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Sovereign Wealth Funds: Attractive Suitor for Smart PE Firms

What's all the fuss about Sovereign Wealth Funds (SWF) these days? Plenty! In the near future, this emerging investor class will literally be connected, to some extent, with every major private equity firm in the world.

Sovereign Wealth Funds currently represent nearly $6 trillion in investable capital globally. In the next five to ten years that figure is projected to grow to nearly $11 trillion. “Sovereigns“ particularly concentrate in large infrastructure-type projects -- such as those involving water, roads, airports and bullet trains in addition to real estate.

The most successful Sovereign Wealth Funds are characterized by a high level of in-house expertise; very conservative, cautious approaches to investing within an institutional business model that has its origins in the government sector. The largest funds are global and include the government pension fund in Norway or the Abu Dhabi investment authority.

Increasingly an attractive asset in the investor mix of large private equity firms, Sovereigns have historically been some of the largest partners (in addition to U.S. pension funds) with leading PE firms especially those in the Middle East. Many large PE firms enjoy strong relationships with Sovereigns as valued sources of capital. Sovereigns enable PE firms to more confidently broaden the diversification of their portfolios by distancing their strategy from the constraints of the traditional next-quarter mentality.

A Shift in Role Playing
Now the historic role Sovereigns have played as passive investors in PE funds is shifting. While they continue to use a private equity approach to diversify their investment capital across sectors, major SWFs are evolving to include more direct investing, driven in part by the desire to avoid management fees charged in private equity and real estate. They have also upgraded their in-house talent with professionals from Western markets, who can provide the value-added expertise in evaluation capabilities.

The big changes being seen with SWFs started around 2003, notably in the PE firms outside of Norway. Before then, there were few highly trained professionals with Wall Street or London banking or investment experience working in the Sovereigns. The shift began with the quality of people being recruited. Compensation packages improved as commodity prices started spiking, injecting more cash into the commodity-based Sovereigns. Today, better trained and experienced professionals are raising the standards in fund performance and transaction results.

However, it takes a lot of resources to manage new assets in Sovereigns, once they are acquired; the larger ones are not going to be able to manage those types of investments directly. They must utilize other vehicles. More situations will occur in which outsourced specialists will be needed to improve the on-the-ground operations of assets in order to increase their cash flow and drive EBITDA for better returns in a more time-sensitive investment lifecycle.

As with all investment classes, the pendulum will continue to swing in accordance with the highs and lows of commodity prices. With oil at over $100 per barrel for four years now, large amounts of cash continue to flow into commodity-based Sovereigns for investing purposes outside their own countries. Funds are being deployed into direct deals. Nevertheless, with the size of their capital pools, SWF managers continue to invest in diversified portfolios in order to fully participate in the global economy.

With the large Sovereigns in Norway, Abu Dhabi and China, there are PE groups that know those emerging markets well from experience. The Gulf-based Sovereigns are recognized as very sophisticated emerging market investors, due in part to their different view of risk as compared to U.S. or London-based institutions. They are always searching for good opportunities that are accompanied by strong management -- whether it's a PE managed fund or a large-ticket infrastructure opportunity in which they would participate directly.

Improving PE Firm Readiness for a Sovereign Wealth Fund Relationship
For PE firms, a successful relationship with a Sovereign Wealth Fund is akin to a marriage. It involves a protracted process of courtship in which both parties, the PE firm managers and the Fund managers, get to know each other. PE leaders need to exercise the personal touch of significant face time as well as develop a strategy for visibility in the markets to support ongoing disclosure and partner accountability to the Fund. Ultimately, SWFs are government-owned institutions that need to be regularly advised on the status of their investments. This is no more critical than when a situation, directly or indirectly, rises to the attention of the media. PE firms will do well to become vigilant about the sensitivities SWFs have for public scrutiny in any form.

Additionally, Sovereigns are increasingly focusing on understanding a PE firm's investment criteria in order to feel comfortable with the decisions that the PE team makes. They also evaluate the PE team's ability to adjust to the needs of the market place, such as adding value to portfolio companies and integrating sustainability practices. Since there is no longer access to cheap and significant amounts of debt, expanding multiples are harder to come by and more equity has to be formulated into transactions, PE leaders need to change their historic pattern toward portfolio companies. Those that perform analysis, operations and supply chain optimization, as well as sustainability initiatives, early on in the acquisition lifecycle will be viewed positively. Directly impacting how companies are actually operating on the ground will produce improvements that push the return profile of the PE firm up the quartile rankings.

The larger PE firms understand the relationship process with Sovereigns and continue to devote resources to getting it right. On the other hand, middle market PE firms looking to secure relationships with Sovereigns should focus on developing a long-term strategy.

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