David Neuenhaus & Eric Janowak at KPMG talk about the significance of sovereign wealth funds as they apply more active investment models to their growing capital base
The aggregate assets under management (AUM) of sovereign wealth funds (SWFs), including public pensions, is enormous by any standard. While estimates vary, $33tn serves as a fair approximation. Increasingly, the importance of this special class of asset owners cannot be measured by AUM alone. Many SWFs continue to evolve toward more active and direct investment models, with a corresponding expansion of in-house enabling skill sets. As enhanced capabilities are applied to an ever-expanding capital base, the significance of SWFs continues to increase. It should be anticipated that the ascension of SWFs will continue, with a few key trends to watch in the coming years.
Taking the lead
SWFs have long been involved in consortiums and co-investment arrangements with fund sponsors and managers. These arrangements have historically been led by fund sponsors, leveraging SWF participation as limited partners. Many SWFs, enabled by their increased capabilities and know-how, now have the wherewithal to lead such consortium opportunities themselves. We expect this to continue as SWFs gain experience. Further, such arrangements can provide improved economics and investment governance for investors.
Perhaps the most interesting step in evolutionary terms is a movement of certain sophisticated SWFs toward marketing and monetizing their expertise to other SWFs, highlighting their unique common alignment, and understanding of their peers’ demands. For instance, SWFs can establish affiliated management companies to offer fee-generating asset management expertise to other investors. These arrangements can leverage a sovereign’s relationships and provide opportunities to monetize existing portfolios, while reducing concentration in certain assets by syndicating interests to third parties. In the past, certain SWFs had considered – but ultimately abandoned – such arrangements. While challenges remain, the new and improved capabilities of SWFs have renewed both the potential viability of and interest in such ventures.
Expanding the aperture
SWF investors have long sat atop the league tables of capital invested into private equity, real estate, infrastructure, and other core alternative asset classes. As the need to diversify increases and in-house expertise expands, so too does the ability to invest in an ever-expanding universe of assets. For example, SWFs are increasingly investing in early-stage, innovation-driven businesses, often alongside established venture capital (VC) participants. Only a few years ago, the allocation of capital by SWFs to VC-type opportunities was quite limited and almost exclusively facilitated through indirect investments as limited partners. Today, a growing number of sovereigns have dedicated teams focused on direct investment into early venture opportunities, with many SWFs establishing offices directly in venture-rich locations for greater exposure and access to deal flow.
Credit is another evolving space to watch. Credit as an asset class has flourished for many non-bank investors since 2008, with many alternative lenders stepping in to fill the space left by banks and regulatory requirements. SWFs have been active participants, first as investors in secondary positions, and then by expanded participation in origination arrangements. For instance, some SWFs have invested in private credit fund managers, while some have formed partnerships with credit managers. Others have established direct origination platforms, staffed by their own underwriting teams. Regardless of the structures used, the need for private debt will continue to grow, and SWFs will likely be at the forefront of the funding solutions for private credit needs.
Fleet of foot
The most nascent trend may be a gradual but growing interest by SWFs in assets other than those of a strictly long-term nature. Shorter-term investments have always occurred from time to time, but the frequency of strategic, short-term investments appears to be accelerating, as SWFs can lean into their investment expertise to capitalize on opportunistic, high-return situations. SWFs have improved their ability to identify, analyze, and execute investment opportunities where time is of the essence (on both the buy and sell side, across front office, back office, and investment committee processes). Of course, patient capital and long-term portfolio management will always be core to SWFs, but the ability and willingness to move strategically and quickly when short-term opportunities present themselves is a trend worth noting.
The relationship between SWFs and ESG
Finally, the impact of SWFs on environmental, social, and governance (ESG)-related trends. While ESG packaging is relatively new, the substance has existed for some time. For example, the US established the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) to remediate hazardous environmental areas (‘Superfund’ sites) in 1980, but poor governance has long been a concern for investors due to mixed records of success. However, the importance of ESG as a concept, which is gaining traction as a prioritized aggregate of concerns, may have been strengthened by SWFs wielding the ‘golden rule’. SWFs made it clear that capital would not be committed without the engagement of ESG principles by companies and managers seeking capital. As governments, NGOs, and industry participants engaged in climate and human rights discussions, advanced the United Nations (UN) Sustainable Development Goals, and promoted the UN Principles for Responsible Investment, SWFs provided the muscle to bring these concepts to bear. We expect ESG considerations to continue to be a common precondition for investment commitments by SWFs.
Where to from here?
SWFs are central to many important, positive capital market trends. But these trends are not without headwinds. How might investee countries and territories and other market participants react? While governments and managers compete to attract the capital of SWFs, there are limitations. There are examples of protectionism and geopolitical issues that continue to pose significant challenges. Cross-border sovereign investment can be a sensitive topic and is sometimes viewed as a threat to the economic and political sovereignty of the recipient country when large sums or potentially sensitive assets are involved. Yet the tailwind may be that SWFs, in conjunction with other institutional investors, can help steady markets when faced with serious global challenges.
It will be critical for SWFs to balance their role as investors with the needs of regulators, governments, counterparties, and the public. SWFs are unique stewards of capital, generally sharing one of three common objectives: stability, savings, and/or local development. It is important that stakeholders understand the objectives, how they align for common benefit, and how they serve as both a natural governor to the pursuits of SWFs and a positive influence within the investment community. By working together, these trends can be harnessed for the common benefit of all.
About
David leads KPMG’s Global Institutional Investor Tax network and serves as the firm’s Partner in Charge - Tax, for the NY Financial Services business unit. David has more than 25 years of experience advising many of the worlds largest and most complex public pension systems, sovereign wealth funds, and asset managers as they navigate the ever-evolving challenges and opportunities that confront the industry.
Eric is a Managing Director in KPMG’s NY Financial Services Tax practice and the Deputy lead for the Global Institutional Investor Tax network, which includes sovereign wealth and pension funds. Based in London, Eric specializes in structuring and tax advisory for sovereign investors, as well as cross-border asset management. He has extensive experience working with sovereign wealth funds, institutional investors, and alternative asset managers. Prior to KPMG, Eric worked as an attorney and in-house tax counsel for a global investment bank, a sovereign wealth fund, and an alternative asset manager.