Do Sovereign Fund Direct Private Investments Deliver Value?

As sovereign funds boost direct private equity and venture capital investment, new research suggests that they may be missing out on returns.


Nestled blocks away from the Space Needle in downtown Seattle, biotechnology start-up Juno Therapeutics has seen its share price skyrocket from $24 at its initial public offering last December to $59.68 on March 19. That surge has delivered a windfall of unrealized returns for its cornerstone investor, Alaska Permanent Fund Corp., which manages the state’s $51.1 billion sovereign wealth fund.

APFC made direct investments totaling $128.5 million in Juno, and now its 28 percent stake is worth $1.5 billion. The allocation was a “real home run,” says APFC chief executive Michael Burns. “We’re really proud of it, but it does distort our direct investment performance, as it wasn’t the norm.”

Sovereign wealth funds’ ability to deploy large amounts of capital, combined with their long-term horizons and lack of liabilities, makes them natural candidates for private equity and venture capital investments, whether they allocate directly or through external managers. In the past few years, direct investing and co-investing — making a direct investment alongside private equity general partners — have garnered more attention as sovereign funds seek to reduce fees and carry while gaining more control over their portfolio companies. But new research suggests that even the most sophisticated investors may not beat venture capital firms, although they save on fees.

“The economics of the fees never outweigh the economics of getting the right deals,” Burns asserts. As a relatively conservative investor, APFC hires outside managers for most of its private equity allocation, which is targeted at 6 percent of the total portfolio. It started investing in private equity funds in 2004 and began negotiating for co-investment rights in 2013. Burns expects that the fund will keep moving toward more private assets as it builds the in-house expertise needed to go direct.




Josh Lerner, a professor of investment banking at Harvard Business School, is seeing sovereign wealth funds show a renewed interest in direct venture capital investments, attracted by flashy headlines and the prospect of high returns. “My sense is that people tried venture [capital], it didn’t do very well and they got disillusioned,” Lerner says. “But now they’re starting to jump back in the pool.”

In a forthcoming paper in the Journal of Financial Economics, Lerner, along with two associate professors of finance, Harvard colleague Victoria Ivashina and INSEAD’s Lily Fang, examined direct private equity investments by large unnamed institutions, including sovereign wealth funds, pensions, endowments and insurers, from 1991 to 2011. With an average size of $94 billion in 2012, the seven firms in the sample “are among the more sophisticated private equity investors in the industry,” the study notes. Yet when they invested alone in venture capital transactions, they lagged the fund benchmark, with internal rates of return 18.5 percent lower than that of their average solo deal.

Choosing and monitoring start-ups is harder than investing in later-stage companies, according to Robert Mah, executive vice president of private investments at Alberta Investment Management Corp. “If you’re not one of the Silicon Valley funds, you’re basically susceptible to getting all the deals they don’t want to do,” Mah explains. “It’s natural selection.”

AIMCo, which manages C$85 billion ($67 billion) in assets for 27 clients, including the Alberta Heritage Savings Trust Fund, the Canadian province’s C$17.2 billion sovereign wealth fund, has been directly investing in private equity and venture capital since 2009 and 2010, respectively. But in Mah’s view, fund investments are an important complement to a direct investment program. “We can’t hire enough people to do everything,” he says. “We need funds to deploy capital.” Also, private equity general partners facilitate deal flow and share resources and expertise, Mah adds.

Lerner and his co-authors’ study found that co-investment portfolio companies underperformed the private equity funds in which they were held by about 9 percent on average. “You don’t need to have some paranoid view that GPs are out to get you,” Lerner says. “It’s about when they need help filling out their dance card.” The 103 co-investments in the sample tended to cluster around market peaks when valuations were higher, resulting in lower return prospects.

APFC’s Burns thinks all of the co-investment deals offered to his fund have been attractive. “If our partners were offering us leftovers, they wouldn’t be our partners very long,” he says. The Alaskan sovereign fund most often passes on co-investments based on portfolio constraints, not because the deals are bad, Burns notes.

Joseph Konzelmann, New York–based senior sovereigns strategist and managing director at Goldman Sachs Asset Management, has noticed an uptick in sovereign wealth funds striking co-investment deals with global partners ranging from private equity firms to fellow public investors.

“Sovereign funds have been increasingly focused on co-investing given their desire to invest more capital, reduce fees and construct a more concentrated portfolio across industries and markets,” Konzelmann says. “Additionally, co-investing provides sovereign funds greater transparency, an ability to better control the pacing and timing of their investments and the ability to target their exposures in sectors and regions about which they feel most constructive.”

AIMCo’s Mah attributes success to having expert staff, a competitive compensation structure and strong partnerships. “We like the fact that there are people like sovereign wealth funds that we can partner with,” he says, adding that it’s all about having the right team and investment processes. “If you have that, you can tackle any asset class.”•