Sovereign Wealth Funds: Pot Of Gold Or Mirage?

Sovereign wealth funds manage more assets than the combined holdings of the world’s hedge funds and private equity firms. Their appetite for alternative assets, already large, is only going to grow. In fact, a Morgan Stanley economist recently predicted that sovereign wealth funds would funnel $200 billion globally to alternative fund managers—including those managed by hedge funds and private equity firms—in each of the next five years.

But so far mid-market buyout shops haven’t had much luck cracking the market.

Most of the big sovereign wealth funds continue to concentrate their bets in the hands of a small number of U.S.-based buyout firms, a strategy that often secures them special treatment in the form of generous terms and conditions not given to typical limited partners. For example, buyout firms often create separate accounts to house the money of sovereign wealth funds and to ensure that fees are eliminated or minimized; several shops have also sold stakes in their general partnerships to sovereign wealth funds. Stakes in general partnerships are generally viewed as advantageous to LPs, giving them greater visibility into a firm’s behavior and better terms on fund profits.

Sovereign wealth funds are “not simply looking for exposure per se,” said Steve Costabile, managing director of AIG Investments’s global funds-of-funds group. “They typically don’t want capital in the same pot as other investors.”

The most recent example: the $4 billion fund announced in April by financial services specialist J.C. Flowers & Co. and the China Investment Corp. The $200 billion sovereign wealth fund has agreed to commit 80 percent of the fund’s capital, with J.C. Flowers contributing 10 percent, and unnamed investors providing the rest. J.C. Flowers will manage the fund, which is geared toward investments in the U.S. financial services market. Because Beijing-based China Investment Corp. is buying such a large position in the fund, the sovereign wealth fund is going to pay half the fees and half the carry that a normal LP would, according to a source familiar with the new fund.

That deal follows several similar ones over the last several months, all involving brand-name buyout firms. Apollo Management, for instance, last year sold 9 percent of its general partnership to the Abu Dhabi Investment Authority, while The Blackstone Group sold a piece of its management company to the China Investment Corp. for $3 billion, making the sovereign wealth fund a partner in Blackstone Group’s efforts to expand its investing in Asia. The Carlyle Group, meantime, sold 7.5 percent itself last year to Mubadala Development Corp. in Abu Dhabi.

To be sure, not all deep-pocketed government asset managers require special treatment. Singapore’s two sovereign wealth funds, Temasek Holdings and GIC Special Investments, which combined manage more than $200 billion, commit regularly to general partnerships and rarely, if ever, demand separate accounts or other exceptions to LP norms, said Andrew Ostrognai, head of the Asian private equity practice for law firm Debevoise & Plimpton. “At the fund level, they can be passive investors like any other LP,” he said. Temasek Holdings has backed such firms as Affinity Equity Partners, Candover Partners and Madison Dearborn Partners. GIC Special Investments, meanwhile, has backed Advent International, Hellman & Friedman, the Jordan Co. and TPG.

But whatever their strategies or requirements, these government investment funds unquestionably have money to put to work. With a collective $3.5 trillion of assets under management, sovereign wealth funds already account for an estimated 10 percent of global private equity commitments, equivalent to about $150 billion. The big questions now: Will mid-market buyout firms find a way to share in the bounty, or will they continue to be shut out?