The Power of Catalytic Capital

Last week I presented some ‘work-in-progress’ from a multi-year project I’m doing on主权发展基金(SDFs). Specifically, my presentation was on the potential for institutional investors to partner with SDFs in certain appealing economies. With SDFs popping up at an increasing rate in countries around the world -- in places fromRussiaandFrancetoNigeriaandOman-- many traditional investors are beginning to wonder how these funds should be viewed and whether they could be trusted partners.

Before I get into my views on this topic, here’s a bit of background for the uninitiated: SDFs are government-owned and -sponsored investment vehicles that focus on commercially attractive projects and companies that also promote industrial policies that can raise a country’s potential output growth or serve some strategic objective. States around the world have taken to using SDFs to achieve a variety of local development objectives. For example, governments generally launch SDFs to (try to): unlock private capital for industries or regions that would otherwise remain capital-starved; create efficiency and discipline where oftentimes none exist via the introduction of private capital (e.g., restructuring SOEs); and/or develop new industries and thereby create jobs.

Given that the motivations to launch SDFs tend to involve bringing private capital into local markets, it should come as no surprise that SDFs have been increasingly active in approaching traditional institutional investors with co-investment opportunities. The question that the latter funds have is whether the former funds have anything of value to offer. (There are many that view a government’s active participation in the private sector as a recipe for underperformance, and, as such, they view SDFs with quite a bit of suspicion.)

Over the past few months, however, our research has shown that SDFs can be remarkably creative and successful in the ways in which they engage with the private sector. Moreover, some SDFs have demonstrated outstanding investment track records (among our case studies we found SDFs with decennial IRRs of 15%, 13%; 12%; 10% and so on). These return numbers are legit.

The most successful SDFs seem to be those that see their role as launching new industries and then participating alongside the companies in those industries. These SDFs are thus tapping into the power of ‘catalytic capital’; they are the "first investors in" to a new industry and geography. And they get to take these risks (that other investors can’t) THANKS to their political mandate. And, as the returns above demonstrate, the risks that these funds are taking – risks that the private sector is unwilling to take without additional encouragement – are compensated at a high level.

Anyway, given the potential to generate high returns, I argued in my presentation last week that, in the right places and at the right time, SDFs can in fact be attractive co-investment partners. In fact, I suggested that their local knowledge, proprietary deal flow, unique structuring capability (e.g., ability to take first loss) and provision of political cover (e.g., ability to mitigate headline risk) can all be very valuable to non-local investors.

Shocking? Not really. Many of us here in Silicon Valley can rattle off private sector success stories that owe their existence to some sort of government backing. Tesla, Palantir, the iPhone, GPS, the Internet and, why not, evenlaser beamstrace their origin back to some "centralplanner" ingovernmentthat made a decision to invest in the development of a new technology. Why do you think some of Silicon Valley’s brightest minds have been lobbying government so hard these past few years? (Actually, don’t answer that... that’s Pandora’s box.)

Back to the topic at hand, the only big caution flag I’d wave for traditional investors looking at SDFs as co-investors is when politicians articulate an SDF’s double-bottom line constraint in weak, fluffy terms that are difficult to translate into an optimization problem. As I have come to see it, SDFs can be quite successful when they have clearly defined missions, such as maximizing financial and commercial returns within a specific industry or geography. The industry and region may be of developmental value, but the decision-making of the team (which also has to be first rate by the way) must be purely commercial. The "financial" component of the SDF can generally handle developmental constraints that are very well defined.

Follow? Let me try again: The developmental constraints should be set at a public policy level, while the execution should be purely commercial.

Anyway, in sum, money flows away from uncertainty; so an SDF is often looked at by policymakers as a vehicle to remove as much uncertainty as possible. By removing uncertainty, the SDF should catalyze new economic opportunity and thus foster development. Interestingly, it’s in this process of catalyzing new economic activity that these vehicles should be able to generate high levels of performance... and provide interesting co-investment opportunities.