Investors worldwide are continuing to seek out alternative assets. Romil Patel looks at their growing prominence in the Middle East.
Much like the physical one we live in, the alternative investment universe is expanding. In addition, it is particularly appealing to investors looking for increased portfolio diversification, higher returns (against a backdrop of low interest rates) and a hedge against crises.
Globally, sovereign wealth funds allocate almost a quarter (23%) of the $7.4 trillion total assets under management (AuM) to alternatives, according to a 2018 joint study by consultancy PwC and the World Gold Council.
The allocation towards alternatives from sovereign wealth funds in the Middle East – which largely target intergenerational wealth accumulation through a broad stabilisation strategy – has jumped on average from 3.7% to 6.1% of total assets over a five-year period. The appetite appears to show no signs of abating as these giants in the region become increasingly sophisticated investors and build out their capabilities.
Regional sovereign wealth funds continue to grow in importance as they become more dominant financial players. There are reportedly 14 active sovereign wealth funds in the Middle East, whose AuM account for 38% of the global total.
As they raise their average target allocation to alternatives, their large allocation to the domestic economy – which has been overrepresented in their portfolio – is growing smaller, according to Ehsan Khoman, head of MENA research at MUFG Bank.
Regional sovereign wealth funds are moving more in line with their global peers and away from this home bias. Rather than looking for an allocation into bonds or equities, they are increasingly adopting more sophisticated alternative investment strategies.
Sovereign wealth funds are becoming central to economic diversification efforts in the Middle East, which traditionally has relied heavily on hydrocarbons. This push was exacerbated by the collapse in oil prices in 2014.
One thing is clear: Middle East countries want to use these institutions as a key generator of non-oil revenue. Saudi Arabia is intensifying its efforts to arm its Public Investment Fund (PIF) with $2 trillion in assets under management by 2030, from $224 billion at present. In order to fund this, the strategy is to list 5% of the state-owned oil giant Saudi Aramco.
Riyadh has redoubled its efforts to strike deals quickly and in the past year, agreements include investments of up to $45 billion in SoftBank Group’s technology fund and $20 billion in an infrastructure fund with US private equity firm Blackstone.
“They’re mega-projects or mega-partnerships,” says Michael Slater, head of Middle East at Northern Trust. “These deals are all around getting Saudi Arabia to have deal flow. You look at SoftBank and Blackstone – these are very well-connected entities globally and their ability to get at the forefront of senior or important venture capital, technology, infrastructure and these types of activities are exactly what Saudi is buying into, in my opinion.
“They don’t have that infrastructure build inside of Saudi Arabia. If you look at a lot of sovereigns around the world, they’ve built their infrastructure to be connected globally and to have an aptitude and energy to be able to get into each of these. Saudi doesn’t at this point, so the quickest way into it is to utilise these global firms that do have that connectivity and that’s how they’re utilising it.”
Putting money to work
In its 2016 global sovereign asset management study, Invesco noted that real estate was “becoming the primary driver of increasing alternative allocations.” While they also liked other alternative assets, the reason sovereign wealth funds ended up owning more real estate was simply because they could, says Alex Millar, head of EMEA sovereigns at Invesco.
With substantial regional markets in the US, UK and Asia and developed commercial, industrial and retail, sovereign wealth funds have been able to deploy money more quickly and easily into real estate, whereas private equity and infrastructure have been far more difficult to invest in.
“What we’ve seen is that a number of funds like the theoretical characteristics of say, infrastructure, but are having trouble harvesting those characteristics into their portfolios in the real world,” says Millar.
By 2017, Invesco observed a shift in the way sovereign wealth funds were using real estate within their portfolios. It noted a transition from seeing real estate as an illiquid alternative asset class, where one is trying to trade the illiquidity premium, into being much more of an income generator.
“This ties in with the growth of sovereign pension funds, but also, in an environment where some sovereigns are receiving less new funding, receiving income can be useful for portfolio repositioning,” says Millar.
“This change in the way real estate was being used is an interesting element that started to come through, but also the fact that they are continuing to look to invest in other alternatives.”
Internalisation vs externalisation
Another trend Invesco observed in 2017 was the inability of sovereigns to respond to growing shortfalls through asset allocation alone and a shift towards looking at how to evolve their business models to drive more efficient realisation against portfolio objectives.
This raised questions around how sovereigns were investing in alternatives and how much they were doing themselves versus third parties. For example, sovereign investors will often want to hold assets over the long term, so the ability to invest in them directly and retain control over them over time is an attractive option.
“What we’ve seen is a number of funds begin to think about what is the best business model for investing in alternatives. They have looked at using third parties, doing it themselves as well as analysing their competitive strengths and weaknesses. Therefore the approach tends to vary fund by fund, asset class by asset class,” says Millar.
Because of the search for yield and also the expensive fees as far as alternatives are concerned, sovereigns are looking at different business models, and real estate is an interesting prospect.
“You’re also seeing some of the progressive [sovereign wealth funds] becoming real estate developers,” says Will Jackson-Moore, global private equity and sovereign investment funds leader at PwC.
“So they’re not only buying a prime asset but actually taking on the development risk, and I think going forward, one of the interesting developments is whether we see any of the sovereigns starting to take on development risks in the infrastructure space,” he adds.
A number of significant sovereigns have moved away from utilising third parties to actually developing teams in-house that travel around the world and make significant real estate decisions.
Sovereign wealth funds will continue to play an important role in the Middle East, although there will be ebbs and flows in terms of funding, which depends on the oil price and will vary over time. The role they play is well established, however.
At this stage, the growth of alternatives “still seems to be very much on the agenda”, says Millar. Alternatives are relatively less liquid and longer-term investments. Strategically, this plays to the strengths of sovereign wealth funds, which are long-term investors – if anybody can harvest a long-term illiquidity premium, they can.
“Portfolio allocations, as time goes by, will increasingly grow in alternatives as managers and sovereign wealth funds in the region become more accustomed with allocating them in their books,” says Khoman.
As the alternatives universe expands, however, finding the right allocation strategy will make the difference between a giant leap for managers and a failure to launch.
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