Embracing Private Markets, SWFs Thrive in Tough Times

September 05, 2013 by Loch Adamson

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Source: Institutional Investor’s Sovereign Wealth Center.

In a world of constrained capital, sovereign wealth funds are investing more widely, capturing illiquidity premiums in private markets and growing their assets under management. In September, Institutional Investor’s Sovereign Wealth Center examined what’s driving this expansion and developed a ranking system for the magazine’s fourth annual survey of the largest sovereign funds. The 2013 ranking captures data for 46 funds, proving that an increasing number of institutions that meet the SWC’s rigorous definition of a sovereign wealth fund.

As of December 31, 2012, those 46 funds managed a total of $4.12 trillion in assets. Despite some of the toughest investment conditions in a century, sovereign wealth funds had boosted their assets from $2.35 trillion over the previous five years, a compound annual growth rate of 11.8 percent on a U.S. dollar basis. During the same period global pension funds’ total assets under management only grew 3.2 percent compounded annually on a U.S. dollar basis, from $25.9 trillion to $29.8 trillion, according to New York–based professional services firm Towers Watson & Co.
Between 2007 and 2012 the number of sovereign funds also increased, from 39 to 46. All seven of the new funds except one — Saudi Arabia’s Sanabil Investments — were founded in 2011 and 2012. But at the end of 2012, these new funds only represented 0.3 percent ($12.9 billion) of total sovereign wealth fund assets. Unlike China Investment Corp., founded in 2007 with $200 billion, new funds commonly launch with the equivalent of just a few hundred million dollars and receive ongoing revenue from commodity extraction royalties. Although oil prices have softened over the past two years, funds that derive their capital from government oil and gas revenue continued to dominate the total asset pool. In 2007 they accounted for 57 percent of sovereign wealth funds’ total assets under management, a proportion that had dipped slightly, to 55.5 percent ($2.3 trillion), by the end of 2012.

Funds that derive their capital from fiscal surpluses, such as Singapore’s GIC (formerly Government of Singapore Investment Corp.) and Korea Investment Corp., continued to account for just over one third ($1.4 trillion) of total assets, as they did in 2007. The outperformers were those whose wealth derives from state-owned enterprises, like Malaysia’s Khazanah Nasional and Singapore’s Temasek Holdings, This group enjoyed an average 14 percent compound annual growth rate: Their assets under management swelled from 6 percent ($150 billion) of sovereign wealth funds’ total in 2007 to 10 percent ($410 billion) in 2012.

Total Sovereign Wealth Fund Assets Under Management by Funding Source

Source: Institutional Investor’s Sovereign Wealth Center.

Looking at sovereign wealth fund assets through a geographic lens reveals a picture of remarkable stability over the past five years. In 2012 total assets were more or less equally split among the Asia-Pacific (37 percent, or $1.53 trillion), the Middle East and North Africa (35 percent, or $1.45 trillion) and the rest of the world (28 percent, or $1.13 trillion). Norway’s giant Government Pension Fund Global (GPFG), which had $715 billion in assets at the end of last year. The breakdown was broadly similar in 2007, when the Asia-Pacific contributed 39 percent of the $2.35 trillion total, MENA 37 percent and the rest of the world 24 percent.

Total Sovereign Wealth Fund Assets Under Management by Location

Source: Institutional Investor’s Sovereign Wealth Center.

Given that commodity prices have fallen in recent years, commodity revenue alone doesn’t account for the strong performance of funds that rely on this funding. In several cases governments diverted their oil and gas money to shore up domestic economies during the financial crisis rather than enrich the coffers of rainy-day funds. In the five years since the crisis, sovereign wealth funds have doubled the proportion of assets they invest in private markets such as infrastructure, mezzanine debt, private equity, real estate and venture capital, from 12.6 percent ($297 billion) in 2007 to 24 percent ($988 billion) in 2012. Sovereign wealth funds financed this dramatic swing by shrinking their overall allocation to cash and fixed income from 40.7 percent in 2007 to 29.4 percent in 2012. The proportion of their portfolios invested in publicly listed equities remained constant at 46.7 percent.

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

Source: Institutional Investor’s Sovereign Wealth Center.

Such a shift is perhaps unsurprising. Most sovereign wealth funds have traditionally allocated to investment-grade sovereign debt, which produced attractive returns with a low risk profile before the crisis. But during the crisis investors’ flight to safety drove down yields on triple-A-rated government bonds, and the euro zone’s subsequent troubles made these securities scarcer.
So sovereign wealth funds have had to look elsewhere for yield. Using their long-term investment horizons to harness illiquidity premiums and improve long-term performance, they decided that the private markets offered a better risk-return proposition than its volatile public counterpart. Privately owned assets were often undervalued, and there was little competition for deals.

The financial crisis didn’t precipitate this process, though. Between 2002 and 2007 sovereign wealth funds had already started paring back their bond holdings and making more private investments. But they did so much more slowly, as part of a typical institutional investor life cycle that sees a fund broaden its range of assets and take on more risk as it gains experience.

Although sovereign wealth funds are growing rapidly, the proportion of their assets available to external investment managers declined from about 62 percent in 2007 to some 38 percent in 2012, according to SWC data. Funds are increasingly insourcing investment management, especially in private markets. In 2007 sovereign wealth funds invested a large proportion of their approximately $300 billion worth of unlisted assets with third-party managers. SWC estimates suggest that this might have accounted for roughly 10 percent of the private equity industry’s assets under management, which London-based market research firm Preqin valued at $2.2 trillion.

Many mature sovereign wealth funds, such as the Abu Dhabi Investment Authority and Singapore’s GIC, are making more of their private investments directly in private markets so they can get closer to assets and have greater influence over deal terms. Another incentive is the relative management cost. Keeping private equity investments in-house can be 5.5 times cheaper than using external managers, according to Toronto-based global pension research firm CEM Benchmarking.

The headline growth figures suggest a rich pool of assets for external investment managers. But sovereign wealth funds — many of which had never known a downturn before the financial crisis hit, having launched during the boom years of the mid-1990s — face a steep learning curve. As they grow and develop, they seek to use asset managers to complement internal capacity, provide training or augment knowledge transfer.

Guidance from co-investment partners is proving particularly important in private markets, where sovereign wealth funds are becoming bolder investors. The more-mature sovereign wealth funds are growing more discerning about which managers they use and how they use them. For example, experienced funds often choose to insource passive management in public markets and enlist established outside managers for alpha generation. Meanwhile, younger sovereign wealth funds continue to need basic investment services. Although their assets are relatively small, there’s great potential to develop new partnerships with asset management firms that will become closer and richer over time.

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