Sovereign wealth funds (SWFs) enjoy deep pockets, large and sophisticated investment teams, long investing horizons, strong leverage on fee negotiations, and often first refusal on prized deals.
But even given all of these advantages, they are finding it difficult to outperform in today’s low yield environment.
Asset valuations across many markets appear perilously lofty, and good returns hard to find. Stocks globally have hit record highs. The MSCI All Country World Index—which tracks 23 developed and 24 emerging markets—had gained 20% as of October 13 since Donald Trump’s election to the US presidency on November 8 last year. The prices of alternative assets such as private equity and real estate have also soared, as bonds’ ultra-low yields force investors into other markets in search of returns.
Making money without seeing risks spiral is proving a challenge for SWFs, with their huge war chests. The funds had $6.59 trillion in assets under management as of March 2017, of which Asia Pacific accounts for $3.05 trillion and the Middle East $2.07 trillion, according to an August report from data provider Preqin.
Today’s steep valuations have led some to lower their sights. In August Australia’s respected Future Fund cut its annual target return from between 4.4% and 5.5% over inflation to 4% to 5% over it. The fund is operating a little under its typical market risk level and seeking to build more flexibility into its portfolio, chief executive David Neal told AsianInvestor.
Meanwhile, New Zealand Superannuation Fund has slowly dialled back to a neutral level in relation to its reference portfolio of 80% equity and 20% fixed income, having been closer to a 100% equity allocation a few years ago, said CEO Adrian Orr. NZ Super declined to be more specific on the time frame.
But even amid frothy times the funds need to make money and demonstrate their worth. To do that most are trying to better understand what alpha they are getting and how much they are paying for it. Plus they are experimenting more with illiquid investments, such as private debt and venture capital.
Notably, China’s huge sovereign wealth fund expects its already hefty exposure to alternative assets to exceed 50% in the coming decade, executive vice president Guo Xiangjun said in late September. This allocation—mostly in private markets—has remained a little over a third of total AUM since China Investment Corporation was set up in 2008.
It’s far from the only one looking to do so. “I can’t think of one sovereign wealth fund that isn’t looking to build or continue building its private markets allocation [assuming regulations allow it to do so],” said Simon England-Brammer, Asia-Pacific head of Nuveen TIAA, a US-based manager of traditional and alternative portfolios.
Many sovereign wealth funds have long invested in private equity—now a very crowded space. Increasingly, they are looking towards private debt too.
Private debt is a broad category class that incapsulates non-publicly-traded securities such as asset-backed investments, direct lending, distressed investments and bank portfolio liquidations. Some 39% of SWFs now invest in the asset class, up from 34% the year prior, according to Preqin’s August 2017 Sovereign Wealth Fund Review. Mezzanine debt is the preferred strategy, followed by distressed debt and direct lending.
Moreover, SWFs and other institutions are looking at increasingly niche areas, such as deleveraging of bank balance sheets in Europe, royalty financing and settlement financing in litigation cases, said Paul Price, global head of distribution at Morgan Stanley Investment Management. Fund managers declined to give flow figures.
Even some smaller public funds are building momentum on this front. Korea’s Public Officials Benefit Association has moved into insurance-linked securities and catastrophe bonds in the past year. And in June it selected managers for its first private debt segregated mandates, having already invested in private credit funds.
To better invest, public funds have begun hiring more experts. For instance, Canada Pension Plan Investment Board added two to its principal credit team in Asia in the past year, raising the headcount to five.
Private debt appeals in part because it offers higher yields than traditional fixed income. Added to this, the difference between the return on private equity relative to leveraged private debt or between real estate and real estate debt has narrowed, said England-Brammer.
Now, for a relatively small adjustment of return, institutional investors can move into the debt position and reduce risk thanks to a shorter lock-up period, he noted.
One large and sophisticated Asian SWF, for example, is looking to take profits on strongly performing Australian commercial real estate assets and recycle some of this capital into Australian real estate debt.
Australia’s Future Fund has taken a similarly measured approach when moving up the risk curve. In recent years the institution has sought to buy private assets that many institutions would view as non-core and turn them into core assets.
“We’ve spent much of our time building a portfolio of investments around the edges of those markets; more idiosyncratic, slightly higher-risk investments that require more intensive management,” said Neal.
He cited the example of a power plant where the electricity supply contracts are about to expire. “A core investor does not like those assets, because they want the long-term contracts; that’s their security for...a dependable cash flow stream.”
But that makes such assets much cheaper. The investor takes the risk of renegotiating the supply contracts, but the assets can be revalued up to the core price afterwards. Neal did not elaborate on what kind of profit to expect on such a deal.
The fund has sought out similar opportunities across real estate, infrastructure, credit and even private equity, Neal added. For instance, Future Fund and investment house TH Real Estate bought a 33-storey tower at 685 Third Avenue in Manhattan for $190 million in 2013 (the former with a 49% stake). They renovated it to draw in new tenants and put it on the block in May this year for $450 million.
As AsianInvestor has previously reported, SWFs are also increasingly looking into venture capital (VC), particularly in the technology space.
Preqin noted in a report in August that sovereign funds have been involved in at least 40 major investments in start-ups in 2016. Singapore’s Temasek (with 17 deals), Khazanah (8) and Singapore’s GIC (7), being particularly active. All are experienced VC and startup investors.
Venture capital offers SWFs a few possibilities. First, it can throw off larger and faster returns than private equity. Secondly, VC investment sometimes offer SWFs insight that informs their governments’ national agendas and the strategies of their portfolio companies.
“Institutions that have not spent as much time on venture in the past are spending a bit more time on it now. It’s not just about driving returns but also about the information they can glean from VC investments in technology,” Sheila Patel, chief executive of international at Goldman Sachs Asset Management, told AsianInvestor.
For example, by following the impact of taxi-hailing apps SWFs can better understand trends in the broader transport sector, she noted.
SWFs in the Middle East are also proving keen to get into tech deals, in large part to help diversify their economies away from hydrocarbons, noted Boston Consulting Group in a September report.
QIA is seeking to tap IT expertise, as is Kazakhstan’s Samruk-Kazyna and Saudi Arabia’s Public Investment Fund. The latter demonstrated its seriousness with its commitment of $45 billion over five years to the $93 billion SoftBank Vision Fund. For SWFs, another appealing factor about VC tech deals is that valuations are typically lower than for traditional PE. And they can look at the secondaries market for PE and VC to build exposures, Patel suggested.
“It’s less widely covered so offers a more appealing discount—that’s where some [SWFs] that are newer to venture capital are doing a bit of a catch-up.”
Private market panacea?
Yet while many SWFs are pushing into private markets, some are concerned about such efforts. They are concerned about an erosion of the illiquidity premium—that is, the level of additional return on investments that have to be locked up for long periods of time.
Some of the funds have pulled back from private investments, noted Singapore-based Hon Cheung, chief investment strategist for official institutions at State Street Global Advisors. A notable example is Norges Bank Investment Management (NBIM), the world’s biggest SWF with $1 trillion under management.
Yngve Slyngstad, chief executive of NBIM, told Bloomberg in August that it was not worth moving into new private markets now; that building allocations to private equity or infrastructure would not move the needle sufficiently in terms of returns, given NBIM’s size and where valuations sit today.
Other funds will need to ponder similar issues as they look to increase their allocations to illiquids. Are they being paid enough to lock their money away for years?
Perhaps not. But in today’s low-yielding markets, most would argue they have little choice.