THE SOVEREIGN CONCERN

As oil and gas prices soar, the coffers of sovereign wealth funds (SWFs) based in the Middle East, Russia and Norway are being swelled dramatically. Meanwhile, in October the Chinese government’s sovereign wealth fund Chinese Investment Corp (CIC) was launched with an initial endowment of US$200bn.

An estimate by Morgan Stanley earlier this year put SWFs’ assets at up to US$2.5trn, which would put them ahead of the global hedge fund industry. SWF assets are believed to be growing by about US$500bn a year and within five or six years total SWF assets could equal the official reserves of all countries, according to Morgan Stanley.

This wealth needs somewhere to go, which is why there has been a spending spree by some SWFs, buying businesses or taking equity stakes in numerous European and North American companies. Inevitably, there have been some clashes with private equity houses in the pursuit of assets. For example, a private equity consortium was interested in UK supermarket chain Sainsbury before the Qatari SWF Delta Two developed its (subsequently unsuccessful) bid.

On the other hand, many of the larger buyout houses are targeting SWFs to be limited partners in their funds or, in some cases, taking direct equity stakes in private equity firms themselves. The growth of SWFs also provides a potentially new source of exits for buyout funds.

There is also a broader, political element to the growing power of SWFs. Their increased wealth is down, in large part, to higher oil and gas prices and to global trade imbalances. Higher energy prices are giving countries such as Russia and the Gulf states an immense windfall in their earnings, while countries such as China are accumulating massive foreign exchange reserves thanks to their trading surpluses.

The older SWFs, such as those from the UAE, Kuwait and Norway, were generally regarded as friendly to the West and often restricted their investments to passive holdings, such as US Treasury bonds. But today’s SWFs are more aggressive acquirers of companies and those from countries such as China and Russia less obviously pro-Western. This has led to concern among some EU governments, such as Germany, and the EU Commission is considering how to respond.

Last month, a report commissioned by the British Private Equity and Venture Capital Association (BVCA) called for SWFs to be included among funds that will be urged to follow a new set of disclosure guidelines. The new code will ask funds to publish more detailed accounts for UK companies they own that have more than 1,000 employees. There would also be annual reports on those companies describing the funds’ management and investment strategy.

The report was commissioned following criticism by UK politicians of the secrecy and lack of transparency in private equity funds and was written by former banker, Sir David Walker. It called for more disclosure but the guidelines will only be voluntary.

Private equity houses have complained that if the guidelines only applied to them, they would be at a disadvantage compared with other non-listed companies. In response, Walker said he had held talks with the Qatari fund that backed the Sainsbury bid, which he said had agreed to comply with the code.

At the report’s launch, Walker said: “If these people want to be able to continue to invest here, they will strengthen their position by conforming to high standards and best conduct. The funds are in many ways private equity-like. It’s a good principle they should observe the same set of guidelines.”

But others are sceptical that there will be any substantial adherence to the code by SWFs. “I doubt it’s even on their radar and I can’t see how it would be imposed on them in any case as they’re based overseas,” said one. “It’s different for us because we live in the UK.”

So, are SWFs a threat to buyout houses because they bring increased competition for assets, or are they a positive development in offering new exit opportunities and investment?

First, the potential threat. While there have been cases, such as Sainsbury, in which an SWF has nearly beaten off private equity interest to acquire a company, it can be argued that frequently the two kinds of fund are after different assets. Generally, SWFs are looking for more mature and less operationally complex companies than many buyout houses are seeking.

An example of how this works in practice is hotel chain Travelodge, which was originally acquired by Permira in 2003 and then sold to SWF Dubai International Capital (DIC) in 2006. A source at Permira says that acquiring and transforming Travelodge, which was a carve-out from Compass, was a complex task and not one that most SWFs would jump at. When DIC acquired Travelodge, it was buying a company in much better shape, he says.

As for the Sainsbury example, some in the buyout industry would argue that it was not necessarily an appropriate target for private equity in the first place, as it was regarded as a fairly well-run company, but that perhaps the private equity consortium that considered bidding for it last April was caught up in the general fever around acquiring ever-larger businesses.

Another executive at one of the large European buyout funds argues that firms such as Permira, Apax and some others have spent many years building up their infrastructure and expertise. They have networks of offices across Europe and globally, deep pockets and highly experienced deal-doers.

“The SWFs don’t have the operational expertise or the processes to transform companies in the way that we do and sell them on at a profit, and I think they recognise that,” he says, adding that the SWFs are generally targeting stable and low-growth businesses, often related to infrastructure. “That doesn’t bring them into competition with us but perhaps it would with some other private equity houses,” he adds.

When it comes to the potential benefits of SWFs, one is that they are likely to provide a new market for exits, particularly if they want to avoid businesses that need a lot of operational restructuring.

Buchan Scott, a partner at mid-market house Duke Street Capital, says: “I don’t think the larger buyout houses are intimidated by the prospect of more competition, but see SWFs as another exit route. Having more players in the market can be a good thing for everyone.”

The SWFs probably recognise that they don’t want to compete head-on that much with the private equity houses, says Scott, and instead are looking to get their own exposure to private equity as LPs or taking stakes in buyout houses.

In May, for example, the Chinese SWF bought a 9.9% stake in Blackstone by investing US$3bn in Blackstone’s listed vehicle. In September, Carlyle sold a 7.5% stake to a fund of the Abu Dhabi government, while in July Apollo had also sold a stake to a different arm of the same government.

European houses, particularly Apax, are believed to be pursuing a similar strategy. The approach brings the benefit not only of new capital but also the prospect of preferred status in bidding for assets in the SWF’s host country.

Coming in as LPs is the other way that SWFs are gaining exposure to private equity. Buchan Scott says that it is not just the SWFs that are showing an interest in buyout funds but also other overseas government-related entities, such as post offices.

SWFs are believed to have dramatically increased their presence as LPs in funds raised by the mega funds in the last couple of years. The arrival of SWFs was one of the main reasons that the larger buyout funds were able to double their fund sizes in the last cycle. And SWFs are still needed.

This is because other traditional LPs, notably US state pension funds, are finding it difficult to continue with large investments in buyout funds because of concerns that they will exceed their allocations, having made such good returns from private equity in recent years.

All the big buyout funds are, therefore, busy courting SWFs, some because they want to attract them as future LPs and others for a more permanent arrangement, such as an equity stake.

One director says: “We’ve all done our research on SWFs and looked at how to develop relationships with them. We see a lot of potential for partnerships.”

He adds, however, that the pressure is on the big funds to be able to demonstrate to SWFs the value they bring, saying: “We’re all having to prove that we have the expertise, that we know how to pick the right companies and transform them, and that we haven’t just done well because of a rising market.

“That’s why we’re all investing in new infrastructure, cost base and expertise, so that we can stay part of that select group of eight or 10 firms that are globally competitive.”

A source at one of the leading US houses says: “This idea of SWFs being a threat is got up by the media because it’s a good story, but the reality is that there’s room for all of us. Private equity only has a small percentage of global capital markets and the SWFs are bringing new capital.”

Another director echoes the claim that the media are overplaying the arrival of SWFs, saying: “A year or two ago, all the newspaper stories were about hedge funds and how they had a lower cost of capital and were more flexible than buyout houses and would wipe the floor with private equity, but it didn’t happen.”