Monday 10, July 2017 by Nabilah Annuar

SWF: regional trends

In the shifting regional dynamic of sovereign wealth funds, what is the future outlook? Ihab Khalil, Partner & Managing Director at The Boston Consulting Group Middle East writes.

Sovereign wealth funds (SWFs) in the Middle East control over $2 trillion. Such financial power and prominence indicates that SWFs are a collective power source of capital for global asset classes, and, more critically, they have evolved to be major catalysts for local governments to drive their agendas and diversification efforts.

Despite Middle Eastern SWFs being amongst the oldest and most prominent globally, we have witnessed a recent slowdown, due to a number of regional challenges including a decrease in hydrocarbon inflows with pressure to fund government shortfall, political instability, and the trend of lower returns and higher volatilities. The imperative focus for governments in the region will modernise the transition to the 21st century, adapt to emerging investment trends and market realities, and support governments, not only financially but also in terms of the strategic agenda to deliver on the long term in 2017 and beyond.

Some of the largest SWFs are found in this region, particularly the GCC, including Abu Dhabi Investment Authority in the United Arab Emirates and Kuwait Investment Authority in Kuwait, which ranked fifth and sixth respectively in terms of size. The Public Investment Fund in Saudi Arabia is the anchor SWF in the Kingdom. These also rank in the top Sovereign Wealth Funds according to the Sovereign Wealth Fund Institute. SWFs are key players in local markets as they own substantial assets on behalf of the governments, including some of the region’s most prominent national champions. Some of the Middle East SWFs and government-owned funds own up to 40 per cent of the market cap in their respective public markets.

SWFs typically aim to double their assets every ten years to beat inflation and generate real growth. The targets differ significantly by mandate; the liquidity provider’s key metric is cash returns and capital preservation, while the asset optimiser aims to maximise the total shareholder return on an asset-by-asset basis, while maintaining an overall profitable portfolio. The economic development will have to show success by kick-starting sectors, attracting investors, generating positive returns and other strategic metrics.

Where a government has the capacity for multiple mandates in terms of SWFs, two prominent models have emerged. The first ensures full, legal segregation between the entities to create clarity and focus management, for example, a government may have separate mandates for monetary authority, sovereign wealth funds, and investments. The second model offers single player entities multiple roles with clear organisational segmentation and governance segregation.

Clear segregation of SWFs

In the past, there has been a clear segregation of distinct mandates of SWFs globally. Budget equalisers and liquidity providers typically act as buffers with sufficient assets to cover budget shortfalls over the medium term—usually up to six months. Budget equalisers and liquidity providers form an essential part of government’s liquidity and liability management and discipline. Their assets tend to be highly liquid and invested in low risk assets such as fixed income.

Future Generations Savers are a SWF’s vehicle to invest excess financial resources to generate long-term capital growth for future generations and often supporting or diversifying the sources of government income. These are highly regulation oriented, and generally constrained by legislation to maintain discipline. Future Generations Savers invest globally and outside their core markets and diversify across asset classes, usually investing through external managers. Having said that, several Future Generations Savers have started to internalise capabilities to lower costs and maximise efficiencies. More specifically, many have started to build internal investment capabilities to reduce costs, often leveraging on a consolidated set of selected strategic partnerships. Moreover, a number of SWFs have started to revise their own operating models to bring several middle office functions internally to lower operating and mitigate information costs.

Asset optimisers are typically vehicles that enable governments to optimise their own assets, maximising value and shareholder returns, and often monetising this value at one point in time. In practise, they do not have an asset allocation strategy, rather maximising value at the asset level through disciplined governance, portfolio synergies, and leveraging government’s own access to generate growth opportunities. Rigorous portfolio companies’ governance and management frameworks are typically involved to ensure right intervention and active ownership.

Economic or sectoral development act like venture capitals (VC) for governments, directly or indirectly supporting diversification efforts, leveraging the government’s financial resources directed internally to jump start or unlock sectors otherwise too risky or with too high financial barriers for investors to tap. The ultimate objective remains to be commercial returns, with high risk appetite. They play a critical role to lower the risk threshold of investors and attract strategic players to co-invest locally.

Specialised infrastructure and developmental vehicles cater to the wide expansion of the utilisation of ‘SWFs’ that we are witnessing, even by governments with minimal resources. The objective is to present foreign investors and sovereign partners with commercially oriented vehicles to optimise deal structures and mitigate government bureaucracy.

The Middle Eastern mandate

Historically, Middle Eastern players have been mandated primarily with locking capital for future generations. As hydrocarbon revenues collapsed, several of these players are looking to formalise and evolve their SWF landscape. A number of trends should be observed and these include emphasis on formalising the broader reserve management framework and linking it with the debt, investment, fiscal policies in order to create rule-based systems with clear segregated objectives. These will target and match the forward looking needs of the budget. Specifically, we see a push to formalise asset liability management (ALM), forecasting functions and the budget equalisation mandate.

The region is also witnessing constraints in terms of funding and limited market liquidity, which is forcing governments to reconsider their SWF portfolio. In addition to this, Future Generations Savers are under pressure with sustained and expected low-return environment. Many are revisiting the strategic asset allocation, shifting to riskier asset classes, and moving directly in-line with other peers internationally in order to boost returns.

In addition, we are also witnessing an increased focus on formalising the asset optimiser mandate for local assets to support value creation and potential monetisation by sponsoring large corporations to become national champions through capital support, access to markets leveraging G2G relationships and strategic partnerships to become disciplined active investors. The mandate to create sectors is emerging strongly particularly in Saudi Arabia, essentially creating vehicles to kick-start new sectors in line with top-down economic agenda.

While we are witnessing an emerging trend when it comes to investing in innovation and disruptive sectors, we have to consider the SWF outlook and anticipate performance over the long term. These investments come hand in hand with highly volatile risks however, triumphs largely contribute to the necessary returns and capabilities that can positively be used to help the economy.

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