Sovereign Wealth Funds Shift Focus to Private Markets

Despite SWFs’ success in private markets, internal debate continues about risks

Two white papers released at the end of December by State Street Corp. and the International Forum of Sovereign Wealth Funds reported that over the past three to five years, sovereign wealth funds have significantly increased allocations to private and emerging markets.

They have also reduced their exposure to listed and developed-market investments.

The research also looked at SWFs’ motivations for entering private markets (private equity, real estate and infrastructure), the approaches they had to develop to be successful and what they had learned.

One paper examines how SWFs are keeping up with financial markets in the aftermath of the financial crisis. It includes findings from a survey of eight IFSWF members, representing a wide range of SWFs.

“Much like all investors in today’s economic climate, SWFs are balancing traditional financial theory with the complexities presented by today’s real-world circumstances,” Will Kinlaw, senior managing director and global head of State Street’s academic affiliate, State Street Associates, said in a statement.

“They recognize that, in many cases, their long investment horizons represent an advantage, and they are seeking investments that will provide attractive long-term return, risk and diversification properties. What looks appealing based on monthly returns may look much less so when the horizon is measured over multiple years.”

The survey found that none of the funds had increased their allocation to foreign government bonds, but half of them had reduced their exposure to these securities.

In addition, half had added to their investment emerging markets, with none reporting reductions.

As a group, some 30% of the funds in the research had substantially expanded their alternative, unlisted and private investment portfolios, and none said they had reduced their exposure.

“One of the biggest findings from this research is the growing focus on private markets,” Kinlaw said. “Despite the allure of these investments, SWFs are aware of the potential risks, with illiquidity topping the list.

“However, many have invested considerable time and resource in assessing these markets and have clearly identified attractive opportunities here.”

The second looks at sovereign wealth funds’ approach to investing in the private markets.

It reports that SWFs often opted to enter private markets in the belief that their long-dated liabilities meant they could benefit from the illiquidity premium these assets offer.

They also thought that private markets were less efficient and could present more opportunities for return.

Although SWFs have enjoyed success in private markets, according to the paper, many reported continuing internal debate about whether the return premium was fair compensation for the risks these types of investments add to the portfolio.

At the same time, they cited a variety of factors that led to success in private markets:

  • Fostering a culture of long-term investing
  • Attracting and retaining qualified staff
  • Partnering with other SWFs
  • Assigning multidisciplinary due diligence teams
  • Proceeding slowly to keep pace with developing in-house capabilities

Of the funds interviewed for the paper, half said they had had to amend their governance process in order to overcome challenges related to the speed of decision-making regarding private market opportunities.

“The investment landscape has evolved significantly in recent years, and SWFs have contended with an ever-expanding array of investment opportunities in both public and private markets,” Roberto Marsella, leader of IFSWF’s investment practice committee, said in the statement.

“In response, many are re-evaluating the methods they employ to construct portfolios and measure and manage portfolio risk. The low interest rate environment creates new challenges and requires reassessment of investment methodologies and professional skills.”

--- Check out 10 Analysts’ Predictions for Private Equity, Venture Capital and M&A in 2017 on ThinkAdvisor.

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