Institutional Investor

What Is an Institutional Investor?

An institution invests certain types of assets or those held for other institutions, for instance, investment and pension funds, which pool the funds from various investors like retail investors, for-profit enterprises, and other legal entities

Institutional investors are often considered well-educated and experienced, with extensive investment philosophy and knowledge. They usually prepare in-depth analysis and due diligence (DD) and present complex and sophisticated valuation models.

Because of presenting extremely detailed due diligence and analysis, they are most likely to make robust investment decisions compared to other individual or retail investors.

Institutional investors generally make investment decisions using the funds provided by their members or clients but also have their capital to invest, along with others’ funds.

Institutional investors have access to private investment funds and options, which other retail investors do not have, for example, private equity placements and real estate at the institutional level.

They generally have investment principles, clear objectives, and separate risk and compliance management teams to prevent investment-related difficulties and deviations.

Investment returns do not go directly to institutional investors since the clients and members provide the capital investment to generate returns on their invested capital (ROIC).

Only the return provided to institutional investors is management fees charged for the asset under management and incentive fees charged when the return on invested capital reaches a certain percentage.

There are various types of institutional investors in the financial markets, and each has specialized types of certain asset classes and customized investment strategies. Those investors are the following but are not limited to:

• Hedge funds

• Pension funds

• Endowment funds

• Insurance companies

• Private equity and venture capital funds

Types of Institutional Investors

Buying, selling, and managing stocks, bonds, and other investment securities on behalf of its members, customers, clients, or shareholders is the responsibility of an institutional investor.

Endowment funds, commercial banks, mutual funds, hedge funds, pension funds, and insurance companies are the six main categories of institutional investors.

Due to the belief that institutional investors are more experienced and capable of protecting themselves, they are subject to fewer protective rules than ordinary investors. 

As above-mentioned institutional investors are considered important financial market participants since they mainly deal with the investment management of their clients, members, for-profit and legal enterprises, and organizations.

Hedge funds

Hedge funds usually pool the capital of investors and invest that capital to generate positive excess returns. As a result, hedge funds are typically considered funds that have more flexibility in investment strategies than particular investment management funds.

Many investment hedge funds attempt to generate profit in all different types of markets by utilizing leverage, which is about borrowing funds to increase exposure to investment and associated risk.

Short selling and other types of speculative investment strategies are also the main aspects of hedge funds that most investment funds rarely use.

Not all retail or individual investors can contribute investment capital in hedge funds since that investor must meet certain investment capability criteria like a minimum level of assets, income, and available funds to invest in hedge funds.

Investors typically, clients of hedge funds are insurance companies, pension funds, extremely wealthy individual investors, and other institutional investors. In terms of regulations that are subject to institutional investors are not directed to hedge funds.

Regarding the number and amount of assets under management in the hedge funds recommended by the hedge fund manager, most hedge fund managers are not required to be registered or to file their annual public financial reports with regulatory authorities.

Also, hedge funds are usually less likely to experience fraud, and the fund managers have a fiduciary duty toward the funds under their management sphere and the clients.

Every hedge fund has its prepared investment strategies. For example, some hedge funds consider the diversification of multiple investment strategies and asset classes, while others may consider the concentrated specific areas, positions, and strategies.

The eligible investors and other institutional investors should understand the level of risk of the hedge fund’s investment strategy and should be mindful of the suitability of the hedge funds to their investment objectives, time horizons, and the ability to take a risk.

Since the investment objective can be generally higher, the risk involved can be relatively or proportionally higher, which has a positive correlation.

Pension Funds

Pension funds are the pool of savings and investments that are collected during the period of the working life of certain individuals. During the provided period, they are the cash flows of the employer organization and the employee’s additional contributions, income, and benefits.

Pension funds are classified into two: open pension funds and closed pension funds. Open pension funds represent at minimum one plan without any necessary restriction on a fund membership; while there is only one pension plan, it is limited to a certain number of employees.

Closed pension funds can even be classified into multi-employer and single-employer pension funds. In single-employer pension funds, the contributions of a pension plan are initiated by a single employee or sponsor and are pooled together.

Multi-employer pension funds are funds established by the pools of contributions of pension plans by different plan sponsors or employees. Multi-employer pension funds are further classified into industry, group, and collective pension funds.

Group pension funds are specialized for the number of employers of the companies that belong to or are financially related to one holding group.

Regarding industry pension funds, plans are specialized for unrelated employer companies operating in the same trade union or industry sphere.

Endowment Funds

Endowment funds are considered funds or foundations that will receive a perpetual stream of income cash flows to support the activities and operations of that sponsoring organization.

Most of the endowment fund plans and policies are according to the purpose of the stream of cash flows.

Key characteristics of establishing endowment funds are the following, but are not limited to:

• The stream of income cash flows should be in a predictable manner for budgeting and planning analysis purposes

• The amount of that stream of income cash flows should be sufficient to support its purchasing power to sustain that particular organization.

The sponsor of the endowment fund is considered the sole owner of that fund. There are two types of endowment, which are board-designated endowment and donor-designated endowment.

The donor-designated endowment is a fund that the contributor specializes to this fund with the purpose of the endowment.

To secure the agreement with its contributors and the regulating organization, the sponsor is required not to make any withdrawals that exceed the annual income.

When it comes to the board-designated endowment fund, it is the fund that the sponsor's board of directors decides to treat the fund as an endowment fund.

In the future, the board of directors can withdraw at any given period, even the whole principal amount of funds, if necessary.

Nevertheless, the sponsor has a reason to consider a board-designated endowment as a true endowment fund by investing a long-term horizon in future boards that will treat the endowment fund.

Insurance Companies

Insurance companies provide financial protection to their clients against identified risks that may occur in a certain future period.

The insurance industry's cost of service and insurance products are typically unknown before the actual contingent event occurs, according to the insurance product policies.

While there is a stream of insurance, premium cash flows from the client are known or can be determined at the insurance contract policies.

Insurance companies are often seen as facilitating institutions that transfer the risk of other entities, businesses, individuals, and investment management institutions.

Large insurance companies deal with the design of most risk-related and adjusted insurance products for the financial market participants.

Insurance companies play a huge role in the financial market by risk spreading, which includes diversification features, and risk pooling, in terms of the packaging.

Because the correlation among the various insurance contracts is supposed to be not positive or perfect, it is preferred to diversify those insurance contracts to decrease the insurance firm-related risks.

The future uncertainty regarding the future consequences of that insurance portfolio of similar insurance event assets are not perfectly correlated and is considered a better choice than obtaining only a single insurance contract.

All of the insurance companies in the industry always provide one or a number of the following activities to their clients in the financial markets:

• Insurance contract underwriting

• Collection of insurance premiums and billing

• Claims investigation and settlement

The premium amount received from the policyholders is charged up-front. However, when it comes to the reimbursement of the contingent liability, once an event according to the insurance policy occurs, the policyholder will be reimbursed for the loss he had.

Private Equity And Venture Capital Funds

Private equity is considered a term for invested capital made into companies, which are listed enterprises, unlisted private enterprises, or unlisted enterprises with the purpose of privatization of the target entity or entities, which are similar to private equity-backed enterprises.

The purpose of a private equity fund in the investment is to increase the worth of a business or certain entity, which can be put on sale after a certain period to generate a profit for the investors.

It is typically a closed deal within three to 5 years of its investment or event-driven acquisitions.

There are different types of strategies that are utilized by PE funds to increase the wealth of their investors; they are the following:

1. Venture Capital: 

VC is about the financing process of start-up, early, or growth-stage companies by equity financing rather than debt financing. 

VE funds are typically related to capital-intensive start-up companies in healthcare, biotechnology, technology, and engineering industries, where the start-up costs are significantly high, and it is virtually impossible to finance them with debt.

It is because of uncertainty related to that company's success and ability to generate future revenue and profit.

2. Buy-outs:

The most popular, also referred to as leveraged buyout (LBO), in which investment capital is made of equity and debt securities. Once the fixed financing cost of debt financing is satisfied, the remaining net capital gains are considered profit for the investors.

The greater the proportion of debt financing in the equity structure to equity financing, the greater the profit generated for the investors.

One of the most general statements about LBOs is that this strategy is most likely involved with financial engineering while generating little strategic and operational value.

3. Growth capital:

When the enterprise aspires to make an expansion of its business operations, it feels a necessity for investment capital. This enterprise can be listed or not listed.

Provided the enterprise is listed, the transaction process of private investment in public equity or PIPE occurs. The incoming private equity investors will get a certain type and amount in the enterprise that is not registered in the market for a certain period.

Researched and Authored by Bakhtiyorjon (Ben) Yakubov | Linkedin

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