Sovereign Wealth Funds: The New Wealth Of Nations

Andrew Lomax - Fri 31 Aug, 2007

The recent press interest in sovereign wealth funds (SWF) seems to stem from their high profile equity investments involving Blackstone and Barclays Bank. Who are these cash rich faceless entities and what are their motives? To name names, the biggest SWFs by assets include the Abu Dhabi Investment Authority ($875bn), Temasek (the Singapore government pension fund- $100bn), the China Investment Co ($1,200bn) and the Qatar Investment Authority ($40bn). These mainly Middle and Far Eastern groups are basically trust funds that can be called on to meet pension or state liabilities in the future.

The recent press interest in sovereign wealth funds (SWF) seems to stem from their high profile equity investments involving Blackstone and Barclays Bank. Who are these cash rich faceless entities and what are their motives?

To name names, the biggest SWFs by assets include the Abu Dhabi Investment Authority ($875bn), Temasek (the Singapore government pension fund- $100bn), the China Investment Co ($1,200bn) and the Qatar Investment Authority ($40bn). These mainly Middle and Far Eastern groups are basically trust funds that can be called on to meet pension or state liabilities in the future. An SWF shares a trust like structure; it has a wealth preservation objective, but may cause controversy not least because their investment mandate and beneficiaries can be altered.

The common thread appears to be the SWF’s desire to buy and hold long term investments to provide an income substitute when another income stream runs out. Good examples include the Alaska Permanent Fund, the Brunei Investment Agency and the Government Pension Fund of Norway. These were set up to provide a sort of grain store, keeping cash stashed away to cope with declining oil income and other “bad harvest” sort of events, ie if the country had a major natural disaster.

On the face of it, if big investors, in the case of SWFs, large benevolent government controlled institutions want to buy billions of dollars worth of shares, for the benefit of their future generations, then sorry but what crime is being committed? Aren’t there more important things to worry about? The SWF issue, if there is one, is really one for the taxpayers in these countries.

Post the collapse of Bretton Woods in 1971, central bankers, pension providers and national investing entities struggled to find sufficiently large and liquid asset classes capable of delivering long term returns.

Their options were limited to holding gold, foreign currencies held in money market deposits and US and other G7 government bonds. Gold was alright in the very long term, but has a major handicap in not producing an inflation proof short-term income. The Bank of England sold down its gold reserves from 715 tonnes in 1999 precisely because it wanted better asset diversification.

US bonds ticked plenty of boxes but the five year depreciation of the US dollar, (which has continued so long that it must be deliberate), has now started worrying plenty of SWFs. Dollar aversion may be a major reason for the interest in blue chip stocks.

The surprise decision by the China Investment Company, a state entity to invest $3bn in the Blackstone IPO, deserves special consideration. Firstly the Chinese cannot sell a single Blackstone share (it is restricted “locked up” stock) for four years, hence the press consternation over the $540m underperformance of the stock post IPO (it is now $22.98 vs $31at its June IPO) totally misses the point. The Chinese are not following the mark to market convention anyway. Secondly an investment of $3bn in the context of China’s $1,200bn reserves, growing at $200bn odd pa is obviously a manageable drop in the ocean that provides a large measure of comic relief for the Chinese, in that US investment bankers (colourful and engaging types) are now queuing up to sell IPOs to Beijing!

The real reason might be to get inside Blackstone, understand more clearly how the private equity/LBO mechanism works overseas, possibly to replicate the approach in China and gain access to Blackstone executives for US deals that state controlled Chinese companies want to do. CNOOC/ Unocal in 2005 could be cited as a deal that China lost, possibly in its eyes, because it did not understand the US buyout market sufficiently. Access to the best minds at Blackstone might help Chinese ambitions considerably.

Both China Development Bank and Temasek invested £2.4bn in Barclays in July ostensibly to help Barclays acquire ABN Amro. The investment will rise to £6.5bn if the ABN acquisition goes through, at which point the Chinese will own 7.7% of Barclays/ ABN. The CDB has said it will not increase the stake above 9.9% but nevertheless has strengthened the Barclays board credibility, and lengthened the queue of investment bankers in Beijing.

Investment in equities is inherent with risk, as recent events amply demonstrate. When a large investor is also a stake builder, they will often need to pay a premium to buy 10%- 20% of their target company. Given that SWFs are likely to be paying premiums to the share price, then this is positive for existing shareholders.

Sometimes sovereign wealth investments are unwelcome. The Kuwait Investment Authority (the oldest SWF established in 1953!) spotted a bargain and rode to the rescue of the UK government’s ill fated 1987 BP public offer. They built up a 21.6% stake by March 1988, only to prompt an inquiry by the Monopolies & Mergers Commission that required the KIA to divest to below 9.9% by October 1989. The UK government had a rethink and decided it did not want the KIA, an arm of an OPEC country to hold a major stake in BP. The KIA, it reasoned were naughty because they did not bother getting the regulatory nod beforehand. A large part of the Kuwaiti stake was sold back to BP in the end, though they still have around 3%. This overt snub happened in Britain, a country we are told welcomes foreign investors. The episode suggested there are potential risks for SWFs who amass large stakes in “national
champion” type companies.

The current oil boom and large trade surpluses in China are creating sizeable transfers of cash funds to SWFs. The build-up of financial assets is likely to result in more direct portfolio investments. It is entirely possible that the pace of SWF investments quickens and they become the sort of dream passive investor like Berkshire Hathaway that big companies like to have. Alternatively SWFs could avoid the publicity by simply buying the market via setting up their own tracker funds. They might help by buying distressed ABS portfolios providing liquidity for exiting investors.

An important factor in the SWF thinking is the local public interest. The Chinese surpluses have generated plenty of internal debate over the merits of keeping vast reserves of US Treasury bonds at a time when China is revaluing the renminbi and US interest rates are rising. Similar debates happened in Japan, when Japanese investment in the USA took off in the late 1980s. Should either China or Japan decide to hold off, this could force America to be more fiscally prudent and address trade imbalances. The SWF would enter a more politically charged environment if it rapidly changed its asset allocation policy. However in the mid term it would encourage US fiscal restraint, lowering the cost of borrowing for all. We raise a glass to SWFs; they are a blessing in disguise!

Regards

Andrew Lomax

Editor’s note: Andrew Lomax is an investment analyst and this article was first published in the Fleet Street Letter.

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