Sovereign Wealth Funds, whiich are creations of foreign central governments and structured like private equity corporations to realize better returns when investing their excess foreign exchange reserves, have sustained some significant and very public losses over the past year and a half, including what turned out to be a perhaps ill-timed investment foray, albeit non-controlling, into some of the world’s largest financial institutions.
The sovereign nations that benefit from the SWF investments must clearly be disappointed in their recent performance. However, a key advantage of SWFs is that they do not answer to a pool of investors or limited partners and as a result can weather downturns without the added pressure of redemptions that other pools of capital have struggled with recently. Even as asset values in their portfolios decrease, additional funds are being contributed to the SWFs, typically as a by-product of continuing commodity exports. In contrast, hedge funds and private equity funds do not have that luxury and such differences may put them at a competitive disadvantage relative to SWFs as world markets eventually begin to recover from the credit crises.
In a post-credit crunch world, the same advantages that SWFs have previously enjoyed will continue to play a significant role, such as ready access to less costly capital; a willingness to underwrite to lower return thresholds over longer hold periods (i.e, to be patient capital not prone to flight risk or capital calls); and an ability to invest at higher equity to debt ratios. These advantages, as well as the lessons that SWFs have learned during the past investment cycle and changes in the credit markets, could well propel SWFs into an even greater role in global investing in the next decade and beyond. SWFs have learned that greater transparency, accountability, and the hiring of more diversified investment professionals could well lead to much less fear and greater acceptance within the world investment and political communities.
As markets continue to contract throughout the world, countries that are home to many of the largest SWFs are facing declining revenues from decreased foreign demand for their exports, including commodities (most importantly, oil). As a result, many SWFs are facing pressure from local stakeholders to provide investment capital to local markets instead of using their capital to provide stabilization abroad by rescuing failing foreign companies, in particular financial institutions. SWFs more recently have been focusing on smaller deals, closer to home, but they have not retreated from pursuing their more traditional targets in the world’s most dynamic economies. In fact, a number of recent deals such as Chinalco/Rio Tinto, make clear that natural resource-related foreign investments (with off-take features) may be a significant focus of SWFs in the future.
Short-Term Losses, Long-Term Growth
A Morgan Stanley research report recently estimated that SWFs collectively may have lost between $500 and $700 billion in 2008, which if correct, would reduce the total holdings of such funds from a high of $3 trillion to $2.3 trillion. However, Morgan Stanley also estimated that the funds would grow to $2.5 trillion in the short term, within the next 12 months. Other estimates have put the total at $3.9 trillion prior to the downturn and had predicted assets to grow to more than $5 trillion by the end of 2010. The United Nations estimates that the SWFs collectively have already passed the $5 trillion mark. No matter which estimate is to be believed, SWFs now control pools of capital larger than that of the world’s hedge funds or private equity funds, and are likely to grow at a faster pace given their sources of investment capital
Since initially appearing on the investment scene more than fifty years ago, SWFs have not only continued to grow assets under management but have begun in recent years to proliferate as well. Most estimates put the number of SWFs at greater than forty, a dramatic increase from just 10 to 15 years earlier. Many of the newer SWFs, particularly in Asia and the Middle East, have been established by countries that have significant foreign exchange reserves generated by export trade. As their size and number continue to grow, there is little doubt that their influence will continue to grow as well, and many constituencies are concerned with how this influence will manifest itself. In recent years, there has been an increased focus on how such influence will be wielded and how best to integrate SWFs into the world investment community. Many sovereign governments, such as the United States and Great Britain, and many world bodies, such as the United Nations and the International Monetary Fund, have either undertaken new studies of SWFs or instituted new rules designed to control or influence their behavior and investments.
Transparency: “The Santiago Principles”
In October 2008, the International Working Group of Sovereign Wealth Funds published a voluntary code of conduct for SWFs called “Generally Accepted Principles and Practices,” also known as the “Santiago Principles.” The codified principles, which are contained in a detailed report, include 24 separate principles that cover the legal framework, objectives, coordination with macroeconomic policies, institutional framework, governance structure, and investment and risk management framework of SWFs. The principles are in part a response to criticism voiced by Western governments and commentators regarding the activities of SWFs. They are intended to improve the understanding of SWFs as economically and financially oriented entities in order to, among other things, help forestall unilateral protectionist measures targeting SWFs. Some of the principles call for annual reporting, auditing to international standards, management independence from ownership, a financial rather than political focus and, in general, greater verifiable transparency.
Many commentators believe that the SWFs that embrace greater transparency in general and the Santiago Principles in particular will have a much easier time breaking down existing barriers of fear and suspicion and thereby gaining acceptance abroad. For example, in the case of Dubai Ports World’s purchase (and subsequent partial divestiture) of Peninsular and Orient Steam Navigation Company, which included certain U.S. port operations managed by its port operations subsidiary, the transaction had actually passed the scrutiny of the U.S. Committee on Foreign Investment in the United States.
The issues and controversy surrounding the purchase were not raised by regulatory officials but rather by news commentators, members of Congress and internet bloggers. In this case, perceptions in the local community about the investor and its motives actually drove a public debate and the subsequent decision by Dubai Ports World to voluntarily divest the assets in question. U.S. political reaction was also demonstrated earlier when the 70 percent Chinese state-owned CNOOC tried to buy Unocal in 2005. The political opposition was so strong that CNOOC was forced to accept Chevron Texaco’s lower bid. SWFs around the world took note of these developments and undoubtedly learned important lessons regarding public perception and transparency. SWFs that adopt the Santiago Principles and publish independently verified information about themselves, their holdings and their motives should experience much less of the fear that is generated by the unknown.
Regulation Of SWF Investment
Last June, the Organization for Economic Co-operation and Development (OECD) released a report, which it had undertaken at the request of the Group of Seven industrialized nations, detailing its conclusions after studying the issue of whether or not additional guidance or controls were needed to deal with SWF investment. The report concluded that member countries already had at their disposal sufficient guidance to deal with SWF investments and that any national security exemption blocking inbound investments should be used with restraint.
The United States created the U.S. Committee on Foreign Investment in the United States, known as CIFIUS, more than 30 years ago to review the national security implications of foreign investment in U.S. companies or operations and has been recently updated by the Foreign Investment and National Security Act of 2007. The committee is an inter-agency group chaired by the Secretary of the Treasury and includes representatives from nine different government agencies, including the Departments of Defense, Homeland Security, State and Commerce. Foreign investors proposing to acquire a U.S. business that may affect national security or the country’s critical infrastructure are encouraged to voluntarily notify the committee. However, the committee reserves the right to review any transactions whether or not voluntarily submitted.
The initial review calls for a 30-day period during which CIFIUS will either take no action or begin a statutory investigation. A statutory investigation triggers another 45-day period during which the committee decides whether to permit the acquisition or order divestment. Any foreign investor that does not voluntarily file runs the risk of the committee unwinding the transaction after it closes. Transactions that would result in foreign government control would typically be expected to trigger the second review period. However, in practice, most transactions are approved without issue and the vast majority of foreign investors proposing transactions in sensitive industries choose to file. One perceived advantage of a CIFIUS-type approach is that foreign investors have a set of guidelines, albeit not crystal-clear, to help determine whether or not a particular investment is likely to require additional review and possible prohibition.
SWFs will continue to play an increasingly influential role in foreign investment worldwide, particularly in OECD countries, and will find greater acceptance in turbulent markets where they are seen as having a stabilizing effect. SWFs that adapt to new pressures to provide greater transparency by complying with developing international standards, such as the Santiago Principles, likely will have an advantage over those that do not, particularly in the United States, where regulation, public sentiment and perceptions regarding foreign investment are more pronounced than in most other OECD countries. That sentiment, of course, may be impacted by the increasing U.S. Government role, short of outright nationalization, (and perhaps de facto SWF-type government investments) in banks, other financial services providers and non-bank companies and industries. In the investment cycle following the credit crisis, it is likely that SWFs will use their advantages to compete successfully with other pools of capital such as hedge funds and private equity funds. The SWF investment activity to date is very likely just a prelude to a much greater role for SWFs in the future.
Mark G. Pedretti serves as Chair of the Private Equity Group and as Deputy Managing Partner of Reed Smith’s New York office. He specializes in the areas of private equity, mergers and acquisitions, securities, and transactional intellectual property matters. He can be reached at email@example.com. Patrick F. Rice is counsel and serves as Deputy Chair of the Private Equity Group in Reed Smith’s New York office. His practice focuses on corporate and securities law, with an emphasis on the representation of clients in mergers and acquisitions, divestitures, corporate finance, and general corporate and securities law matters. He can be reached at firstname.lastname@example.org. Nicole K. O’Sullivan, an associate in the Corporate and Securities Group in the firm’s New York office, assisted in the research for this article. She can be reached at email@example.com