Sovereign funds mix and match their private equity deals

The Middle East’s investment landscape has undergone a seismic shift as principal investors increased their private equity (PE) activity and take a more direct role in managing those investments.

Sovereign wealth funds (SWFs) play an influential role in the principal investor segment, especially in the Middle East where they represent one-third of the close to $8 trillion (Dh29 million) in total assets under management SWFs oversee globally. Their investments serve as a major source of long-term strategic capital for the region and play a pivotal role in local economic development.

Like other principal investors, the search for growth has spurred SWFs to pursue direct PE opportunities, especially as yields in traditional asset classes have shrunk. Over the past five years, Middle Eastern SWFs have doubled the number of direct PE deals closed, most of them co-investments, increasing value by 67 per cent over the same period.

The prospect of higher returns in PE means that SWFs are likely to continue to take a more proactive portfolio management composition. Doing so successfully, however, requires thinking through a number of important strategic questions. They include:

How to choose the right direct investment model?

Principal investors can choose from four direct investment models based on the desired level of involvement, the type of performance to be achieved and the degree of influence granted by the investor’s investment stake:

* Arm’s-length Investor: Provides high-level guidance through board representatives;

* Counsellor: Serves as a trusted adviser, engaging more deeply in board selection, remuneration and governance;

* Active Tutor: Acts as a key in-house resource for company management and provision of ongoing decision guidance; and

* Operationally Involved: Plays a significant decision-making role in nearly every aspect of the business.

Many principal investors currently choose models with a modest level of involvement, especially as the practice of direct engagement is relatively new. For instance, the Arm’s-length Investor model, which is the least resource and cost-intensive approach, is favoured by 37 per cent of SWFs and 31 per cent of pension funds globally.

However, the more active and involved the principal investor is, the greater the value potential. Given SWFs’ mandate to maximise national economic impact, some may be inclined to pursue Operationally Involved PE models, even though that approach is also the most hands-on and time and cost-intensive.

How to assess the total value creation potential?

Investors need to evaluate whether the total value creation potential can deliver returns in line with, or above, the identified investment thesis. Principal investors must ensure that funds are benchmarked against internal capabilities to protect and grow value.

An evaluation of internal expertise to actively engage the level of investment is key, given that a higher level of involvement on an investor’s part will lead to higher demand for operational support and industry knowledge.

Secondly, investors need to assess the scale of operations to determine whether their asset concentration in relevant sectors is sufficient to cover the cost of acquiring the expert talent needed to manage direct PE investments effectively. In addition, they need to secure a sizeable-enough investment stake at the individual asset level to be able to engage at the board level.

How to offer the right governance and organisational support?

Given the long-term nature of SWF investments, managing direct PE holdings will require a significant shift in strategy and resources. Principal investors will need to match their degree of involvement with the right level of operational support and define clear roles for the investment team, the portfolio management team, and board representatives.

In a highly competitive market, investors are increasingly focused on operational efficiency. Principal investors pursuing an arm’s-length investor or counsellor model tend to have minimal influence and are usually accorded an average of one board seat.

In contrast, Active Tutor and Operationally Involved investors have more influence and would likely be better positioned to institute a formal engagement and consultation process upon the board representative’s request.

Additional modifications to consider include refining the shareholder opinion and investment thesis, codifying best practices around board engagement, clarifying roles and responsibilities on the investment and portfolio management team, as well as considering whether to create a consolidated portfolio management team where one does not already exist.

Three potential scenarios are likely to shape the development of direct PE investment in the years ahead.

First, principal investors will increase direct exposure and engagement — While average PE returns are expected to fall from 16 per cent in 2016 to 10 per cent in 2020, the forecasted yields will, nonetheless, remain more viable than other options. Given that PE investments are generally not marked to market, limiting short-term volatility, we believe the share of direct PE investment will eventually expand to account for about one-third of all new PE investments.

Second, principal investors will likely converge around a counsellor model — The active management approach for most principal investors will plateau in international assets, as skilled resources are hard to find and expensive to hire. To secure additional required capabilities, investors will need to acquire significant scale in direct PE. Larger funds will likely create more value by building in-house teams, while smaller ones may opt to co-invest.

Third, PE firms will explore new revenue streams and models — Principal investors will exert growing influence in the PE space. Their pursuit of higher returns will increase competition.

The resulting price pressure may result in a change to fee structure. As a result, PE funds will expand their service offerings and deliver a broader array of advisory services to strengthen tenure and lower the risk of their current offerings to maximise value creation.

Above all, our research illustrates a revised approach towards PE investment in the Middle East. It must evolve in order to not only better meet the needs of investors, but also to play a crucial role in shaping the region’s economic future.

(Markus Massi is Senior Partner and Managing Director at The Boston Consulting Group Middle East. Alessandro Scortecci is a Principal at the firm.)`