Fiduciary duty principles must be adaptive to change and the US has fallen behind. The authors argue that a more comprehensive application of fiduciary duty principles in the US is necessary to protect the life savings of ERISA plan participants. In particular impartiality is important for pension plans where funds are managed for multiple generations.

Recently proposed US Department of Labor regulations on fiduciary duties under the Employees Retirement Income Security Act on consideration of environmental, social and governance (“ESG”) factors by private pension plans are a vast improvement over existing Trump Administration rules but they completely ignore the fiduciary duty of impartiality and related principles.

The proposed DOL rules, issued on October 14, 2021 “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” should address the full range of fiduciary duty principles that are material to ESG issues and to the exercise of shareholder rights.

Comments submitted to DOL by the Intentional Endowments Network highlight the overlooked fiduciary duty principles that can be highly material to consideration of ESG factors and the exercise of shareholder rights. The comments argue that final rules should emphasise the following:

  • The duty of impartiality, which is part of the duty of loyalty and requires identification of and good faith efforts to balance divergent inter-generational risk tolerances and return needs of plan participants;
  • Presumptive use of longer investment time horizons that link investment processes with the timelines for obligations to fund participants; and
  • Dynamic aspects of the duty of prudence, including that it does notimpose a “lemming” standard of care that mandates herding behaviors or discourage adoption of improved investment practices.

The IEN comment letter, which two of this article’s authors helped write, provides guidance on why a more comprehensive application of fiduciary duty principles is necessary to protect the life savings of ERISA plan participants.

Fiduciary duty of impartiality

The United States Supreme Court in 1996 recognised that ERISA fiduciary duties include a duty of impartiality. When interpreting §§404 and 409 of ERISA in Varity v. Howe, the Supreme Court cited the following common law principle as part of the foundation for its holding. “The common law of trusts recognises the need to preserve assets to satisfy future, as well as present, claims and requires a trustee to take impartial account of the interests of all beneficiaries.

This common law principle referenced by the Supreme Court is now set forth in the Restatement (Third) of Trusts:

“The ‘Duty of Impartiality’ requires that fiduciaries identify and impartially balance conflicting interests of different trust fund groups, including current and future beneficiaries.” Restatement (Third) of Trusts §79.[i]

Impartiality is of particular importance for pension plans, where funds are managed for multiple generations. Since different generations of participants will become entitled to distributions at different times, they are likely to have different risk tolerance levels and time horizons. Inter-generational obligations also raise the potential for uncompensated transfer of risks and returns across fund participant generations. The duty of impartiality mandates careful consideration and good faith efforts to reasonably balance these conflicts.

In addition, systematic risks, costs and opportunities are often invisible to fiduciaries that focus exclusively on generation of short-term returns or evaluate investments against only a market-relative performance benchmark. Nevertheless, systematic risks and costs can spread across portfolio companies and compound over time, increasing risk exposures and degrading future returns to fund participants. For a diversified investor, systematic risks drive most of returns.

Climate change presents perhaps the most obvious set of both company specific and systematic risks that raise potentially conflicting inter-generational investment risk and return impacts and implicate the duty of impartiality. For example, failure to address climate risks and opportunities over the near term is likely to generate increased future economic costs and risks that will be primarily borne by today’s younger fund participants.

However, climate change is not the only systematic financial cost or risk with duty of impartiality implications.  For instance, other financially material ESG factors with varying inter-generational or other beneficiary group impacts can include things like water and air pollution; growing microbial antibiotic resistance in the food chain; shareholder pressure on companies to generate short-term earnings at the risk of undermining future growth; inadequate attention to product safety and health; ecosystem limits on future economic activity; effects of growing income inequality on consumer demand; and political instability fostered by social media business models based on distribution of misinformation.

The duty of impartiality is a fundamental aspect of fiduciary law that governs ERISA funds, as well as other institutional investor trustees.

We believe that a major flaw in the proposal is its failure to explicitly recognise and apply this principle of fiduciary law. We also see the duty of impartiality as driving a need to address time horizon issues.

The tragedy of the horizons

The proposal states that investment analyses should apply the appropriate time horizon.

However, given the overwhelming long-term duration of pension fund liabilities and the current influence of irrational short-termism in the markets (discussed below), we believe the final rule should explicitly recognise a presumption that a long-term investment horizon will nearly always be an appropriate primary time horizon (although perhaps not the exclusive time horizon) for an ERISA fiduciary’s strategic investment decision-making processes.

From a duty of impartiality perspective, it seems implausible that an investment strategy developed without attention to long-term risks, costs and inter-generational wealth transfers could meet standards referenced by the Supreme Court in Varity v. Howe.  The duty of prudence obligation to investigate material facts also poses increasing questions about the influence of irrational short-termism on investment decisions.

Nicholas Stern, Professor of Economics and Government and Chair of the Grantham Research Institute on Climate Change and the Environment at the London School of Economics, highlighted the perverse impact of irrational short-termism in a recent speech:

“The economics profession has also misunderstood the basics of discounting, in relation to, particularly, its dependence on future living standards. It means economists have grossly undervalued the lives of young people and future generations who are most at threat from the devastating impacts of climate change. . . . Discounting has been applied in such a way that it is effectively discrimination by date of birth.”[ii]

The Bank of England has expressed similar concerns:

“In the UK and US, cash-flows 5 years ahead are discounted at rates more appropriate 8 or more years hence; 10 year ahead cash-flows are valued as if 16 or more years ahead; and cash-flows more than 30 years ahead are scarcely valued at all. The long is short.”[iii]

The CFA Institute undertook a study in 2020 to examine the costs of this short-termism for investors.

“CFA Institute partnered with the firm Fund Governance Analytics to take a more academic approach to the issue of short-termism. We took a quantitative look at the data concerning the issue of short-termism between 1996 and 2018 to see whether any short-term behaviors were evident that investors and issuers should better understand. 

We found that companies that failed to invest in research and development (R&D); selling, general, and administrative (SG&A) expenses; and capital expenditure (CapEx) tended to underperform in the midterm (three to five years). . . .

 The study summarized in this report estimated the agency costs (foregone earnings) of short-termism at $1.7 trillion over the 22-year period covered by our analysis, or about $79.1 billion annually.”[iv]

We recommend that the final rule affirm presumptive application of a long-term investment horizon by ERISA fiduciaries.  This could be linked with the duty of impartiality, the duty of prudence and the reference in the proposal’s preamble to evolution of investment fiduciary practices over time.

Implementation of fiduciary duties evolves over time

We believe that the final rule should emphasise how application of fiduciary principles is a dynamic process that evolves in response to changes in knowledge and circumstances. ESG-related developments and advances in knowledge since the turn of the twenty-first century present a challenge for ERISA fiduciaries. However, change is a natural constant, and fiduciaries should understand the perpetual obligation to identify, evaluate, and respond to changed circumstances and new information.

This is not a new concept.  The most recent major transition in implementation of fiduciary duties took place in the last half of the 20th century. It involved an evolution from legal lists of permitted investments and the prudent person standard of care to the application of Modern Portfolio Theory and adoption of the prudent expert standard.

That shift in practices took several decades, leaving fiduciaries caught between two seemingly inconsistent investment approaches. One 1988 commentator described the tension during that transition between adopting modern investment practices and being held back by outdated rules:

“A fiduciary cannot behave as a careful, wise, discreet, judicious and prudent man if he acts within the strictures of a prudent man rule that forces him to behave imprudently in the contemporary economic marketplace.”

In response to this late 20th century evolution of the investment industry knowledge base, the following provisions were added to the Restatement of Trusts to incorporate lessons learned from the transition:

“There are no universally accepted and enduring theories of financial markets or prescriptions for investment that can provide clear and specific guidance to trustees and courts.”  Restatement Third) of Trusts §227, Comment (f).

“Trust investment law should reflect and accommodate current knowledge and concepts.  It should avoid repeating the mistake of freezing its rules against future learning and developments.”  Restatement (Third) of Trusts, §227, Introduction.

These statements speak to us today as investor fiduciaries face similar industry transition challenges. We believe that including more of this background in the preamble would provide clarifying historical context to demonstrate that fiduciary duty principles must be adaptive to change.

However, it should be stressed that the direction of change in the current evolution of investment industry knowledge and practices is clear and is largely being driven by mainstream global investors and by regulators in other countries. The US has fallen behind other markets in this transition.

Comparisons to the 20th century evolution from the prudent person standard to Modern Portfolio Theory could help the US move forward by demonstrating that evolution of investment industry theory and practices are to be expected when knowledge and circumstances change.

In order to address the full range of investor fiduciary duties, the final DOL rule should be modified to:

  • Explicitlyincorporate principles from the fiduciary duty of impartiality, which has been applied to ERISA by the US Supreme Court;
  • Establisha presumption that ERISA fund investment analyses nearly always require inclusion of a long-term investment horizon in order to reflect pension plan obligations;
  • Containadditional preamble background commentary on the principle that prudent investment practices have evolved in the past, and are expected to evolve in the future, in response to changes in knowledge and factual circumstances. Prudence is not a static

 

Keith Johnson is former co-chair of the Institutional Investor Services Group at Reinhart Boerner Van Deuren s.c. and was chief legal counsel for the State of Wisconsin Investment Board. Susan Gary is a Professor Emerita (formerly Orlando J. and Marian H. Hollis Professor) at the University of Oregon School of Law and served as reporter for the Uniform Prudent Management of Institutional Funds Act. Tiffany Reeves is head of investor fiduciary and governance services at Reinhart Boerner Van Deuren s.c. and was previously deputy executive director and chief legal counsel at the Chicago Teachers’ Pension Fund.

 

 

 

The United Nations Joint Staff Pension Fund plans to explore impact investment for part of the $90 billion portfolio including in developing and emerging markets like Africa. Alongside exploring investing for impact in consultation with its investment committee and board, the asset owner plans to boost diversification of its investments across developed, developing and emerging markets, according to the UN General Assembly’s recent Resolution on 2021 Pension Matters, published in January.

“The General Assembly noted the fund’s consistent outperformance of the 3.5 per cent annual real rate of return benchmark for the 10-year and 15-year periods and requested continued diversification of the fund’s investment portfolio among developing and emerging markets, including impact criteria for a part of the portfolio,” states a report on the Resolution. UNJSPF has had a 15-year rolling annualised return of 4.6 per cent.

The value of UNJSPF’s assets grew by more than 10 per cent in 2021 after an increase of 13 per cent in 2020, to reach an estimated $90 billion as of the end of December 2021. As it stands, the UNJSPF is fully funded, and in a position to assume pension liabilities for decades to come, said the statement. Around 82 per cent of the fund is managed internally and growth assets account for about 71 per cent of the allocation.

Streamlined governance

Regarding governance, the General Assembly endorsed an earlier vision expressed by the board regarding a more efficient and effective decision-making process.  Governance reform includes updated and strengthened terms of reference for board members, chair, bureau and committees. Elsewhere, the board will meet more frequently during the year, making use of virtual meetings. The annual in-person meeting will be shortened from seven to five working days or less but the composition of the board’s 33 members, representing the 25 member organizations on a tripartite basis, remains unchanged.

“These important changes initiated at the request of the General Assembly should assist the United Nations Joint Staff Pension Board in effectively administering the fund in the coming years,” said the statement.

Sustainable investment

UNJSPF’s approach to sustainable investment incorporates forward looking methodologies in evaluating the impact of climate change on the investment portfolio. The fund has created partnerships with climate specialists and alternative data providers to supplement its internal resources and build ESG technology. For example, the office of investment management, in charge of the UNJSPF assets, has signed a strategic partnership exploring predictive climate analytics.

According to UNJSP website, OIM is also conducting research on developing quantifiable SDG scores using artificial intelligence (AI) to leverage big data and systematically measure companies’ impact on the SDGs. This research will aim to provide empirical evidence that will address the widespread perception that there is a trade-off between incorporating ESG or SDG considerations into investment decisions and generating strong financial returns.

“It will strengthen our understanding of the interdependencies between a firm’s long-term economic value and its societal impact,” states the website.

Asset allocation

UNJSPF’s global public equity portfolio (57.5 per cent) is managed internally by four teams: North America, Europe, Asia Pacific, and Global Emerging Markets (GEM). The global fixed income portfolio (25 per cent) seeks to achieve an above benchmark return by investing globally in local currency, investment grade securities. The portfolio is traded actively.

Real assets

The 7 per cent allocation to real assets comprises real estate, infrastructure, timber and commodities through around 100 externally managed funds. The real estate allocation (6.7 per cent) comprises 50 per cent core “open ended” funds and 50 percent non-core “closed end” funds. The fund’s core funds are diversified by geography and property type, and its non-core funds are diversified by vintage year, geography, property type and risk profile.

The real assets team also invests in externally managed infrastructure funds. Selection is based on moderate leverage, strong cash flow and a demonstrated record of realizations. Modest allocations to timber and commodities funds, invested on a global basis, are also part of the portfolio.

The alternative investments team is responsible for investments primarily in private equity (6.7 per cent) through externally managed funds in a program begun in 2010 diversified by vintage year, private equity sub-sectors and geography.

 

 

A white-hot year for private equity has resulted in exceptional absolute returns for Oregon Public Employee Retirement Fund’s $25 billion private equity portfolio. However, given a more complex relative return picture, and the allocation relative to target remaining stubbornly high, due to outsized mark-ups and gains, the portfolio is not without its frustrations.

“The challenges in terms of the appreciation in the portfolio and the impact on total asset allocation is a universal problem in private equity investors of scale,” said Tom Martin, global head of private equity at advisory firm Askia in a presentation with Michael Langdon, director of private markets at Oregon State Treasury, to council members, guardians of Oregon’s state funds including the $85.5 billion OPERF portfolio.

At the end of last year, the private equity allocation represented roughly 26 per cent of the entire portfolio, at the top end of the fund’s 15-28 per cent target allocation. One-year returns were 41.8 per cent exceeding the fund’s policy benchmark Russell 3000 Index plus 300 basis points, but trailing the benchmark for the asset class, Burgiss All Funds Ex. Real Assets.

Money back

Although unprecedented IPO activity drove exit volumes in 2021, council members heard that IPOs don’t necessarily result in meaningful distributions for private equity partnerships. In most cases, liquidity is dripped over time.

“Exits don’t immediately translate into liquidity,” said Martin. “Private equity managers can be reluctant to upload public holdings, it takes time to unwind out of the portfolio.”

The council heard how distributions are largely at the discretion of the GP and asset owner influence is confined to dialogue and advisory board-seats – or choosing not to invest again.

“It depends on where GPs are in the fundraising cycle. Investors are not too keen to support managers that don’t return capital that is readily available to be returned,” he said.

It’s not only difficult for investors to control or time distributions. Asset owners also struggle to control when managers will activate funds, a process that can be pushed into the following year.

“We can’t control when managers will activate funds. It’s impossible to precision engineer a $3 billion number so our range is important. It’s important to try and focus on the things we can control.”

The council heard how for the calendar year 2021, the private equity portfolio processed capital calls totalling $5.5 billion and distributions totalling $7.6 billion for net distributions of $2.1 billion.

Manager relationships

Another key focus of strategy has involved ongoing rationalisation of GP relationships in terms of both size and absolute exposures. Although a “long list” of relationships have been cut, OPERF has signed up with a handful of new, sought-after managers.

“Even in a constrained pacing environment, we made room for these relationships,” said Martin. “We now have a core set of relationships that feels good. We might see some opportunistic adds in terms of new names, but on a limited basis and drawn off a long-term wish list.”

Pacing

Council members heard how strategy centres around consistent and disciplined pacing. Memories of the fund’s uneven pacing before and after the GFC which saw it ramp up commitments before the crisis at a weak time for the asset class and sharply retreat in the private equity boom that followed, are still front of mind. Still, holding the line in today’s active fundraising cycle, when pressure to invest and chase the market abounds, is difficult. Total pacing through the year amounted to $3.6 billion, modestly above the top end of OPERF’s target pacing range of $2.5-3.5 billion.

“Maintaining consistent pacing hasn’t caused us to make sacrifices from a quality perspective,” said Martin. “We haven’t been chasing the market.”

Secondaries

In recent years, Oregon has also developed a successful Secondaries program selling off vintage allocations. However, Langdon flagged that today’s healthy secondaries market could get tougher as the supply and demand dynamic shifts in the medium term.

“We don’t want to be forced into a buyers-market,” he said. “All you are ever doing when you are placing this stuff in the secondary market is pulling forward distributions. And in every trade, at either a premium or discount, there are frictional costs – it’s not free. We have to balance what we give up. If we have a strong feeling that the distributions are coming, the better choice is to wait it out.”

Push into VC

This year Oregon’s private equity team will look at how to get more money to work into VC. The fund has a small (5 per cent on a roll forward basis) allocation to VC shaped around a handful of good relationships, but growth is challenged by accessing the best managers where Langdon explained VC investment skill often rests with single individuals.

“When done right, it’s the best return in the world, but good venture deals are done by good individuals and there are very few of them.”  This year the team will study the best, scalable implementation models with the view to pick up another 5 per cent.

“We will spend time on it,” he said.

OPERF’s private equity portfolio is structured around three key aspects. A primary program that consists of 45 strong GP relationships where the average commitment is around $250 million per GP split between style, geography, sector and size. Fee mitigation comes courtesy of a co-investment program, outsourced to Pathway Capital. Co-investment currently represent around 20 per cent of pacing, negotiated and structured around discounts where possible.

A third pillar to strategy is smooth pacing, targeting around $2.5-3.5 billion per annum of new commitments to 10-15 opportunities.

Finally, an enhanced monitoring and liquidity program, also with Pathway, manages legacy investments and relationships, as well as vintage exposures.

 

AP7, Sweden’s SEK 849 billion ($90 billion) DC state pension plan, is in the process of re-tendering mandates in its large ACWI exposure in accordance with procurement rules. Mandates for the passive, global, allocation are currently run by State Street Global Advisors, Northern Trust and BlackRock.

“We have just entered a new phase in our procurement process for a big part of the portfolio; it’s quite a large mandate,” says chief investment officer Ingrid Albinsson speaking to Top1000funds.com from the fund’s Stockholm headquarters.

The bulk of AP7’s equity exposure, which in turn accounts for the vast majority of the portfolio, is and will remain in the global market cap ACWI allocation.

Still, she notes that in global equities AP7 is beginning to diversify away from its pure market weighted ACWI index. Other allocations with a risk premium include private equity, small cap, some thematic strategies and some alpha strategies – where new mandates are also being added.

The small alpha allocation currently comprises three equity neutral long short mandates, two of which are run by Japanese managers (Nomura and Sumitomo Mitsui Trust) and one is with an internal team.

“We are in the process of adding mandates to some of alpha strategies,” she says. “We will communicate the details as soon as we can, but we are planning to increase the number of mandates.”

The current fine tuning of the equity allocation reflects the outsized role equity plays in the portfolio. AP7’s main life cycle product comprises a small allocation to fixed income (primarily Swedish exposure) with all the remainder in equity in a full throttle approach.

Established in the late 1990s, AP7’s guiding belief is that risk is essential to generate returns. Others include diversification – AP7 invests in over 3,000 companies spread across all the world’s sectors and regions – sustainability, long term strategies that benefit from mean reversion in asset prices over time, transparency and an active approach shaped by key objectives of AP7’s savers that include building cost efficient blocs. In the past 10 years, AP7’s fixed income fund has returned 13 per cent compared to 326 per cent by the equity fund.

Leverage

Leverage is also a key part of strategy, specifically used to boost global equity risk and create a more efficient risk exposure in contrast to other funds that use leverage to diversify or reduce correlations.

“We can take on a bit of risk – and to get that additional risk we use leverage. We could add risk via a number of strategies, but we add risk where it suits us best and this is via leverage on our global equity exposure.” AP7 sources its leverage from OTC derivative total return swaps.

The level of leverage, currently set at 115 per cent, is determined by the fund’s risk framework based on long-term analysis. It is neither tactical nor dynamic but shaped instead around the design of AP7’s Life Cycle product.

“We are systematic and long term. Everything is related to the risk premium in the equity market and valuations in the equity market.”

Managers

Around 80 per cent of the portfolio – the bulk of physical assets – is invested with a growing cohort of external managers. Fixed income, the derivatives programme and currency strategies are managed internally. A Swedish long-short equity mandate, the risk framework and all holistic management of the fund are also managed internally by a team of eleven.

“There are a lot of building blocs to our structure,” she says.

Re-tendering and hunting for new manages will be easier now COVID restrictions are easing and allowing face-to-face meetings, notes Albinsson.

“Meeting managers physically in their locations is a very important part of the long-term relationship. It’s important to be able to meet beyond just digitally.”

She concludes that the fund selects managers based on their product, cost efficiency and quality.

“We look for a long, proven track record and appreciate managers aligned with our objectives and philosophy. We develop things together; external managers are a strong part of us.”

 

 

Asset allocators should prioritise creating their own accountability system for diversity, equity and inclusion in 2022 according to Jason Lamin founder and chief executive of DEI specialist Lenox Park Solutions.

Lamin says processes and behaviours including regularly reporting to the board, whether formally or informally, become a catalyst for change.

“One of our clients’s CIO reports regularly on DEI to its board and by doing that the staff, executive management team and CIO have to get very serious about what they are going to be reporting on,” Lamin says.

Importantly these practices can address the structural barriers to improvement such as goal setting.

“It comes down to fundamental business management, that is the only way this works,” he says. “Clients that want to check a box will fail. The only way it works is organic, bottom-up change that starts with being accountable and that rolls into data and measurement.”

Lamin advocates reporting to some governance structure and some level of accountability as an important catalyst. What comes next is measuring progress with analytics that give context to the entire industry.

“People want to know what to do on Monday morning. One of the biggest impediments to DEI advancement is we have made the discussion in rhetoric and have laid out grand expectations but come Monday morning when I get to the office what do I do?”

Lenox Partners, whose work is rooted in a metrics-driven approach, now has asset owners with combined $5.5 trillion as clients including CalPERS, Illinois Teachers, Mass PRIM and New York State Common. Financial services clients include JP Morgan, Prudential and NY Life.

Lamin says being able to scientifically measure DEI is an important step in incorporating it into decision making and has developed a statistically rigorous methodology to rank asset management industry participants on diversity data.

The Lenox Park Diversity Impact Score (LPI) is calculated using 10 components related to gender and ethnic diversity data for firm ownership, leadership, and total workforce. The score is constructed so more components – such as disability, LGBTQ and gender pay equity – can be added as the data becomes available. Clients survey their managers collecting data to create the score that can be used as a benchmark for change. The score is shared with the client, and the underlying managers.

Holding managers to account

While asset owners in many ways set the rules for DEI among their managers, Lamin warns against setting those rules in terms without context.

This means asset owners demonstrating they have also made progress in their own organisations so there is a collaborative effort to improve the industry.

“LPs showing they have done the work goes a long way to bringing the GPs into the conversation,” he says.

In a peer-aware industry such as financial services Lamin also says measurement needs to be meaningful to the market.

“Measurement needs to mean something in the market which is why the peer score is important. There needs to be realistic benchmarks and expectations of the manager.”

For example he says different asset classes need to be treated differently, pointing to real assets versus public markets where the demographic makeup among managers is very different.

“If we set goals as a blanket x per cent in all asset classes we are not meeting the market where it is,” he says. “We need to be realistic on what the expectation should be and put the scores into context, that’s important.”

The foundation space has been the fastest moving of all institutional investors in the adoption of the LPI metric for assessing DEI among their managers and Lenox Partners is now the standard.

“That makes it easier for everyone. The foundations can hold their mangers accountable and it makes it easier for the managers to have a clear idea of the expectations of them. Our technology makes it easier for all sides. That’s happening most clearly in the foundation space.”

Lamin says when investors have tools they can change behaviour very quickly and this is true for DEI scores also.

“I was surprised at how quickly the decision makers on the allocator side have incorporated the analytics into their decision making,” he says. “One [large pension fund] client already says to managers they need to disclose their DEI score in order to be considered by the investment committee. It’s not exclusionary but is another metric to assessment, we think that is a huge advancement.”

Singapore’s investment company Temasek is at the forefront of blockchain investment. Pradyumna Agrawal explains why going early and deep in tech investment is a sweet spot, encapsulated in the giant investor founding and building tech companies from scratch.

The professional network LinkedIn, founded 18 years ago and positively ancient by social media standards, depends on peer reviews to verify if someone is telling the truth. Singapore’s SGD381 billion ($283 billion) state-owned investment company Temasek recently backed a new job seeking platform supported by blockchain technology that gives people digital identities with verifiable credentials.

Targeting blue-collar job seekers in India, Goodworker helps lower income groups establish their identities in a verifiable manner. It’s one of the companies leveraging self-sovereign identity solutions built by tech company Affinidi – founded by Temasek – designed to give people a verifiable digital presence and allow the seamless capturing and sharing of data.

Temasek’s investment in digitisation and emerging technologies goes beyond the hunt for returns to playing a role in accelerating the trends that it believes will drive returns in the future. The strategy rests on a core belief that as digitisation and technology evolve, the tech world will migrate from today’s extreme centralisation to one of open networks and portable data, ushering in a wave of new business models in its wake.

“It’s taken time and we are only now beginning to see the benefits in specific application areas,” says Pradyumna Agrawal, managing director, investment (blockchain) at Temasek in an interview from Singapore.

Like Partior, a joint venture with banks DBS and JP Morgan, that is revolutionising cross-border payments and settlements using blockchain to enable programable value transfers. Or its partnership with the Singapore Exchange (SGX) that uses blockchain to replace the hundreds of laborious steps multiple parties take around coupon payments, issuing and servicing, OTC bonds.

“Blockchain technology puts everyone on a common workflow. It also adds liquidity because assets can be tokenised,” enthuses Agrawal.

Strategic capabilities

Tech investment at Temasek falls under different umbrellas. In some cases, it invests in funds and in others it goes direct. In a third and most startling seam, strategy involves creating companies from scratch effectively building its own strategic capabilities rather than wait to back entrepreneurs in the space. It’s rooted in the investor’s decision to catalyse solutions to unmet needs, either on its own or working with partners, by bringing businesses to life.

“Creating a business is a pretty unconventional approach,” he admits. “It started as an experiment; asking ourselves if we could solve a particular problem.”

Starting a business involves more than just capital. In a world flush with liquidity there is no shortage. What is just as valuable is Temasek’s credibility, neutrality, networks, talent and its ability to make long term commitments upfront that give staying power. Agrawal also makes much of the investor’s single-minded focus on solving challenges. Indeed, such is the importance of these other ingredients beyond capital that he often finds Temasek executives advocate against inviting other investors in too early on projects.

“Their reaction is often ‘not yet’,” he says.

Sweet spot

And going in early – or at the beginning – and deep particularly chimes with tech investment, an area where it is often difficult to capture the inflection point and access the best risk reward before the crowds arrive.

“We made the decision three to five years ago to systematically go deeper earlier,” says Agrawal. “This is the sweet spot where we find ourselves today.”

Looking through a pure investment return lens, he describes a strong commercial logic to building a business from scratch, particularly compared to the original capital outlay. It is also a virtuous circle whereby successfully solving one problem triggers new investments to deliver other outcomes.

Patience

Temasek’s ability and appetite to invest at the forefront of new technology is rooted in its ability to provide long-term, permanent capital able to see early-stage companies through their long gestation periods and across every stage of their business growth.

“The equity risk opportunity balance is in our DNA,” he says.

For sure, there will be some mortality; not every business will end up a thriving commercial venture. But Agrawal says Temasek has little appetite to sell during any stage up until IPO, at which point it might liquidate its shares or decide to keep a stake if it remains excited by the business – similar to how it evaluates other investment opportunities.

“The ideal scenario is to be able to list all these businesses and avoid selling the businesses to highly centralised organisations,” he says. “By staying focused on the viability and the gap the business is trying to solve, we hope many will end up floating on the stock market, allowing a broader set of investors to participate and support longer term growth.”

Importantly, Temasek never set out to invest a fixed amount of money in emerging technologies. From the very beginning, strategy was shaped around creating a foothold in the space from which organic growth would flow – aka using technology to find answers to solve problems and not viewing blockchain as a technology that needs a solution. And for all its success, his department is still small – although Agrawal says Temasek stopped measuring the significance of a team by its size or investment dollars long ago.

Mandated conviction

As the conversation draws to a close, Agrawal reflects again on the roots of success. Key elements include Temasek’s status as an investment company without any liabilities affording a bold mandate to invest across the life cycle of a company. This also comes with a governance structure that ensures the many companies Temasek wholly owns are independently run. The other pillar is conviction.

“We are only able to do this because our firm has a deep conviction on the potential of technology. There is no way we would build these platforms if we weren’t convinced about the need for a particular solution.”

As for the challenges ahead, he is most concerned by the shortage of talent in the tech space. A looming crisis that is compounded by the time it takes to garner real experience. It will make compensation (he describes a “massive” repricing of talent already underway) and building projects people believe in, key to retaining staff. As for investors, he reiterates the benefits Temasek reaps in its different,  operating role.

“Investors can patiently wait for someone else to build something and invest for 3-5X returns – or they can build their own capability.”