Sovereign wealth funds, which once were viewed as ‘dumb money’ in some circles, have gone to school and smartened up about investing in private debt and other alternatives.
Since the global financial crisis, big state-owned investors – which include sovereign wealth and public pension funds that represent $27.5 trillion in assets – have been buying stakes in private credit fund managers, supplying cornerstone capital to funds, beefing up their in-house investment teams and making significant partnership deals with the likes of Apollo, Barings and Credit Suisse. They have also bought or backed seasoned credit managers, such as Antares and AGL, and have even started to co-invest with one another.
The pandemic has only intensified the interest of sovereigns and other institutional investors in private debt. Central banks’ suppression of interest rates to record lows had already occasioned a search for stable, low-risk yield in the less volatile private markets. Given that rates could remain historically low for some time, sovereigns, which are already assembling their own deals, could one day be vying with fund managers for private credit investment dollars in the same way, but on a much larger scale, as they are now competing with venture capitalists such as Sequoia.
In the past few years, sovereign wealth funds “have started to develop a big appetite for private debt globally”, says Sikander Ahmed, head of private credit at NBK Capital Partners, the alternative investments arm of Kuwait’s largest bank. In March, it launched its third-generation credit fund – its first that is sharia-compliant – with an anchor investment from Saudi Arabia’s $360 billion Public Investment Fund.
In January, Global SWF, a data platform that tracks over sovereign wealth funds, stated in its 2021 annual report: “With fixed income operating in a difficult environment, public equity rocked by high volatility and rising fears that a private equity bubble is about to burst, private credit is becoming increasingly popular among state-owned investors in the hunt for yield.”
The report, which named private debt “asset class of the year”, found that allocations to the asset class by the top 10 SWFs had risen to 3.2 percent, or $121 billion, of their portfolios in 2020 from 2 percent in 2015.
Sovereigns’ private debt portfolios are likely to keep growing. Diego Lopez, managing director of Global SWF, suggests that sovereigns could double their private debt allocations in the next few years, although the growth is likely to come largely from the top players.
Sovereign funds “have so much capital to put to work and a lower cost of capital, which means they are stepping in to underwrite some of the largest deals in the market while working with managers they know”, says Emily Pollock, alternatives director of private asset sales at Schroders in London. “When you’re talking about the big sovereign wealth funds, it’s truly a different scale.”
Pollock estimates that only the top 20-25 sovereigns are big enough to engage in such arrangements.
Victoria Barbary, communications director at the International Forum of Sovereign Wealth Funds in London, notes that only about 10 SWFs currently have any “meaningful exposure” to private credit. According to a PwC report, Sovereign Investors 2020: A Growing Force, the top 15 hold more than 60 percent of the total assets across all classes.
But as the universe of private investment continues to grow, smaller funds as well as those in emerging markets will begin to increase their participation. Although sovereigns in Asia-Pacific, the Middle East, Norway, the US and Canada dominate the alternative investing landscape, African investor assets are expected to grow by 11.4 percent in the next five years, according to PwC’s report.
Global SWF estimates that the entire investment universe of state-owned funds – which include SWF stabilisation, savings and development or strategic funds, as well as public pensions – will mushroom to more than $50 trillion by the end of the decade. State-owned investors’ assets doubled from $13.8 trillion in 2008 to $27.5 trillion in 2020. Their average asset allocation to alternatives jumped from 12 percent to 24 percent during that period.
In the meantime, “the debt world has grown exponentially”, says Treabhor Mac Eochaidh, head of debt services at asset servicer MUFG Investor Services, a strategic business of Mitsubishi UFJ Financial Group – with some estimating direct lending will double to $1.5 trillion over the next five years. Sovereigns now regard private debt “as a mature asset class”, he says. “Even during covid it remained very strong.”
Saving on fees
Given the interest rate environment and the volatility of the public fixed-
income markets, the climate is ripe for increased private debt investment among all institutional investors, including sovereigns. “Central bank policies are creating a lot of distortions and malinvestment, and that’s why sovereigns are going more into credit,” says Michael Maduell, president of the Sovereign Wealth Fund Institute, which analyses public asset owners.
Increasingly, the big sovereign players “desire to have less intermediation, and to save on fees and carried interest”, says Babak Nikravesh, a partner in the Silicon Valley office of law firm Hogan Lovells. “The objective among many sovereigns is more and more direct transactions, which requires a level of investment knowledge and developed in-house teams.”
That gives the lie to the stereotype of sovereigns being ‘deep-pocketed, dumb money’.
To be sure, before the global financial crisis “sovereign wealth funds were not the most sophisticated investors” in asset classes outside their traditional focus on infrastructure and real estate, says Lopez of Global SWF.
“Large investors, including sovereign wealth funds, increasingly are trying to identify managers who are better at specific things”
AGL Credit Management
However, he adds that sovereigns have gone to private debt school by working alongside general partners, by building in-house teams and, at times, by poaching key personnel from their GPs. Instead of participating in one-off deals, sovereigns are developing long-term relationships with managers and concentrating their allocations in fewer of them. “Over time, they’ve consolidated their positions and are giving money to people they really trust,” Lopez says.
NBK Capital’s Ahmed says it has taken 10 years of patiently convincing investors about the benefits of private debt to get them comfortable with the asset class. “Time after time, investors told us that, ‘Equity gives us more returns. Why should we invest in private debt?’”
But Ahmed, who believes NBK is one of the first funds from the Middle East to snag a sovereign as a cornerstone investor, says returns and statistics have shown that “private debt is a much more stable asset class than private equity”.
Private debt has less volatility and more stable cash yields and returns than PE. And unlike PE, where “everything is based on an exit event”, private debt charges a cash yield of, say, 8-10 percent annually and the funds “keep on de-risking every year and keep on getting capital back”, Ahmed says.
Private debt “is very resilient” says MUFG Investor Services’ Mac Eochaidh. The asset class is “still offering very high yields from the high single digits into the teens”.
The lack of transparency among many state-owned investors, their heterogeneity and their differing reporting times make it difficult to get a sense of average returns. However, Global SWF posited some calculations in its annual report based on the asset allocations and benchmarks of the top 100 state-owned funds. It found that, across all asset classes, sovereigns have returned, on average, 5 percent annually in the past 12 years, barely outpacing their 4.8 percent benchmark. Australia’s FutureFund, China’s CIC and Alaska’s PFC funds were the best-performing sovereigns, on average, in the 12-year period.
Global SWF also found that in the particularly challenging year of 2020, California’s CalPERS and CalSTRS and Canada’s CPP all stood out. Among SWFs, Alaska’s PFC and New Zealand’s NZ Super managed to post positive returns.
“Time after time, investors told us that, ‘Equity gives us more returns. Why should we invest in private debt?’”
NBK Capital Partners
Broadly syndicated loans “performed incredibly well in the covid recession”, says Peter Gleysteen, founder, chief executive and chief investment officer of AGL Credit Management. Although short-term interest rates have disappeared, BSL spreads have remained the same, he says, bouncing around in the range of 3.73-4.5 percent over the past decade. “The loan market offers even more relative value, and is on a tear, because of that.”
Returns also vary among regions and type of debt. Ahmed notes that his funds’ unlevered returns are higher than those in the developed world because there are fewer competitors in the emerging markets, where private debt is still a nascent product.
Increased regulation by the European Central Bank and the Bank of England “has opened up the opportunity for non-bank lenders to make senior secured or first-mortgage loans at very full yields”, says Stuart Fiertz, co-founder, president and director of research at Cheyne Capital Management in London. Sovereigns can achieve gross returns, unlevered, of about 10 percent on those types of loans.
Lower call protection
Marcus Frampton, chief investment officer of Alaska’s PFC, believes private credit lenders are receiving call protection of 12-18 months, which is perhaps lower than in the past, and that pricing on mid-market private credit loans is generally in the range of LIBOR plus 800 basis points.
Matt Koelliker, president of M360 Advisors, which invests in niche segments of private credit, says commercial real estate private debt enables sovereigns and other institutional investors “to get fixed-income-like exposure with yields of 8 percent instead of 2 percent”.
The greater sophistication among sovereigns has driven them to seek a more active role in managing their assets. “The trend is that big pools of capital will get closer to how they invest their capital,” says Gleysteen, whose other founding partners include private equity pioneer Thomas H Lee and a subsidiary of the Abu Dhabi Investment Authority, which has $726 billion of AUM. But the trend, he says, “is not to replace the external manager, but to supplement investing with an internal capability”.
The typical progression is for sovereigns to start off by investing in funds, says Isabel Dische, who co-leads Ropes & Gray’s institutional investor law practice in New York. As SWFs’ programmes have grown, the firm has seen them writing bigger cheques and negotiating bespoke fund arrangements. However, she adds that there are “a number of institutions that have built their own investing teams, some of whom are looking at originating loans”.
According to PwC, when it comes to real estate, sovereigns have traditionally acquired 100 percent or majority stakes, sharing them only with the developer or operator of the property. However, it adds that sovereigns are also forming real estate co-investment partnerships to make landmark acquisitions. These include Brookfield’s partnership with the Qatar Investment Authority to invest in London’s Canary Wharf Group.
Co-investing between sovereigns and fund managers is growing “because there are no diversification restrictions similar to what a fund will have”, says Audrey Nangle, executive director of private equity and real assets at MUFG Investor Services.
Investors that have already committed to deals through established funds are invited by a manager to bring in another big slug of capital to enhance their participation in the deal. In other cases, the asset manager and the cornerstone investor set up a separate partnership structure, like the one formed last year by Apollo and Mubadala, the Abu Dhabi-based SWF with $232 billion under management. These arrangements, Nangle adds, allow sovereigns to say to the manager: “We’re going into business with you. We want more say.”
Nikravesh of Hogan Lovells adds that co-investing arrangements or outright partnerships between sovereigns and sponsors can give sovereigns important governance rights as well as reduce or even eliminate fees.
Sovereigns are looking for a “partnership-style” arrangement, says Adam Wheeler, co-head of global private finance at fund manager Barings in London. “They are looking to invest in an asset class that can generate positive returns through a cycle,” adds Wheeler, who oversaw the Barings deal with Mubadala that was announced last September. The strategic partnership was launched with a $3.5 billion platform to finance European mid-market businesses. The platform is anchored by Mubadala, which will invest alongside capital from Barings and its owner, international investment management firm MassMutual.
Wheeler says Barings is also in talks about large-scale deals with other big sovereigns. Some of these SWFs want more control over the types of assets that go into their account, while others are seeking a more traditional, separately managed account set-up.
“What you’re seeing in Europe is a consolidation of direct lenders,” Wheeler says. These larger players have taken market share “because they’re a known quantity to their counterparty, and relationships have become extremely important to the borrower”.
Sole lenders wanted
In the European market, where banks have pulled back from the direct lending market, borrowers are looking for a “sole lender solution, where there’s quite a high barrier to entry”, Wheeler adds. “There aren’t a lot of players with the scale to deploy more than $250 million,” and sovereigns have significant capital to invest. Barings, he says, tends to be the sole lender.
Fiertz of Cheyne Capital Management says that separately managed accounts and co-investments “are illustrations of sovereigns increasingly working closely with fund managers to tailor these programmes to their liking”. Given that the US market is much more efficient and that it is estimated that European banks had $2 trillion of non- or underperforming loans even before the pandemic, he says that sovereigns are increasingly gravitating to the European market.
Unlike venture capital, where commitments are typically smaller, when giant SWFs such as Singapore’s $200 billion GIC invest in private credit deals, “they can deploy $1 billion to $2 billion a pop, which takes them quickly to the deployment target”, says Global SWF’s Lopez. “It’s a more efficient and less risky way of deploying capital.”
The $12 billion strategic partnership forged last year between the UAE’s Mubadala development fund and Apollo is a case in point. “There are a ton of direct lenders that can do the smaller stuff and only a handful can do the bigger stuff,” John Zito, deputy chief investment officer of Apollo Credit, told Private Debt Investor at the time. “Very large pools of capital need yield in scale, and you can get it by investing in larger companies.” The partnership between Apollo and Mubadala will be making loans as large as $1 billion, in what Zito called “the white space” between the mid-market and the broadly syndicated loan market.
Although capital-rich sovereigns tend to operate in the upper part of the mid-market, AGL’s Gleysteen distinguishes between managers that can do specific things on a large scale and those that are big and doing many things. “Large investors, including sovereign wealth funds, increasingly are trying to identify managers who are better at specific things,” he says. “Scale can be a big advantage, while sheer size and complexity can be a big disadvantage.”
Bringing it all back home
Given their growing sophistication and in-house capabilities, sovereigns are likely to become even more active in managing their own considerable wealth and in their own backyards – as many of them did a century ago by taking over the management of their countries’ oil assets from foreigners. Ahmed of NBK Capital notes the sharia-compliant fund anchored by Saudi Arabia’s PIF “is becoming a conduit to efficiently deploy capital” back into its own region.
Co-investing and separately managed accounts will continue, but in some cases will evolve into partnerships where sovereigns share in fund management fees. The PwC report notes that sovereigns have already started looking at building joint venture or co-investment vehicles, including a deal between ADIA and Singapore’s GIC to buy the Time Warner headquarters in New York.
In the next five years, PwC expects co-investments to spread and consolidate, regardless of the type and mandate of the sovereign. It cited the inaugural Co-Investment Roundtable of Sovereign and Pension Funds, which was organised by the Korean Investment Corporation a year ago. It brought together more than 30 sovereigns and pension funds, as well as a number of GPs, and resulted in a co-investment agreement signed by 12 sovereigns to discuss investment ideas on a regular basis.
At some point, look for more sovereigns to graduate from the more traditional arrangements and to start to throw their weight around by building their own credit portfolios.