I recently found myself the lucky moderator of a candid discussion among a group of asset owners — mostly sovereign wealth funds and public pensions — on innovative investment models and creative approaches to deal sourcing. One of the Giants in the room, whom I‘ll anonymize to protect the innocent, was opining on his fund’s approach to accessing emerging market economies. This individual was thirty seconds into a description when another individual in the room caught his eye. He stopped. “You know what,” he said, “The fund that we learned this from is in the room...” And he gestured to another Giant.
Turning to the latter, I asked what it was that had inspired his fund to take such an innovative approach. The individual thanked me for the question as well as thanking the gentleman from the first Giant for being so gracious and then he paused... for what felt to the moderator like a long while. His eventual response was worth the wait: “National survival,” he said. “We had to be creative and do something like this. The future of our country was, if we’re honest about it, depending on us finding a new way to drive development. And we did.”
Confused? Yeah, that’s understandable. Here’s basically what went down: An iconic public pension fund known above all else for its purity of financial motives and professionalization credited a sovereign development fund — one that acknowledges publicly that it has a strategic overlay — for inspiring its approach. Say, what?
It’s largely for this reason that I became interested in sovereign development funds, as I believe these organizations could serve as important catalysts for change in financial markets generally. Admittedly, my views on this matter have been clouded by the 18 percent dollar returns generated by Temasek since it launched 40 years ago and the 14 percent dollar returns Malaysia’s Khazanah has generated since its reorganization in 2004 and the double digit decennial returns generated by many other SDFs, such as the Palestine Investment Fund or the Public Investment Corporation of South Africa. More to the point, some of these funds (though clearly not all) have posted remarkable returns while doing things in their local economies that could be described as “off the beaten financial path.”
As I see it, most institutional investors are so far removed from the real economy that they fail to see the connection between their future prosperity and that of the economic system they are financing. They buy products not assets and invest in managers not companies. And this disconnect between long-term investors and long-term value creation leads to fundamental problems in our capitalist system.
But with SDFs, there’s a remarkable opportunity — in fact, it’s a requirement — to re-root investment organizations in the “real,” and to take a limited pool of capital and create wealth in general terms. SDFs aren’t burdened by the constraints or complications that can come with traditional portfolio theories. In fact, they are empowered by their additional necessities. Their extra-financial mandates are, in a way, a license to think outside the box and to take on big problems. It’s also often permission to develop internal capabilities. Why? If there were financial products for sale in a region or market offering “development,” the government wouldn’t need an SDF in the first place. Being the first investors in to a new industry or geography demands such professionalism.
Is it crazy that a strategic investment vehicle would outperform pure financial investors? Not really. Research suggests that corporate venture capital creates more value when it is strategic in nature than when it is purely financial. How can that be, you ask? As it turns out, the strategic focus of corporate VC is what attracts the time and attention of the key players at the sponsoring company. This, in turn, drives increased coordination and knowledge sharing, which leads to two-way value creation... and better overall outcomes.
I continually scratch my head when I hear people say, without thinking, that impact or developmental investing erodes financial returns. Return erosion is, obviously, a possible outcome from strategic investing done poorly, but I don’t see the two as necessarily linked. Rather I see a strategic overlay as a license for investment organizations to be highly creative. And I think creativity is the single most important building block of long-term investment success.
In sum, you can either view the strategic objective of SDFs as a distraction from running traditional financial models, or you can view it as a unique opportunity to cultivate structural alpha. Perhaps I’m a naïve optimist, but I often sit in the latter camp. I genuinely believe that a strategic overlay can help bolster a well-governed fund’s returns by giving the investment organization a longer duration mindset, a closer link to the real economy (from which all economic value will ultimately emerge), a mandate to build internal capabilities and a license to innovate. And so, I think it natural that highly professional “financial investors” are now looking to strategic investors for inspiration and advice.
