Are sovereign wealth funds becoming a growing force in private equity?
They definitely are, and for three reasons. Firstly there is a greater number of SWFs than there used to be. Secondly, the assets managed by SWFs, in aggregate, are growing. And thirdly, there’s a greater appetite within many sovereigns for private equity.
To put the phenomenon in perspective, the global foreign exchange reserves for global sovereigns were around $5 trillion in 2007; in 2012 they had risen to about $10 trillion. They’re expected to reach $11.5 trillion by the end of 2013. Equally, SWF assets, according to the SWF Institute, have risen from $3.3 trillion to $5.5 trillion over the same period. Not all of that is available for investing in PE, but that gives us a sense of where this is going.
Does that mean they are likely to become increasingly active investors?
Absolutely. The starting point for quite a lot of SWFs has been that of LP in funds of funds, because they get more immediate diversification by investing there rather than in a primary fund. Then, as they get more ambitious and sophisticated, they’ll tend to increase exposure to primary funds – and, in some cases, move away from the fund of fund model. Perhaps because they feel, rightly or wrongly, that the layering of fees is weighing on their returns.
Then, once they have built a good array of relationships directly with GPs, they look at securing co-investment opportunities to sit alongside their LP positions. In fact, in a growing number of cases, the sovereign will be more interested in co-investing: as a price for securing the co-investment, they agree to put something into the fund – but you'll often find that there’s actually more money going into co-investment than there is into the fund.
Finally, if you take it one stage further, the more sophisticated sovereigns are recruiting teams from those GPs and doing direct deals themselves. That’s a sort of natural progression.
But are SWFs really well-equipped to take on a more active role in private equity?
There is a lot of diversity. There are some very long-standing and sophisticated sovereigns who have a good critical mass of investment professionals in house, that they’ve either grown themselves or recruited from their GP relationships. At the other end of the spectrum you’ve got smaller sovereigns, or ones who haven't been investing for so long that are pretty thinly staffed internally, and who are still very reliant on their external GP network. So there’s sometimes a bit of a lag: some sovereigns see the merits of moving into the more direct space, but haven’t yet got the internal resources to do that. But we see a number of sovereigns who we know are building teams, and who are doing so from the obvious places – namely the GPs and the investment banks.
Are some of them going too fast?
The problem for SWFs is that they have huge amounts of capital that they need to deploy every year. So in a way they have no choice: they’ve got to put this money to work somewhere. So there is a real appetite for finding good quality investment opportunities – and big ticket ones at that. Because they have a limited number of people, who are tasked with deploying tens of billions of dollars of capital every year, it’s much easier for them to do it by executing a few billion dollar deals rather than many smaller deals. That’s why you see them going to private equity, which is an asset class that can deliver some nice chunky deals.
What criteria do they look at when choosing GPs?
Track record is essential. There are GPs who have had a recent track record that’s not been great, and we’ve seen them getting into trouble raising the next fund. That’s because the sovereigns, but also the other investors, are a bit spoiled for choice when it comes to new funds.
Size also matters a lot. Most sovereigns like to keep a reasonably low profile in a fund. So there are quite a number of them that will have an upper limit on the percentage of a fund they can hold, and that might be as low as 10 percent. But they want to put in a decent amount of capital, $250 million for example. Which, in that case, would mean the fund needs to get to $2.5 billion for their stake to be 10 percent.
Then it comes a lot down to relationships and individuals. Like any other investors, sovereigns are very interested in the individuals that are going to be deploying capital for them. So things like key person provisions continue to be very important.
Finally, at least for some sovereigns, is the will to find a GP that will allow them to invest in the GP itself. So not only do they want to invest in the fund, not only do they want co-investment rights, but they also want to have a slice of the manager – that gives them access to the profits of the manager and possibly the carry, but also allows for a more hard-wired relationship with the GP.
Are there any risks GPs should be aware of when starting a relationship with sovereigns?
I think the credit risk is low on the whole. They are usually, by their nature, cash rich and haven't for example engaged the over-commitment strategies that some of the funds of funds suffered from in the post-2008 era. They also aren’t generally looking for liability-matched returns, unlike the pension funds and insurance investors and this in some ways make them a more obvious investor in private equity.
I guess there are at least theoretical immunity type risks, where a sovereign seeks to secure sovereign immunity from suit and enforcement. But I think this is mainly theoretical as I’ve yet to see a sovereign who’s tried to walk away from its obligations under a limited partnership agreement.
And I suppose there’s another potential risk, fairly small again, linked to sanctions. Certain sovereigns are based in countries where there are sanctions or restrictions, so GPs can’t access capital form those sovereigns. But to be frank they’re in a very small minority.
So I wouldn’t say it’s a risk free investor class. But once you’ve secured the commitment, I don’t think the risks are generally greater than for other institutional investors. That's not to say that SWFs are not demanding investors: for a variety of reasons, including because they aren't always driven by conventional economic factors, the investment of time and management resources which GPs need to make to secure sovereign capital should not be underestimated.