Knock, knock, knocking on sovereign doors

The credit crunch is causing US banks to lose their scruples when it comes to inviting investment from sovereign wealth funds from emerging economies such as Abu Dhabi, China and Singapore.

WHEN Dubai Ports World was seeking take over the management contracts for several of the USA’s busiest seaports as part of its P&O acquisition in February 2006, it met with fierce resistance.

The notion that a Middle Eastern state-owned entity might acquire strategic assets such as the ports of New York, New Jersey and Philadelphia was anathema to many Americans. Dressing up protectionism and even xenophobia in the cloak of “strategic concerns”, opponents of the deal including then senator Barack Obama circled their wagons and managed to torpedo it.

A change of heart

Fast-forward a couple of years and the mood in the USA has changed considerably. Post-credit crunch and with their economy teetering on the brink of a recession, Americans now have far fewer qualms about allowing sovereign wealth funds to snap up some of their most prized assets.

Indeed, once-proud institutions such as Citigroup and Merrill Lynch have in recent months been actively seeking money from this new breed of investor – something that would have been unthinkable a couple of years earlier. The attitudinal shift is not the result of some new Rainbow spirit of openness and multiculturalism in the Land of the Free; it has more to do with pragmatism, even desperation.

The idea of Wall Street’s finest having to go cap-in-hand to seek cash injections from the wealth funds of emerging economies such as Abu Dhabi, China and Singapore is also powerfully evocative. In some ways, it is symbolic of the continuing shift in economic and financial power from West to East.

The US investment banks’ needed cash urgently to shore up their balance sheets as a result of their ill-advised investments in subprime related instruments that turned out to be worth much less than imagined. Rather than wait for the sovereign wealth funds to come knocking, they went to the sovereign wealth funds.

Speaking to the Washington Post in March, Bader Al Saad, managing director of the Kuwaiti Investment Authority (which has taken a $3bn stake in Citigroup and a $2bn stake in Merrill Lynch) confirmed this.

“They called us,” says al-Saad.

Overall, since the liquidity crisis erupted in August 2007, sovereign wealth funds, mainly from the Persian Gulf and Singapore, have injected a total of $60 billion into US and Swiss banks.

The $200bn China Investment Corporation (CIC), which manages part of China’s foreign exchange reserves, provided a curtain-raiser with its $3bn purchase of a stake in Blackstone Group, the world’s leading buyout house, ahead of Blackstone’s flotation in May 2007. Then the Abu Dhabi Investment Authority – which, with assets of $900bn, is the largest sovereign wealth fund in the world – purchased $7.5bn worth of Citigroup securities in November.

The following month Singapore’s Temasek Holdings acquired $4.4bn stake in Merrill Lynch, the Government of Singapore Investment Corp (GIC), took a $9.5bn stake in UBS and CIC acquired a $5bn stake in Morgan Stanley.

SWFs — a brief history

Even though the sovereign wealth funds are probably delighted to have gained some influence at the high table of global finance, their bank and private equity fund manager investments have, in the short term at least, turned out to be spectacularly poorly performing. The continuing collapse of global banking and financial stocks, precipitated by the collapse of Bear Sterns and the HBOS ‘bear raid’ in March 2007, have left most of them nursing losses of some 40% plus on their investments.

Sovereign wealth funds were virtually unheard until they rode to the rescue of western capitalism last year. So from whence did this shining knight come? And how did they build up their huge volume of assets?

Many of the largest funds were created by oil-rich countries like Norway and Gulf states as a means of utilizing their current account surpluses. Asian countries such as Singapore and China, whose trade surpluses have generated big foreign exchange reserves, also have immense sovereign funds.

Stephen Jen, managing director and chief currency economist at Morgan Stanley, says that although sovereign wealth funds have been around for decades, they changed their spots in recent years. “Before 2000, they were largely set up to stabilize the impact of fluctuating prices in oil and other natural resources,” said Jen. “They acted more like giant savings accounts to balance the inevitable boom-and-bust cycles commodities-driven economies had to endure.”

However in 2002, when the oil price spiked upwards along with the price of other commodities, countries with sovereign wealth funds fundamentally reconsidered the purpose of their funds, according to Jen.

“It became apparent that demand [for oil and other resources] had outstripped supply to the point where prices wouldn’t collapse anytime soon.”

As a result, sovereign wealth funds started to feel they could become more focused on the long-term. This led them to reduce their dependence on fixed-income investing and instead to become more active in the higher risk, higher return investment space.

Transparency matters

The world’s four biggest sovereign wealth funds are those of Abu Dhabi, Singapore, Norway and Kuwait, according to figures from Standard Chartered. However the SWFs of China and Russia are snapping at their heels and could supersede them in the next few years.

Morgan Stanley’s Jen believes the sovereign wealth funds are likely to supplant official foreign reserves held by central banks as the main driver of global capital investment. Altogether, the funds control about $3.3 trillion, but this is poised to climb to $10 to $12 trillion by 2015. According to Mergermarket they will also become the main driver of global M&A over the next 12 months.

Because the sovereign wealth funds have changed their spots so rapidly in recent years, regulators and global corporate governance watchdogs are struggling to catch up. There have been persistent calls from multilateral organisations, governments, regulators and investor groups for the sovereign wealth funds to become more open and transparent.

These calls have been reaching a crescendo of late. EU trade commissioner Peter Mandelson in March warned the funds that they risk seeing future investments blocked as a result of protectionism and xenophobia unless they start behaving more transparently.

“It would be a mistake for them to ignore the political environment in which they are operating,” said Mandelson. “[sovereign wealth funds] simply cannot afford to underestimate how important reassurance about systems of transparency and governance is in ensuring that unfounded suspicion doesn’t mushroom into a protectionism that is in nobody’s interest.” Both the OECD and the IMF are currently working on creating separate frameworks for the corporate governance of SWFs.

Meanwhile the International Corporate Governance Network (ICGN) is urging sovereign wealth funds to ensure they use their voting rights at annual general meetings.

However these entreaties have mainly fallen on deaf ears at the sovereign wealth funds. One reason for this is that, other than in Norway, concepts like openness and transparency and the responsible use of shareholder votes, perhaps run counter to the grain of normal practice in their home cultures. Another is they believe they are being unfairly singled out. Calls for hedge funds and private equity houses to open up their books have been much less strident.

Could it be that the US and Europe are arguably being hypocritical when it comes to their treatment of sovereign wealth funds?

At an investment conference held in Hong Kong in early April 2008, Chinese officials said they believed that sovereign wealth funds are being unfairly victimised by western governments. “Sovereign wealth funds are not being treated fairly at this point,” said Jesse Wang, vice-president and chief risk officer at China Investment Corp. “The reality is we are seeing rising protectionism and nationalism.”

Wang added: “CIC is one of the most transparent sovereign wealth funds in the world. CIC also intends to invest up to $80 billion overseas and is targeting mid- single-digit, slightly higher returns.”

Even so two sovereign wealth funds – those of Abu Dhabi and Singapore – have been persuaded by the US treasury secretary Henry “Hank” Paulson to adopt rules for greater disclosure and to ensure that their investments are used for economic, not “geopolitical” purposes.

Looking ahead

Despite the kerfuffle over transparency, there are many who believe that sovereign wealth funds will exert a beneficial influence on global markets in the long run.

Some observers believe that the fact they have longer time horizons than conventional long-only equity investors and hedge funds means they could in fact have a stabilising influence on global capital markets.

Morgan Stanley’s Jen said: “To the extent that SWFs improve market liquidity, particularly in a way that is not herdish, like other types of short-term capital flows, SWFs should be a positive factor for markets in general.”

Given the amounts they are looking to invest, coupled with their relative lack of some types of investment experience, they should also present fund managers with some lucrative opportunities to build assets under management in coming years.

Morgan Stanley has suggested that sovereign wealth funds may, in aggregate, outsource around 20% of their total portfolios to external investment management firms. That could see them placing as much as $200 billion in the next five years. This could suit institutionally-orientated asset managers such as AllianceBernstein, Allianz RCM and State Street Global Advisers. “A lot of the biggest SWFs are still relatively young. They realise it’s going to take time to develop a sophisticated equities strategy on their own,” said Jen.

A related trend is that sovereign wealth funds are expected to seek to buy stakes in, or even acquire, established asset management business as a means of giving themselves a rapid infusion of skills. Already Dubai International Capital holds a $1.3 billion stake in Och-Ziff Capital Management, and Istithmar, another of Dubai’s SWFs, purchased a 3% stake in the hedge fund group GLG Partners in June 2007. The CIC investment in Blackstone was probably made for similar reasons.

In a report published last October, the brokerage Merrill Lynch estimated that $3.1 trillion to $6 trillion in new investment dollars will be pumped into global markets by sovereign wealth funds by 2013. That, said Merrill, could generate $4 billion to $8 billion in additional fees for asset managers.

Merrill Lynch’s head of international economics Alex Patelis, said that investment groups would be foolish to ignore this sizeable new client base. He added: “Investors should rejoice in the more balanced global economy to which these tectonic shifts should contribute. Enjoy the bubble bath.”

 This article was published in the May/June 2008 issue of EFM – European Fund Manager