2014 H1 - Overview

October 28, 2014

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The first six months of 2014 marked a transition for sovereign wealth funds as perceptions of frothiness ratcheted up concerns in a range of markets. Many of the developments of 2013, such as a competitive M&A environment and high real asset prices, kept playing out. Meanwhile, some of the obvious trends from the third quarter — particularly a drive to invest in technology-based consumer and health businesses — were gestating in the first half of the year.

Moving Out of Real Estate

One trend stands out: a plunge in sovereign wealth funds’ real estate investments. Here the adage "location, location, location" has been replaced by "valuation, valuation, valuation." Indeed, 2013 appears to have set a high-water mark for sovereign funds’ direct involvement in global property markets. During the first half of 2014, they closed $5.9 billion worth of property deals, a 43 percent decline from their $10.4 billion total in the same period last year.

Sovereign Wealth Fund Foreign Direct Investments: 2007-’14

Source: Sovereign Wealth Center

One key factor is rising competition. Since 2012 pension funds and insurers have increasingly turned to prime commercial properties in major cities with secure rental incomes, so-called core assets, to replace the reliable revenue they earned from high-grade bonds before the financial crisis.

Such institutional investors share the same long-term investment horizons as sovereign wealth funds, but they often have short-term liquidity needs. Their heightened activity has pushed up bid prices of core assets, making the properties less attractive to state-owned savings funds. But London still draws state-owned investors, whose purchases of prime real estate there continue unabated.

On the whole, though, sovereign wealth funds are looking elsewhere, joining forces with real estate managers to find less fashionable assets, such as logistics and retail complexes, and even residential developments. These properties don’t command the jaw-dropping prices of swank office blocks in major international cities, but their values are likely more sound.

Logistics and retail properties’ income streams are being driven by tectonic shifts in consumer dynamics: The boom in online shopping requires delivery hubs, a growing middle class in the developing world is consuming more, and an emerging-markets elite is traveling to luxury shopping destinations to buy premium brands.

Although sovereign wealth funds haven’t abandoned prime commercial real estate, they’re winning fewer deals as other investors outbid them. So funds are teaming up with partners in the sector by renovating and redeveloping properties to improve those that may not be considered top quality. The Abu Dhabi Investment Authority (ADIA) and the Qatar Investment Authority have both agreed to fund such projects in the hotel industry in 2014.

There is one sovereign wealth fund still in the market for gilded properties — one with a very large checkbook. Norges Bank Investment Management (NBIM), which manages the world’s biggest sovereign wealth fund, published its 2014–’16 investment strategy in June. This document outlines a plan to sink at least 1 percent of the Government Pension Fund Global’s now-$850 billion portfolio into real estate each year through 2016. NBIM has also stated that it will focus on prime commercial property in major global cities, though it has dabbled in logistics and retail properties.

No Longer Going It Alone

Another trend in 2014 is a shift in the relationship between sovereign wealth funds and their asset managers. Since the 2008–’09 financial crisis ripped holes in their balance sheets, many of the largest sovereign funds have decided to manage a greater proportion of their portfolios in-house. Frustrated by hefty fees, unfair incentives and disappointing returns, they have moved to change the balance of power by taking control of big chunks of their own portfolios.

The shift hasn’t been easy: Sovereign wealth funds have had to put in place the financial and human resources to build the capability for running their own money. In doing so, state-owned investors must fight for talent in a competitive marketplace, introduce comprehensive risk management and assume responsibility for returns.

Only a few of the most sophisticated funds have been successful. Although ADIA, Singapore’s GIC and NBIM have built effective internal investment teams, particularly for private markets, others, such as Korea Investment Corp. (KIC), South Korea’s $72 billion pool, have struggled in more-complex, illiquid asset classes.

For example, KIC’s direct private equity investments have substantially underperformed its fund investments in the same markets, gaining an annualized 1.4 percent from 2009 through the end of 2013, compared with 10.2 percent for the latter.

Sovereign wealth funds have sought new ways to tap the expertise of asset managers that align both parties’ interests and reduce fees. Instead of hiring outside firms simply to manage money or committing to commingled investment vehicles, they’re entering strategic partnerships with money management organizations.

Some firms with which sovereign funds invest worry that their state-owned clients will use an alliance to improve the skills of their own staffs without paying full fees. Another fear: The alliance may end with the state-owned investors managing nearly all of their assets in-house, leaving external managers out in the cold.

However, there are broader reasons for sovereign wealth funds to establish such partnerships. The relationships can be less about cutting out asset managers than becoming more knowledgeable and effective investors. The goal is to deliver better returns — whether on a macroeconomic, social or purely financial basis.

The Sovereign Wealth Center has observed this trend across real estate and infrastructure, private equity and hedge funds. But for less seasoned sovereign funds, such as those of Kazakhstan and Timor-Leste, building relationships with money managers is also necessary in traditional asset classes.

As ties between investor and manager have become closer and more complicated, the Sovereign Wealth Center has recorded fewer direct investments by sovereign wealth funds, with the exception of Singapore’s GIC and Temasek Holdings. Still, we see a growing number of innovative co-investment vehicles, joint ventures, partnerships and segregated funds that allow sovereign funds to sink money into less-traditional and difficult-to-manage assets. Doing so allows them to tap private sector asset management expertise less expensively, making them better stewards of their stakeholders’ weath.

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