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.