The rising trend for sovereign wealth funds (SWF) to make direct and co-investments in private deals is raising concerns about the level of debt these institutions are taking on – particularly with a global economic downturn widely forecast in the next two years.

Industry experts also question how large public investors would cope with the impact of a major slowdown on companies in which they own large and potentially controlling stakes.

“The real test of the direct investment model is going to be when we go through the next downturn,” Will Jackson-Moore, global private equity, real assets and sovereign funds leader at consultancy PwC, said on Thursday (May 23). He was speaking on a panel in London at the release of the annual review of the International Forum of Sovereign Wealth Funds (IFSWF).

The research, based on analysis of investment in deals, showed that SWFs are steadily moving away towards co-investing and direct investment and away from allocating to third-party funds. They are also continuing their shift towards unlisted assets, away from public markets.

Last year, unlisted investments accounted for nearly two-thirds (65%) of the number of deals SWFs did, up from about half in 2015 (see graph below). 

SOVEREIGN WEALTH FUNDS INVESTING MORE IN PRIVATE MARKETS
(Click for full view)

These trends have potentially major implications for relationships between investors and their fund managers, and for markets in general, according to Jackson-Moore and Bernardo Bortolotti, research unit director of the sovereign investment lab at Bocconi University in Milan.

RISING DEBT EXPOSURE

After the 2008 global financial crisis financial regulators forced banks to deleverage their balance sheets. That led asset managers to assume more of the debt side of leveraged buyouts.

“And the biggest investors into [or alongside] those [asset managers] … are sovereign funds,” London-based Jackson-Moore said. Hence they are not only increasingly providing the equity for private deals but the debt as well, thereby becoming a much bigger part of that market.

Will Jackson-Moore

Bortolotti made a similar point. Banks used to be big players in sponsoring and financing of private deals, he said. But the de-risking of banks means asset holders are bearing a significant amount of additional risk. “That’s a big issue,” he added.

It raises the question of whether institutional investors are prepared for the implications of all this for their risk exposure and required skill set.

Moreover, it could spark issues for limited partners (LPs, or investors) and their general partners (or asset managers) in the event of a downturn, said Jackson-Moore. For instance, many expect a US recession to hit within the next couple of years, while American-Chinese trade tensions are overshadowing markets.

“Will the funds and their partners be prepared for the complexity of working out a difficult investment?” he asked.

Nowadays, the big PE house will likely still be involved, but there may also be a sovereign wealth funds and large pension schemes directly invested too, each with different stakeholder dynamics, Jackson-Moore said.

In traditional private equity models a private equity firm invests money, alongside a lot of financing that would typically be arranged by a big bank. Any workouts would be a matter for them to sort out. And on the debt side there is also be a series of different investors, many of whom would have to sell off any debt that becomes non-performing, potentially to a special situations fund.

“So you’re going to have a completely different dynamic on the debt side,” Jackson-Moore said. “The complexity of that is going to be a new dynamic for the marketplace more generally.”

COPING WITH A DOWNTURN

Ultimately, sovereign funds may be less well equipped to deal with distressed situations that emerge. Their investment teams tend to be smaller and more domestically focused than those of big private equity firms.

Bernardo Bortolotti

Similarly, private equity houses will view slowdowns as a chance to buy cheap assets in struggling sectors, said Jackson-Moore. That doesn’t necessarily fit with the ultra-long-term, megatrend-focused strategy of SWFs or pension funds.

Private equity firms might move to buy chemical businesses at the bottom of the cycle, at two to three times annual earnings, and looking to sell at 10 times, he added.

“It will be interesting to see how those [sovereign] investment funds deal with that dynamic,” Jackson-Moore said.

He also pointed to the issue of reputational risk. There’s no guarantee that public investment funds would stick with a strategy if some of their portfolio companies were going under and they’re named in headlines.

In the past, Bortolotti said, the name of the game for sovereign funds was asset manager selection.

But now, “insourcing direct investment and finding the right partners is key”, he noted. “Are funds skilled and well prepared to play in this space, especially as they will be on the front line of deal-making?”