The World’s Largest Sovereign Wealth Funds Go Private

Sovereign funds are turning to private market investments to diversify portfolios and boost returns.


THIS YEAR HAS BEEN A TURBULENT ONE FOR Malaysia Airlines. In July, Malaysia Airlines Flight 17 was shot down over war-torn Ukraine, killing all 298 passengers and crew members. Four months earlier another Malaysia Airlines plane mysteriously disappeared en route to Beijing from Kuala Lumpur. The reputational damage from the dual tragedies has torn holes in the company’s balance sheet, passengers are abandoning its flights, cabin crew members are quitting en masse, and the airline is predicted to lose more than 1 billion ringgit ($314.7 million) this year. This follows several years of large losses sparked by higher fuel and maintenance costs, and competition from low-price rivals.

The carrier’s recent tragic spell and longer-term underperformance have been disastrous for investors in parent Malaysian Airline System (MAS), whose shares have plummeted more than 90 percent since January 2010. MAS’s majority shareholder, Malaysia’s $41.4 billion sovereign wealth fund, Khazanah Nasional, hopes to turn around the ailing airline while turning a profit. In August it offered to privatize MAS, proposing to buy out the shareholders of the nearly 31 percent it doesn’t already own, to allow for a “complete overhaul of the national carrier.” The intentions of the sovereign fund, which already allocates 34 percent of its assets to private markets, are clear: In fixing Malaysia Airlines’ operations, finances and business model, Khazanah expects to revive MAS’s profitability within three years. “Success is by no means guaranteed,” warned Khazanah managing director Tan Sri Dato’ Azman bin Hj. Mokhtar in a press release. Though risky, the restructuring could lead to a large return on investment for the sovereign fund when it takes the airline public again.

Khazanah’s private-equity-style deal with Malaysia Airlines is just the latest in a series of private investments by sovereign wealth funds. Billion-dollar real estate and infrastructure investments made by the rainy-day funds accounted for some of the largest and most valuable deals of 2013, as sovereign funds reached beyond their own borders to snap up private assets. As a result, the world’s most iconic skylines, from New York to London and Paris, are increasingly dotted with buildings and bridges owned by foreign countries.

More and more, sovereign wealth funds are using private markets to diversify their portfolios and achieve higher returns by taking on greater risk. Sovereign funds have doubled their allocations to private markets over the past six years, at the same time that other long-term investors — in particular, public pensions — have dialed back risk to meet outstanding liabilities. Although private assets are often viewed as risky because of their lack of liquidity — part of their appeal to investors searching for higher returns — some argue that the portfolio diversification they provide actually reduces risk. The financial crisis, however, challenged this notion: Several sovereign funds that had heavily invested in the private market lost big when they were unexpectedly called upon to shore up their domestic economies.

The sovereign wealth fund universe as a whole is expanding, allowing more capital to be distributed more widely. Combined assets under management total approximately $5 trillion, according to our fifth annual ranking of the world’s largest sovereign wealth funds, up more than $1 trillion from the previous year’s ranking. The data, sourced from Institutional Investor’s Sovereign Wealth Center, shows that wealth is concentrated at the top: The ten biggest sovereigns, led by Norway’s $893 billion Government Pension Fund Global (GPFG), manage a combined $4.1 trillion.


Although a sovereign wealth fund’s exposure to the private market doesn’t necessarily correlate with its size, generally the largest funds allocate more capital. The five biggest funds in the world allocate a combined $431.5 billion to private investments; the five next largest allocate $257.6 billion. The girth of a portfolio serves as a buffer, allowing more-sizable sovereign wealth funds to take greater risks. Bigger sovereign funds enjoy the benefits of scale and can afford to hire external managers specializing in real estate, infrastructure and private equity.

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“Sovereign wealth funds are an extremely diverse group, whether by size, maturity or mandate,” says Patrick Schena, co-head of the Network for Sovereign Wealth and Global Capital (SovereigNet) at Tufts University’s Fletcher School. “All three of these factors, among others, determine funds’ propensity to invest in private markets.” Allocations to private assets are literally all over the map, ranging from 2 to 90 percent, depending on the fund.

Young sovereign wealth funds tend to focus on familiarizing themselves with core assets, like fixed income and listed equities, before delving into private markets. But some smaller players are pretty sophisticated and nimble when it comes to private investments. “Our size, relative to some of the larger funds around the world, is an advantage,” explains Nigel Gormly, head of international direct investment at the New Zealand Superannuation Fund, No. 24 in our ranking, with $22.2 billion in assets. The actively managed fund is mandated to add value over and above a reference portfolio set by NZ Super’s board every five years, forcing its managers to question whether each new active investment will reduce risk, improve returns or both. “We do not have the same pressure [as larger funds] to invest vast amounts of money in private assets,” Gormly says, “which allows us to focus more on the investments where we have the most confidence that we can add value as an investor.” NZ Super doesn’t shy away from private market investments, which represent about 25 percent of its assets, according to its 2013 annual report.

Sovereign wealth funds manage pools of capital allocated by their sponsoring countries, with the goal of earning positive risk-adjusted returns for their nations’ benefit. Individual mandates vary by fund, however, and can affect the exposure to private markets. Mubadala Development Co. and International Petroleum Investment Co., both based in Abu Dhabi, allocate 90 percent and 55 percent, respectively, of their total capital to private assets, according to Sovereign Wealth Center estimates. The Abu Dhabi government requires the funds to invest within the United Arab Emirates to develop economic clusters, like capital- and energy-intensive high-tech industries, and energy-related infrastructure. Norway’s GPFG has a conservative mandate that prompts more-cautious investing. It allocates only 2 percent of its total assets to private markets.

Investing in private markets makes sense for sovereign wealth funds from a structural point of view, as the Emirati funds illustrate. As state-owned investment vehicles designed to save for future generations, some sovereign funds sponsor domestic social and economic development projects that often fall within infrastructure and private equity brackets. “Funding gaps in global infrastructure make sovereign funds in some ways ideally suited as investment partners,” says SovereigNet’s Schena. Investment in other real assets, like real estate, timber and agricultural land, is a corollary to infrastructure deals, he adds. Sovereign funds hold illiquid assets to capitalize on their long-term investment horizons (generally, 20 or more years).

There are several challenges to investing in private assets such as real estate and infrastructure, not the least of which is that they tend to be illiquid, meaning they’re harder to convert to cash at fair market value in the short run. During the financial crisis several sovereign funds were called upon to bail out their sponsoring governments — notably, Ireland’s National Pensions Reserve Fund — forcing funds to sell some illiquid holdings at a loss. Also, as with all international investments, private transactions abroad carry currency risk and face different regulatory and political restrictions.

Sovereign funds hire external managers specializing in specific asset classes to mitigate these uncertainties. Their familiarity with local market conditions, government policies and financial regulations allows sovereign funds to be informed buyers. But, as David Smart, London-based head of Franklin Templeton Solutions for the Europe, Middle East and Africa region, explains, there are risks involved in using external managers. “Manager selection is unusually important insofar as the top decile of managers are the ones that produce the really outstanding returns,” says Smart, who formerly served as global head of sovereign funds and supranationals at Franklin Templeton. A significant portion of the private equity universe struggles to beat public market returns, particularly when leverage is factored in, reckons Smart, whose current role entails advising sovereign funds on strategic asset allocation.

The risk of wasting money on inadequate external management has inspired a wave of sovereign funds to invest directly or coinvest with other funds in private equity, real estate and infrastructure. Co-investment partnerships, whether with fellow sovereign funds or with private equity managers, are an increasingly popular method of directly delving into new markets while hedging against the inherent risks of doing so. Like hiring an external specialist, co-investing allows funds to pool their assets and expertise to skillfully navigate the political and operational intricacies unique to each country and region. Unlike hiring an external specialist, both parties have skin in the game, which better aligns incentives. Co-investors leverage their finite resources and scale to deploy larger amounts of money more quickly and avoid steep manager fees; at the same time, they have the flexibility to enter and exit investments independently of one another.

Investing in private markets “is an entirely logical thing for sovereign funds to be doing,” Smart says. “The fact that sovereign funds are not bound by the regulatory pressures that afflict quite a lot of the world’s pension funds — that is, they don’t have to mark to liabilities on a quarterly basis — lends itself naturally to trying to take advantage of the illiquidity premium associated with private investments.”

SOVEREIGN WEALTH FUNDS’ LOVE WITH PRIVATE MARKETS IS NOT A new phenomenon. Its history dates back to the early 1970s, a turbulent time marked by war, social protests and the first-ever oil shock prompted by an Arab-led embargo, which catapulted industrialized countries into recession. In September 1974 the Kuwait Investment Authority (KIA), widely considered the oldest sovereign fund, acquired St. Martins Property Corp., a London-based real estate development company, through its Kuwait Investment Office. A few months earlier the Abu Dhabi Investment Board (a precursor to the Abu Dhabi Investment Authority) bought insurer Commercial Union Assurance’s headquarters in London. Since then the movement into the private market has intensified: Nearly $1 trillion was committed to private assets across all sovereign funds as of June 2014, according to the Sovereign Wealth Center. KIA, the world’s fifth-largest sovereign fund, with $386.1 billion in assets, has about $58 billion in private investments. St. Martins remains the fund’s primary real estate arm, owning roughly 3 million square feet of commercial property across Europe, Australia and Asia.

In the 1980s soaring interest rates triggered by rampant inflation prompted several countries to establish sovereign wealth funds. Government of Singapore Investment Corp. (now GIC) was launched in 1981 amid the macroeconomic turmoil, with a mandate to invest in private markets to guard the nation’s foreign exchange reserves against high inflation. Real assets like infrastructure, real estate and timber are inflation-sensitive: They respond positively to rising prices and can help preserve the purchasing power of a fund over time. GIC, No. 6 in our ranking, with $315 billion in assets, made its first allocation to private markets in 1982, investing $25 million in a private equity fund managed by New York–based Kohlberg Kravis Roberts & Co.

For all sovereign wealth funds, exposures to real estate and private equity picked up in the 1990s and 2000s as part of the natural investment cycle. Established funds looked to diversify their portfolios and aggressively boost returns as new sovereigns entered the market. In 1999, GIC, which had a 10 percent exposure to real estate, launched two investment companies for private markets: GIC Real Estate (GICRE), considered to be one of the ten largest global real estate investors today, and GIC Special Investments, which focuses on private equity, infrastructure and direct investments. By 2007 sovereign wealth funds had $288 billion in private market investments (12.1 percent of their assets), up from $61 billion (9.4 percent) five years earlier, according to the Sovereign Wealth Center.

Sovereign wealth funds were not immune to the devastating effects of the financial crisis. Then-three-year-old Korea Investment Corp. was forced to rethink its strategy following losses from a $2 billion January 2008 investment in troubled Merrill Lynch & Co. The Seoul-based fund introduced a risk-oriented approach to investing, internalized traditional asset management and began an alternatives portfolio. Today, KIC, the 14th-largest sovereign fund, with $72 billion in assets, allocates just 7 percent of its capital to private market investments.

“Given the fall in the markets, all sovereign funds were negatively impacted [by the crisis], but it’s the ones that were called upon to fund government bailouts at very short notice that arguably suffered the most,” says Franklin Templeton’s Smart.

In the wake of the crisis, institutional investors sought stable, reliable returns, and developed countries’ triple-A-rated government bonds were the safest bet. But euro zone troubles and the resulting surge of credit rating downgrades meant investment-grade bonds were hard to come by, and greater competition for fewer bonds drove prices up and yields down. Private markets were risky but offered a better return for investors like sovereign wealth funds that had long investment horizons and freedom from discrete, short-term liabilities. Sovereign wealth funds nearly doubled their allocations to private markets between 2007 and 2012, to 24 percent, at the same time reducing their exposure to cash and fixed income by more than 11 percentage points.

AUSTRALIA’S FUTURE FUND TAKES THE PRIZE FOR THE LARGEST infrastructure deal among sovereign wealth funds in 2013. In April of last year, the Melbourne-based fund bought the Australian Infrastructure Fund (AIX) for $2.1 billion and secured about half of AIX’s total holdings, mainly transport infrastructure assets. The deal, which included significant minority interests in several Australian airports, represented a sizable chunk of the Future Fund’s capital and reaffirmed its growing interest in domestic aviation infrastructure. Founded in 2006, the Future Fund, No. 11 in our ranking, with $95.2 billion, has been grabbing tangible assets since it began investing. Under its founding legislation, however, it is prohibited from buying nonfinancial assets outright. The AIX acquisition helps the Future Fund build out its burgeoning infrastructure portfolio and harness what it calls high levels of earnings certainty without consolidating risky, illiquid assets onto the Australian government’s balance sheet.

“It’s very hard to get a pure exposure to the Australian economy through the equity markets in size,” explains Raphael Arndt, the Future Fund’s newly minted CIO. “In property and infrastructure we can buy an airport, a shopping center or an office building that’s a much better exposure to the economy.” Arndt formerly served as the fund’s head of infrastructure and timberland.

Infrastructure is popular among sovereign funds because it offers the potential for high returns as well as the steady income from projects like toll roads and bridges. Still, investing in infrastructure has posed more of a challenge to sovereign funds than other private market investments, as large direct deals, particularly beyond a fund’s national borders, have proved hard to source and secure.

KIA finds infrastructure to be worth its while. In April 2013 the Kuwaiti sovereign fund launched Wren House Infrastructure Management out of its London office to help hunt for and invest directly in infrastructure opportunities. The next month KIA teamed up with Canadian pension fund OMERS and Britain’s Universities Superannuation Scheme in an unsolicited, $8.2 billion bid for London-listed water utility Severn Trent that was rejected and later dropped.

Sovereign funds have also shown interest in U.S. energy deals. Renewable energy in particular offers high yields and attractive growth profiles. NZ Super is especially committed to North American gas exploration and production, and to alternative energy: This year the New Zealand fund has committed more than $250 million to several projects, including $100 million to California-based Bloom Energy, a privately held producer of energy-efficient power-generation systems.

Real estate transactions dominated sovereign wealth fund private market activity in 2013. Some $21.5 billion in property deals accounted for roughly half of the value of the funds’ total direct private investments for the year. Developed European markets were the primary beneficiaries, making up nearly 70 percent ($15.1 billion) of the deals. As with infrastructure, investors use real estate to replace fixed-income investments with regular income. Low interest rates in developed markets and growing confidence about the state of the global economy have intensified competition in the U.S. and European premium real estate markets as sovereign wealth funds and other long-term investors, such as pension funds, endowments and insurance companies, seek returns.

For some sovereign funds the attractiveness of real estate has introduced new opportunities. Greater investor interest has increased the valuation of existing portfolios by lifting prices. The Future Fund, whose real estate portfolio is weighted toward retail properties (56 percent), has cashed in on the growing demand for prime real estate by selling rather than buying. The fund enjoyed a nearly 50 percent return when it sold its 33 percent stake in the futuristic Bullring Shopping Center in Birmingham, England, for £307 million ($508.9 million) in May 2013; it purchased the stake in 2009 for £210 million.

But for other sovereign funds, the overcrowding of the real estate market has introduced challenges. As an increasing number of pension funds move into property investing, prices are skyrocketing and yields are falling. More-mature sovereign funds, with higher risk tolerances, are shifting into less conventional geographies, like emerging markets.

In 2014, Singapore’s GICRE invested $400 million in China-based projects alongside Singapore’s Yanlord Land Group and Shenzhen-based China Vanke Co. Other sovereign funds are bullish on Indian real estate. The Abu Dhabi Investment Authority, No. 3 in our ranking, with $589 billion, allocated $200 million to Mumbai investment manager Kotak Realty Fund; Singapore’s GIC and Temasek Holdings (No. 9, $177.2 billion) and the State General Reserve Fund of the Sultanate of Oman (No. 22, $34.4 billion) committed a combined $200 million to a fund managed by Mumbai’s Housing Development Finance Corp.

Sovereign wealth funds are also investing in less mainstream, second-tier private assets, including golf courses, luxury hotels and residential development projects. This often requires the appointment of an external manager with superior industry knowledge to help minimize risk.

Funds are increasingly using structural shifts in demographics and social mobility to inform their long-term sector allocation decisions, says SovereigNet’s Schena. “In particular, the funds are directing capital to industries and firms, especially in emerging markets, whose revenue growth is linked to increased urbanization and a rising middle class,” he says. Such sectors include e-commerce, associated network and communications technologies, financial services and health care.

As sovereign funds become more familiar with markets, many are building and expanding in-house teams in lieu of using external managers. In 2010, according to the Sovereign Wealth Center, sovereign funds allocated $2.7 billion to direct real estate investments abroad. By 2013 that number had escalated to $21.5 billion, or nearly three fifths of the total deal value of direct investment overseas.

In private market investing sovereign funds have a leg up over long-term investors with short-term liabilities. Following the financial crisis developed-market regulators introduced accounting rules and regulations that required frequent filings and greater transparency by public pension funds. “There’s been a substantial shift away from equity risk [among pension funds] and to matching liabilities by having very long-duration bond portfolios,” says Franklin Templeton’s Smart. “That dynamic has been singularly missing from sovereign funds, whose liabilities stretch far longer and sometimes deal with potential transfers to generations that haven’t yet been born.”

Most sovereign funds extol the benefits that private market investments bring to their mission in terms of diversification. “I don’t think that having private markets adds risk to a portfolio,” says the Future Fund’s Arndt. “It’s exactly the opposite.” Private equity, property and infrastructure have different risk exposures from equities and traditional fixed income, and when combined can offer better risk-adjusted returns across a portfolio, he explains.

“Private market transactions do not necessarily entail investing with greater risk,” SovereigNet’s Schena agrees.

Sovereign funds are being strategic as they expand their allocations to private markets. They aren’t rushing to snap up real estate, bridges and other income-producing assets simply to quickly build out their private portfolios and absorb alluring returns. As in the case of Khazanah’s pending privatization of Malaysia Airlines, every sovereign investment ultimately comes down to the responsible use of national assets to bolster economic development and help secure a bright future for generations to come. • •