Partners in prime

Sovereign wealth funds may be young institutions, but that hasn’t prevented them from riding this decade’s political and economic shocks in a stately fashion. Many an investor has been troubled by the volatility created by several waves of quantitative easing, continued uncertainty in the eurozone and the consequences of the Arab Spring. Yet the period has seen large sovereigns become asset managers in their own right and smaller ones include infrastructure in their investing universe.

The oil price drop and the end of the commodity boom are now presenting sovereigns, many of which derive their revenues from the stuff, with their most serious test yet – but that needn’t affect their appetite for the asset class too much. Some will certainly see their funding stagnate, while others could suffer withdrawals as governments run out of cash. But better risk and liquidity management systems, developed following the Financial Crisis, mean few are likely to be caught short. This suggests sovereigns will leave their investment strategy on its current course, at least in the short to medium term.

And that’s good news for infrastructure. A study released this week by investment manager Invesco found that sovereigns, in their search for diversification and better risk-adjusted returns, continue to be very keen on alternatives. Infrastructure is king among these, as sovereigns feel their long-term horizon, capacity to absorb large deal sizes and political connections give them an edge to secure transactions. Not only are allocations being raised – past increases, initially faced with execution challenges and lengthy approval processes, are also starting to translate into real money.

But there is a catch: as other institutional investors have found, there’s not that many big deals around. That’s making it more difficult for sovereigns to reach their target allocations, and inducing some to expand the category’s boundaries to include riskier assets. A telling example of this was provided a couple of weeks ago, when the Alaska Permanent Fund added timberland, farmland and leasable hard assets to what it deems worth having in its infrastructure portfolio.

Toughening competition is also frustrating attempts by large sovereigns to go direct. Taking note of persistent capability gaps and mixed track records so far, some are now more likely to seek external help than they were a few years ago. This shift doesn’t mean sovereigns are no longer eager to bolster their internal resources, as our interview with the Future Fund’s Wendy Norris recently demonstrated. But these efforts often aim at being able to make enlightened choices when it comes to enacting co-investment rights, which regularly remain a prerequisite to fund commitments.

Yet such appeals for external advice have recently taken a novel form. While fund managers continue to be seen as key to target specific sectors or geographies, a broader collaboration between sovereigns themselves is a fresh addition to the game. There are good reasons for it to take root: the participation of certain peers to an infrastructure deal can sometimes guarantee swifter board approval; a group of sovereigns can often secure a better price thanks to greater credibility and scale. Referrals are also more common, with introduction by one sovereign to another often reciprocated.

The trend could become more pronounced as institutions seek to make forays in developing countries, as China Investment Corporation announced last March. Emerging market infrastructure remains a risky business, but for some institutions it has a unique appeal compared to other asset classes: local projects generally enjoy the support of local authorities, mitigating political and regulatory risk, while the ability to team up with development banks and governments often protects them from undue intervention. And in those markets, having an insider track on projects can be crucial to source deals.

The nature of collaboration between sovereigns is also changing – suggesting the trend is here to stay. Long driven by government relationships and proximity, it is now more often based on investment expertise. As the Invesco survey noted, this is intuitive: established sovereigns are best placed to help emerging ones enter new asset classes. State-backed funds may be facing headwinds, but their staying power is growing stronger as they build long-lasting bridges.