Saturday, September 06, 2008

Implications Of SWF

Many sovereign funds have had an awful run of late. All the equity injections by Singapore into UBS, Abu Dhabi into Citi, and Kuwait and Korea into Merrill Lynch are well underwater. The US$3bil investment by the Chinese in Blackstone is off about 40%. The UAE is down about 50% on its stake in Och-Ziff.

It may be easy to poke fun at their recent purchases, but how much do we really understand about sovereign wealth funds (SWF) and their implications on the financial markets? Let’s look at the top 10 SWF first:

Abu Dhabi InvestmentAuthority & Corp (ADIA), UAE(US$875bil with as much as 60% held in Index funds)

ADIA’s portfolio mix is 40%-50% North America, 25%-35% Europe, 10%-15% developed Asia, 10%-15% emerging markets. ADIA may be the largest emerging markets equity holder, prefers small stakes below disclosure requirements, significant private equity holdings. It has been reluctant to invest much smaller markets (like MENA equities) to avoid moving the markets.

ADIA asserts that its investments are solely commercial in nature, have no political agenda. 80% of ADIA’s holdings are entrusted to external managers.

ADIA no longer receives all of Abu Dhabi’s surplus revenues (Fitch suggests ADIA receives 70% with ADIC receiving the rest). ADIA has taken some recent significant stakes especially in financial sector (Apollo, Ares, EFG-Hermes; US$7.5bil equity injection to Citigroup). Mudabala, Abu Dhabi’s direct investment arm has stakes in Carlyle, AMD, Ferrari; and joint ventures with Boeing.

GIC Singapore(US$330bil)

It is better known for its high profile investing strategy in global real estate, but has taken some larger stakes more recently including US$6.9bil in Citigroup.

It plans to increase its investment in UBS inspite of losses on US$10bil investment made in January this year and US$1.5bil in Sintonia.

It is also rumoured to be the lead investor in a new TPG fund. GIC, along with ADIA, recently agreed on code of conduct for SWF with US.

Main point being that SWF decisions should be based solely on commercial grounds rather than geopolitical goals.

GIC manages from the country’s forex reserves and it posted an annual return of 9.5% (5.3% inflation-adjusted) over the past 25 years.

Its portfolio mix comprises 50% equities, 20%-30% fixed income, 20% private equity, real estate, commodities, of which 25% is managed externally. Investments abroad comprise: 45% US, 25% Europe, 10% Japan; others in emerging markets, hedge funds and commodities.

Government Pension Fund Norway (GPFN), (US$322bil)

Norges Bank Investment Management manages Norway’s US$322bil Government Pension Fund-Global. GPFN’s results tend to be watched quite closely as it is the most transparent sovereign fund and provides a benchmark for measuring other funds.

The latest quarterly report was for the period ended March 2008 – despite transfers of almost US$18bil from oil revenues, the fund was worth less (in a basket of currencies and in Norwegian Krone) in March 2008 than in December 2007.

Dollar weakness boosted the value of its large euro and pound holdings (about 60% of the portfolio). GPFN’s asset allocation is different from an ‘average’ sovereign wealth fund portfolio, being more exposed to fixed income than most funds and with no exposure to alternative assets.

Saudi Arabia Monetary Agency (SAMA), (US$300bil)

SAMA has mainly liquid assets, but includes some equities and higher risk bonds. Saudi Arabia has a higher share of wealth in private hands than other GCC countries.

Saudi private foreign assets likely exceed US$300bil, half of GCC total private external assets.

Government oil savings has been managed by SAMA which is not a dedicated investment fund like other GCC countries. Some 85% of Saudi Arabia’s foreign exchange reserves is in dollar-denominated fixed income.

Saudi Arabia is finalising plans for a new US$5.3bil investment fund, to invest in foreign equities.

With its large holding of dollar-denominated securities, Saudi Arabia has a significant stake in the fortunes of the US economy and may find diversification a challenge. Having said that, we can see why the US has such a special relationship with the Kingdom of Saudi Arabia. Not all SWFs are created as equals.

Kuwait Investment Authority (KIA), (US$250bil)

KIA manages at least US$300bil (March 2008), mostly in external assets, up from US$213bil a year earlier and US$166bil in 2006.

Of that, the Reserve Fund for Future generations (which receives at least 10% of oil revenues, managed US$218bil and the Reserve Fund managed US$46.5bil (up from US$174bil and US$39bil respectively in 2007.) JIA’s portfolio mix comprises 55%-65% equities, 15%-22% in bonds and 8%-12% in real estate, 4%-6% alts, 3%-7% cash. Of that, 76%-86% is roughly split between US and EU, 13%-17% Asian and Japanese, emerging markets 4%-6%.

KIA had famously invested US$2bil in Merrill and US$3bil in Citi in January 2008. Since then, KIA has made a deliberate change in strategy to target investments in high growing emerging markets in Asia, North Africa and CEE. In Asia they are focusing on Pakistan, India, China, Korea as well as Vietnam and Indonesia. It has significant holdings in Morocco and Egypt as well and may add East Africa to the mix. The fund just announced plans to triple investments in Japan to US$48bil.

China Investment Corp, (US$200bil)

CIC has invested or set aside US$100bil-US$120bil in Chinese financial institutions (stakes in recapitalised state banks and funds available for further recapitalisations). It has as much as US$90bil available for investment abroad. The investment plan, drawn up by Morgan Stanley, calls for US$70bil to be divided up into several mandates including emerging market equities, US equities, European bonds, each appointed to an asset manager decided through open tender.

A single institution will manage an additional US$7 to US$10bil, with a flexible investment strategy based on market trends (perhaps with a similar structure to the JC Flowers JV).

Outright investments taken on so far: US$3bil in Blackstone, US$5bil Morgan Stanley, US$100mil in China Railway IPO and US$100mil in Visa IPO. Significant transaction was the US$4bil stake in JC Flowers fund (80% of fund) targeting distressed financials.

HK Monetary Authority Exchange Fund, (US$160 bil)

Hong Kong’s Exchange Fund, managed by the Hong Kong Monetary Authority, supports the Linked Exchange rate system (dollar peg) of the Hong Kong dollar.

It also manages fiscal reserves of the Hong Kong government. Its value was over US$180bil at the end of 2Q08, but has suffered losses in the market sell-off.

Some 15% of the fund’s portfolio is in equities. It has been reducing its holdings of Hong Kong equities, which it acquired in 1998 to counteract attacks on the dollar peg during the Asian financial crisis.

HKEF has a long-term horizon and has averaged returns of 7% since 1994 Exchange Fund.

It had its best year in 2007 when it recorded a return of 11.8% in HKD terms as the Hang Seng soared.

HKMA has gradually reduced its holding of HK equities but maintains a share worth around 5% of its portfolio. Hong Kong’s exchange fund holds US$19.6bil in the Fannie Mae and Freddie Mac.

Stabilisation Fund of the Russian Federation (The Reserve Fund),(US$127bil)

Russia has two sovereign funds – the Reserve Fund and National wealth fund that manages US$129bil and US$32bil respectively - as of August 2008. Both funds were created in February 2008, emerging out of the Russian oil stabilisation fund which dates from 2004. For now they are invested in bonds, but the Ministry of Finance is expected to set a strategy for national wealth fund by fall. As it stands, these funds are included in the over US$500bil in foreign exchange and gold reserves managed by the Central Bank of Russia. Russia had around US$100bil in US agency bonds at the end of 2007 but now holds less than US$50bil.

For now, both funds invest 80% in foreign government bonds, 15% in bonds of foreign government agencies and 5% in international institutions.

Temasek Holdings, Singapore(US$108bil)

Temasek was started in 1974 with Ministry of Finance as the sole shareholder. It has over US$70bil foreign assets (may be much lower owing to US financials), and has posted an impressive average annual return of 18% compounded, and 19% in past three years. I have my doubts on whether Temasek would want to highlight its performance in 2008 somehow.

Significant financial sector holdings include StanChart, Merrill and some local banks which made up 38% of its portfolio in 2007.

It has growing overseas investment in real estate and banking especially in India and China.

In Feb 2008, it invested US$600mil in Merrill Lynch, followed by another US$900mil in July in spite of suffering whopping losses of some US$4.4bil on this investment last year.

It recently raised its stake in Standard Chartered to 19%. After running afoul of Indonesia’s anti-monopoly laws and in Thailand, it vowed to avoid ‘iconic’ stakes and focus on minority holdings. For an investing icon, Temasek has shown very little appreciation of the differing cultural nuances and political landscapes in the region. It needs to know and understand its neighbours better as professionalism will only get you so far.

Central Hujin Investment Corp (CHIC), China(US$100bil)

Central Huijin is the investment vehicle that manages the PBoC’s investment in three big state commercial banks.

Implications: In recent years, many Sovereign Wealth Funds have emerged with ballooning coffers. Proper reinvesting of trade surpluses and reserves partly explains that trend but the majority of them have basically recycled the petrodollars back into the financial system.

With that, it would be foolish for US and Europe to make life difficult for SWFs.

Most SWF are amenable to “rules and regulations”, are willing to stay away from “politically-sensitive” sectors, and acquire only minority stakes in major companies.

The sheer size of these SWFs imply that only the world’s largest 500 companies are likely to fall under their radar. That also means that these large corporations stand a better chance of seeing improvements in their valuations and the same goes for the sector and the rest of their peers.

Buffett refers to SWF as “innocent money”. CNBC went further and called them “dumb money”, thanks to the recent poor entry points in pumping capital and buying shares in financial firms.

But I do not think that is fair comment. They are neither silly nor dumb. Looking at their size alone, they know very well that it will be very difficult to buy big into major financials in normal conditions.

Hence they are likely to grab the opportunity when these financials are in distress and seek capital.

These SWF may end up paying higher than what the “real valuation” would dictate, but it’s a significant chance to take up a very strategic stake in global giants of the financial world. Though the recent losses may make them look stupid, over 5-10 years, this may not necessarily be so.

Their strategies are more or less similar. They want exposure in top global players in the field of finance and telecommunications, followed by resources and port facilities.

Owing to the media frenzy and negative coverage on their acquisitions, we are likely to see more SWF buying stakes in major private equity firms.

This will allow a front for them, and at the same time these private equity firms (e.g. Blackstone, JC Flowers) will show the SWF the deal flows, hence allowing them to participate without having to be upfront on them.

The recycling of these funds back into equity markets either via bailouts or minority stakes will be an important source to rebalance the markets.

Previously, big companies were allowed to fail or the government would have had to intervene to prop them up. Now, SWF will act as the new lender of last resort whenever there is a crisis.

By recycling the trade surpluses, petrodollars and reserves, SWF are actually helping to recouple, reallocate and recycle global capital. We should regard SWF as a stabilising force in future financial crises.

Over the longer term, these SWF are likely to repatriate returns to finance their own countries’ budget deficits. Hence, they are essentially cranking up the long-term pressure on their local currencies to appreciate

p/s photos: Coco Chiang Yi

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