Joseph Mariathasan says the long-term goals of sovereign wealth funds mean they can tap the potential of private markets
At a glance
• Sovereign wealth funds see private equity investment, at least in part, as a way of gaining from illiquidity risk.
• Private market investment also helps to diversify portfolios.
• Sovereign wealth funds are forming alliances with each other.
Sovereign wealth funds (SWFs) are increasing their exposures to private equity and are becoming an important source of investment for the asset class. The International Forum of Sovereign Wealth Funds (IFSWF), a voluntary organisation of global sovereign wealth funds, found in a recent survey that they tended to allocate to private markets as they expected to harness a significant return premium over public markets. The boost to returns was seen as the result of the illiquidity of these assets and the fact that the markets are less efficient.
As a spokesman from Singapore’s GIC (formerly the Government of Singapore Investment Corporation) explains, private equity exemplifies an asset class where sovereign wealth funds such as GIC can tap their advantages to reap excess returns from investments that require longer gestation periods to realise their potential.
“Investing in PE enables better long-term returns on our portfolio,” says the spokesman. He adds that the GIC found that PE offers the highest expected return, albeit with the highest volatility, among the main asset classes. In part, this is to compensate investors for assuming illiquidity risk.
But a long-term investor such as GIC can afford to ride through the higher volatility of PE in return for a higher expected long-term return. While PE investment is considered higher risk, this strategy has worked well for GIC so far. GIC’s experience is that returns from the PE asset class since its introduction into the portfolio in 1982 have exceeded returns from public equities. In addition, as GIC’s spokesman adds, PE offers diversification benefits to GIC as its return drivers are somewhat different from those of traditional asset classes. As a result, GIC sees PE as occupying a distinct and important role in its portfolio.
For SWFs, the size of their investments constrains their ability to invest in smaller funds. But, as Adveq CEO Sven Lidén points out, if interest rates are zero, investors do not need to make double-digit returns in PE to be happy. While return expectations for mega funds have come down, SWFs are still happy with them because PE still gives much higher returns than anything else and they do not have to constantly reinvest the money, which is also an issue. What they need to do is invest in size. “If you are a $100bn (€93bn) fund, it doesn’t make any sense to chase an opportunity for $50m. SWFs are getting special deals to lower fees and allocate even more money,” says Lidén.
For SWFs, private equity is just one manifestation of a larger trend to increase exposure to private markets in general, which encompass real estate and infrastructure alongside private equity. As the IFSWS explains, private markets provide specific exposures for their SWF members that are impossible or difficult to access in public markets. For example, venture capital provides the opportunity to invest in new innovations in a deeper and richer way than in the public market.
“SWFs are getting special deals to lower fees and allocate even more money”
Public markets also offer limited opportunities for exposure to infrastructure and real estate. One SWF found that real estate investment trusts (REITs), are embryonic in Europe and still developing in Asia. Listed real estate and infrastructure companies also have structural issues that prevent them from providing SWFs with pure exposure to the underlying assets.
Sovereign wealth funds also acknowledge that private-market investments help diversify their portfolios. However, there is a common view that the diversification benefits may be overstated (and risk may be understated) given that valuations of private markets investments are not marked to market. What is more positive is that investment manager performance is seen to be more consistent in certain private markets areas, such as private equity, making it easier to select skilled managers.
SWFs like GIC invest both indirectly via funds and directly into companies. GIC has more than 100 active relationships with PE fund managers in all regions of the world. It also invests directly in minority stakes in companies, either alongside their fund managers, with other like-minded investors or independently, and has investments in over 100 companies globally. Its investments are spread across the capital structure through junior and senior debt. GIC itself is often seen a thought leader for SWFs.
As Javier Capapé a director at Sovereign Wealth Lab at IE Business School in Madrid explains, the more sophisticated SWFs like the GIC example, are active in co-investments. They have learnt how to do undertake the GP role, not only accepting LP roles. This is related to a deliberate strategy to build out their capacity in private markets. “We have witnessed a lot of Western bank hirings in the last five years; bankers heading infrastructure, PE, real estate units coming from London or NYC,” says Capapé.
He points out that the focus of SWF private investments so far has been on developed markets. But there is more interest in investing in the emerging countries (south-south investments) as is already happening in China and India. GIC, for example, has the bulk of its investments in developed markets, particularly in North America and Europe. However, it was one of the earliest PE investors in Asia and has a substantial presence in emerging markets with satellite offices in São Paolo, Beijing and Mumbai. Given that SWFs are long-term investors, Capapé argues that they are well suited to capturing long-term economic trends such as the growing middle classes and urbanisation.
Another interesting feature is the growing interest by SWFs in the venture sector. The IE Business School calls them ‘sovereign venture funds’. GIC again, along with Temasek in Singapore are the leaders in the sector, but there are many examples of SWFs making major investments in venture opportunities. As the Sovereign Wealth Lab points out in a recent report, some SWFs have even opened offices in Palo Alto from which to invest in US start-ups. These include Malaysia’s Khazanah, which has invested in General Fusion, and GIC, which has invested in Ancestry. It also argues that the investment strategies of SWFs will change.
In the past, the strategy of the funds had often been to invest in collaboration with venture capital funds that they themselves fund. However, SWFs are now forming alliances with other SWFs to invest in venture capital. The Abu Dhabi Investment Authority, Alberta Investment Management (Canada) and the New Zealand Superannuation Fund created the Innovation Alliance in 2013 to provide growth capital to the start-ups presented, both through venture capital funds in which they have stakes and through other companies in which they previously had no stake.
For the private equity industry it is clear that SWFs, along with university endowments, are their ideal investors. Entities such as the IFSWF are likely to play an increasingly important role in transferring expertise in private markets from the leaders to the laggards.
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