PART II: Institutional Investors Embracing a New Wave

Gintare Hennick
12 February 2024
Last week, we examined how the diminishing denominator effect and the importance of steady commitment pacing encourage institutional investors to reengage in private markets to capitalize on unique investment opportunities that arise maybe once in a decade. Whilst there is a strong interest in resuming activities, we explore how this reengagement will compare to previous efforts and changing market dynamics.

Been There, Done That, What's Next
The institutional investors, especially the ones with infinite investment horizons and lower liquidity needs, have been the major source of growth in private markets, that helped to bring total AUM to $13tn in 2022. Particularly, the rise of sovereign wealth funds ("SWF") and their gradual allocation increase in alternative investments. The Invesco report showed that SWFs only allocation to illiquid alternatives has substantially gone up from 13% in 2016 to 23% in 2023. Whilst equities and fixed income have seen a patchy ride over the years in terms of capital allocations, private equity remained on the "increase allocation" side over the years. According to the same report, SWFs ranked private equity as top 3 asset class among "attractiveness of asset classes for the next 5 years". Unsurprisingly, top 10 world's largest SWFs have built up substantial allocations to alternatives, ranging between 22% to 65% of their total portfolios.

Source: Invesco "Invesco Global Sovereign Asset Management Study 2023"

The famous David Swensen's Yale endowment model, known for heavy allocation towards alternative investments and use of external managers, became a guiding point for majority of institutional investors. The use of external manager is very often the first stepping stone to start investing in private markets, with a view to expand the internal knowledge base, build out appropriate internal team, establish networking and sourcing channels. The next step usually involves  allocation to co-investments alongside GPs to average down the fees and get better exposure and the ultimate step is to make direct deals even if there is no GP sponsor attached to. No wonder that we see more and more sophisticated and established institutional investors participating in co-investment rounds or making direct investments in the companies. According Pitchbook, the top 5 most active LPs in the co-investment and direct deal space in 2022 were: GIC, Bpifrance, Mubadala Investment Company, CPP Investments and Abu Dhabi Investment Authority. Financial Times argues that Yale's endowment model will be challenged even further with institutional investors becoming more sophisticated, whilst also aiming for lower fees and higher upside through direct deals and co-investments. We believe that the investors' willingness to bring their portfolio construction to the next level and the rise of direct institutional investors will drive the transaction volume up in the private markets.

Source: Pitchbook "The 20 most active LPs in direct PE investments"

New Kid on the Block (potentially)
Whilst all the largest SWFs have been investing in alternatives for a while now and have built 22% - 65% allocations to this asset class, one stands at stark contrast. Norges Bank Investment Management ("NBIM"), which also happens to be the world's largest SWF with roughly $1.4tn AUM, has only 2% exposure to alternatives. The investment focus so far has been on public equities and fixed income, with a small portion of real estate and infrastructure. The fund has invested in 8,859 companies in 65 countries in equities and 1,389 bonds in 46 countries in fixed income, a highly diversified portfolio with huge geographical coverage. Given the scale of the fund and the investment constraints, at some point it might be challenging to find interesting investment opportunities in public markets, to say the least.

Source: Global SWF, as at February 2024


The more important point, however, is that the world's largest SWF might be missing out on investment and diversification opportunities, as outlined in the insightful report "Evaluating Investments in Unlisted Equity for the Norwegian Government Pension Fund Global, 2018" by Trond M. Døskeland and Per Strömberg. The paper also discusses implications of headline and ESG risk, which arguably have been a one of the key concerns for NBIM's board in the past. Goldman Sachs' research also shows that private markets has consistently outperformed public markets in different time frames and the universe of private equity backed companies has grown while the public one has shrunk. NBIM has tried in the past, as recent as 2018, to bring private equity into asset allocation mix and failed. This time around Nicolai Tangen, the current CEO of NBIM, is bringing the proposal back on the table and in a very different market conditions than 2018. If approved, this could potentially bring $70bn fresh capital into private markets, which is still less than 5% of total NBIM's AUM. This is an important and potentially historical decision that will not be taken lightly. Nonetheless, the size of private markets reached the scale that cannot be ignored and embracing the changing future is as important to a company as it is to any capital allocator.

Source: Goldman Sachs "Going Private: Considerations for Investors Allocating to Private Markets"

The Ways to Start
So what happens, if the NBIM board says "yes"? We would assume even more preparation and discussion with peers and major consultants: everything from higher level points like strategy, phases and pace of deployment, mechanisms for deployment, to more granular - hiring the right investment team, agreeing suitable KPIs to measure the progress and performance, deciding on internal investment due diligence and approval process, setting-up treasury to meet capital calls but also manage the cash drag on total fund returns.

The key to this process will be an experienced investment team that has been around the block and in hands-on private markets roles. The external advisors are important part of this ecosystem, especially when providing market insights on the project of this scale, but tapping into and building the internal knowledge will be a key for the long term success.

As for project and deployment phases, it will all depend how fast and how much needs to be deployed. The prudent approach could be deploying in at least three phases: fund of funds, direct funds, direct funds + co-investments. The funds of funds allows for higher diversification at fund, company and vintage year levels, J-curve mitigation and getting money to work faster, especially for those that look to deploy capital at scale. Albeit it might have higher fees and cap the upside potential in some cases. The next phase could include investing directly in the funds, having ironed out the internal approval processes, built out the team and internal data base of managers. Last but not least, utilising the mix of direct fund investments and co-investments to get more upside and average down the fees. Pure direct investments without GP sponsor is also an option but that requires a very different set-up than the later ones. If this historical step is taken by NBIM, we are most certain it will be well researched and thought through to set things for the long run, given the infinite investment horizon.

The institutional investors are back and deploying to private markets, some have not paused at all. We will see more investors using their skills and new found negotiating power to get more co-investment flow and potentially make more direct investments in private companies. The new very sizeable entrants such as NBIM could bring sizeable amounts of fresh new capital in the coming years. Whilst NBIM could be the most sizeable single entrant in the market this year, we see another source of capital on the horizon, albeit more with gradual deployment than the SWFs.

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