000 active investment managers in the world from which any asset owner or OCIO can build an “all-star team”, we question why any single manager’s proprietary asset management services should emerge as the winner from a lift out transaction. When it comes to implementation, there is huge dispersion in the capabilities of the best and worst performing managers in any asset class; the managers with competitive advantages changes over time,? and diversification across great underlying managers remains a free lunch.?

In short, there is a lot for stakeholders to consider in evaluating whether or under what circumstances to seriously explore a lift out.? Given the strength of the trends identified above, we anticipate the incidence of lift outs across all segments, but particularly in DB, will continue to accelerate going forward.

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