LP interview: Sweden's AP2

AP2, one of five buffer funds within the Swedish pension system, is a parliamentary vote away from doubling its PE allocation to around 10%. The proposed change – part of a wider reform that would allow AP2 to increase its overall illiquid assets exposure from 17% to 40% – could release an additional SEK17.6 billion ($1.96 billion) for investment. Though a significant step in financial terms, it is seen by some as simply a response to changing market conditions.

“It is an adaptation to what has been happening in financial markets since our legislation was written in 2000. Back then, the alternatives space was smaller and private equity was less mature as an asset class,” says Anders Strömblad, head of alternative investments at AP2. “It has grown over time and we’ve seen new products develop. For example, the secondaries market wasn’t built out in 2000, but now there are many secondary specialists. The illiquid asset class has become more liquid over time.”

The proposal applies to four of the AP2 funds, which between them have around SEK1.4 trillion in assets. Private equity is currently subject to a 5% cap. There is no upper limit on real estate, although AP2’s 12% allocation – it is on track to reach 15% – is not unusual. Both would fall under the 40% ceiling. Guidelines for the specific limit on PE exposure have yet to be released, but initial indications are it would nearly double. In addition, the minimum allocation to high-risk credit instruments would fall from 30% to 20%.

A bill to this effect was put before parliament in June, but the vote was delayed until after Sweden’s general election in September. Two months on, the country remains mired in political uncertainty as a surge in support for the far-right party meant neither of the two main centrist parliamentary blocs could secure a majority. There is still no new government, though it is possible that the amended legislation could be passed into law by January 1.

Should this happen, Strömblad will have more capital at his disposal but limited resources to oversee its deployment. The alternatives team is seven-strong, with another member scheduled to join and take on a specific environmental, social and governance (ESG) brief. An increase in the allocation might warrant one more new hire. “We would not double the number of commitments, we would try to write some bigger checks to individual managers,” Strömblad notes.

Alternatives by numbers

As of June 2018, AP2 had SEK352.4 billion in assets, of which SEK92.4 billion – or 26.2% – was in alternatives. The strategic portfolio for 2017 allowed for a 24% allocation: 11% in real estate, 5% in private equity, 3% in alternative risk premiums (such as reinsurance premiums), 2% in alternative credit, 2% in China A-shares (they are treated as long-hold assets), and 1% in Chinese government bonds. Ten years ago, all AP2 had was a 1% in PE and 5% in real estate.

The fund’s overall net return for 2017 was 9%, while its annualized returns on a five and 10-year basis were 9.8% and 6%, respectively. Alternatives generated 9.5% in 2017. The returns for real estate, excluding timberland and farmland, and for private equity were 11.6% and 9.9%. Since 2001, SEK25.5 billion has been invested in PE with distributions of SEK22.3 billion.

AP2 hasn’t been able to drive up performance through zero-fee co-investment because holding private investments on the balance sheet is forbidden unless a target asset is nearing an IPO. The Ministry of Finance has said it will consider other liberalization measures, including widening the scope for direct and co-investments. However, Strömblad is doubtful whether AP2 would participate if given the chance.

“To make good co-investments or direct investments you need a strong team in place, you need to incentivize those people, and you would want a diversified portfolio, so you aren’t trapped in a couple of very big co-investments,” he says. “To do this, you must be global, with offices not only in Sweden but in Hong Kong and the US as well. As a state pension, that just doesn’t work.”

The PE portfolio was 56% deployed in North America as of December 2017, 23% in Europe and 18% in Asia. Nearly 60% of AP2’s capital was in buyout and growth funds and 23% in venture capital. Check sizes are in the $25-75 million range. All new fund investments are direct; the last commitment made through a fund-of-funds was in 2012.

AP2 has close to 40 active GP relationships and about a dozen of these are in Asia. Pan-regional buyout coverage comes through Bain Capital, Baring Private Equity Asia, MBK Partners and TPG Capital, while FountainVest Partners and Primavera Capital Group offer exposure to China alone, and Anchor Equity Partners performs a similar role in Korea. Sequoia Capital China is the main VC relationship.

“The Asia portfolio will continue to grow because the PE market is becoming more mature and there is more proof of concept in Asia. At the same time, Asia is taking a bigger share of global GDP. If those three things move in the right direction, it’s natural for us to increase the Asia allocation,” Strömblad says. He identifies language and culture as particular challenges in the region.

Points of concern

While increasing fund sizes are seen in a similar context – they reflect growth in the underlying economies – the speed of these processes means smaller LPs have limited scope to push back on terms. For Strömblad, two issues stand out, although neither is specific to Asia: the use of credit lines to artificially boost IRRs and charges placed on funds that fall outside the management fee.

“If one GP takes a three-month credit line and another GP gets a 15-month credit line, that can cause a big difference in returns, in the short term at least. Making comparisons between funds and against public market equivalents becomes harder,” he explains. “Some investors like credit lines because they are measured on IRR; I think it’s cleaner without, but I can’t change the market. Provided GPs do it sensibly, such as every quarter to make the drawdown process is easier and more condensed, it’s fine.”

Rising interest rates in the US could ultimately curtail credit lines – there is a trade-off between the cost of borrowing capital and the gains derived from delaying capital calls – while the Institutional Limited Partners Association (ILPA) has issued recommendations for standardized reporting of this kind of financial engineering. That said, the ILPA fee reporting template has been around for nearly three years and some problems remain. AP2 always asks managers during due diligence how they employ ILPA templates. A failure to employ is a dark yellow flag rather than a red flag.

On a more positive note, the pension fund has entered the impact investment space in the past 12 months with a commitment to TPG’s $2 billion Rise Fund. The vehicle is intended to appeal to institutional investors by delivering a market-based return as well as societal benefits. AP2 was already familiar with the manager, TPG Growth, having backed its funds since inception.

“The methodology is interesting, it shows that with impact investment there is no need to compromise on returns, although the fund is two years into its lifetime so it’s hard to say where it will go,” Strömblad adds. “There are a lot of very good impact funds, but they are very small. It is hard for us to invest $50 million in a $125 million fund. Taking impact to a larger scale is very interesting.”   

 

SIDEBAR: ESG - Key consideration

Nearly one-third of AP2’s annual report is devoted to sustainability work, and ESG (environmental, social and governance) is referenced 35 times. Part of this focus is government-mandated, but Anders Strömblad, head of alternatives at the Swedish pension fund, adds that sustainability is embedded into the organization. “We are believers,” he says. “If you are managing assets with a strong ESG profile that will create better value in the long run.” 

As part of ongoing efforts to integrate sustainability investment process, the pension fund has set a near-term target of having three-quarters of PE funds in its portfolio issue an annual ESG report. In 2017, 72% were compliant. “We have those commitments from GPs in side letters, but if you go back to 2004-2005 we couldn’t demand that,” Strömblad says. AP2 is leveraging the resources of the UN-backed Principles for Responsible Investment (PRI) and the Institutional Limited Partners Association (ILPA) to encourage the adoption of best practices for ESG.

Strömblad notes that Asian GPs have made significant progress in this area, particularly among the larger, more sophisticated managers. A poor approach to ESG can be an obstacle when committing to funds in the region, although not necessarily due to the absence of a formal policy.

“We must be aware, through conversations with senior and junior team members, that ESG is part of their wider investment approach and they think about those topics, even though there might not be an ESG label on it,” he explains. “We are not just asking managers what they think about ESG, we are interested in their culture, values, and investment beliefs.” 

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Europe
• LPs
• Investments
• Credit/Special Situations
• ESG