For Private Equity Firms, A Rush of SWF Cash Flow Seems Poised to Grow

February 19, 2015 by Loch Adamson

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David Mark Rubenstein is an American financier and philanthropist best known as co-founder and co-chief executive officer of The Carlyle Group
David Rubenstein, co-founder and co-CEO of Washington D.C.-based Carlyle Group

Sovereign wealth funds are pouring more money into non-listed assets, especially private equity. The biggest and most-established firms are the ones likeliest to benefit.


David Rubenstein, co-founder and joint CEO of Washington, D.C.-based Carlyle Group , sounded bullish last week about future sovereign wealth fund investments in his firm. "What we have seen is that the large sovereign wealth funds are now coming in to the market in very large sizes and making very, very large commitments, much more than we’ve ever seen before," he said in a conference call after the private equity firm reported record earnings.

Sovereign Wealth Center data certainly backs the notion that state-owned investors are deploying more capital in alternative investments like private equity. Part of that, naturally, is just due to the breakneck growth of Sovereign Wealth funds themselves. "Many of the largest institutional investors in the world have seen substantial increases in their assets in recent years," Rubenstein said.

Since 2002, state-owned investors’ total assets have more than quadrupled and the percentage of their assets they allocate to unlisted assets has more than doubled. That trend has only accelerated over the past two years as interest rates remain at historic lows, and some stock markets have become expensive. So investors of many stripes are seeking alternatives, sending a wave of money into private markets, especially from the Middle East and Asia.

Total Sovereign Wealth Fund Assets Under Management by Asset Class, 2002–’12

Source: Sovereign Wealth Center.

But is this phenomenon benefitting private equity managers like Carlyle as Rubenstein claims? Over the past half decade, sovereign wealth funds have become more active direct investors. In 2014, they committed $38.7 billion to unlisted assets, including real estate, infrastructure, unlisted companies and loans. This represents a 153 percent increase on 2010, when they invested just $15.3 billion in these types of assets.

Indeed, investments outside the publicly traded stock and bond markets accounted for almost 70 percent of sovereign wealth funds’ foreign direct investments (excluding indexed strategies) in 2014, up from 41 percent in 2010, according to Sovereign Wealth Center data.

Sovereign Wealth Fund Investment in Public and Private Markets 2010–’14

Source: Sovereign Wealth Center.

But burgeoning direct private market dealmaking doesn’t necessarily mean sovereign wealth funds are abandoning private equity managers. State-owned investors still need PE firms.

Since they rarely get preferential access to deals, if they choose to only invest directly in private equity sovereign wealth funds are forced to rely on other intermediaries, such as investment banks to build their pipelines. That increases the risk of being brought into a deal late in the process, when the upside potential is more limited — a particular danger in the technology sector where some state-owned funds have invested steep valuations.

Attracting Talent

Instead, some sovereign wealth funds have decided to work with their private equity managers, investing alongside them, rather than through their funds. And it’s not only about cutting fees.

"Investing directly is not just about the disintermediation of the market," says a senior private equity professional at a major sovereign wealth fund. "It’s about finding good deals." While direct private market investing can increase profits, he says a less obvious benefit is developing a sovereign wealth fund’s internal expertise. Among other things, it helps in recruiting higher quality staff. "It becomes easier to attract talent, because these people want to work on the most interesting and challenging deals."

So the rise in direct private market investments is partly due to closer relationships between manager and investor. There are benefits for private equity firms too: They don’t need to shop deals to rival firms. There is also a better alignment of interests, which may lead to better profits for both.

In some cases, sovereign wealth funds have bought positions in the private equity firm to seal that relationship. For example, Abu Dhabi’s Mubadala Development Co . is a major investor in Carlyle, the Hong Kong Monetary Authority Exchange Fund , Singapore’s GIC , and the Kuwait Investment Authority (KIA) all own stakes in London-based CVC Capital Partners , and GIC and KIA, both own stakes in Fort Worth, Texas-based TPG Capital .

Good Managers

Rising sovereign wealth fund allocations to private equity are favoring larger firms because of their scale and perceived abilities. Newer state-owned investors look at private equity as a way to benefit from the diversification provided by unlisted assets. Such funds consider large firms more attractive because they see them as lower risk.

There’s some easy money to be harvested. As Rubenstein said during the earnings call, sovereign wealth fund commitments to Carlyle’s funds are rising across the board. The firm raised 37 percent of its new committed capital from state-owned investors in 2014, versus a historical average of 17 percent. Such a large rise is not just a result of new sovereign wealth money, or existing investors accelerating their allocations.

With interest rates likely set to remain low, sovereign wealth funds are now seeking out more esoteric types of private assets. In 2014, for example, Carlyle started raising its second energy mezzanine fund and its first Asia structured credit fund. The two funds, Rubenstein believes are "likely to hit their target levels fairly quickly."

Big, reputable private equity firms that offer a range of strategies and flexible investing relationships will continue to attract sovereign wealth fund capital. Don’t forget the most crucial element: skill. Our sovereign wealth fund private equity manager says "Good managers will always justify their fees."


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