Rise of the sovereign wealth funds

May 2015 | FEATURE | FINANCE & INVESTMENT

Financier Worldwide Magazine

Though they are by no means a new phenomenon, sovereign wealth funds (SWFs) have become increasingly prevalent since the turn of the century. Over the last decade and a half, SWFs have multiplied greatly, thanks in no small part to the rise of resource rich countries in the Middle East. SWFs in the Cooperation Council for the Arab States of the Gulf (GCC) have been particularly active in recent years.

SWFs are renowned for their long term planning. As such, the financial crisis of the late 2000s provided them with a golden opening, with investment opportunities springing up across multiple jurisdictions. Southern Europe, for example, attracted significant SWF investment during the protracted European debt crisis. According to research from ESADEgeo, a Spanish think-thank affiliated with the ESADE Business School, SWFs poured around €40bn worth of investment into Spain between 2009 and 2014.

Today, SWFs have become major players on the global financial scene. By the end of 2014, they had more than $7 trillion in assets worldwide. “While the majority of SWFs continue to deploy their funds in bonds and global equities, a relatively low interest rate environment, continually evolving investment strategies and a growing appetite for alternative asset classes are resulting in a shift away from what has typically been a passive investment philosophy,” said Vikas Papriwal, a partner at KPMG.

Increasingly, SWFs are targeting markets in Asia, Europe, Australasia and Africa and are pouring huge sums of money into infrastructure projects. As Brad Whittfield, an associate director at KPMG, notes “2014 was an active year for SWFs from an investment perspective. Interestingly, we saw a continuing shift towards direct and co-investment. I think this is the result of the funds building their in-house capabilities and also a strategic decision to be a more active and closer investment partner. We also saw an increase in the focus on emerging markets such as Africa. This continent has very favourable demographics from an investment perspective and is benefitting from an increase in investment in infrastructure.”

Direct investment was a genuine growth area for SWFs last year. These funds have been increasingly aggressive in the M&A space, investing directly in start-ups and helping to drive valuations of new businesses. For example, 2014 saw Singapore’s GIC Private Ltd invest directly in Chinese smartphone maker Xiaomi Corp. Elsewhere, Qatar Investment Authority (QIA) invested in ride-sharing firm Uber Technologies Inc., which raised $1.2bn of funding with the help of QIA. GIC Private Ltd also became directly involved in helping to fund Indian e-commerce company Flipkart Internet Pvt.

SWFs are likely to continue investing directly in alternative assets going forward. “We see the 2014 trends continuing into 2015 – an increasing focus on emerging markets and alternative asset classes for example,” says Mr Whittfield. “With the large number of regional infrastructure projects and committed pipeline, such as the UAE’s EXPO 2020 and Qatar’s Football World Cup, we would expect the proportion of fund allocation regionally to remain strong.”

Diversification

One of the chief contributing factors to the rise of SWFs has been the need for resource rich countries to protect their surplus revenues from oil exports. Diversification has resulted in many funds investing heavily in large scale infrastructure projects, as well as retail and hospitality real estate deals.

The year-long decline in oil prices has affected some funds, if not all. The Russian economy has endured a turbulent 18 months or so, with economic sanctions being heaped on top of the volatility in commodities prices – an area on which its economy relies. As a result, the Russian government has been required to utilise its sovereign wealth fund in an attempt to support the country’s faltering economy. The Russian Reserve fund has seen around $8bn siphoned off by the Russian government to cover the country’s mushrooming budget deficit.

“Direct investment was a genuine growth area for SWFs last year.”

To date, however, funds in the Middle East have generally weathered the storm of dipping oil prices. “The decline in oil prices will impact sovereign wealth funds differently,” explains Mr Whittfield. “Countries have differing break even oil prices – the price that oil needs to remain above in order to balance their respective fiscal budgets. For example, Saudi Arabia’s breakeven oil price is approximately US$97 a barrel whereas the UAE’s is much lower at approximately US$77 a barrel. In the short term, we have not seen too much of an impact in terms of investment appetite as most Middle Eastern countries have successfully built up large cash reserves. However, if prices remain depressed for a period of time, I would certainly expect a more cautious approach to investment as these cash reserves are reduced.”

Yet some SWFs have begun to cast their net further in order to chase significant returns. A great number have invested in hotels and real estate in recent years – a trend which is likely to continue for some time to come. Norway’s Government Pension Fund Global has moved into the real estate space, and now has around $893bn worth of assets under its management, according to the Sovereign Wealth Fund Institute and the Qatar Investment Authority. In 2010, Norway’s fund managers committed to shifting 5 percent of the fund’s resources into the real estate sector. Also, funds are believed to have invested around $10bn in London’s real estate market.

The hospitality sector has become a key target for SWFs, particularly those funds emanating from the GCC. Hospitality real estate investing, either directly or indirectly, has become one of the most utilised and profitable sources of cash flow for SWFs, particularly because it allows for greater diversification, and is generally perceived to be a safe investment.

Diversification has become more important over the last year or so, as a result of volatility in commodities markets. The dwindling oil prices since June 2014 has had a considerable impact on some oil producing countries. In Africa, many sub-Saharan African countries were late to the SWF party, missing out on the chief commodities boom of the 2000s; accordingly, these nations have been playing catch-up with their more established counterparts. Angola’s SWF – known as Fundo Soberano de Angola, or FSDEA – has prioritised diversification, since the country is almost entirely reliant on oil production. According to FSDEA’s chairman, José Filomeno dos Santos, the fund is now looking further afield for opportunities, and will continue to do so “especially during periods such as the one we are in now, of low commodity prices and – specifically for Angola – low oil prices, which impact the economy. It is a challenging time for Angola because it revealed, once again, the very high exposure to this type of commodity. The main goals of the fund are to preserve state reserves but also to create additional sources of revenue. We will invest in assets that give the state returns that have a different pattern of behaviour to the oil sector.”

Many African SWFs are also looking to hospitality, considered to be a relatively safe investment sector. Funds from Mozambique, Nigeria and Ghana are all hoping to exploit the recent rises in tourism to Africa. Angola’s FSDEA has earmarked the tourism space as a particularly potent area, allocating $500m of equity capital to a Hotel Fund for Africa. The FSDEA has also noted that it is in position to take up to 50 percent debt; accordingly, the fund could double its total investment capability going forward.

Elsewhere, the Abu Dhabi Investment Authority (ADIA) has also been active in the hospitality space. ADIA, the world’s second largest sovereign wealth fund with around $773bn worth of assets under management, has recently made a number of additions to its hotel portfolio, purchasing luxury boutique hotels from Marriott International. In February, ADIA acquired the Miami Beach Edition hotel for around $230m. This deal came just over a year after the fund acquired Marriot’s London Edition hotel. The two groups are believed to be in negotiations over the sale of Marriot’s New York Edition hotel.

The telecoms sector has also become a key investment area for many SWFs. The O2 and Three mobile networks in particular have attracted attention from funds in China, Singapore and Qatar over the last 12 months.

Infrastructure development

A further primary area of SWF investment in recent years has been infrastructure development. Infrastructure stands out as an attractive and viable option – especially since the global infrastructure funding gap is expected to reach around $500bn per year by 2030.

The long-term investment horizon of SWFs makes them ideal financiers of large infrastructure projects, and with much of the developing world in need of significant infrastructure investment, it is inevitable that funds will look to deploy reserves heavily in this space. Emerging markets often make ideal investment destinations for SWFs, given the relative lack of competition, the greater need for capital and the opportunities for economic growth.

In Europe, SWFs are having a significant impact on infrastructure development, helping to finance much needed projects and realising massive profits in the process. This is set to continue, although the level of competition is likely to intensify and valuations are expected to climb.

Conclusion

As SWFs seek new assets and become more ubiquitous in the global investment market, they must be wary of increasing prices and competition. Should funds be able to navigate these challenges, 2015 is likely to be a particularly active year, with sectors such as infrastructure and hospitality remaining a key focus. Collectively, SWFs have trillions of dollars worth of assets under management, and if funds are able to navigate the potential risks in front of them – namely the availability of viable and affordable investment opportunities – the value of controlled assets could be substantially higher in 2016.

Richard Summerfield