Panel 1: Risk Management in Uncertain Global Markets
- Moderator: Patrick Schena, Adjunct Assistant Professor of International Business Relations at The Fletcher School, Tufts University
- Zhao Haiying, Chief Risk Officer, China Investment Corporation
- Keith Featherstone, Senior Tax Counsel, Abu Dhabi Investment Authority
- Serikzhan Rysbekov, Deputy CEO, Chief Risk Officer, National Investment Corporation, National Bank of Kazakhstan
- Abed Al Abwah, Chief Audit Executive, Palestine Investment Fund
The panel discussed how do SWFs think about risk, and what types of risks are most relevant today. Normally the larger funds have three lines of defence: the front office (or investment teams), the middle office (or risk office), and the back office. Most funds have a comprehensive structure in place. The larger and more conservative funds, are very sensitive to reputational risk and want to stay out of the headlines. Consequently, they try to avoid any schemes or investment structures that might compromise their reputation. Some other development funds are structured as holding companies and monitor risk at each portfolio company’s level. Reputational risk is so important that you can’t even put a price on it. Most participants said their institutions received a lot of advice on a transactional basis from external advisers including legal counsel, but very little support on reputation.
How to prioritise risks?
Many organisations put the risk management team front and centre of their investment process. For this reason, the risk team always checks the due diligence memorandum for each investment. The risk team also prepares risk tests ahead of major political changes, for example, all major funds had prepared a scenario planning ahead of Brexit in 2016.
From a reputational perspective, it is very important to identify suitable partners from the start. The panel debated the risk associated with opportunity costs; for example, committing to direct investments in consortia. When all parties are performing due diligence, sometimes there is a tendency to rush through the checks to prevent letting the other investors down, to avoid running the risk that they might lose potential opportunities with those partners in the future.
In general, financial institutions are under institutional pressure, but as SWFs are owned by governments they are under greater domestic scrutiny because they manage public savings.
Additionally, as government-owned institutions, sovereign wealth funds are also looked at more closely by foreign regulators when then invest abroad. For instance, it is a corporate offence to fail to prevent tax evasion in the UK. The Criminal Finances Bill 2016 (when enacted) will create the corporate crime of failure to prevent the criminal facilitation of tax evasion. If sovereign wealth funds’ government owners do not meet the UK’s stringent laws on tax evasion, it might lead to an additional administrative burden, or prevent them from investing in the UK. This legislation only applies to the UK, but if other jurisdictions follow it could be problematic for the free flow of capital from sovereign wealth funds across the globe.
For development funds investing in certain projects, reputation is also very important, but they also face organisational changes risk, when people or process change within a portfolio company.
Does lower for longer imply a new risk?
The rebalancing of the Chinese economy, and China’s economic growth more generally is a new and important risk to take into consideration as China provides one third of global growth. Most sovereign wealth funds will have some sort of direct or indirect exposure to the Chinese market. The so-called China factor, currently provides growth to a portfolio, but investors need to be wary that this might change one day.
The China factor can be reversed as in certain jurisdictions Chinese entities cannot invest above a certain quota to avoid being thought to have “control” over an asset. For this reason, CIC tries to keep its investments in any foreign assets below 10% to avoid any regulatory challenges, particularly in the US where the Committee on Foreign Investment in the United States (CFIUS) has been particularly challenging for Chinese investors.
All panellists agreed that political risk is on the rise, and they all prefer to invest in countries where there are consistent policy and regulatory environments.
Panel 2: Asset Allocation in a Low-Return World
- Moderator: Abdiel Santiago, Secretary, Fondo Ahorro de Panama
- Francisco Vergara, Head of SWF Unit, Ministry of Finance, Chile
- David Neal, CEO, Future Fund
- Sheila Patel, Chief Executive Officer of International & Global Co-Head of Client Business, Goldman Sachs Asset Management
- Louis de Montpellier, Head of Official Institutions, State Street Global Advisors
The panellists discussed their diverse experiences in dealing with low returns. Some are increasing allocations to private markets, others are looking for different ways to diversify their portfolios and find alpha. Some others chose not to chase returns by moving up the risk curve, and simply communicate better with their stakeholders.
The panel discussed different approaches to asset allocation such as strategic tilting and reference portfolio models. One participant suggested that an absolute or relative return target was more effective at generating better risk-adjusted returns than a reference portfolio, particularly when interest rates and bond yields were low and equity markets subdued, as these indices are used to create the reference portfolio.
There is much research highlighting the changes of sovereign wealth fund asset allocation since the global financial crisis. While many other institutional investors were de-risking and dropping their private markets allocation, many sovereign wealth funds increased their investments to private equity, as demonstrated in last year’s IFSWF research.
The panel also discussed different approaches to investing in illiquid markets. Some funds have built new teams for this purpose, with specialists talking with external managers all the time and picking the best fit for their liquidity needs and risk tolerance One panellist discussed the process at his institution when it decided to make its portfolio more flexible, and bring down the exposure to illiquid assets, The fund managed to do so after talking to its portfolio managers who had the feel for the market, and consequently decided to reduce exposure to private markets at a profit. The illiquidity premium has shrunk a lot since then, and it is almost not worth the risk now. Managing private markets is difficult, he added, if you don’t have the resources, staff, or scale to dictate terms to private equity firms.
Liquidity requirements are also an important aspect to portfolio allocation. For those sovereign funds with liabilities, it was important to understand their finance ministries’ perspective. Central governments are often concerned that agreeing to a lower benchmark would be a signal to markets, for example, or that future budget might have to be cut to accommodate lower returns.
This debate is set against the backdrop of research showing that governments and SWFs allocate less efficiently than private firms. One participant also pointed out that global financial crisis was a failure of Washington consensus policies, but the panel agreed that growth fuelled by high debt was the real culprit.
Panel 3: ESG for Public and Private Markets
- Moderator: Catherine Savage, Chair, New Zealand Superannuation Fund
- Eugene O’Callaghan, CEO, Ireland Strategic Investment Fund
- Tarik Senhaji, CEO, Ithmar Capital
- Baljeet Kaur Grewal, Managing Director for Strategy and Portfolio Investment, Samruk–Kazyna
- Archie Beeching, Senior Manager, Fixed income and infrastructure, PRI
ESG considerations have become increasingly important to the investment and risk management processes. But how they are applied varies widely depending on the type of asset. This panel took a wide-ranging look at methods used by investors in public and private markets. There are three different methodologies to implement ESG in the investment process: screening, thematic, and combined. Sovereign development funds each have their own definition of integrating ESG principles as they select the parts of ESG matching their specific mandates to develop the local economy. Some of them, for example, try to promote the use of renewables or to create a so-called green economy in their region.
Engaging the local community on ESG issues is particularly important for sovereign development funds. They must understand specific local issues and concerns on each project. Sometimes the local community is not only concerned about the creation of local jobs, but the protection of the environment and resources, and above all a shared sense of ownership. For example, one panellist reported that his sovereign development fund offered free access to the beach to locals at a tourist resort development that his fund was backing. The project has been successful and three hotels have so far been completed.
The main difference in applying ESG principles in private markets versus public markets, is that it is much more time-consuming to engage at the governance level.
How to implement ESG into the Investment Process
An easy way to start implementing ESG into investments is by excluding everything that is considered illegal by the local government, after this first step the funds can start to integrate more and later build an ESG team to sets all processes. The most important stakeholders are politicians but also some non-governmental organisations, particularly for some domestic development funds.
All panellists believed it to be important to engage with stakeholders before a change in policy or investment needs to be made. It is better to have soft conversations before a specific issue arises rather than hard ones when there is a conflict. Climate Change It is possible to measure the performance of climate change investments, but so far there is data only for the last 10 years. If a sovereign investor believes that carbon is mispriced, it should protect its portfolio against it, and the simplest way of doing it is reducing or excluding carbon investments.
The feeling of not being rewarded for the risk is a very important one. Adrian Orr, the New Zealand Superannuation Fund CEO said “It was the easiest decision to make for NZ Super but it was much harder to explain. Even if carbon price doesn’t change much in the next 20 years it still would be a good decision.”
There are some studies showing that SWFs do follow and integrate ESG in their portfolios but when they do so, is generally a top-bottom approach, as the key stakeholders decide. The major stimulus to ESG is therefore likely to happen in those SWFs with public shareholders. All panellists agreed that standardisation of data in the ESG industry will be essential to improve the sector.
Panel 4: Technology on the Rise: how can SWFs be ready?
- Moderator: Stephen Lawrence, Head of Quantextual Research, State Street Global Exchange
- John Tang, Managing Director, Private Equity, GIC
- Yeszhan Birtanov, Former CEO, National Investment Corporation of National Bank of Kazakhstan
- Tarek Selim, CFO/COO, Arabesque Asset Management
To improve efficiency, the financial services industry is adopting advances in data science and machine learning at a rapid pace. These innovations will affect the way investors identify alpha opportunities, analyse risks, manage data, and reconcile trades.
The panel debated how SWFs are harnessing technology in their organisation, focusing on portfolio and risk management activities. The most sophisticated sovereign wealth funds see technology as very important when risk-assessing their investments. For sovereign funds investing in public markets, the last five years there have seen big advances in how listed companies are using data, and releasing more information to investors. Forensic accounting can now avoid nasty surprises to investors; big accounting frauds like those happened in the early 2000s, are now very difficult to perpetrate.
The level of availability of data, is also changing. In China, for example, investors can have access to unstructured data such as doctor’s prescriptions because of China’s light regulation of data protection.
Data-ownership and accuracy
One of the major themes that are going to affect all investors is data ownership. So far, very few observers have acknowledged how many companies are taking advantage of data gathered from external sources such as customers (social networks are a case in point), but the owners of the data (the customers) are so far not remunerated (if not with a free access to a service).
In the future, data will start being priced by the owners, and investors will have to consider the implications of the change.
Another important theme to consider is data accuracy. Accurate data is more important than a sophisticated machine learning analysis on bad data. However, clean data is still not pervasive in the finance industry, as it is an industry mainly based on trust, and the human element is still very important.
The world’s changing demographic structure will also affect financial services and the mutual fund industry. The so-called millennial generation will be much more demanding towards mutual funds than their parents. In 10-20 years’ time, when millennials receive their inheritance from baby-boomers, they won't re-invest with mutual funds as their parents did, because of a different set of values and trust in technology.
How SWFs are Using Tech in their Organisations
Some sovereign funds have a very sophisticated approach to data and use it in the investment process across different asset classes. In public equity, investment teams can now use machine learning to go through hours and hours of conference calls. The recordings and analysis resulted in backing estimates in those companies where CEOs or CFOs were sharing numbers, and data. They turned out to provide results more in line with analyst forecasts than others sharing less data, for example.
An important thing for sovereign wealth funds to learn is that data can be used as an “Omega” to gel Alpha and Beta. All funds are looking to exceed expected returns with Alpha, then they generally use asset allocation to get Beta, and then with shared data across different investment teams they can put all the pieces together and get the Omega.
Some sovereign funds use the information received and used by private equity teams to understand new sub-sectors that can affect public markets in the future or vice versa.
Risks
The widespread use of decision-making based on data is risky because the data must be accurate, or the decisions taken from the analysis will be wrong: an effect known as GIGO (Garbage in, garbage out) in data science. Big data is scary, and bigger data is even scarier. In China, privacy doesn’t exist and there are providers already aggregating a lot of personal information and reselling it. The light regulation gives China also an advantage in certain nascent sectors. For example, there are over 2,000 peer-to-peer lending platforms versus a few dozen internationally.
Cryptocurrencies and the blockchain are other examples of technologies that have been taken to mainstream investors much more quickly in China than anywhere else in the world.
Private Equity Transaction Workshop
- Moderators: Gavin Wilson, CEO, IFC Asset Management Company; Reyaz Ahmad CIO & Head, Fund of Funds, IFC Asset Management Company
- John Tang, Managing Director, Private Equity, GIC
- Uche Orji, CEO, Nigeria Sovereign Investment Authority
- Mario Giannini, CEO, Hamilton Lane
- Will Jackson-Moore, Global Private Equity & Sovereign Investment Fund Leader, PwC
The discussants introduced the panel highlighting that private equity (PE) has different underlying value drivers versus public equity that investors need to consider:
- A concentrated shareholder group with a hands-on approach, and a better alignment of interest.
- Ability to take a longer-term view, rather than focus on quarterly performance
- Exposure to different segments of the underlying economy (especially in emerging markets)
When investing in private equity through funds, investors should make sure there is a strong alignment of interest between fund managers and fund investors. The fund structure gives a predictable time of investment and divestment. The result of which is an asset class that has historically outperformed public equities over long periods of time, and provided correlation relief to portfolios. Making it an attractive addition to the portfolios of most institutional investors, despite its inherent illiquidity (although the liquidity of the asset class has increased over time as the secondary market has taken off in importance).
Cheap capital in the form of quantitative easing means that valuations across all asset classes are high, driving increased interest in PE, and historically high "dry powder".
The global PE industry has never been bigger, and fund selection remains key, although Hamilton Lane’s research showed that over three-quarters of the funds exceeded return expectations. Historical 2-and-20 fee model has largely survived, apart from large investors (including some SWFs) that can negotiate terms.
The panel agreed that the best way for LPs to have access to co-investment opportunities is to put more capital to work with fewer GPs, and/or to insource PE where possible. When an SWF decides to launch a private-equity team insourcing most of its investments, it gains access to two types of transactions: direct investments, and club deals. This allows greater control, and curbs the fees or/and carry to an external firm. This is generally the norm for investors with necessary scale, and resources.
Club Investments (deals negotiated in a consortium) are a variant of fund investments, and co-investments. Investors without the requisite scale or resources (or pursuing niche strategies) can outsource part or all their PE investment activity to third parties for a fee.
Exposure to PE can be achieved through PE funds in the following ways:
- The use of external consultants/advisors
- Fund of Funds (FoFs)
- Separately managed accounts (SMAs)
Direct Investing:
- Proactive deal-sourcing is key
- Local relationships often central to initial selection
- Target country/region
- Target space or sector
- Stage & deal size
- Control, minority or effective control with other partners?
- Management team
- Each investor will have their own specific areas of focus
In many cases (always in emerging markets) investors needs a corporate governance (CG) assessment and a CG action plan:
- Could use in-house corporate governance specialists or external consultants
- CG assessment/action plan should be mandatory for larger investments
- Good CG is a core business issue and should not be left to the ‘experts’
Structuring focus
It is important to understand board composition and how directors are appointed (e.g. based on the percentage of shares or negotiated right) and who can change this. What board committees are needed and membership of such committees. Appoint internal staff or vetted external professionals to serve on the board, depending on the nature of the investment.
Listed equities in EM are often concentrated and illiquid. EM public markets are dominated by a handful of companies (by market capitalisation), which limits investors’ access to small and mid-size companies and restricts diversification. PE offers sectorial diversification and consumer exposure. PE funds offer a more diversification across sectors as well as more consumer-driven exposure than listed equities in EM. In recent vintages, EM PE has continued to outperform listed equities, while mid-cap focused funds in emerging markets often outperform growth equity funds with larger ticket sizes as well as those with a focus on SMEs.