Sovereign funds “disrupting” co-investment market

State institutions are set to pour up to $300 billion into private equity assets in the next few years, increasingly through direct and co-investments, creating a new market dynamic.
Sovereign funds “disrupting” co-investment market

Sovereign wealth funds could invest almost $300 billion into private equity in the coming five years, which will see them increasingly competing with traditional PE operators as well as co-investing alongside them, according to a new report from consultancy PwC.

The chief investment officer of one US-based sovereign investor went so far as to say: “Sovereign wealth funds are disrupting the co-investment market."

An analysis of sovereign wealth asset growth to 2020, released late last month by PwC, predicts a multi-fold rise in PE investment.

SWFs’ average level of asset allocation to private equity was 5% in 2014. However, this encompasses a broad spectrum of engagement. Some entities are not investing into PE at all today, while others, such as Singapore’s GIC and more recently China Investment Corporation, have created specific PE programmes.

By 2020, the allocation to private equity within SWF alternative portfolios may range from 31% for ‘economic development’ sovereign investors to 38% for ‘capital maximisation’ SWFs, PwC predicted.

Sovereign wealth funds can invest in private equity in various ways, depending on their sophistication. They can be passive limited partners (LPs, or simple investors into separate private equity funds), they can co-invest alongside a general partner (GPs, lead PE fund managers) or they can directly invest into a target company, essentially acting much like a PE manager themselves.

PwC’s report says several sovereign investors are taking their private equity investing to the next level by hiring executives with consolidated experience in specific industries. That means they co-invest and leverage their relationships with the general partners, or PE fund managers, in addition to acting as passive limited partners. 

Moreover, SWFs are likely to increase the number of direct investments they make in the coming years, according to the PwC report. Almost half of the surveyed LPs said they would invest in targets directly, compared to just 21% in 2014. Singapore's Temasek and GIC are known to be active direct private equity investors, and China Investment Corporation set up CIC Capital in early 2015 to focus on foreign direct investments.

Co-investment is also an increasing trend among sovereign investors, noted PwC. "During the next five years, we expect the use of co-investments to spread and consolidate, regardless of the type and mandate of the sovereign investor.”

For new fund commitments, a large number of LPs now ask for co-investment rights, which are usually granted. In addition, while some sovereign investors consider co-investments separately, others include them as part of their broader private equity fund allocation.

SWFs have two main reasons to co-invest alongside a PE fund in which they are LPs. First, by doing so they gain control over the transaction and get direct exposure to its investment executives, while reducing the LP fees they have to pay. Second, the liquidity provided early in the transaction mitigates the 'J-curve' effect associated with private equity deals (whereby returns only start to come after a few years) and may help to outperform the returns of traditional fund investing.

The PwC report noted that Korea Investment Corporation hosted its first roundtable of sovereign and pension funds in Seoul in November 2015, to discuss potential alliances and co-investment opportunities. More than 30 sovereigns and pension funds attended, alongside several GPs, and 12 of the attending investors signed a co-investment agreement after the event.

Inevitably, the growing trend toward co-investment means the SWFs will end up competing with GPs and is having a significant impact on how PE managers run their businesses.

Diego López, global SWF director at PwC in Abu Dhabi, said: “This increasing collaboration has had an impact in the investor relations department of the major private equity houses. [US PE giant] KKR is said to have now over 50 people fully dedicated to IR, who need not only to deal with fundraising and asset management, but also to understand and originate co-investment opportunities.”

To put this in perspective, while sovereign funds are continuing to boost their PE allocations and buy stakes of buyout and venture capital funds, López said only a handful of sovereign investors had the capabilities and appetite to compete directly with PE firms for buyouts on a stand-alone basis. “But in the current market conditions, GPs have started to appreciate the importance of aligning interests and governance with them.”

Meanwhile, as SWFs become more aggressive PE investors, their investment preferences are likely to evolve, particularly given the scarcity of attractive targets in the US, said the report. These SWFs look set to direct more capital towards healthcare, natural resources and commodities, as well as new industries and technologies.

¬ Haymarket Media Limited. All rights reserved.