As oil rises yet again above $100 a barrel, petrodollars are once more rushing into the supertankers of capital known as sovereign wealth funds. An increasing portion of this new money will likely find its way to alternative investments, including private equity, but the sheer size of the inflow presents its own set of challenges.
The addition of new capital—plus the recent market rebound—have pushed the assets of sovereign wealth funds to the $4 trillion mark for the first time, and in the last year, those assets have increased 11 percent, according to a report by Preqin, an alternative investment research firm.
While that is a big swing, most sovereign funds are still smarting from the financial crisis, when they collectively lost hundreds of billions of dollars.
The partial recovery has given sovereign funds a new urgency to diversify their portfolios into alternative investments. Given the need for these new funds to be invested somewhere, the big question among asset managers is: where? One destination is private equity. The portion of sovereign wealth funds investing in private equity rose to 59 percent in 2011 from 55 percent the year before, according to Preqin.
That increase is set to continue. “More money will be allocated to those opportunities,” said Patrick Thompson, the global head of sovereigns at JPMorgan, which manages $65 billion in sovereign wealth assets. “But sovereign wealth funds are becoming a more discerning investors. They’re gaining more in-house expertise, and they’re looking for more specific types of exposure to diversify their portfolios.”
Almost all of the biggest funds count themselves in the private equity club, and one of the biggest holdouts, the $531 billion
Yet the shear volume of new money that needs to be deployed creates a new challenge of figuring out how to invest it in ways that move the needle. “The size of some sovereign wealth funds is a huge problem for deploying the money outside of the major buyout firms,” said Stefan Naef, a partner at the
The size of a ticket needs to match the capabilities of a private equity firm to invest that money effectively, Naef said. The key is to balance the need for diversification with the need to make investments big enough to register.
“The bigger funds are able to offer the bigger opportunities. They’re the ones that are going to be able to get in there and gain commitments,” said Tim Friedman, executive editor at Preqin. “For smaller funds, it’s going to be difficult to get the attention of sovereign wealth funds.”
Big Funds Win
Not surprisingly, it’s the biggest private equity firms that have the most known commitments from sovereign funds, according to Preqin (see figure 1).
With six known commitments each,
For the private equity firms that get commitments, they usually become highly valued partners, said JP Morgan’s Thompson. “They (SWFs) are getting larger and larger and will continue to grow, so if you can start a relationship today, they’ll be with you for a long while.”
One way that sovereign funds have been dealing with the size dilemma is by co-investing alongside private equity funds. About 12 percent of sovereign funds make co-investments, according to Preqin.
“We are seeing a lot of sovereign funds investing directly,” said Preqin’s Friedman. In fact, some are demanding it. “In the current market, big investors certainly want co-investment opportunities. The power is certainly in favor of the LPs, rather than the GPs, and I think they are more able to dictate terms, such as access to co-investment opportunities.”
Stefan Naef of the Partners Group agrees, but cautions that the trend toward more co-investment is not a universally good thing. “With co-investments,” he said, “there is obviously much higher risk that your investments are not diversified.”
Among sources of sovereign wealth capital, oil and gas remain the biggest source of new money with 54 percent of aggregate funds coming from hydrocarbons.
To be sure, not all such wealth is from petrodollars. Asia, in particular, is home to six of the world’s 10 largest sovereign funds In countries like China and Singapore, wealth has accumulated from years of running current-account and budget surpluses.
Finally, given the recent turmoil in the Middle East, it has become increasingly important for asset managers need to factor in risks of managing the money from certain nations. Money managers investing funds from nations like Libya risk being put into a situation where they must choose between fulfilling their obligations to their investors and following the laws of the country in which they are based.