More governments eyeing sovereign wealth funds

The number of governments considering setting up some form of sovereign wealth fund is on the upswing, giving global money managers the opportunity to run new pools of assets.

Sources said the number of funds in the process of being set up, or that are under consideration, worldwide continues to grow. In Africa alone, more than 20 countries are discussing the implementation of a sovereign investment fund — encompassing SWFs and national pension funds — said the 2017 Preqin Sovereign Wealth Fund Review by alternatives data and intelligence firm Preqin Ltd.

“More governments are certainly coming to see the value in founding sovereign wealth funds as a tool to help stabilize the national economy in times of market shocks,” said Selina Sy, editor of the Preqin report, based in London.

Diego Lopez, vice president, SWF coverage at PricewaterhouseCoopers Corporate Finance LLC, based in New York, is “most definitely” seeing an increase in SWFs. “The SWF industry is fairly recent, and some of the success stories are making governments around the world consider the establishment of new investment vehicles,” he said.

Sources cited Turks & Caicos, Tanzania, Turkey, Georgia, India and Taiwan as examples of countries inspiring SWF-related headlines last year. “While debates are constructive, it is yet unclear how many funds will materialize, and most importantly, how successful they will be in fulfilling their mandate,” added Mr. Lopez.

“Anything that's an excess reserve you can invest more aggressively through a sovereign fund, which gives you an opportunity to mitigate an external risk you are worried about” such as commodity prices, said Ashby Monk, executive director and research director of Stanford University's Global Projects Center, Palo Alto, Calif. “Most SWFs set up today exist to minimize the volatility in commodity revenues or currency prices or government revenues generally.”

Continued growth in sovereign wealth fund launches has not gone unnoticed in the money management industry. General asset growth in existing funds slowed in the year ended March 2017, growing 1% to $6.59 trillion, according to Preqin. That compares to growth rates of 3.2% for the year ended March 2016, and 17.3% the year prior.

New sovereign wealth funds are an “incredible opportunity for asset managers. Generally, these vehicles are immediately big — they don't take decades to grow into the billions, and so they appeal. You've got these massive entities where a single mandate could be incredibly lucrative and for the most part, where they are building from scratch, they don't yet have the internal capabilities to run the fund,” said Mr. Monk.

Patrick Thomson, head of international institutional clients at J.P. Morgan Asset Management in London, said while the creation of such funds is not a new phenomenon, it is accelerating. One of the drivers “is continued growth in the balance sheets of the countries, particularly (in) emerging markets, whereby (these countries) are recovering, FX reserves as an indication of financial or fiscal health continue to grow, and the question from the government is, "What do we do with this money?'” The choice is leaving it with the central bank or to use it “creatively,” said Mr. Thomson. The firm's sovereign client assets under management globally were $64.5 billion at the end of March.

The main rationale for governments setting up a sovereign wealth fund is to “battle the resource curse and the mismanagement of budget surpluses, regardless of the economy's size and status,” added Mr. Lopez.

Assets are placed in a sovereign wealth fund largely for two reasons, said Ms. Sy: to house the profits from sales of hydrocarbons or other natural resources; or to invest in a country's infrastructure as a way of boosting GDP and “encouraging foreign involvement and investment in the national economy.”

The way these new funds will invest depends on the type of vehicle and its purpose. Mr. Thomson said there are broadly three types of funds: traditional FX reserves; country wealth, such as national pension funds; and those set up to invest in companies supporting the nation.

The type of fund also will dictate relationships with money management firms.

Whatever type of fund is created, Mr. Thomson said, “they are all naturally going to want to engage with asset managers ... it is not inconceivable to build your own (domestic) investment capability. But investing overseas is much harder; that is where you have to make a judgment on the build-or-buy argument.”

But he says it gets interesting when considering the different parameters and philosophies of these funds. For example, central banks are traditionally conservative and fixed-income oriented. While they might consider broadening into other asset classes, generally a relationship with an external money manager will be dominated by fixed-income allocations, he said.

“SWFs have a much broader allocation, invest across the spectrum ... and engagement with asset managers depends on the gaps they feel they have (that are) better served by asset managers,” said Mr. Thomson. He is seeing more appetite for alternatives such as private equity and private credit, “which is very prominent at the moment.”

Pensions & Investments reported in February 2016 that the Seoul-based Korea Investment Corp. will aim to boost its alternatives allocations to 20% of overall assets by 2020, from 12.4% at the end of 2015.

The final category, sovereign investment funds, “typically have a more idiosyncratic relationship with managers. It might revolve around a much heavier emphasis on alternatives, as they are typically taking direct stakes in companies, and also (take part in) co-investments,” he said.

Mr. Lopez agreed the overall allocation to alternatives by sovereign wealth funds has increased in the past few years. The Preqin report said 61% of SWFs surveyed for its 2017 report invest in private equity, up from 55% in the 2016 survey and 47% in 2015. Private debt allocations are up to 39%, from 35% in 2016 and 24% in the 2015 report.

He agreed the relationship with external money managers will largely depend on the mandate and infrastructure of the fund.

“However, the switch into more complex portfolios with real estate, infrastructure and private equities among other asset classes, as well as the focus onto new geographies looking for higher yields, will also mean a larger dependence into external managers that are reliable and have a strong track record in that specific asset class or region,” Mr. Lopez said.

Stanford's Mr. Monk said opportunities for external managers is “really true of reserve investment corporations, stabilization funds and long-term pension funds. Where it's not true is for strategic investment funds or sovereign development funds. Those I see popping up more and more,” he said. These funds are used to “make profit, while fostering development by crowding in money to an underserved sector. So almost by definition there are not investment products for those groups to buy, which means they have to go it alone.”

He said the returns of some of these types of funds have been very strong, “so a lot of countries are now saying, we want to think about a strategic investment fund, such as India with the (National Investment and Infrastructure Fund). That's not going to help the asset management industry generally, though could help private equity and venture capital,” Mr. Monk said.

And governance is a focus for new funds. J.P. Morgan's experience right now is that a number of funds being set up want advice and to know about best practices, and are asking for help.

“The hardest thing for them is governance — that's the hardest nut to crack,” said Mr. Thomson. Those overseeing the fund need to ensure they can meet objectives “without undue political interference” and have a well understood set of rules around spending of the money. “When we are asked to advise or help, we always start with governance. If you can't crack that, it's unlikely that the fund is going to be successful,” said Mr. Thomson.