Asia’s sovereigns: Partners or competitors?

EQT Partners closed its sixth fund in October at EUR4.75 billion ($6.5 billion) in what was the biggest fundraising effort in Europe since 2007. The task would have been harder were it not for Asian sovereign wealth funds. Asia Pacific investors put in 23% of the total capital, compared to 7% in the previous vehicle, while the sovereign wealth fund share rose from 31% to 53%.

With the Middle East and North America chipping in 27%, it is the first time European investors haven't accounted for the majority of an EQT fund. It probably won't be the last.

Sovereign wealth funds, Asian or otherwise, have are becoming ever more significant as private investors. Whether or not they are categorized alongside the largest Western pension funds, these long-term and highly strategic institutions are both alluring sources of capital as LPs and alarming potential competitors for independent GPs.

China Investment Corporation's (CIC) investment in Apax Partners, which won UK regulatory approval in February 2010, is a case in point. The Beijing-based entity made a $956 million commitment to the Apax Europe VII buyout fund, acquiring the unfunded commitments of existing LPs, and took a 2.3% stake in the management company as part of the deal.

But does CIC's move represent a powerful vote of confidence in private equity or a sovereign wealth fund looking to deepen its understanding of the asset class with a view to taking on the incumbents at their own game?

"Sovereign wealth funds are in private equity for diversification and excess returns, and sometimes for strategic reasons such as stimulating private equity - especially the VC industry as a tool for supporting small- and medium-sized enterprises or innovative companies," says Michael Prahl, a senior researcher with INSEAD's Global Private Equity Initiative in Singapore.

Josh Lerner, Jacob H. Schiff professor of investment banking at Harvard Business School, agrees that attractive returns are the primary motivation, citing various studies that conclude private equity has outperformed public markets in recent years. Investors with the resources and staff to develop a deep understanding of the asset class should see strong returns, he adds.

Capital to deploy

The world's 53 largest funds accounted for $4.7 trillion in assets as of October 2011, according to the Sovereign Wealth Fund Institute. There are 11 Asian entrants on the list, with total assets of $1.9 trillion, and six of these were set up since 2000. The largest regional representative, China's State Administration of Foreign Exchange (SAFE), which controls an estimated $567.9 billion, is not active in the alternatives space.

But others are. They have the portfolio size, the independence and discretion in terms of asset classes, the long-term investment horizons, and the absence of short-term responsibilities to enable them to invest heavily in alternatives. Neither are they bound to remaining in listed assets to satisfy regulatory and liquidity requirements.

CIC said in its 2010 annual report that exposure to private equity, hedge funds, real estate and infrastructure increased sharply to 21% from 6% in 2009. As of March 2011, one quarter of GIC's assets were held in alternatives, with private equity and infrastructure accounting for 10%. Temasek gives less detail, saying only that 22% of its portfolio was in unlisted assets, which covers LP allocations but not all direct investments.

Regarding LP commitments, these institutions have the scale, connections and importance to gain privileged access to top-quartile funds. Joseph Landy, co-president of Warburg Pincus, said in September that Asian LPs - including sovereign wealth funds - were not cutting back on their private equity allocations, and in many cases were increasing them. He added that a lack of understanding and certainty on how and how much to invest was more of a problem than any shortage of capital.

Warburg Pincus is reportedly seeking to raise a $12 billion global buyout fund. It is one of a host of leading US and European buyout firms preparing their latest round of mega-funds - the first time many have tapped the market for large sums of money since before the global financial crisis. With traditional LPs reducing allocation amounts or shifting capital to the small and mid-market, the expectation is that Asian sovereign wealth funds, drawn by private equity's brand names, will help make up the difference.

However, this is not a one-way street. "The sovereign wealth funds I have seen are questioning their allocations to private equity, given declining returns in the asset class in general," cautions Honson To, head of transactions and restructuring at KPMG China. "They are not rushing out to sign checks."

And as one leading authority on the field points out, traditional Asian institutions and sovereign funds, even those who already have active private equity programs, are constrained by the size of the funds and the investment opportunities - indeed, of the whole industry - in Asia Pacific. This leads to a circular debate which is unlikely to be resolved any time soon.

These factors pour water on gathering speculation that Asia is well on its way to surpass the West as the leading source of private equity capital. Given the regions' respective current positions, INSEAD's Prahl notes that Western numbers would need to stagnate or shrink and Asian numbers to increase rapidly for many years for this tectonic shift to occur. The emergence of institutional investors such as pension funds and insurance companies, as well as high net worth individuals and sovereign wealth funds, is creating new pools of capital, but private equity can't expect to consume it all.

"In Asia, arguably a lot of more conventional investment strategies - such as infrastructure - are likely to generate higher economic and societal benefit in the short term," Prahl says.

Furthermore, sovereign wealth funds are not being profligate with their money. "I have seen too many people flocking to the sovereign funds, not just PE but real estate, infrastructure and generally most industries," cautions To. "They have to remember that these funds have a wide range of investment choices and this allows them to be much more discriminating. I am sure North American pension funds are the same."

Active or passive?

Opinion is divided on the extent to which sovereign wealth funds are interventionist and pose a threat to the traditional model of the passive LP. To some market participants, these funds are only becoming more aggressive in their requests for information; they don't seek to tell GPs how to run operations or where to place the capital. At the same time, certain sovereign wealth funds stand accused of demanding special conditions and more of say in investment strategy, which can make standard LPs quite uncomfortable.

According to the provisional findings of a still-to-be-finalized paper by Adair Morse, a professor at the University of Chicago Booth School of Business, the biggest cornerstone investors in private equity funds do have a significant influence on GPs' behavior and performance. Sovereign wealth funds especially tend to get directly involved in both investments and exits, with slightly detrimental results on the deal side, but somewhat beneficial impact on the exit side.

It is of course incumbent on the GP to ensure that other LPs share both the information and the resulting benefits. But in the current fundraising environment, those raising big funds might have little choice but to digest any resulting conflicts of interest and fairness issues.

It is not unusual for an Asian sovereign wealth fund to contribute 25% or more of the capital required by a regional or single-country fund and in return get perks such as first refusal on co-investment opportunities, a discounted management fee and part ownership of the GP. Committing $500 million to a US buyout fund would command a smaller overall stake and fewer special conditions. However, one of the largest global funds raised recently - Lexington Partners' seventh secondary fund, worth $7 billion - includes separate accounts for two investors who each committed $500 million. One of them is CIC.

Referring to investments in the management units of global private equity firms such as CIC's arrangement with Apax, Lerner of Harvard Business School points to conflicting pressures. These deals can pave the way for a more strategic relationship or they can create - or exacerbate - incentive issues within the GP.

Prahl, formerly a principal at Apax, balances the benefits highlighted by Lerner against the fact that the fund manager is locking himself into a typically illiquid relationship. "This restricts your ability for rigorous portfolio management as well as for unproven returns on investment as ‘new' strategy," he says.

Evolving partnerships

Partnerships with sovereign wealth funds may be a double-edged sword, but the industry is becoming sufficiently diversified that it is no longer and black and white issue. First, other classes of large investors are now asking GPs for the same kind of special arrangements typically associated with sovereign wealth funds. On this basis, a sovereign fund able to offer its own proprietary deal access and reasonably acceptable terms might be the preferred option.

Second, GPs aren't the only prospective partners for the likes of GIC, CIC and Temasek. Sovereign funds appear to be pursuing all kinds of collaborative initiatives with their peers.

Abu Dhabi Investment Corporation (ADIC) has launched a $100 million joint investment fund with Japan's SBI Holdings, targeting opportunities in Turkey, following a similar-size fund launched in September 2010 targeting Africa. Abu Dhabi Investment Authority (ADIA), Allianz Capital Partners and Canada Pension Plan Investment Board teamed up to acquire almost 25% of Gassled Joint Venture, a natural gas transportation network feeding Norwegian gas to the rest of Europe. Malaysia's Khazanah Nasional and India's Infrastructure Development Finance Company have an infrastructure joint venture targeting India.

Dr Ashby Monk of the Oxford SWF Project explains there are numerous advantages to this kind of co-investment, including the pooling of resources in areas such as governance, domain knowledge, local expertise, and post-deal operational management, as well as the financial benefits of economies of scale and club-deal discounts.

"We have a high level of international connectivity with leading global peers with similar investment needs and practices," the New Zealand Superannuation Fund said in its July 2011 Statement of Intent. "We are actively pursuing co-investment and research opportunities and partnerships. Success in this activity will widen our ability to access global and, in particular, illiquid opportunities we would be unlikely to access on our own."

However, it added that this is a strategic objective, not a rapid process.

These consortia may not post a competitive threat to independent GPs because the kind of initiatives they back aren't necessarily accessible to pure financial investors in the first places. But they do represent at the very least a diversion of effort, and more proof that sovereign wealth funds are looking to be active in

vestors rather than passive LPs in private equity funds.
The standard GP response is that sovereign funds have deep pockets and will likely prudently diversify across both options. Suspicion persists, though, that they may have learned lessons from their investee GPs all too well.

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• Topics
• LPs
• Investments
• Sovereign wealth fund
• LPs
• CIC
• GIC Private
• Temasek Holdings
• Abu Dhabi Investment Authority (ADIA)
• Khazanah Nasional