When Apples taste like Oranges
Why Capital Design is a Necessary New Lens for Institutional Capital Allocation
Recently, Fuse Partners Chaz Legge and Jordan Ostapchuk shared the stage at the Private Markets Forum convened by Institutional Connect in Montreal. Below is an edited transcript of the discussion on Capital Design, a new approach to institutional capital allocation that considers the changing nature of private market asset classes and the need for new portfolio tools. Notably, Chaz and Jordan have way too much fun when given the mics in front of a room full of investors (photo evidence included).
CONTEXT
C: We’ve heard already about the growing allocation to private market assets. But it’s not just the flow of capital that is changing. What else is going on?
J: Two things related things are happening.
More allocation is flowing to private market assets.
And the variety of opportunities within private assets is also increasing.
We see more investment opportunities that fall between asset classes. Energy transition is a great example of this. Take for example an E-bus business that has contracts to swap out batteries. It could be categorized in many ways. Is it transportation? Is it energy? Is it infrastructure or is it PE? Or something new altogether?
It's no longer just about classifying investments but understanding their unique characteristics in a shifting macro environment.
C: Interesting. But isn’t this what investment teams are supposed to be good at? Sourcing, filtering and diligencing deals, and putting them into the right asset class bucket, with the right risk/return?
J: Yes, in a world where asset classes and risk ratings reflect the world around us, this is historically what institutional investors do well.
PROBLEM
C: So what’s the problem then? Why should investors be concerned?
J: Not being able to discuss risks and uncertainties because they don’t fit your categories is a problem. Fiduciaries should always be concerned about their ability to deploy capital and generate returns well into the future.
It’s less of a knowledge problem and more of an understanding problem.
Institutional investors need a new way to understand risk and uncertainty inherent in their portfolio, and be able to discuss it at the root cause level. We investors love to overcomplicate things with models. They have their place. But at the end of the day, management teams need to make decisions, critical trade offs with limited information.
I think it’s simply better if you have more and different types of information to decide from.
C: That sounds interesting, can you give us some examples?
J: Investment decision making has historically relied on ‘comparing apples to apples’.
Two related challenges here. To use the fruit analogy, Investors must account for new types of fruit – oranges, pears, etc. But the same fruits also look different in a new macro environment. Apples that taste like oranges.
Let’s use two examples to explain. A data centre and a regulated transmission utility.
The data centre shows the challenge of segmenting assets. Data centres are relatively new to investors. Huge tailwind behind it, with AI, autonomous driving, you name it.
There are components of infrastructure, real estate, and private equity in this opportunity. How you categorize this asset informs what you can do with it. Classify it as infra, and you’ll lean towards cash flow. Classify it as PE and you might pursue an M&A strategy. You will also be more willing to take certain risks and will model the business plan on different macro factors. This data centre could be a banana, pineapple, or orange, depending on how you price and manage it.
Now take the regulated transmission utility. This is something investors know very well. However, the need to decarbonize the grid has turned this asset on its head.
Companies need to invest significant capex to build the grid, support interconnections for renewable energy, build out the network of EV charging and so on.
Suddenly, this safe and yielding asset looks far different on your books from a risk/return perspective compared to your underwriting case. Doesn’t mean it’s a bad asset, it just behaves differently now. This apple suddenly tastes more like an orange.
C: Jordan, you are making me both hungry and curious! It seems like there are several implications and unintended consequences stemming from the mismatch between investors’ fixed world view and the changing opportunities it is presented with.
J: Absolutely, the evolving market landscape leads to several key challenges within the investment organization, affecting everyone from the CIO to risk and asset management teams.
You might have unintended exposures, as strategies aiming for traditional infrastructure-like returns might conflict with emerging decarbonization goals.
You might have trouble sourcing deals becomes challenging when an organization is known for strictly adhering to conventional asset class definitions, limiting flexibility and adaptability in a changing investment environment.
You might have hidden correlations between seemingly disparate assets in your portfolio.
SOLUTION
C: As fiduciaries, that’s not a great outlook… You’ve spent the last 7 minutes scaring us. Please tell us that there is some hope?
J: There is hope! I faced these exact challenges in my decade in and around pension plans. It’s a common challenge – in talking to our peer funds in Canada, Australia, Europe and the Middle East, we’re all experiencing the same thing.
The deals coming to investment committees look less and less like “traditional” Infrastructure/Private Equity/Real Estate. The world was changing in ways that couldn’t be neatly quantified in Excel. I saw the same with my colleagues in Venture Capital and Real Estate.
The research was my attempt to solve my own problem. Besides, my mom always said, don’t be part of the problem, be part of the solution! I looked around, wasn’t satisfied with the current tools, and needed to build my own. I looked to design, which I had experience with.
The result is Capital Design. It blends the rigor of investing with the logic of design.
The concept was so new that I did a PhD in it, to make sure the research was rigorous, and that I could do it in a systematic way. This was a challenge that institutional investors everywhere will face.
C: So you’ve spent the past 3 years researching a new set of tools for investors which you call Capital Design. We know some things about capital – explain a little about design. What is it?
J: Design is a set of capabilities that help us ask better questions, integrate different perspectives, envision novel and preferable outcomes, and help create them.
Design merges creativity with strategy. It's a powerful tool for businesses, to solve complex problems.
You’re seeing big business schools like Stanford, Rotman and others incorporate design into MBAs because it’s proven to be such a complementary tool for value creation.
C: What is Capital Design and how does it work?
J: Capital Design applies proven design capabilities at specific points in the investment process. Based on what worked in our global fund research and case studies, we've organized the relevant principles into a three-step process tailored for investment decision-making.
You can use this approach to distill complex portfolios to their core drivers, design strategies around these insights, and deploy them to capitalize on new opportunities.
Distill, design and deploy. It's meant to be user-friendly and intuitive. There is value in simplification here. The point is to discuss these uncertainties, not hide them in risk models.
Distill: You can simplify complex portfolios to a few key drivers, like AI’s impact on productivity and global population flows, assessing how these factors influence your portfolio. This step involves abstraction and foresight, aiming to simplify our natural inclination as investors towards unnecessary complexity.
Try it for yourself: take a grouping of assets – could be by class, sector or region, and ask what’s the one thing that is common across all of these? And if this thing changes, what happens? Now try it again for a grouping of random assets and see the similarities or differences.
Design: You can develop strategies in response to your portfolio drivers by examining your current strategy in light of these new scenarios. This stage focuses on synthesizing diverse perspectives to form cohesive strategies. You can then reframe your strategy, given these scenarios. Maybe you need to reposition capital, or start looking for different qualities in your assets, or management teams?
Try it for yourself: if you did the first exercise, you now have a sense of the underlying factors that influence your portfolio one way or another. Ask yourself, “what really matters here?” given your goals. If you are a fund that needs to pay pensions, cash yield matters a lot. How might this change your investment strategy? How might you do asset management differently?
Deploy: Armed with a forward-looking perspective, you can pivot your approach to the evolving market landscape. This involves synthesizing new strategies that match your organizational strengths and mandates. The goal is to integrate new insights with existing capabilities. You want ideally want to be able to better understand and explain where risks and returns will come from in your portfolio. Better understanding, and more easily articulated than you had before.
Try it for yourself: You can use a Roger Martin classic question here: ask yourself what would have to be true for my portfolio to succeed in these scenarios, with these exposures? What are the implications to how we assess risk, run investment committees, and to governance? What do I need to be good at?
In summary, the process is intended to be accessible for a broad range of people, including your Board. It allows investors to move from order takers to order makers – you can design your desired future. Your investment then becomes not just a reactive return-generating function. It is also a proactive future value creation function.
C: So, Capital Design not only addresses current problems but also sets the stage for future investment?
J: Exactly. It equips Boards, CIOs, investment committees, risk professionals, auditors and policymakers with new tools to ask critical questions, evaluate portfolio impacts, understand expectations, process uncertainty, and invest accordingly.
It's about making transformative investments amidst uncertainty. If you can’t discuss a problem, you can’t understand it.
C: Let’s bring it home. Summarize this for us in 30 seconds or less:
J: Capital Design is a novel, design-based approach to investment that helps navigate the complexities of private markets.
It enables better strategy formulation, risk management, and opportunity identification. You have a more understandable and discussable sense of future value in the evolving investment landscape.
Best of all, it’s meant to be simple and a heuristic way to grapple with massive complexity.
If shows you how and why what matters to society will matter to your portfolio. Because after all, we’re all invested in this infinite game.
C: Excellent, thanks Jordan.
And to our audience at home, we’re always open to questions, challenges, and comments – reach us at hi@fusestrategy.co.