Sovereigns shift to alternative assets

Global Edge, September 2010

Across the Asia Pacific region, sovereign wealth funds are shifting more and more towards alternative asset classes. They differ in the pace and degree, but almost without exception they are making the transition.

Some sovereign funds have been active in alternatives for many years anyway. One of the most sophisticated funds in this respect is the Government of Singapore Investment Corporation (GIC), which has separate divisions for real estate and special investments – by which it means private equity and infrastructure – alongside its mainstream asset management arm. As of March 31 2009, when GIC’s asset allocation mix was last disclosed, 30% of the portfolio was allocated to what it calls alternatives: 12% in real estate, 11% in private equity, venture capital and infrastructure, 3% in absolute return strategies, and 4% in natural resources.  Even within its public market GIC Asset Management division, it has a separate department for natural resources.

At GIC, it’s not just the allocation figure that stands out but the degree of understanding and specialisation. GIC Special Investments isn’t just a vague private equity division, but looks individually at buyouts, venture capital, special situations such as mezzanine debt, growth capital, and secondary fund investments. In infrastructure it has developed a model of going directly into mature operating assets with a high degree of cashflow visibility in regulated environments; in private equity, it picks funds and partners to invest in and grow with over the long term. It is believed to have over 100 active fund manager relationships and has partnered with most of the biggest names in the business: Texas Pacific Group, Carlyle, KKR, Blackstone, Bain, CVC and Sequoia to name but a few, as well as younger managers such as Ironbridge Capital in Australia, for which it was a cornerstone investor in the first fund in 2004.

As for GIC Real Estate, it has been running as a GIC department for nearly 30 years and is one of the largest global real estate investment firms in the world in its own right, with over 150 dedicated staff and 300 investments in 30 countries.

This level of sophistication is actually problematic for external managers as it is exceptionally difficult to come to them with a new idea they haven’t already thought of, and probably implemented, themselves. Private equity and hedge funds have a far greater chance of new investment from GIC than a long-only powerhouse fund manager. The main relationship in the external managers department, Adeline Li, hails from an alternative background and managers say that has affected the sort of mandates that are likely to be awarded.

The same problem of over-sophistication is true of Temasek, arguably the most evolved of all sovereign wealth funds in that it does almost everything itself, and has its own fund management arm, Fullerton, as a subsidiary (with another, the as-yet opaque Seatown Holdings, to follow). Fullerton has partnered with many institutions over the years, among them Alliance Capital Asset Management, Mizuho Asset Management, Kookmin Bank, Nomura Asset Management, Eurizon Capital, and Bosera Asset Management. But increasingly it’s a direct investor in its own right. Similarly, rather than outsourcing property investments, it does so itself through another subsidiary, Mapletree.

For external managers, then, an easier area of focus is on sovereign funds that are newer, or at least newer to the idea of alternatives.

One sovereign institution fund managers are talking about is the Korea Investment Corporation, only launched in 2005 but getting noticed for its vibrant approach and its willingness to outsource. It is also closely watched because of comments by its chief investment officer, Scott Kalb, that he hopes to deploy 20% of the fund’s assets into alternatives, arguing that illiquid alternatives have become more attractively valued relative to liquid public markets. Kalb believes distressed real estate, credit and private equity are in the early stages of a four or five year positive cycle.

That will represent quite a shift: as of December 31 2009, traditional assets accounted for 93.2% of the overall portfolio. Then, private equity, hedge funds and strategic investments accounted for 4.8% combined, and real estate and commodities a further 2%.

This progression reflects a gradual approach of moving into new asset classes, becoming comfortable with them, and only then looking to be more daring: KIC entered global bonds in November 2006, global equities in April 2007, strategic investments in February 2008 and alternatives in August 2009. It was only in 2009 that the scope of investment was expanded to include, for example, commodities indices, private equity, hedge funds and real estate.

The good news for external managers is that whenever entering a new asset class, KIC has tended to begin by outsourcing, then bring the funds back in-house once the expertise has been developed. So at this stage, most alternative allocations are being outsourced. A core portfolio of hedge funds was put together in 2009, bringing together external managers with expertise in global macro, equity long-short, credit investing, and fund of funds. In strategic investments, KIC has said it is seeking M&A opportunities in line with green growth – a government policy – and natural resources.

The China Investment Corporation has also been increasing its allocation to alternatives. CIC operates a benchmark portfolio structure that has a separate allocation towards alternative investments, although it has not disclosed what that benchmark allocation is. CIC’s four investment departments include one, private markets, dedicated to private equity investment through external managers, co-investment vehicles, partnerships and separate accounts; another, tactical investment, which outsources liquid absolute return portfolios, among other things;  and a third called special investments. Its recently-released 2009 annual report showed an increase in alternative assets from US$0.4 billion to US$7.4 billion, and at the end of December 2009 alternatives accounted for 6% of the total international portfolio. Incidentally, if CIC does turn out to be a potential buyer of Liverpool Football Club, as was rumoured at the time of writing, that would be considered an alternative investment too since Liverpool is unlisted.

Elsewhere, institutions that have previously stayed clear of alternatives have also been active. The Hong Kong Monetary Authority has part of its wealth, called the Investment Portfolio, in a vehicle that has sovereign wealth fund characteristics. This has stayed steadily invested in bonds and equities, but in April this year reports began to circulate that it was considering putting some of the portfolio into hedge funds and private equity.

And a little further afield, Australia’s Future Fund has been dedicated to alternatives since the outset. Its long term strategic allocation includes a 15% commitment to alternative assets – already relatively high – but the fact is, by most people’s definitions of alternatives, the actual figure is much higher. The Future Fund also has a 30% benchmark allocation to what it calls tangible assets, which include real estate, infrastructure, utilities and timber, in a listed or unlisted form. (The bit that the Future Fund calls alternatives refers mainly to hedge funds and other absolute return investments). In theory, as much as half of the fund can be in areas outside mainstream debt and equity.

Since the Future Fund outsources everything except its direct investments in areas like timber, this is also good news for alternative managers. And the theme that comes through across Asia Pacific is that, for managers seeking to get new mandates from sovereign funds, there is simply no better place to be than alternatives. Naturally managers need a good and reasonably long-term track record, and a demonstrable ability to help diversify a portfolio; it helps, too, to be on the radar screen of the big consultants engaged by sovereign funds to help with manager selection (typically including Mercer, Cambridge and Watson Wyatt.)

Managers should expect, too, to be pressed hard by skilled and knowledgeable internal manager selection teams wanting to know exactly how and why a strategy is different to the herd. Sovereign funds expect frequent and detailed reporting and can be demanding clients, particularly on fees. But for those who tick the right boxes, expertise in an alternative asset class is one of the only ways to get noticed by these exceptionally powerful institutions.