Figure 5.1 Sovereign Wealth Fund Global Investment 2002-2008
SOURCE:Thomson Reuters
Sovereign wealth funds may have helped save the world, but their emergence was not without controversy. Sovereign wealth funds are government-sponsored investment funds created to invest their country’s foreign currency reserves. As such, these funds are mostly creatures of countries that have unduly benefited from economic globalization and the now-past commodity boom, namely, oil producers or exporters of goods to the United States, most prominently China. In 2008, 7 of the 10 largest sovereign wealth funds were held by non-Western oil producers: Algeria, Kuwait, Libya, Qatar, Russia, Saudi Arabia, and the United Arab Emirates.3 China had one of the largest funds, capitalized initially in 2007 by the Chinese government with $200 billion.4 None of these countries are democracies, and some are possible U.S. enemies. Many in the United States expressed concern that these countries would use these investments to wield undue political influence on U.S. corporate interests, as well as to overtly appropriate U.S. technology.
As these funds grow, the issues surrounding sovereign wealth funds are likely to increase over time. Sovereign wealth funds currently have an estimated $2 trillion to $3 trillion in assets. Merrill Lynch and Morgan Stanley estimated in 2007 that these funds may have more than $7.9 trillion in assets by 2011 and $10 trillion in assets by 2015, respectively. 5 These numbers will probably be far less, now that the commodity bubble has deflated and the global recession has taken its toll on exporting economies. Still, the secular trend is toward further accumulation of reserves in these funds, particularly China’s. (See Figure 5.2.) The United States even had its own fund popularized in the past election by the nomination of Governor Sarah Palin as the Republican vice presidential candidate. The $28.3 billion Alaska Permanent Fund holds and invests Alaska’s oil wealth on behalf of that state’s residents.6
Tied into the concern over sovereign wealth funds is a recent, heightened sensitivity to foreign investment in the United States, particularly in light of the economic downturn. The bizarre 2007 uproar over an attempt by Dubai Ports, a company controlled by the United Arab Emirates, to acquire control of a number of U.S. ports spurred Congress to legislate heightened requirements for national security review of foreign acquisitions. The sovereign wealth fund investment spurt came after this controversy and legislation, but the Dubai Ports incident highlights the complexity surrounding the issue of growing foreign investment in the United States.
This chapter is about the increasingly important role foreign investment plays in dealmaking and the U.S. capital markets. It is particularly about the wave of sovereign wealth fund investment and its future direction and regulation. Regulating foreign investment is always a struggle among irrational xenophobia, legitimate national interests, and the need for and benefits of foreign direct investment. Sovereign wealth funds raise even more particular concern as a direct government investment, but this type of investment also highlights the changing nature of the financial marketplace. Sovereign wealth funds stand to become an alternative capital provider for dealmaking, albeit in a likely accompanying rather than direct role.Yet foreign investment will continue to be a place of nuanced risk and reward, where the public relations aspect of the deal machine particularly matters and regulators will continue to play a heightened role. To understand why, it is necessary to begin by discussing the nature of sovereign wealth fund investing.
The Financial Wave of Sovereign Fund Investment
Not surprisingly, the initial prominent sovereign wealth fund investment was tied into the private equity boom and Blackstone. In May 2007, China Jianyin Investment Company, a Chinese government agency, purchased a 9.3 percent interest in Blackstone for $3 billion.
Figure 5.2 Map of Sovereign Wealth Funds (aas of March 2009)
SOURCE: Morgan Stanley
At the time, Blackstone asserted that it accepted the investment for strategic reasons. A relationship with the Chinese government would provide Blackstone superior access to the Chinese market. China probably had a similar rationale for this investment; the government could now steer Blackstone’s investment capital further into China. In addition, China now also had access to the financial expertise of Blackstone’s Schwarzman and his partners, as well as a 9 percent ownership stake, albeit nonvoting, in one of the largest privately held companies in the United States. The investment marked China’s first sovereign wealth investment. Indeed, the Blackstone investment would herald the formation, on September 29, 2007, of an official Chinese sovereign wealth fund, China Investment Corp. Ltd (CIC). The China fund was capitalized by the Chinese government with approximately $200 billion, backed by the approximately $2 trillion in Chinese dollar currency reserves, and it provided a soft government mandate to earn a return of 5 percent on invested capital.7
The Blackstone investment was the first significant sovereign wealth fund investment in a U.S. financial institution. It was also a creature of the private equity boom. The Chinese government purchased a nonvoting stake in Blackstone at a price that even at the time appeared heady. But highlighting the issue surrounding these investments, the economic returns may have been secondary to the strategic and technical benefits China gained from access to Blackstone. After all, why else would China pay full price for a nonvoting stake at a time when market observers were calling a private equity bubble?
In hindsight at least, the full price CIC paid for Blackstone was indeed too much. But into the fall of 2007, the continuing credit crisis drew in sovereign wealth funds looking to profit from the stock market decline and the visible distress of financial institutions. In September, Mubadala Development Company, the investment arm of the Abu Dhabi government, purchased a 7.5 percent stake in the Carlyle Group for $1.35 billion.8 Also in September, the Borse Dubai, the stock exchange controlled by Abu Dhabi agreed to, purchase a 19.99 percent stake in the Nasdaq Group Inc. and in connection with that purchase also agreed to acquire Nasdaq’s 28 percent stake in the London Stock Exchange Group PLC.9 The investment accelerated toward the end of 2007. In November through January, Citigroup, Merrill Lynch, and Morgan Stanley alone collectively raised $37.8 billion with over three quarters of that coming from sovereign wealth funds.10 (See Table 5.1.)
Table 5.1 Share Performance of Selected Sovereign Wealth Fund Public Financial Investments 2007-2008
In 2008, sovereign wealth funds announced $23.7 billion worth of investment into the United States. Financial institutions were the top targeted industry, with $32.7 billion in global investment.The next two investment categories were not even close: oil and gas with $7.1 billion and real estate with $4.4 billion of investment.11 By investing in financial assets, such as investment banks, sovereign wealth funds were taking advantage of the market distress to obtain access to the highest reaches of the institution’s management. Sovereign wealth fund investments were thus of a very different type than those made in the 1980s by the Japanese. Back then, the Japanese for the most part bought cyclical assets at the top of another bubble, purchasing trophy properties such as Pebble Beach and Rockefeller Center.12 Sovereign wealth funds appeared in part to break with the investment pattern set by the Japanese, focusing instead on distressed financial institutions and operating companies.
Investment in financial institutions opened up access for the sovereign wealth fund to a bigger menu of investments. It also provided the funds greater opportunity to channel investment into their own countries to nurture domestic businesses and industries.The Blackstone investment was not unique; these financial institution investments appeared to be generally made for more than just a return. Moreover, purchasing an interest in these financial companies was a means for the managers of sovereign wealth funds to access the world’s leading investors and their investing skill.
Many of these sovereign wealth funds are newly created.Two prominent exceptions are the Kuwait Investment Office, which has been around in some form since 1953, and Norway’s Government Pension Fund, establis
hed in 1990.13 The people running sovereign wealth funds are smart but often relatively inexperienced global investors. The sovereign wealth funds were attempting to cover this deficit by purchasing investment and financial acumen. As such, these were also strategic investments made for long-term gain beyond an economic return. These funds may have been willing to earn a lower return than other investors might have sought, due to the funds’ other investment purposes. Sovereign wealth funds generally target a low return in any event because of their government origin, lower cost of capital, and the tax-free status of their investing due to their sovereign nature.
What do financial institutions gain from this relationship? To understand the benefits to each party and the corporate flight to these funds, it is worth looking at the terms of a particular investment: Temasek Holdings’ Christmas Eve 2007 $4.4 billion purchase of a 9.4 percent interest in Merrill Lynch. This was viewed as a coup for now-tarnished ex-Merrill CEO Jonathan Thain. At the time, Temasek purchased this interest at $48 dollars a share, received no special corporate governance rights, and agreed to a standstill that prohibited it from purchasing more than 10 percent of the company.14
The Temasek investment was typical for the time.The paradigmatic fund investment in a public company in the past two years has been a 5 to 20 percent stake in a financial institution. In many of these investments, the securities purchased by the fund did not have a voting ability or provide the fund with seats on the company’s board of directors. In other words, sovereign wealth funds during this time made largely passive, noncontrolling investments. Passive here refers to the actual rights the funds are receiving, not any soft influence they now wielded due to their stakes.
Merrill took Singapore’s money, first, because it could be raised fast. Sovereign wealth funds here offered a compelling advantage as willing investors who could quickly deploy money in a capital-starved world. Merrill also benefited from Temasek’s willingness to take a noncontrolling, passive interest. Keeping the stake below 10 percent had regulatory advantages. In particular, at the time of this investment, there was a general view that a passive stake of this nature was not subject to review by the U.S. government for national security purposes.
The question, though, was who was fooling whom? Were the banks taking advantage of the funds, or was it vice versa? The banks accepted capital from these investors in part because of the funds’ willingness to quickly make passive, noncontrolling investments in a manner that sidestepped extensive regulatory review. However, at the time of these investments, the public markets remained open enough to raise equity or other capital. For example, in January 2008, Bank of America Corp. raised $12.9 billion through a public offering of preferred stock.15 Hedge funds, private equity, and other U.S. institutional investors also remained possible investors.
These other institutional investors, though, would probably have wanted a measure of control rights along with their large investments. In contrast, a sale to a sovereign wealth fund largely meant that the investor would be a passive one. Even if Temasek had negotiated management rights, it was unlikely that the government of Singapore would launch a proxy contest to unseat the Merrill board or otherwise attempt to overtly influence the company. Instead, any influence was likely to come through soft power, steering business and investment expertise to these countries. Sovereign investment also insulated management from any unsolicited takeovers or other shareholder activity. The net result was that sovereign wealth fund investment was preferable to management because it was likely to leave them with much wider latitude to operate their business.
In the short term, the returns have been horrible (see Table 5.1). It appears that the banks have gotten the better of the funds.16 And the wave of government investment starting in the fall of 2008 significantly diluted this wave of sovereign wealth fund investment. Here, some funds benefited from negotiating more sophisticated investment rights. Temasek, for example, had negotiated a repricing right if Merrill raised equity at a lower price within a year of their initial investment. On July 29, 2008, Merrill announced plans to raise another $9.8 billion in capital. At that time, Merrill’s stock price was about half of what Temasek paid for it, entitling Temasek to $2.5 billion of compensation. However, Temasek agreed to reinvest this amount and purchase another $900 million in Merrill common stock without any future reset protection.17
This provision ultimately saved Temasek money but did not spare it from a loss. At the time Merrill was sold to Bank of America, it was said to have an estimated loss on paper of $2 billion. Since its Merrill investment, Temasek has suffered even further losses on investments in Barclays Plc and Bank of China and a general decline in the value of its fund on account of its 40 percent concentration in financial assets.18 Temasek’s most recent return figures calculated as of November 31, 2008, reveal that Temasek’s investments were worth about $85 billion, a decline of 31 percent from March 31, 2008.19
Citic Securities, a top state-controlled investment bank in China, was one fund that dodged a bullet. Citic had yet to invest the $1 billion in Bear Stearns it had agreed to and therefore was able to cancel its investment and save its government a billion dollars when Bear Stearns collapsed. But overall, the sovereign wealth fund investments during this time have been much less fortunate. For example, China’s $3 billion investment in Blackstone had by early 2009 lost four-fifths of its value. Notably, CIC has since renegotiated its agreement with Blackstone to obtain another 2.6 percent of the company, without any additional investment of funds.20 In hindsight, sovereign wealth funds moved too early to invest in financial institutions, and more experienced investors benefited by waiting. Mitsubishi UFJ, for example, invested $9 billion in Morgan Stanley in October 2008. The price was effectively $25.25 per share, less than half the effective per-share price, ranging from $48.07 to $57.68 per share, CIC had paid in December 2007 to invest in that company.21 Sovereign wealth funds may have been investing for purposes other than economic returns, but the losses meant that they paid quite dearly for these opportunities.
These funds, though, appear to be long-term investors, and the true returns will only be known years from now. Saudi Arabian Prince Alwaleed bin Talal made billions investing in Citigroup back during its last financial crisis in the early 1990s (money he largely lost in this financial crisis).The sovereign wealth funds certainly know this, though they clearly would have preferred to get into their investments during the September 2008 crash. Moreover, the funds are learning. Whereas some of these early investments such as in Blackstone were in nonvoting equity without a guaranteed return, later investments have been made in the form of preferred investments that assure a minimum return. For example, when CIC invested in Morgan Stanley, it did not purchase common stock. Rather, CIC sought some assurances on its investment by purchasing equity units that were mandatorily convertible into common stock on August 17, 2010. In the meantime, the equity units yielded 9 percent on their investment, a way to ensure a more certain return than an investment in common stock.22 Of course, in hindsight, CIC still has on paper lost a tremendous amount of money on that investment, but it could have been worse.
Sovereign wealth fund investment has thus had mixed results for the funds themselves. Most did not pan out as the financial sector further deteriorated. In August and September 2008, when the financial firms reached a breaking point, the sovereign wealth funds were nowhere to be seen. Instead, licking their wounds, these funds have begun to invest in different areas. For example, in one week in September 2008, the sovereign wealth fund of Abu Dhabi bid $354 million for the English soccer team Manchester City and announced that it was investing $1 billion in Hollywood, Bollywood, and entertainment.23 Sovereign wealth funds thus remain active although quite wary after the losses of the past years. Their investment will probably continue, albeit at a quieter and more subdued pace. This was illustrated by the 2009 Davos gathering. Sovereign wealth funds had been the star of the 2008 conclave and a source of heated debate, but by 2009, their presence
was muted in light of the financial crisis and their significant losses.24
Individual countries still remain significant holders of sovereign assets. These funds will continue to remain a force in investing. Their trillions will eventually begin to flow into other industries and investments beyond financial institutions. For example, Aluminum Corporation of China, the Chinese state-controlled aluminum company known as Chinalco, together with Alcoa in 2008, announced the surprise acquisition of a $14 billion stake in Australian miner Rio Tinto. This investment made in the midst of BHP Billiton’s bid for Rio Tinto was generally viewed as a means for Chinalco to cement a source of supply for its aluminum factories.25 It was a commodity boom deal and yet another one where China will in the short term lose significant sums. Nonetheless, the transaction showed the potential direction of sovereign wealth funds.These funds will gradually move beyond their current passive stakes to larger purchases, often flowing to the greater strategic benefit of the country. Chinalco would attempt in February 2009 to follow up with another $19.5 billion investment in Rio Tinto by purchasing $12.3 billion of Rio Tinto’s mining assets as a joint venture and $7.2 billion of convertible bonds.26 This second investment was cancelled amidst public angst and outcry in Australia over excessive Chinese investment in key Australian assets. Still Chinalco’s first investment would constitute the largest outward investment transaction from China to date.27
Sovereign wealth funds are also liable to specialize, depending on their origin. Mideast funds are likely to focus on petrochemical and similar investments that leverage their oil-driven economic expertise. Meanwhile, Chinese and other exporter country sovereign investment funds are likely to focus on cementing their supply chain and generally building up their financial and technical expertise. The difference may lie in whether they begin to become more like investment banks in nature, investing funds but also serving as capital providers and arrangers. This may indeed come to pass for some of the larger funds. However, it will take time for these funds to build the necessary expertise and apparatus to provide quick, regular capital funds. This process is likely to be further slowed by the funds’ investing losses and short-term needs to finance their own country’s declining economies. In fact, the slowdown of many of these commodity-driven and trade-driven economies is likely to diminish the sovereign wealth “problem” to a handful of funds as these entities are depleted for domestic purposes.
Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion Page 14
