The chief investment officer of Australia’s sovereign Future Fund says its groundbreaking private equity allocation has reached maturity, in a model that other sovereign vehicles around the world are watching closely. “There has never been a more important time for a long-term investor to have a meaningful exposure to private equity,” says Raphael Arndt.
The private equity team at the Future Fund stands out for two reasons. The first is a model through which, increasingly, the fund will co-invest alongside the managers it works with, though it will not make direct private equity investments completely on its own.
The second is its scale. Most sovereign funds invest little or nothing in private equity and even the two considered the most visionary for their use of alternative assets only allocate between 2% and 8% (Abu Dhabi Investment Authority), and 9% (Government of Singapore Investment Corporation) in the asset class. But at the Future Fund on June 30 the figure stood at 10.4%, reflecting $12.8 billion of investment.
This is part of the highest allocation to alternative assets in the sovereign wealth world: on the same date the Future Fund had 13.7% in what it calls alternatives (by its definition, hedge funds), 6.7% in infrastructure and timberland, and 7% in direct property. That totals 37.8% of the portfolio in illiquid or alternative asset classes; at ADIA the maximum is 33% (and the minimum just 13%), and at GIC stood at 16% on March 31 2015, the most recent reported date.
Arndt says that ‘maturity’, in private equity terms, means a programme without the fee drag that occurs in the early years of a private equity investment strategy, when money is committed yet not invested. Also, cash starts to come back as investments are realized.
“Eventually the commitments you are investing and the assets that are being sold tend to match,” he says. “We measure maturity that way: when it becomes self-funding.” A team of seven in-house staff runs manager selection, most of it through LP positions in private equity funds, but with a skew towards venture capital and growth equity, and with far lower leverage than is commonplace in bigger funds.
“Most of the returns that come from our investments come from a great idea, or the skill of the manager in putting it together in the right growth market, rather than a tail-wind of cheap debt and economic growth,” Arndt says. “We’re looking for a private equity portfolio diversified away from cheap equity risk.
“There are no mega-buyout funds: we tend to have none of the brand names like TPG, KKR or Carlyle. They focus on large companies, using a lot of leverage to generate returns, and being reliant on markets being strong for exits. That’s not what you want out of private equity.”
It’s a distinct approach and it appears to be working. Arndt says the private equity programme has outperformed an equivalent public equities market exposure by over 300 basis points a year since inception, and that since reaching maturity it has increased to fully 10%, net of all fees and costs, relative to public equity returns. Quantifying this is naturally open to interpretation in an illiquid asset class, but he believes that a mature programme is easier to measure than a new one.
“Your question is, should I believe these returns or not? It’s fair to say that during the formative part of a PE programme they are less reliable because they haven’t started realizing sales yet,” he says. “But once they are mature, you have direct visibility to the exits. I’m comfortable we get it right across all managers.”
The co-investment model may become increasingly widespread among sovereign funds in private equity.
In early-stage investment, many of the managers the Future Fund invests in will find themselves capped out in their investment in a particular business, even if they have the conviction for more.
“So we have started to say: why don’t we come in and take that position?” says Arndt. “We’ve agreed to do that with three of our managers and have done over 20 venture capital co-investments, $30 million to $50 million cheques. For that, we pay no fees at all, and more importantly, gain visibility into the tech space. We are starting to use that to inform disruption risk in the rest of our portfolio.”
The fund has a longer track record with buying directly into infrastructure. It is distinctive for not taking a purely buy-and-hold approach to this much-demanded asset class. “We’ve got a much more active approach to portfolio construction [in infrastructure] than many funds,” Arndt says. “We’re busy selling as well as buying. We prefer to recycle into new ideas.”
A recent example was selling out of Southern Water in the UK – which, Arndt reveals, was partly a consequence of Brexit risks. “They were high quality assets, but very exposed to some of those risks, and we felt the market wasn’t pricing them.”
In an environment where traditional asset classes are either underperforming or under siege, Future Fund’s decision to bolster illiquid alternatives when it was set up in 2007 looks prescient. But, Arndt says: “It’s not as simple as saying let’s buy property, infrastructure and private equity. The range of possible macroeconomic paths from here is so wide and often unpalatable, we’ve never been in this position before. It isn’t going to be fixed in two years. I think we’re here for a decade or more.”