Capital is Sovereign
Sovereign wealth funds (SWFs) have undergone a remarkable expansion both in number and assets in recent decades, emerging as influential players in global capital markets. Before 2000, only a handful of SWFs existed worldwide, primarily investing state-owned profits from fiscal surpluses, official foreign currency operations, privatisation proceeds, or revenues from commodity exports particularly oil. By 2009, over 50 SWFs operated across 35 nations, collectively managing $3.2 trillion in assets.
The origins of SWFs can be traced back to the establishment of the Kuwait Investment Authority in 1953, which was formed to manage the nation's oil revenues for future generations. Other countries followed suit, creating various vehicles to oversee state-owned assets. The growth of SWFs accelerated after 2002, fuelled by surging oil prices, expanding Asian trade surpluses, and rising commodity prices.
Recently, war and sanctions have driven up hydrocarbon prices, benefiting fuel-exporting countries. The IMF forecasts that the Middle East’s oil and gas producers are set to reap up to $1.3 trillion in additional revenues over the next four years due to energy prices being pushed up by Russia’s war in Ukraine. Much of this revenue will flow to the Gulf, home to top crude exporter Saudi Arabia and the largest liquefied natural gas exporter Qatar. Historically, these countries recycled their profits in Western capital markets, supported by an implicit agreement where the U.S. provided military aid and purchased oil in exchange for investments in American assets. However, this agreement is eroding as the US becomes a major oil exporter and Gulf states seek closer ties with other regions.
This shift is evident in Abu Dhabi's sovereign wealth funds, where ADIA, traditionally the main recipient of oil windfalls, now receives less, with more funds directed to ADQ, a newer $157bn fund focusing on strategic industries. Another Abu Dhabi fund, Mubadala, has also grown significantly and now manages nearly $300bn, with a portfolio shifting towards renewables and technology. The majority of its investments are in private markets, reflecting a broadening scope and ambition. Saudi Arabia is also redirecting its focus towards building its domestic economy, with its Public Investment Fund (PIF), undergoing a radical reinvention to lead Riyadh’s plans for economic diversification and development. PIF is committing significant funds to domestic projects and strategic investments, reflecting a shift in priorities. Additionally, Gulf states like Saudi Arabia are providing financial aid to other countries during crises, as seen with Turkey receiving aid from Gulf states instead of traditional sources like the IMF or European banks. This signals a broader trend of Gulf states using their considerable financial reserves to exert influence and support strategic interests.
SWFs have also been increasingly diversifying their portfolios, with a significant uptick in allocations to alternative investments, now constituting 27% (excluding direct strategic investments) according to the 2023 Invesco Global Sovereign Asset Management Study. Notably, allocations to infrastructure have risen over the past year, comprising 7.1% of portfolios, which has partially offset a decline in real estate holdings and stable allocations to private equity. Traditionally, private credit has often been classified under private equity by many sovereign investors. However, the growing allocations to private credit have led to its recognition as a distinct asset class, supported by the establishment of dedicated investment teams. While funds pointed to a desire for increased diversification within their real estate portfolios, they also noted deals are generally opportunity led, with investments assessed on a deal-by-deal basis. Indeed, despite office sector challenges, some investors saw the current environment as an opportunity.
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Real estate’s role in SWFs has been questioned after Norway’s SWF found that real estate added no extra return after 10 years. According to one SWF, quoted in the International Forum of Sovereign Wealth Funds, volatility can be higher than anticipated after de-smoothing the returns to adjust for the lags in valuations and adjusting for leverage. The fund believed that “for US real estate, these adjustments can push the volatility into double digits”. “Risk is trickier than returns,” said another. Most SWFs we surveyed agreed that risk management in private markets is largely a qualitative exercise. “We manage risk through diversification, transaction structure and governance. But quantifying the risk using data analysis doesn’t seem to lead to meaningful conclusions,” said the same fund. “We’re constantly thinking about risk, trying to manage it downwards using transparency, access, governance control, and oversight to manage the risks.”
Although SWFs are more cautious in real estate, due to concerns about a potential property market crash amid global interest rate hikes, they continue to invest in certain segments, focusing on long-term trends like data centres and affordable housing. According to the publication Global SWF 2024 Annual Report entitled “State-Owned Investors Powering Through Crises”, some segments continued to witness growth as Sovereign Investors oriented their portfolios towards megatrends, notably data centres and affordable housing. “Decades ago, real estate investments by SWFs were dominated by Middle Eastern investors snapping up trophy assets, such as luxury hotels and skyscrapers. Today, the industry is more sophisticated, examining how to expose their real estate portfolios to mega-trends, such as the development of the digital economy and tech disruption. In 2023, data centre investments by SWF’s grew 150% to a record $7.6 billion.
Newer SWFs may be more inclined to invest in real estate and several are planned. With significant tax windfalls and a potential pensions time bomb looming, the Irish government is considering setting up a SWF, with potentially profound implications for the country's real estate sector. Finance Minister Michael McGrath presented a paper on a future fund to a cabinet meeting in early May, aimed at leveraging government finances awash with corporate tax receipts, primarily from U.S. tech and pharma giants. The figures are substantial, with Dublin expecting to net €65bn in budget surpluses between now and 2025. The paper examined similar plans in Norway, Japan, and Australia and set out criteria for the fund, which is to be managed by the National Treasury Management Agency. “Overall most SWFs tend to allocate 5-10% to real estate, across direct investment, funds and funds of funds, and they often invest overseas, partly as a function of diversifying risk and partly because they want to avoid overcrowding their own market,” PwC UK Global Sovereign Investment Fund Leader Richard Rollinshaw said.
There is growth in Africa too, a region that typically relied on investments from Middle East SWFs. There are approximately 25 state-owned investment funds on the African continent that can be categorised as SWFs according to the Boston Consulting Group. These domestic funds have a unique role to play in the development of their home economies, as well as in attracting capital from international investors. African SWFs are not as strongly capitalised as the Middle Eastern SWFs that have been active in Africa, nor do they have big government surpluses to tap into. The average ticket size for African SWF transactions over the past few years was $84m, compared with $383m for Middle Eastern SWF activity in Africa. The largest African SWF is Ethiopian Investment Holdings (EIH), which launched in 2022 with $45bn worth of state-owned assets and is seeking partnerships with foreign direct investors to fuel the expansion of the private sector. The Nigeria Sovereign Investment Authority (NSIA) is the most active fund, with ten known transactions between 2018 and 2022. Morocco’s Mohammed VI Fund for Investment (M6FI) with $1.5bn in equity will be operating largely as a fund of funds, with a plan to allocate $5bn from investment partners to a series of thematic portfolios that support the growth of strategic sectors, including infrastructure and small- to mid-sized businesses with high potential.
Zongyuan Zoe Liu in her fascinating book “How The Communist Party of China Finances Its Global Ambitions” talks through China’s sovereign funds, and explains how China’s stand out from others due to their unique financial mechanisms and strategic objectives, including the China Investment Corporation (CIC) which emerged to fix structural issues in China's financial system. It is a Sovereign Leveraged Fund established to free China's foreign exchange reserves from low yielding U.S. Treasury bonds and instead use them to serve China's development needs and minimise opportunity costs. The establishment of CIC in 2007 marked a more proactive approach to managing foreign exchange reserves. While most foreign exchange reserves are invested in low-risk liquid assets such as U.S. Treasuries, CIC’s investment portfolio spans public equities, real estate, infrastructure, and startups. This structure essentially expands the state's balance sheet through the issuance of bonds, capitalising a new institution that invests in less liquid and secure assets compared to U.S. Treasuries, utilising leverage. A great anecdote in Liu’s book, depicts how in April 2008, CIC partnered with JC Flowers to launch a $4 billion private equity fund to buy distressed assets. CIC agreed to provide 80% of the new funds equity, being the only limited partner in the fund. Later that year, an investment group, including CIC and led by JC Flowers, bought a 29.5% stake (for €1.1 billion) in Hypo Real Estate, then Germany's second largest commercial property lender. Typically, German companies hesitated to take investments from government related entities like CIC, but in this case, because CIC was only a limited partner with JC Flowers, the deal was able to proceed. Much has changed since 2008, and few SWF need to be screened to establish their authenticity or for businesses to accept their money. Indeed, now they are often the first call.
Given the increasingly multipolar world, SWF’s investment objectives have adapted and investments can be politically driven too. Long gone are the days of the perception that SWF employed unsophisticated investment practitioners with a penchant for trophy assets. SWFs are now both large enough to catalyse megatrends and nimble enough to make investments in them opportunistically. Despite the proliferation of SWFs across the globe, what hasn’t changed is the dominance of Middle Eastern Sovereign Wealth Funds.