by Philip Kurzrock, Nikita Kuhlen, Finn Stockwald
This spring, the Norwegian Finance Ministry decided not to allow the country’s Oil Fund to invest into unlisted equities. This decision sent shockwaves through the institutional investor landscape, because of the sheer size of Norway’s Oil Fund and its status as a model investor.
In our article, we examine what made Norges Bank Investment Management consider investments into unlisted equities. First, we introduce Norway’s Oil Fund. Then, we look at the characteristics of private equity as an asset class from the perspective of a large institutional investor as the GPFG. Finally, we investigate why the Ministry declined to expand the investment universe to unlisted equities.
History, size and investment strategy of the Oil Fund
The Norwegian Government Pension Fund Global (GPFG), often referred to as the Norwegian Oil Fund, has recently sent ripples through the Private Equity industry because it considered to dedicate capital to private company investments. With a current market value of Norwegian Kroner (NOK) 8,383 billion (as of 2 May 2018), or over USD 1 trillion in 2017, GPFG represents one of today’s largest and most influential funds.
With the discovery of Ekofisk in 1969, the largest oil field to be discovered at sea, Norway has risen to become one of the biggest oil producers in the world. Since then, Norwegian petroleum revenues, through taxation and the sale of mining licenses, have accumulated substantial surplus wealth as well as a strong dependency on the oil industry. The financial challenges of volatile oil prices, an expected decline in oil revenue and an aging population, have prompted Norway’s government to set up the GPFG in 1990. The fund is capitalized through the petroleum profit streams and invests outside of Norway. With a strong focus on long-term returns, the GPFG solely invested in government bonds until 1998, at which point the Norges Bank was tasked with the management of the fund. Until today, Norges Bank Investment Management operationally manages the fund, being governed by the Ministry of Finance.
The GPFG’s investment strategy emphasises excess long-term returns as well as ethical investment choices. Currently, the GPFG holds 66% in equity, 31% in fixed income and 3% in unlisted real estate. While the fund already represents the largest shareholder in Europe, its mandate dictates a gradual move towards a 70% equity benchmark. The fund proactively utilizes its size to globally diversify and achieve high risk-adjusted long-term returns. Furthermore, the fund’s capital structure limits the fund’s short-term liquidity needs greatly and enables it to manage its investments under less constraints. Between 1998 and the first quarter of 2018 (ended March 31, 2018) the fund has achieved an annualized return of 5.9% (the figure reduces to 4.0% when adjusted for inflation and management costs). Beyond the strong long-term returns, the fund has achieved an annual growth rate of 13.7% in 2017. Based on these returns and the GPFG’s historical growth rate, the Ministry of Finance projects the fund to achieve annual real returns of 3% from 2018 onwards and reach a market value of NOK 10,698 billion by 2025 (see Table 1).
In recent years, the GPFG took a more predominant role as an active shareholder, pushing for more ethical and environmentally sustainable company strategies. The socially responsible investment strategy, mandated by the Ministry of Finance, has led the GPFG to exclude a list of companies, which violate the GPFG’s code of ethics. The active stance as a shareholder has greatly impacted the equity investing landscape and displays the power the GPFG has. The fund is further distinguished as a responsible investor by holding itself to high transparency standards.
The size of the GPFG, its strong track record and its high ethical standards have earned it a reputation as a model investor. That is why the fund’s decisions are scrutinized by investors globally.
Norges Bank’s recommendation to invest into unlisted equities
In January, Norges Bank proposed to the Ministry of Finance to include unlisted equities in the GPFG’s portfolio. First, this would permit a better diversification and higher returns than investments solely in public equities. Also, most of the investors in GPFG’s peer group, including other sovereign wealth funds and large institutional investors, have substantial investments in unlisted equities with an average of 8.5% of their respective assets under management.
Currently, the GPFG can only invest equity into listed companies. However, the fund may invest in private companies that will shortly be listed on the stock market. The fund is restricted from owning 10% or more of a company. Norges Bank proposes to allow the GPFG to acquire stakes of more than 10% in unlisted companies and to follow the framework set up for investments into unlisted real estate. Practically, Norges Bank should be left with the decision on the amount and type of private company investments. In a rough calculation, Norges Bank sets forth a possible limit of unlisted equity investments of 4% of the fund and 6% of the equity portfolio, where the more conservative figure shall prevail.
Norges Bank outlines different ways to invest into unlisted equities and assesses their merits, costs and required know-how. Investors can either directly or indirectly allocate their money with private companies. Indirect investments are made through private equity funds or funds of funds. For direct investments, the GPFG could either team up with a private equity fund or act on its own. In its letter, Norges Bank focuses on investments either in or alongside private equity funds. These investments are the most common for institutional investors and offer data to quantify the returns and costs. Private equity funds managed USD 2.5 trillion at the end of 2016. This represents ca. 5% of the USD 51 trillion capitalisation of GPFG’s benchmark index “FTSE Global All Cap” at the same time. For a large investor as the GPFG, the investable private equity market amounts to USD 1.5 trillion, as estimated by the expert group. Private equity funds can be categorised as buyout, growth, venture or other funds. For an investor of the size of GPFG most venture funds are too small for efficient investments. Thus, buyouts and growth equity would form most of potential investment opportunities for GPFG.
Norges Bank proposes including unlisted equities in GPFG’s portfolio as a reaction to a steady and global decline in the number of listed firms. In the US, the number of listed firms has halved since the fund started its operations in 1990. In the same period, the total number of US companies has increased. Thus, this trend is due to the decline in new stock market listings. The UK shows a similar trend as the US, whereas the rest of the world has seen the number of listed firms decrease at a slower pace. Based on recent research, Norges Bank proposes three possible reasons. Firstly, the costs of a listing have increased due to regulatory changes. Secondly, firms often choose to merge with other companies to realize gains from synergies. Lastly, the decline in listings might be due to the increase in the importance of private capital investors, such as private equity funds and institutional investors. Private capital as a source of funding is prevalent in growth sectors and growing regions, such as technology companies and emerging markets. Thus, by the restriction to public markets, GPFG systematically misses the chance to share in the growth of certain types of companies.
Historically, private equity performance after costs has exceeded public equity index returns, as examined in the report of the expert group mandated by the Ministry of Finance. Norges Bank thus recommends investments into private equity to improve the GPFG’s returns. The evaluation of private equity performance is more difficult than for public equities. Firstly, the transparency of private equity funds is lower, as there are fewer disclosure requirements. Secondly, the lack of a market price complicates the regular calculation of prices and returns in private equity. Because of these difficulties, it is hard to tell whether the average investor has been appropriately compensated for the risks taken. However, some remarks on private equity performance can be made. The performance depends heavily on the fund type. For instance, buyout funds tend to deliver more consistent returns than venture funds. Generally, there is no evidence that a private equity fund’s past performance makes a good indicator for future performance. That is why an investment into private equity requires thorough due diligence of the fund’s type, investment approach and key personnel.
The success of an investment into unlisted equities is significantly influenced by the costs of the private equity fund. On average, the management fees and performance-based remuneration of private equity funds cost 6-7% annually. Here, GPFG might be able to leverage its size and reputation to achieve lower fees. Research shows that larger investors have historically achieved higher returns. Whereas investments in private equity funds require limited know-how on the part of the GPFG, they are subject to higher fees. Investments alongside private equity funds do not lead to fees, but the GPFG would have to build the necessary expertise. A further influence on the cost is the timing of the investment. Money can be allocated to private equity funds during the fundraising period or through the secondary market. The secondary market for fund interests poses a cost-efficient way of investing in private equity. Given the GPFG’s ability to take on liquidity risks, it could benefit from high liquidity premiums during economic downturns. That is because investors who are constrained to sell their stake under time pressure are bound to accept discounts to gain access to liquidity.
In conclusion, the fund’s size, long-term horizon and limited liquidity needs may make it well-suited to investing in unlisted equity. Also, the expert group’s report has outlined best-practice models from other large institutional investors, such as Canada’s Ontario Teachers’ pension fund that the GPFG could adopt.In light of the attractiveness of private equity for an investor as the GPFG, the Ministry of Finance’s decision not to allow the GPFG to invest into unlisted equities seems questionable. In a current white paper, the Ministry outlines the criterions of the fund’s management model: transparency, benchmarking and low asset management costs. First, when it comes to transparency, private equity funds have a bad track record. They often disclose little information, making the portfolio companies more difficult to monitor than listed companies. As mentioned above, the current statutes allow investments in private companies that have published their intention to be listed publicly. As these companies are fulfilling disclosure requirements in the listing process, the information problem can be overcome. Second, Norges Bank puts high emphasis on benchmarking its investments. Whereas listed companies can be benchmarked with little effort, private equity investments pose difficulties in this regard. Third, GPFG seeks to minimize asset management costs. Currently, these costs accrue to 0.06% of assets under management. For investments with private equity funds, this figure is estimated to be 6%. This runs counter the Ministry’s goal of a slim investment management organization. Moreover, the GPFG would take on a substantial reputational risk, as private equity funds have often been perceived negatively in the public. Even though studies show otherwise, private equity funds have often been accused of creating social costs such as job losses. As an investor into a private equity fund, the GPFG would have no say in the fund’s investment decisions. In case of a controversial investment, the GPFG’s reputation could be damaged.
Authors: Philip Kurzrock, Nikita Kuhlen, Finn Stockwald
Editor responsible: Edoardo Cogliati