Components of the investment policy

executive officer was extensively involved in defining for marguerite an investment strategy as aligned as possible with fund industry best practices (see the case study in appendix A).

COMPONENTS OF THE INVESTMENT POLICY

Key elements of the investment policy include the following.

• Policy purpose. Investment policy statements generally start with an identification of the SIF’s purpose and double bottom line mandate. This simple but vital statement sets the stage for the subsequent rules. It also adheres to two key generally accepted principles and practices (gAPP) set out in the Santiago

Principles: (1) gAPP 18, which states that “the SWF’s investment policy should be clear and consistent with its defined objectives, risk tolerance, and investment strategy, as set by the owner or the governing body(ies)”; and (2) gAPP 19.1, which states that, “if investment decisions are subject to other than economic and financial considerations, these should be clearly set out in the investment policy and be publicly disclosed” (IWg 2008, 8). nSIA-nIF’s investment policy, for instance, complies with both by clarifying the objectives of the fund up front, stating its double bottom line objective, and indicating an overall elevated focus on financial returns: “The Fund seeks to make a positive financial return on its investments in the infrastructure sector in nigeria. It also aims to attract and support foreign investment and enable growth” (nSIA 2019).12 Similarly, malaysia’s Khazanah nasional Berhad clarifies the bifurcation of financial and economic return objectives when it states that its “commercial fund aims to achieve optimal risk-adjusted returns, whilst its strategic fund undertakes strategic investments and holds strategic national assets with long-term economic benefits.”13 • Alignment with national priorities. Public capital SIF investment policies are generally crafted to align with the sponsor’s overall vision for socioeconomic development. For instance, Articles 42.1 and 42.2 of the nSIA Act 2011 require that nSIA-nIF investments align as far as possible with national infrastructure priorities, with a specific prioritization of federation-level economic benefits over local or regional ones. Similarly, ISIF’s Investment Strategy 2.0 is informed by the objectives of Project Ireland 2040, which focuses on five priority themes (ISIF 2019). Public capital SIFs typically focus on national-level priorities, and mixed capital SIFs may reflect similar value systems. marguerite I’s management board had the ability to veto transactions if a proposed investment was potentially contrary to european union (eu) policy objectives or publicly stated national policy in the country where the project was located.14 • Eligible investments. In line with the policy purpose discussed earlier, the public sponsor provides a broad definition of the eligible investments the fund can make, focusing on private markets. The priority placed on investing in unlisted assets is core to the definition of a SIF: it is hard to justify the additionality of investments in listed companies whose securities are routinely purchased and sold by other capital market investors. For example, marguerite funds are required to invest, on a commercial basis, in policy-driven infrastructure projects in the eu and eu preaccession states, with particular focus on greenfield infrastructure, and based on a list of eligible sectors aligned with eu and national policies. These eligible sectors

include transport, energy and renewables, telecommunications, and water.

This generic definition of eligible investments is usually broken down further in the investment strategy (as discussed in the next section). • Investment horizon. The investment horizon indicates the tenure over which the fund is expected to be operationalized and returns are generated (mulder et al. 2009). notwithstanding the SIF’s role as a provider of long-term patient capital (Halland et al. 2016), SIFs can have different time horizons dictated by their policy objective and the investor base they seek. As discussed in earlier chapters, public capital SIFs often tend to be structured as permanent capital vehicles with the flexibility for longer investment horizons because they are funded solely by the sovereign. For instance, nSIA-nIF’s investment policy prescribes a 20-year investment horizon for nIF, in alignment with the long-term characteristics of infrastructure investment (nSIA 2019).

Ireland’s nTmA Act 2014 does not restrict ISIF’s investment horizon, which

ISIF clarifies can extend to over 30 years (see the case study in appendix A).

A longer investment horizon enables public capital SIF involvement in, for instance, greenfield infrastructure deals (which have longer gestation periods) and corporate investments (or restructurings) that require a long time to bear fruit. mixed capital SIFs, by contrast, frequently tend to be finite life funds, with a 10- to 15-year time span, because they seek investment from commercial investors that may be reluctant to commit capital for an indefinite period. The trajectory of the marguerite funds provides a good illustrative example: marguerite II’s fund life was shortened from 20 years (life of the preceding fund, marguerite I) to 10 years to enhance its attractiveness to private investors and in response to the preferences of most of its sponsors (see the case study in appendix A). Finite life SIFs must deploy their capital, exit the investments, and distribute the proceeds back to the fund investors within a contractually agreed term (usually 10–15 years). This requirement may prevent such funds from investing in greenfield projects at the early stages of development, such as the design phase. • Return expectations. As discussed earlier, unlike traditional SWFs that invest primarily in publicly traded investments, SIFs focus on privately traded investments. A SIF’s investment policy will set target returns to provide visibility, hold the SIF accountable to its investors, and discipline the manager’s search for deal opportunities. return targets for investment funds fall into two categories:

1. Absolute returns. Funds investing in unlisted securities and particularly private equity tend to set their returns on an absolute basis (for example, 20 percent gross internal rate of return). 2. Relative returns. Funds investing in publicly traded securities (stocks or bonds) set performance targets versus a benchmark index of publicly traded securities.

For SIFs that operate closely to the private equity model (limited fund life and focus on one specific layer of the capital structure, such as equity or mezzanine), the absolute returns target model is the most appropriate. For instance, marguerite II targets a 10 percent net internal rate of return (see the case study in appendix A). However, this model is harder to apply to public capital SIFs that have the flexibility to invest across the capital structure (across different risk-return asset classes) and may not have the finite life of a private equity fund. In this case, it is advisable to

– Set a minimum return threshold at the portfolio level, possibly benchmarked to the SIF’s cost of capital, such as the cost of sovereign debt if the sovereign is the primary contributor of capital to the SIF; and – define specific return targets for the different asset classes invested in, because the portfolio-level threshold may not accurately reflect the different risk or reward profiles of debt and equity.

Both thresholds are required because setting a minimum fund-level target linked only to the cost of sovereign debt, without a further specification of target returns for equity investments, would risk giving the SIF leeway to pursue equity deals at subcommercial equity returns. For instance, ISIF’s investment policy, as articulated in the nTmA Act 2014, requires the fund as a whole to generate returns that are over the cost of long-term sovereign debt averaged over five years, although Article 39.4 of the act allows that the manager may aim for different returns for different types of investment in the portfolio.

• Special carveout for investments with high economic returns. SIFs vary in their approach to prioritizing the dual financial and economic return objectives. Some SIFs explicitly accommodate subcommercial returns in their investment policy, as long as doing so results in persuasive economic returns, and may anticipate changes in investment approach as a result of such strategy. Article 43 of nigeria’s nSIA Act 2011, for instance, allows nIF investments to have a lower target internal rate of return as long as they have compelling economic returns. Article 41.5 of the act allows 10 percent of nIF funds available for investment in any fiscal year to be invested in social infrastructure projects, even if they have less attractive commercial returns. In tandem, the nSIA-nIF investment policy provides for a longterm investment horizon to ensure that the fund can realize both a commercial objective and economic returns (nSIA 2019).15 FOnSIS’s law gives much more clear-cut focus to the economic return objective by explicitly allowing FOnSIS to make nonprofit investment decisions.16 (See discussion in chapter 2 on exceptional circumstances that may justify concessionality in a SIF.) • Risk tolerance. risk management for any fund, including SIFs, is a complex, multifaceted exercise that could hardly be summarized in a high-level document such as the investment policy. (See the section in this chapter on risk management framework for a detailed discussion of all aspects of risk management.) nevertheless, the investment policy ideally provides an indication of the SIF’s overall risk tolerance, whether by direct reference to the topic or cautionary statements inserted throughout the document. nSIA-nIF’s investment policy, for instance, opts for the latter approach. In a section called

“Investment Principles,” the policy (1) refers to portfolio diversification as an important tool of risk management and careful valuation analysis of each project as a way to reduce downside risk (as well as enhance returns); (2) solicits the design of measures to reduce liquidity risk;17 (3) calls for portfolio diversification to take into account the fund’s risk tolerance, and to avoid portfolio concentration risk; and (4) sets limits to the percentage of assets that could be dedicated to external funds or third-party fund managers, to avoid manager concentration risk (nSIA 2019). • Discretionary aspects of the investment policy and flexibility for modifications. The public sponsor may choose to retain discretion over aspects of the investment policy for reasons such as national interest. For

instance, the nTmA Act 2014, Article 42, allows the Irish minister for

Finance, in consultation with the central bank, to channel ISIF funds to finance credit institutions during an economic crisis or in cases of instability in the financial system.18 In addition, the public sponsor may retain the flexibility to alter the investment policy in light of evolving economic conditions. For instance, ISIF’s original investment strategy19 was reviewed in 2017–18, in compliance with Section 40 of the nTmA Act 2014, which requires a periodic review of the strategy, and amended to reflect the rapidly improving economic situation of Ireland and changing opportunity set for ISIF (IFSWF 2019). The initial strategy reflected

Ireland’s need to attract capital and stimulate the economy in the aftermath of the global financial crisis that severely affected the country. In

July 2018, the minister for Finance and for Public expenditure and reform announced a refocusing of ISIF within its overall policy mandate centered on five key economic priorities: indigenous industry, regional development, sectors adversely affected by Brexit, climate change, and housing supply (IFSWF 2019). A new ISIF strategy was therefore published in February 2019 (ISIF 2019). Similarly, nSIA’s board decided in 2019 to increase the allocation to nIF from 40 percent to 50 percent of capital contributions to nSIA, reflecting the government’s view of the importance of infrastructure to nigeria’s economic needs (nSIA 2018). mixed capital SIFs may also modify their investment policy to reflect economic conditions. For instance, marguerite I was launched right after the global financial crisis, when any investment in greenfield infrastructure in europe was hard to fund. By the time of the launch of marguerite II, abundant liquidity had returned to both the brownfield and shovel-ready greenfield segments (in certain eu member states and sectors perceived to be less risky), but a gap still persisted in development-stage projects and certain geographic regions and sectors. Therefore, unlike marguerite

I, which focused primarily on shovel-ready greenfield projects, marguerite II can consider development-stage investments (see the case study in appendix A). • Responsible investment policy. given the policy-driven focus of SIFs, and the affiliation to the sovereign for a public capital SIF, a responsible investment approach is usually embedded within the investment policy of the SIF. For example, marguerite’s investment policy requires it to focus on environmental, social, and governance (eSg) considerations, and the fund applies the european Investment Bank’s eSg criteria within the investment process (see the case study in appendix A). marguerite has also cosigned the united nations Principles for responsible Investment and aligns with the equator

III Principles and other eSg standards.20 Similarly, India’s nIIF and its underlying funds, investee funds, companies, and projects are required to align with eSg principles and assess eSg considerations during due diligence while monitoring and managing portfolio-level risk.21 Likewise, adhering to rigorous eSg practices is part of ACP’s core identity. The fund integrates

AdB’s eSg framework into all stages of its investment process (see the case study in appendix A). • Framework to review fund performance. The investment policy also sets out the framework for monitoring the SIF’s compliance with the terms set out in the policy. For example, nSIA-nIF’s investment policy lays out the key performance indicators for the fund, clarifying the rationale for each, the