Will sovereign wealth funds fill the FDI gap?

In 2015, global FDI levels surpassed the $2000bn mark according to Unctad and crossborder investments set a new historical high, eight years after the start of the financial crisis. Four years later, growing conservative sentiment and a higher perception of political risk around the world has driven this number down by more than one-third, with the EU and the US being particularly affected.

Furthermore, the decline in FDI was in line with the trend in other crossborder capital flows, including foreign portfolio investments (FPI), which generally refer to the purchase of non-controlling stakes in foreign companies, and other flows, including bank loans. All three concepts combined represented 5.9% of global GDP in 2018, a decline of more than 20% from 2017.

At the same time, during this four-year period, private capital has continued to accumulate and the global dry powder – or capital available for fund managers to deploy – reached historical highs, also more than $2000bn, at the end of June 2018 according to a report from data solutions company Preqin. Paradoxically, 58% of this unused capital sits with private equity managers, and more than half of the total is in North America.

But beyond fund managers, there is a universe that is starting to be particularly relevant in the global markets: asset owners. Among them, sovereign wealth funds (SWFs) are starting to become crucial in the FDI global investment paradigm, and could present an interesting alternative to countries trying to attract and facilitate further inbound capital.

How relevant are they?

Asset owners represent a large universe, with $72,000bn of investable capital, according to the CFA Institute. More than one-fifth of this, that is $15,000bn, is owned by the top 100 SWFs and ‘SWF-like’ pension funds. These government-owned vehicles comprise a highly heterogeneous, powerful and very young industry, with an average portfolio of $150bn, and an average life of just 29 years old.

As the industry matures, the main players are becoming increasingly sophisticated. For example, several funds abide by the Santiago Principles for transparency and good governance, while others have joined forces in the One Planet SWF Framework, to pursue environmental, social and corporate governance-related investments. Most funds have now highly skilled in-house teams and representative offices around the world.

According to their mandate, SWFs can present very different risk profiles and asset allocations. On average, 37% of their portfolios is invested in fixed income, 38% in public equities and 25% in alternative asset classes, including real estate, infrastructure, private equities and hedge funds. Given that most of the focus is on buying assets overseas, we could assume that these 100 vehicles alone have a potential for about $11,000bn in FPI, and $4000bn in FDI.

However, their investments continue to drop, given the low-return environment. SWF's annual deployment in private markets has decreased by 53% in the past four years, from $90bn to $43bn, according to figures from the International Forum of Sovereign Wealth Funds, which is punching well below their weight. As the battle for yield intensifies, this figure would be expected to bounce back and increase significantly.

FDI-related funds 

One such kind of SWF is sovereign development funds (SDFs), which have a dual mandate of achieving commercial returns while contributing to the development of their domestic economy. Among these funds, there are two differentiated sub-sets:

• SDFs that were given a portfolio of national champions to be managed, and have grown to the point where they may also pursue investments overseas, including Singapore’s Temasek, United Arab Emirates’ Mubadala, Malaysia’s Khazanah, Iran’s NDFI and Kazakhstan’s SK.
• SDFs that were established with no significant paid-in capital but have the aim of attracting FDI into the country from other foreign SWFs. These funds include Russia’s RDIF, Italy’s FSI/CDP Equity, France’s CDC International, India’s NIIF, and Nigeria’s NSIA/NIF. 

The latter is particularly interesting as a facilitating vehicle of FDI. In just seven years since its establishment, RDIF has attracted $40bn into joint funds to invest in Russian companies, from 18 countries across Europe, the Middle East and Asia. Similarly, NIIF is managing to put to good use the $3bn that its government recently committed, and has already attracted a number of foreign SWFs into Indian infrastructure and energy assets. 

From the point of view of an international investor, the attraction of such arrangement is obvious, as co-investing with local partners gives them confidence, further visibility and lower management fees. And this is especially true when it comes to developing countries such as Russia and India, whose regulatory, legal and tax regimes can be burdensome to deal with.

The role of IPAs

In this context, investment promotion agencies (IPAs) can and should play a vital role in setting up and pushing the agenda of these FDI-related SDFs, as the main interface between the local government and foreign investors. Some IPAs work as ‘pro-bono investment bankers’, where they source off-the-market deals and offer them to institutional investors as a free service. 

Most IPAs have the mandate of (i) targeting and identifying institutional investors that might be interested in specific assets and/or the country in general; (ii) facilitating and creating investible opportunities and bankable projects across different sectors; (iii) partnering with other government agencies; and (iv) advocating for policies to support and facilitate FDI into the country. 

It is now apparent that some IPAs are more advanced and proactive than others. World body Waipa, which recently held its annual World Investment Conference in Warsaw, comprises 126 IPAs from 100 countries with very different degrees of commitment and activity. Its new board will be composed of IPAs from Azerbaijan, Brazil, Bulgaria, Costa Rica, Dubai, Egypt, Finland, Ghana, India, South Korea and Samoa. European agencies are generally not as active, and SelectUSA is definitely less heard-of than CFIUS, the US body reviewing foreign acquisitions.

Funds operate in very different environments and there is no ‘one size fits all’ solution, but having an FDI-related fund and an active IPA seems like a good place to start for a country seeking to attract foreign investment. Fostering trust and regulatory stability for the various stakeholders, facilitating public-private partnership mechanisms, and offering a variety of domestic partners, co-investors or general partners to choose from are usually other prerequisites for SWFs to accept a country’s political risk.

What’s next?

Given their significant size and increasing appetite for assets on foreign soil, SWFs represent an unparallelled opportunity to offset the fall in FDI in both developed and developing economies. The poor performance of their portfolios in 2018 may indicate them being overweight in bonds and stocks, and a stress in private markets may follow in the next few years.

Even though some sub-sets of SWFs may be minority investors, others may go beyond the 10% threshold when it comes to attractive properties, infrastructure assets and private equities, which will invariably help increase FDI levels worldwide. In certain circumstances, this may occur via co-investments with general partners or other limited partners, stressing the collaboration aspect of these funds.

We expect that SDFs in particular will gain a pivotal role around FDI. Some pursue controlling stakes and partnerships overseas, while others create a welcoming environment at home. Some of these funds have been extremely successful and we expect they will only continue flourishing around the world.

Governments will bear the ultimate responsibility of fostering such an environment, by nurturing the establishment of such funds while investing in active promotion agencies. Once these agencies are up and running, international investors will certainly look at the destination country with fresh eyes.

Diego López is managing director of Global SWF, an advisory boutique specialised in sovereign wealth funds and other institutional investors.