Elephantine sovereign wealth funds trying to fly “below the radar”

Private Equity 31 Jan 2011

It seems that sovereign wealth funds are the latest “scary” thing in the media – perhaps scarier than high-frequency traders, Irish banks, Greek tax collectors or U.S. subprime borrowers. But there’s a difference: where the latter may blow up an economy, SWFs merely threaten to take it over, or at least its commanding heights (whatever those are these days).

Sovereign wealth funds are not a terribly new idea of course: Kuwait’s sovereign wealth fund dates back to 1953, Norway’s to 1967. But, with assets of around $3 trillion today, they could shortly expand to $9 trillion or more – almost the size of the U.S. national debt. Sobering numbers to be sure. A recent McKinsey study, which we reported on in September, identifies SWFs as one of five regions in the asset management universe that are likely to grow significantly in coming years (along with ETFs, alternative investments, international investments and retirement assets).

More intriguing however, is not so much what they buy, but why and when. Obviously, there are strategic investments involved, such as energy assets in Canada. That’s if the SWF doesn’t draw its assets from energy. Why double up? Then there’s agricultural land in Africa, where it might serve as a hedge against desertification. Then again, it might pay better than foreign currency reserves earning next to nothing in U.S. T-bills.

A new paper by Sofia Johan, April Knill and Nathan Mauck, “Determinants of Sovereign Wealth Fund Investment in Private Equity,” looks at one promising area: .

According to the paper, they found that “SWFs investments are more often in private firms when the market returns of target nations are negatively correlated to the market returns of the SWF nations.” Sounds like sensible asset allocation. Still, there’s more to it.

They examined 50 SWFs across the globe, covering 903 public and private transactions, canvassing a pair of hypotheses. The first is the financial one – to get the best returns. The other is to seek a strategic – or non-financial – advantage, despite less-than-rewarding returns (another blow to the efficient market hypothesis, one might argue).

As the authors note, “SWFs make investments in public and private firms for both financial and non-financial, more strategic reasons. Investments in privately held firms are however riskier. If SWFs have purely financial motives for investment, we would expect SWFs to invest in private firms based in nations with stronger legal environments to mitigate idiosyncratic risk. If, however, SWFs invest for strategic reasons…we would expect SWFs to invest in private firms based in weaker legal environments.”

Weaker legal environments? In the aftermath of the Great Recession – the awesome bonfire of valuations from Lehman Brothers to AIG – it’s sometimes hard to distinguish a weak legal environment. But SWFs aren’t necessarily passive victims of systemic failure (though some did lose a bundle on U.S. investment banks). Their “strategic reasons may be as innocent as piggy-backing on existing firms to develop skills in acquirer nations to the slightly more suspicious such as obtaining defence-related technology…or access to scarce resources or vital infrastructure. Likewise, SWFs’ strategic focus appears to come at a cost of sacrificed financial returns.”

In any case, there has been a decided shift to private equity. (See chart below from the paper.)

With private equity, Johan and her colleagues postulate that “SWFs may be more interested in increasing earnings by investing in riskier, potentially high-yielding direct private equity in addition to further diversifying their portfolio holdings. […] Analogously, one could imagine a scenario where SWFs, who are sometimes blocked from investing in large, public firms, seek to invest ‘below the radar,’ that is, take advantage of public versus private regulatory arbitrage by investing in the less scrutinized private equity.”

Notably, the authors divided their sample pool into two: SWFs whose assets are derived from energy and SWFs whose source of funding comes from foreign exchange reserves. However, there is no difference in investment behaviour between the two.

To get at the possible objectives of going private, Johan and her colleagues look at market correlations, legal conditions and bilateral relations. Market correlations would indicate a desire for diversification. Weaker legal conditions and divergences between governments might indicate a non-financial motive.

They conclude:

First, the results suggest that SWFs invest significantly more in direct private equity as a proportion of all target firms in nations that have a legality index lower than in the SWF nation. This result … suggests that SWFs that invest for strategic reasons are more likely to invest in nations with less sophisticated legal systems.

However, the notion that SWFs are investing under the radar because of awkward political relations finds no statistical support. Instead, “the results suggest that SWFs invest in a higher percentage of private firms versus public firms when political relations are better than the median.”

On the other hand, “the results suggest that SWFs invest in a larger proportion of private firms in nations where there is negative market correlation.”

Now, which is the chief factor: diversification or political calculation? Mostly it’s market correlations. But sometimes deteriorating political relations predominate.

One policy consideration falls out of this: For nations wary of SWFs, you can protect your private equity sector by turning scary monsters into good friends and neighbours.

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