A couple of items to note for the Sovereign Wealth Fund trend-watchers out there.
First, a milestone of sorts. The Sovereign Wealth Fund Institute just reported that SWF assets have crossed the $4,000bn mark, put over the top by the latest update from Norway’s Government Pension Fund Global. With the caveat that these estimates are bound to be somewhat imprecise, you can click here to see the updated rankings.
Second, from a new report by the Monitor Group, a summary of what these funds were doing in the first half of 2010, such as:
— investing more frequently but in smaller amounts
— cautiously returning to investments in North America
— diversifying further into natural resources and energy
— looking increasingly towards frontier markets
— Chinese and Singaporean funds remain the most active
The report contains a lot of detail and some wonderful chart porn if you want to dig deeper, but far more interesting to us is a discussion near the end of the paper about the reasons certain SWFs are increasingly raising funds from private markets.
A few recent examples:
These are normally sovereign funds that have big stakes in real assets: government-linked companies, real estate, joint ventures. And in addition to straightforward debt issuance, the funds also issue bonds on their subsidiary holdings (backed by these real assets) and offer stakes in IPOs of holdings they plan on taking public.
There are some some obvious reasons for doing this. The added liquidity allows SWFs to keep their illiquid real-asset holdings while continuing to diversify elsewhere. And low interest rates make such financing cheap, which also allows sovereign funds to refinance their current debt into longer maturities. And when the debt is issued at home, it has the added benefit of developing local bond markets in countries that need it.
But there is another, less obvious reason. As we’ve noted before, sovereign wealth funds now occupy a strange place in the investment landscape. It’s often tough to discern if they more closely resemble government-backed hedge funds, sovereign shadow banks, economic weapons used for political ends, or something else entirely.
As the Monitor report emphasizes, raising private money can address some of these worries:
There are still concerns that some funds invest in a politically motivated manner to the detriment of other states’ economic or political interests. If the funds hold private, international capital, their critics have less room to take this line, as private investors are primarily concerned with financial, not political, return. Equally, funds might be seeking legitimacy from their domestic populations, particularly at a time when some SWFs faced criticism over their 2008 and 2009 losses. If private investors are willing to entrust their money to such a fund, this displays confidence in gaining acceptable returns. Bringing in private in- vestors thus may bolster a fund’s damaged domestic reputation. …
Having private bondholders or shareholders also forces a SWF to maintain or improve its level of transparency and reporting as well as corporate governance, which may bolster investor confidence in the fund. The practice also serves to improve a fund’s reputation by demon- strating both the apolitical character of its investment strategy and the independence of its management.
There’s more. If the private money is coming in the form of IPO stakes, the SWFs have new responsibilities:
The directors and officers of the fund are thus bound by fiduciary duties to act in the best interest of the sharehold- ers. Equally, the SWF has to take into account shareholder rights to vote on matters such as elections to the board of directors, which remove its ability to appoint their chosen candidates unilater- ally. Consequently, the government loses full control of the assets that the fund has accrued using government capital.
Sovereign funds, in other words, will have to be more aggressive in how they deal with their portfolio companies.
You can probably already see the main complications coming ’round the bend. One is that it signals the deeper integration of government into markets, which can make a lot of people queasy.
Another is that, not having stakeholders other than their governments, sovereign wealth funds have enjoyed the advantage of taking certain kinds of risks — longer-term, less liquid, less accessible — than other asset managers can afford to.
As a recent paper from the Oxford SWF Project explained, sovereign funds are frequently deciding between investments that are meant to “realise the benefits of technological innovation and the fundamental drivers of economic competitiveness” and those that are chosen as a way to beat a shorter-term performance benchmark. (That’s a simplification, but you get the point.)
Inserting private stakeholders into the mix only makes this a messier issue. The added transparency and accountability that come with taking private money can act as a constraint, pushing funds to take only risks that are deemed “acceptable” by the new stakeholders. It’s not entirely clear how this will influence returns later on.
This trend remains a very small part of the SWF universe, but it will be an intriguing one to watch in the coming years.
The self-denying sovereign wealth fund – FT Alphaville
Adventures in equity knife-catching, SWF edition (updated) – FT Alphaville