California scheming

The legislators were primarily targeting SWFs which are linked to governments that have not signed up to certain international human rights treaties.

The proposed legislation, known as the Responsible Private Equity Act, or AB 1967, could have affected investment by the huge public pension funds CalPERS (California Public Employees Retirement System) and CalSTRS (California State Teachers’ Retirement System). The two funds have significant investments in private equity. CalSTRS, for example, has total assets of around US$166bn, of which US$15.5bn are in alternative investments including private equity. Last year private equity was CalSTRS’ best-performing investment class.

The bill was introduced into the California legislature by Democratic assemblyman Alberto Torrico and the trade union Service Employees Union International. Congressman Torrico was the only sponsor of the bill in the legislature – he is a former assistant majority whip, which suggests he has experience on how to get bills through the legislative process. On the other hand, the two large pension funds have been the target in the past of attempts to use them for political ends, such as trying to force them to invest more locally, and they’ve usually succeeded in maintaining their investment freedom.

The bill is part of a groundswell of suspicion towards SWFs across the US and, increasingly, parts of Europe, says Jan Randolph, head of sovereign risk at economic and financial analysts Global Insight. “It’s part of a growing move towards financial protectionism that is coming to the surface and has been partly triggered by the credit crunch and the subsequent stakes SWFs have taken in Western banks,” says Randolph. He adds that the big question policy makers are asking themselves is whether SWFs are “vultures or white knights”.

The bill’s text states that California public pension funds invest in PE firms “owned in significant part by SWFs…that rank among the least transparent and that are funded by governing regimes repeatedly found to have violated basic human rights.” Even if a SWF’s government had signed up to the relevant treaties, the bill says that the pension fund would still need to evaluate the SWF before committing to an investment. The pension fund would need to issue detailed written reports on the SWF’s transparency, democratic practices and other factors.

Several of the largest US private equity firms have accepted SWFs as investors in the past year. China Investment Corp bought a stake in Blackstone, Abu Dhabi-based Mubadala Development Corp owns part of Carlyle Group and the Abu Dhabi Investment Authority holds a major stake in Apollo Management. SWFs have also bought into capital-needy banks, such as Citigroup, Morgan Stanley and Merrill Lynch. There are also reports that SWFs are investing up to US$10bn into funds managed by PE houses TPG and JC Flowers.

Jan Randolph argues that there is a particular attraction among SWFs for private equity funds. Both SWFs and PE firms prize secrecy and don’t like regulation, he says. “SWFs like private equity because it’s less subject to reporting than public companies and it could provide some cover for SWFs that have some notoriety.”

But, unlike some of the legislators, Randolph does not believe the SWFs’ role in Westerns banking markets has been negative: “With the financial crisis in the West it’s emerging markets that have come to the rescue, in the guise of sovereign wealth funds, which is a reversal of the situation in the 1990s.” He adds that SWFs have helped calm the market’s nerves more than Western governments, which have tried to provide liquidity but not capital.

There is some uncertainty about whether the California bill, should it pass, will actually force PE firms to become better corporate citizens as the funds they can expect to get from SWFs may far outstrip those available from the state’s pension schemes.

There is also the argument that, to be consistent, the California legislators should be seeking to outlaw investment in any public company that has an SWF as a shareholder. This could prevent investment in a whole host of blue chip stocks, beginning with several of the Wall Street banks.

Arnab Das, global head of emerging markets at Dresdner Kleinwort, believes that SWFs need to address the fears of Western politicians that they are seeking to buy political influence rather than simply make commercial investment decisions. Das believes SWFs are likely to face the least political pressure from politicians in California and elsewhere if they behave as passive investors at arm’s length from their stakes, whether as creditors or equity stakeholders. “From this perspective, they are likely to benefit from the activism of shareholders with a long and well-known institutional track record of behaving in the best interests of all shareholders by taking the long, but commercial/economic view.”

He adds that G7 democratic political systems find it incongruous and intrinsically at odds with their values that government-owned and controlled investment funds can operate with public resources in private markets: What is called into question by this, he says, is the theory that capital and other resources, such as managerial and technical capital, are efficiently allocated through free-market price systems.

SWFs in the newly capital-rich countries, particularly Russia and China, also present concerns in the geopolitical sense, for some policy makers, he adds: “Unlike the more transparent players like Norway, or others with a longstanding track record like Singapore’s GIC or Abu Dhabi’s ADIA, they are neither from Western-style democracies, nor are they in the clear geopolitical ambit of the United States.”

Das supports plans by the IMF to draw up a code of conduct for SWFs and believes that initiatives such as this could take the sting out of suspicion by some politicians. “The SWFs should consider signing up voluntarily to a code of conduct, as and when promulgated by the IMF and OECD, and also join forces at arm’s length with activist Western shareholders.”

One private equity director, who asked not to be named, says he does not expect the California bill to be passed. If it is, he expects it will be repealed at some point in the future because he believes that such legislation often fails to meet its objectives. He points, for example, to the Sudan Accountability and Divestment Act, which was signed into force by President Bush at the beginning of this year, and which will allow state and local governments to withdraw investment from companies that do business in Sudan. The law is aimed at putting Sudan under pressure to end the violence in the Darfur region but, according to Kubr, may actually have unintended consequences, such as penalising companies that supply the Red Cross with syringes bound for Sudan.

Thomas Kubr, chief executive of private equity group Capital Dynamics, says that if the California legislation goes through it would be “terrible” news for the pensioners that belong to CalPERS and CalSTRS because it would put pressure on their funds’ ability to deliver returns. CalSTRS itself makes a similar point, noting that in 2007 private equity was the best-performing investment, posting a 33% return. The bill would increase the pension scheme’s costs, both to its portfolio and to its operations.

CalSTRS estimates that it could have to forego some US$1.5bn in revenue in the next five years if it had to give up its investment in PE firms Carlyle Group and Apollo Management, which are both partially owned by SWFs linked to the Abu Dhabi Government. If other PE firms that CalSTRS invests in also accepted SWFs as shareholders, the pension fund would have to forego around US$5.3bn over five years. Following a vote by the pension fund opposing the bill, in early March, CalSTRS chief executive Jack Ehnes said the proposed legislation, “ignores the realities of the global financial marketplace where sovereign wealth funds are passive investors in a growing number of the most attractive investment opportunities in the world.”

A statement from CalSTRS said the pension fund had had policies for more than 20 years to help define the role of social risks in making investment decisions. Most recently, in 2007, the trustees had decided to support the principles for responsible investment, a scheme in partnership with the United Nations Environment Program Finance Initiative and the United Nations Global Compact.

Ehnes added that, due to the trend towards blending of public and private ownership structures, the bill could also apply to real estate and fixed income investment vehicles. This would put more pressure on the pension fund in the coming years, as CalSTRS faces a shortfall of nearly US$20bn in its long-term benefit liabilities.

Buyout firm directors are believed to be irritated that that private equity is being targeted by some politicians in California. One director argues that, by and large, private equity plays a positive ethical role in world markets: “I’ve seen a lot of business sectors in my time and private equity is extremely ethical. That’s because it has to take a long-term view on its investments, which means it is in the firms’ interests to see that companies are well run and the kind of short-cuts for a quick buck that some other Wall Street players have engaged in are not generally part of private equity.”

If the bill, which was introduced in February this year and is still under discussion, did become law it is unclear what the stance of the large PE firms would be. Given the huge sums available to the SWFs it is possible that PE houses would prefer to have them as investors rather than having the California pension funds, with all their demanding investment requirements.

It would be another matter if other large US states followed the California example. The trade union supporting the bill in California would probably seek to get similar legislation enacted in other states. In that case the PE firms affected would probably have to say no to SWF funds. But some in the private equity industry believe that California would find itself relatively isolated and a large-scale movement across the US is unlikely.

There have also been arguments that CalPERS and CalSTRS act in a similar way to SWFs and that the California legislation is hypocritical. As well as being LPs in private equity funds, CalPERS has taken direct stakes in buyout groups. One private equity director says: “In a way, the politicians that are suspicious of the SWFs because they see them as wanting to using private equity firms for their own influence, are actually behaving in a similar way themselves. They are using the public pension funds to promote their own ideas.”