Deployment challenges are limiting sovereign ability to match targets
In previous reports, we observed sovereigns’ return gaps, driven by low interest rates and challenging targets for fixed income allocations. We have also noted how appetite for alternatives has grown as sovereigns seek greater returns from private markets. In last year’s report, we demonstrated that high levels of competition in infrastructure and private equity were causing sovereigns to shift deployment of real assets towards real estate.
Competition for infrastructure and private equity deals has accelerated in 2016, with deployment times increasing across alternative asset classes (figure 4). While the growth in these times is small, it is significant: sovereigns are increasingly dependent on their alternative investments to generate yields, however, growing levels of undeployed capital for alternative investments are being held in cash and money market funds, so that sovereigns can respond quickly when real asset opportunities arise. These highly liquid investments offer limited returns, particularly in comparison to sovereign targets for real asset investments, causing further growth in the return gap.
Risk of fund withdrawals is slowing further
illiquid asset investment
The ability of sovereigns to respond to the return
gap is being limited by the increasing likelihood of withdrawals. Over the past three years, governments have responded to economic volatility by reducing new funding to sovereigns and, in some cases, drawing down from sovereign reserves, as seen
in figure 5.
While previously only liability sovereigns experienced regular drawdown of funds (in the form of outflows to beneficiaries), an increasing propensity for government withdrawals is encouraging investment and liquidity sovereigns to consider the liquidity of their portfolio. Liquidity sovereigns were comfortable in their ability to withdraw from their portfolio at short notice, however, many sovereigns stated that liquidity management was an entirely new objective, with certain investment sovereigns responding by creating tactical allocations to cash and money market funds. This has led to conflicting liquidity requirements: sovereigns have to manage withdrawal risks by shortening time horizons while simultaneously seeking to access illiquidity premia to generate greater returns.
Fig 5. Expected new funding and cancelled investments (% AUM)
Sovereign sample Investment sovereigns
2015 2016 2017 2015 2016 2017 on 56 58 ] 10 10
Liability sovereigns
2015 17 20 2G 14 6 8 fe 14 13
New funding i Cancelled investments
Liquidity sovereigns Development sovereigns
2016 2017 «2015 2016 2017 2015 2016 2017
Sample is based on sovereign investors and excludes central banks. Sample sizes shown in grey. Data is not weighted by AUM. Periods shown reflect past year new funding/cancellations.
09
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