September 3, 2015
Interviewed by: Tom Franco
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Former ADIA Chief: Sovereign Wealth Funds and the Future of PE

The former head of private equity at one of the world’s largest institutional investors, James Kester, gives an overview of the rise of sovereign wealth funds and their diversity, and the challenges of resourcing and governance. Also: Why he thinks too many LPs approach co-investing as a “fool’s errand.”

The former head of private equity at one of the world’s largest institutional investors, James Kester, gives an overview of the rise of sovereign wealth funds and their diversity, and the challenges of resourcing and governance. Also: Why he thinks too many LPs approach co-investing as a “fool’s errand.”

Sovereign Wealth Funds and the Future of Private Equity
With James Kester, Former CIO – Private Equity, Abu Dhabi Investment Authority

Dan Feder, Washington University Investment Management Co.: Hello, I’m Dan Feder and I’m here with Tom Franco and Jim Kester. Jim, you’ve had experience working with very large pools of capital including at a large sovereign wealth fund. I’d be interested to hear your thoughts about where you see sovereign wealth funds participating in private equity and, looking forward, what you think the world looks like from that perspective in five or 10 years.

Jim Kester, Abu Dhabi Investment Authority: First, I would say that the definition of sovereign wealth funds is often, I find, a bit parochial and a bit misapplied sometimes. From the U.S. perspective, it seems to a broad group of—

Tom Franco, CD&R: Guys with a lot of money.

Kester: —pools of capital associated with other countries outside this one that have lots of capital. And I think one needs to differentiate a bit between central-bank reserve funds, pension funds, government pension funds and other sovereigns and I guess the definition applies mostly to those with a developmental or strategic mandate. That’s a relatively small group. Then, you get into other differentiating characteristics around size and mandate and liquidity profile, etc.

So, broadly speaking, they’re relatively new. ADIA, the firm I work for, is one of the older sovereigns. It’s been around since 1976 and has been a relatively early participant in the private markets as well going back to the late ‘80s. But many of them are newer pools of capital and newer participants in the private markets and private equity in particular. To answer your question about where might we be with this broad group of investors 10 years hence: what I observe is that, like many new entrants to the market, they’re learning by doing, both good and bad. So I think they’ll find that the private equity markets are a good place for their capital. I think they’ll modulate what’s the right allocation to those types of illiquid assets going forward. And, most importantly, over time, they’ll adjust their resources and capabilities to fit whatever that mandate is within their overall portfolio for private markets. I think [that], over time, they will become more established and regular participants in the private equity markets.

Franco: They seem to be evolving quite rapidly, particularly with respect to co-investment and even direct investment. So, where are we in that cycle of development among the sovereign wealth funds? I guess it’s different for different organizations.

Kester: Where you will see them acquiring in sole-controlled transactions, assets that are strategic to their countries. Whether that is natural resource-oriented acquisitions or corporate acquisitions that can then be imported into their countries. Setting those aside—

Franco: Consumer brands, too.

Kester: Yes, although I fail to see the strategic importance of some of those acquisitions. Again, setting that aside, I think—as you sit here today, you see a fairly broad spectrum of capabilities in the sovereigns in this area. And, in some cases, a view to developing that or restructuring that, the one modulating factor I would say is—well, you’ve got two: you’ve got size, because size begets resources. Being a passive co-investor in post-close syndications doesn’t take much resourcing and many investors do that. Quite frankly, it’s a bit of a mystery to me as to why they choose to participate in co-investing that way.

I think the raison d’etre I hear most is that it is a way to lower their overall cost of owning private assets. I think that’s a bit of a fool’s errand, personally, but if you move away from that and move toward a more active co-investing activity, where you are moving from being a minority participant in an acquisition syndicate to being a co-sponsor to being a sole-control investor. The other modulating factor besides resources is your tax status, quite frankly. Certain investors and certain investor types, in certain countries like Canada, have a dual-tax treaty with the U.S., which permits them to take sole-control positions. Many sovereigns in many counties don’t have that and they operate under Section 892 of the IRS code, which—if deemed to be investing in operating businesses, not even in the U.S., anywhere—would potentially taint their tax-exempt status on all their assets as it relates to the U.S.

Certainly, there are some extraordinarily-sized pools that are classified as sovereign wealth funds. At the same time, there are many U.S. state pension pools that are just as big. The statistics I’ve seen is that you drop out of the top 10 in terms of sovereigns and you’re below $100 billion in assets. And certainly there are U.S. state pension funds that are higher than that or Canadian pension funds that have more assets than that. So, size alone, I would say, is not necessarily a differentiating factor, particularly if you bring the U.S. public funds into the discussion. Despite having as much capital as some of their Canadian counterparts, they have taken a very different approach to the private equity market.

Resourcing is really issue number one. They seem to continue to be constrained by their ability to hire and retain professionals. I guess a large California pension fund versus one of the large Canadians. A large California fund announced in September of last year they are starting a co-investing activity and hired a gentleman to do that. And they will hire four people for that activity. Canadians, I can’t recall exactly, but I think later participants in the private markets, generally speaking, have been co-investing since 2004 and 2007. Set up a dedicated principal investing team. Have 35 professionals already, offices in major financial capitals around the world, four offices. Size of pool of capital [is] about the same. So, you tell me. Size is not the constraint itself, I don’t believe. It gets to governance and a view of the private markets.

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