A new era for SWFs?

Bernardo Bortolotti, SIL Director

SWF have never managed as much money as they do today. In a relatively short time span, SWF have gained magnitude, power, and reputation. All that is undeniable but the big question before us today hints at something more transformative. Have we entered a new era of sovereign wealth? Are the new global macroeconomic fundamentals and political climate challenging the conventional models of sovereign wealth management? If so, how should SWF adjust behavior and strategies in order to thrive and prosper in the 21st century?

There is no “one true answer” to these questions but we can confidently claim that the end of extrapolation has been reached: the outlook of sovereign wealth cannot be drawn with lines from the past.

The rapid accumulation of foreign exchange reserves over the last two decades has been an uncommon phenomenon from a historical point of view. Since the early 2000s, sovereign wealth grew by more than 10 per cent per year and by the end of 2014 it had reached an all-time-high of USD 17.3 trillion. SWFs account for 15 percent of the global fund management industry, closing quickly the gap with other institutional investors such as pension funds, mutual funds or insurers.

But in 2014, a tipping point was reached, associated with a structural break in the dynamics of sovereign wealth accumulation. Two related factors triggered this change, derailing the heavy train. First, the oil shock and the slowing down of global trade turned the two engines of SWF growth into a spent force. Second, governments started to tap assets to equalize lost revenues and to stabilize their domestic economies, scathing sovereign wealth for the first time in recent history.

These shocks were not short-term cyclical phenomena to be quickly absorbed. In fact, they proved being structural issues, which are still looming large today. Let us start with oil. After reaching a historical low in mid 2015, oil prices have stabilized, but absent major geopolitical events, supply and demand arguments suggest at high level of confidence that oil prices will remain reasonably low in the foreseeable future.

But it is not just the commodity supercycle being over: global trade is also going south, and at a quite rapid pace.  According to a recent WTO release dated August 9, trade expansion is slowing and will likely slow further as we reach the end of 2018. This loss of momentum reflects weakness in export orders and automobile production and sales, which may be responding to the ratcheting up of trade tensions.

Let us now turn to the second critical (related) factor. The terms of trade shock curbed revenues and swept current account surpluses in commodity exporting economies. With oil prices averaging current levels or slightly higher, Middle Eastern oil-exporting economies will strive to maintain a balanced budget for the rest of this decade. Some countries had and will have to tap into sovereign wealth in order to fill their budgets’ shortfall.

What happened in the Gulf occurred to some extent also in China and Asian emerging markets.  In 2015, for the first time in many years, central banks liquidated FX reserves in order to stem currencies devaluation and avoid a balance of payments crisis.

The data speak for themselves: from the all-time high recorded in 2014, today global foreign exchange reserves are worth 11.8 US trillion. For some countries, the drop has been dramatic: Saudi Arabia is down 33%, Qatar almost 40%, China 21%, Russia 15%.

These new economic fundamentals set off profound, structural, and long lasting repercussions in the SWF community, and that is why I claimed that we reached the end of extrapolation. The future will not be as we thought it could be.

The fundamental regime change is the collapse of the belief the SWF being “liability free” economic entity. Amongst practitioners but also in the academic literature, SWF were often referred to as funds without any explicit liability stream to cover, as opposed to pension funds or insurance companies. In the last years, implicit liabilities (a.k.a. distressed governments’ request to become lender of last resort) abruptly materialized, causing painful portfolio adjustment and capital impairment. Furthermore, some funds have started to issue plain debt, or sophisticated debt instruments. Nigeria Sovereign Investment Authority Infrastructure-related bonds are a case in point.

So how will the new era of sovereign wealth look like? More precisely, how can our fellow SWF thrive and prosper in this new, challenging scenario?

Up to now, the SWF community showed an impressive degree of resilience. With a few exceptions, SWFs weathered the storm quite well, with their capital unscathed, or even increased, in spite of the recent headwinds.

I see three main possible directions of change regarding i) risk management, ii) investment strategy, and iii) investment governance.

Most funds have made great progress in risk management recently, SWF may think about embracing strategic sovereign asset and liability frameworks (SSAL), endowing the organization with state-of-the-art risk management tools, and streamlining mandates within funds, central banks and other state entities to ensure better macro-fiscal policy coordination. In some cases, reorganization and restructuring may be required, and I see progress in some funds that have recently chosen to merge to fulfil better their mission.

Second, SWFs should seek internal growth leveraging upon their quintessential features of long-term, patient investors. In an environment characterised by lower inflows or even outflows, the return on accumulated wealth can be an important source of funding for the sponsoring government. SWFs should rely on illiquid assets classes and strategic direct investments to capture long term, above market returns. The enhanced focus on developmental aspects and investment to address market failures will be a key feature of the new strategy.

Third, and finally, SWFs should leverage upon one special characteristic, which is genuinely unique in the institutional investor industry. SWFs are a very small group of players relative to the size of the assets they manage. This massive concentration of financial wealth allows unprecedented direction and coordination of investments. By teaming up with fellow SWFs and engaging private partners, they can develop transformative coinvestment projects across the board. Importantly, these ventures will deepen gov-to-gov relations, strengthen economic diplomacy, and promote international capital mobility against the mounting protectionism tide.

Dealing with disruptions. Global SWF investment trends from the IFSWF-SIL report

Our dataset reveals that, in 2017, SWFs completed more direct equity investments than they did in 2016 (303 versus 290), but that the value of these has largely stayed flat: $52.6 billion, compared to 2016’s $51.4 billion.

Consequently, their median equity cheque was $50 million, just over half that of 2016, which was $90 million. Excluding real assets, such as bricks-and-mortar properties and infrastructure projects, this trend was even more marked. In this case, the median equity investment was $27 million, plummeting from that of previous years: $60 million in 2016, and $58 million in 2015.

We observed four investment trends in sovereign wealth fund direct investment activity that may explain this observation:

  1. Private market deal activity slows
  2. A greater emphasis on partnership and co-operation with other institutions
  3. A changing approach to the consumer goods and services sector
  4. Taking India public

Taming Leviathan. How can SWFs mitigate political risk?

Extant research finds that targets of sovereign wealth fund (SWF) investments experience a weaker stock price reaction at investment announcement than targets of private-sector investments. In a new paper, we investigate the determinants of this “SWF discount” and possible mitigating mechanisms. We find that SWFs from non-

democratic countries can mitigate this discount by signaling a passive stance by investing through subsidiaries, buying small stakes, and refraining from acquiring control. Conversely, SWFs from democratic countries suffer from smaller discounts when signaling an active stance. Consistent, long-term operating performance of democratic (autarchic) SWF investment targets is positively affected by an active (passive) stance. Despite the negative impact, funds from autarchic countries are more likely to take an active stance.


> Innovation at State Owned Enterprises

> Working Papers

Debunking Mazzucato: innovation at state-owned enterprises

Marianna Mazzucato’s 2013 book, The Entrepreneurial State, has provoked widespread debate about the role of government in innovation, supporting the view that the state should be entrepreneurial by participating in the upside of its innovation funding. But beyond examples and narratives, do her arguments survive a rigorous empirical test and stack up as a guide to policy? In a recent paper, we investigate the impact of state ownership on the innovativeness of firms, as measured by the number, quality, and value of the patents produced. In a sample of listed European firms, we find that minority government ownership increases investment in research and development,   especially   for   financially   constrained   firms   and   during   “normal”  macroeconomic  conditions.  Yet, government  control  leads  to  the  opposite  effect,  by  imposing myopic goals and complicating access to private equity markets. Overall, state owned enterprises (SOEs) produce fewer patents per dollar invested and about 10% fewer patents in absolute terms. When comparing SOE patents to private-sector patents, we find no difference in patent quality as measured by the number of citations received per patent or by the market  reaction  at  patent  publication. Furthermore,  we  find  no  increase  in  the  number  of  patents  focused  on  sustainable  technologies,  suggesting  that  SOEs  do  not  emphasize innovation that produces public goods or social spillovers.


> Innovation at State Owned Enterprises

> Working Papers

The hidden cost of democracy: Norway GPFG’s ban on private equity

Bernardo Bortolotti and Raphael Mimoun

The Norwegian SWF (the Government Pension Fund Global “GPFG”) is the largest fund by assets under management around the world. Established in 1990, it received the first allocation in 1996, and then it steadily grew thanks to net cash flows contribution from all petroleum activities (including the dividends from the national oil company Statoil) to reach $1 trillion market value this year. GPFG is owned by the Ministry of Finance, and professionally managed by a dedicated arm of the central bank, the Norges Bank Investment Management. The MOF retains the decision-making power, and determines the fund’s investment strategy, following advice from among others Norges Bank Investment Management and discussions in Parliament. By law, the management mandate defines the investment universe and the fund’s strategic reference index.

On April 11th 2018, the Government of Norway announced its decision not to expand the mandate to invest in unlisted equities on a general basis. Presented by Norway’s Minister of Finance Siv Jensen, the government’s white paper on the GPFG claimed that “unlisted equities would challenge key characteristics of the current management model [of the Fund], such as low asset management costs, closely tracking the benchmark and a high degree of transparency” .

This decision caught observers by surprise. First, because there has been increasing appetite of SWFs for PE investment and unlisted targets. Examples from various geographies abound, including Saudi Arabia’s $ 40 billion JV infrastructure fund between the Public Investment Fund and Blackstone, or Panama $1.4 billion SWF’s decision to start investing in unlisted equities by end-2018, with a target allocation of 5-10% of assets. Second, the government’s decision came against recommendations from both Norges Bank Investment Management and a government-appointed expert group that was set up last August to discuss the opportunity to expand the scope of the fund’s mandate beyond public assets and real estate.

Beyond transparency and management fees, the MOF may have considered a “late entry” in an already crowded market translating into significant difficulties to source appropriate investment opportunities. Total amount of capital committed – but not yet invested – to private equity has surpassed $1 trillion in 2017 , reflecting a growing imbalance between demand and supply of PE investment opportunities. Indeed, GPFG’s sheer size would make it difficult to achieve even a small allocation target in unlisted equities. Based on end-2017 assets, a target of 5% would require approximately $50bn of investment, i.e. a level on par with the biggest private equity firms in the world. This partially explains why the fund has so far failed to achieve its allocation target for unlisted real estate, since getting approval to invest in this asset class in 2010 (2.6% of the portfolio at end-2017, i.e. half of the target).

Nevertheless, the decision of a blanket ban on an entire asset class is puzzling. Mandates typically design a general framework for strategic asset allocation which should not be affected by current market conditions but to a fact-based assessment of the contribution a given asset can to the long-term risk-adjusted performance. Indeed, from a financial economics standpoint, there are compelling reasons for the GPFG to expand its portfolio towards PE investment.

Broadly speaking, investments in unlisted equities are particularly suited to the characteristics of the GPFG, a long-term investor without explicit liabilities and thus able to harvest illiquidity premia over long horizons. Investment in PE would also allow the fund to boost its sub-par return. Between Jan. 1st 1998 and end-2017, the fund generated only a 6.1% annual return , certainly a modest performance given the large exposure to stocks. In 2017, the Fund reached a return of 13.7% return up only 0.7% on its benchmark index . Key peers of the fund, such as Swedish AP funds, Canadian pension funds or the Netherlands’ pension fund (ABP), have consistently outperformed the GPFG while having more stringent rules on capital allocation (pension funds have to maintain liquidity buffers to ensure payments to policy holders).

PE investment would also participate in reducing the Fund’s exposure to stocks, which makes it vulnerable to market fluctuations. In March 2018, the Fund published estimates indicating that – owing to the strong exposure of the fund to listed equities –  it could lose over 40% of its portfolio value in a single year, should adverse stock market price developments combine with a strengthening of the Norwegian Krone. As of end-2017, the GPFG’s portfolio consisted of 97.4% of listed investments (66.6% in equity investments – to be increased to 70% in the medium-term –  and 30.8% in fixed income) and 2.6% allocated to unlisted real estate.  Even without the materialization of a “Black Swan” scenario, the fund’s overexposure to Europe and the U.S. makes it vulnerable to growing risks such as demographic decline or increasing sovereign debt levels. Besides, the decision of the government to increase its equity exposure to 70% will need to be carefully and gradually implemented in order to avoid buying stocks at inflated prices, as previous decisions of the GPFG to increase its equity exposure were made close to market highs (2007 and 1997).

Further to the government’s decision, Per Stomberg, the director of the expert group, declared that the government’s decision not to pursue PE investment would likely “come at a considerable cost in lower returns in the future”.  A back-of-the-envelope calculation of the opportunity cost of not investing in PE, assuming a 12% return and a gradual portfolio rebalancing to reach a 10% allocation in this asset class in five years time, yields a cost estimate in the ballpark of $70bn over a ten year holding period.

This statement begs a question: Why a respected, sophisticated organization with access to state-of-the-art knowledge and skills deliberately leaves so much money on the table? Our answer lies in the legacy of an overtly prudent, ultra-conventional investment style imposed in these last two decades by the political system. Seeking widespread political legitimacy in an established democracy founded on accountability and transparency, decision makers opted for the easiest investment model to explain to their electorate, the globally diversified portfolio of liquid stocks and bonds. The last decision on PE just follows in this wake. To some extent, the Norwegian democracy imposes an excessive risk aversion in the design and implementation of investment mandates, another form of political interference. This governance conundrum has led to a rather paradoxical situation whereby instead of investing in transformative projects that could shape tomorrow’s global economy, the world’s biggest sovereign wealth fund is sticking to a passive index tracking approach that is neither generating development impact, nor yielding a strong return.