This past week, the Financial Times ran a front-page piece on the increased role of sovereign wealth funds (SWFs) in providing debt to support private equity firms’ acquisitions. As the global credit market copes with the subprime crisis and slowing economic growth, SWFs — particularly those in the Gulf — remain strong and are a crucial source of capital and liquidity.
The FT quoted a Terra Firma executive who asserted that the Abu Dhabi Investment Authority (ADIA) “will effectively replace Wall Street.” While sovereign funds do have the capacity to provide debt financing, it is crucial to remember that they approach debt as principal investors, not as financial agents. When engaged as genuine co-investors — rather than as a new flavor of “banker”– SWFs can make private equity firms more effective and enable higher levels of return for all.
Private equity firms have long tapped sovereigns, like other large institutional investors, as investors in their funds. SWFs have the core attributes that private equity funds seek in their investors: deep pockets, sophistication, risk tolerance, and the patience needed to accept the illiquid nature of PE investments. Now, PE firms are looking to SWFs for the debt financing of individual investments.
Typically, the debt component of private equity transactions has been provided by large banks. These banks have the ability to either syndicate the debt to clients or otherwise mitigate their own risk through client funds. Wealth funds providing debt in buyout situations, however, generally do not syndicate the debt. Instead, they hold on to it.
Holding the investment is consistent with sovereign funds’ mission of being principal investors but, at the same time, it does expose the sovereign to the full credit risk. In other words, SWFs lend their own money more than banks do.
Therefore, a more appropriate way for private equity firms and sovereign wealth funds to approach their collaboration is as co-investors. Not only does this reflect the reality of SWFs’ “principal risk,” but it also highlights the importance of collaborating in areas where the co-investors bring complementary capabilities and skill sets.
(For more on the increased sophistication of Gulf investors, see “Chapter 8 — Capable Capital: The GCC as a Source of Capital” of Dubai & Co.)
In today’s environment, sovereign wealth funds can insist on a genuine partnership with private equity firms by which they are more than merely providers of debt. At the same time, private equity firms can benefit from sovereigns’ increased investment savvy and their ability to help portfolio companies grow. Since SWFs share a principal investor mindset with private equity firms, seeing them as a “replacement” for bankers misses out on the benefits of a more holistic relationship.