RGE MONITOR 9/17/08 Sidelined sovereign wealth… Rachel Ziemba

RGE MONITOR

9/17/08
Sidelined sovereign wealth…

Rachel Ziemba

In the midst of the financial meltdown, many people have been wondering where the sovereign wealth funds are or rather what their long-term role might be in providing capital. The financial sector has been a major focus for sovereign investors in part because such investments dovetailed with domestic financial development goals – and investing in asset managers was also a conduit to other investments. As some people have noted, only nine months ago, sovereign wealth funds were first on the scene to recapitalize the banking system, taking a series of stakes in Merrill, Morgan Stanley, Citi, UBS – it added up to about $42 billion within the space of a few months or just under half the capital raised in the Q4 of 2007 and Q1 of 2008. (a list of all sovereign fund recaps in major global banks). However, overall capital from sovereign funds now makes up less than a fifth of the total capital raised by U.S. Institutions in the last year. It also pales in comparison to the funds provided by central banks in the period.

However since before Bear Stearns blew up sovereign funds have been pretty non-existent in the recapitalization business– especially in the U.S. market. Qatar's involvement in the Barclay's rights issue was a notable exception, but that was the U.K. The only notable stake in a U.S. financial institution this summer was Temasek's decision to increase its stake in Merrill by putting in an additional 0.9% after also converting its previous holdings into the newly issued common stock – It and other sovereign investors are likely rather worried about the implications of the BoA takeover and the conversion rates, though some reports suggest that the premium BoA will pay on Merrill stocks could mean a slight profit for the sovereign investors. Now instead of foreign capital, the U.S. government is stepping in to bailout AIG, as it did with Bear Stearns. So what's driving sovereign capital and why have they stepped back from financing?

There could be a number of explanations – and odds are it's a combination. And first a caveat, its very hard to talk about sovereign funds in aggregate – they vary greatly. So much of the discussion below concerns a group of the more active funds.

[Note, most of the links point to related RGE spotlight issues which can be accessed through blog registration.]

1. Licking their wounds. Since the large recapitalizations have lost money so far (if the holdings they have are marked to market, which they may not be), funds might be reluctant to get back in the water. In other words, they might have invested too much too soon. While it is hard to calculate losses given that many of the investments were in preferred shares, its not hard to assume that sovereign funds hoped for better pay off now and in the future. Even the high coupon payments they negotiated fail to offset the fall in share prices - and may have assumed falling prices. Furthermore, some were smart enough to require compensation if the institution issued more common stock (KIA, KIC and Temasek with Merrill) The jury is still out though. Many of the high profile investments in equities in the financial and non-financial sectors have fallen over the past year. Furthermore if sovereign funds probably weren't immune to asset market losses. Take the GCC as an example. if the funds held an indexed portfolio, their losses on equity and alternative assets may have offset any gains from new transfers from expensive oil.

2. Pricing issues – in the current climate, pricing the value of securities and underlying companies is very difficult. And pricers have been consistently, over optimistic. And a pervasive buyers strike has set in, some of the sovereign funds and other may wish they had been more sanguine. If we are far from the bottom – an assuming the persistence of toxic waste and other unpriceable assets on the balance sheets of many financial institutions, many investors are in wait and see mode – or sell before losses increase. Either way it is a hard time to do due diligence. The sovereign funds may not want to get weighed down with companies that have a lot of bad debts, especially given paper losses. Especially if the purchasees want more for their assets than the buyers want to pay (eg Lehman). The uncertainty about the value of assets may mean that sovereign funds are among those pools of capital waiting for the bottom. And that could still be far off – and despite their long-term focus they might prefer more liquid assets.

3. Overexposed to the financial sector? Seeking new Partnerships?– as a group, sovereign funds have a large exposure to the financial sector. Temasek alone has 38% of its portfolio in financial institutions. Some may have already gained the exposure to the international banking system they sought. In a survey of the direct investments of GCC funds, I found that financial sector captured over half the identifiable stakes taken by the funds in 2007. This concentration matches with policy objectives of the sponsoring countries, many of which have financial development as a key policy goal. Many have stakes in both local and international conventional and Islamic financial institutions. Yet other sectors are also being targeted for partnership, Abu Dhabi's Mubadala (which incidentally got its first ratings yesterday) which suggested it was giving financial institutions a wide berth, has targeted energy (GE linkup), aerospace, metals and several others . Overall more countries are seeking out foreign investments that benefit domestic economy or co-investments (joint ventures). In contrast the financial sector might be more trouble and cost than it is worth. However, it is also a reflection that different institutions target different sectors, other entities in Abu Dhabi, from ADIA or the Investment council might be more focused on banks than Mubadala. At the same time many companies are looking for the kind of guarantee business that investment from a sovereign government might bring.

4. Not quite so much money – most estimates of sovereign wealth emphasize the stock not the flow (new capital) of funds. While sovereign funds have a lot of assets under management – well over $2 trillion, that doesn't mean that all that capital is available. Odds are new capital available last year was more in the neighbourhood of $300 billion and slightly more this year given higher oil prices and persistent surpluses in many Asian countries.

5. Small stakes aren't enough for the financial woes- In a climate like this, its not just about the money. Lots of money has been injected into the system but that the issue is that misallocations still exist. For the most part, at least in the US and EU, sovereign funds still tend to take small stakes (under 5% in most cases) and the risk for an institution like a faltering broker dealer is its role in the financial system and interaction with its counterparties. Research from the IMF and ECB suggest that sovereign capital injections had a positive effect in the short term, leading to a price bump and reduction of credit risk on the given securities, but it was short-lived. This indicates that sovereign capital (or rather the ability of flailing banks to announce new capital as they announced losses) helped a bit but it wasn't enough to banish fears that worse was to come. In a sense accepting those large stakes just drew attention to the underlying weaknesses.

6. Control issues Given all of the above, to take on more risk (especially unknown contingent liabilities) sovereign funds might want more control, that regulators might not want to give. Already, Qatar has faced issues with its partner three delta which it bought out..It didn't want more exposure without more control. But that poses a series of issues in the financial sector. Sovereign funds are not really set up to take more control. Sovereign fund investments tend to be supportive of management especially if they give up their management rights as most of the recaps involved. Its not as if a sovereign fund could take over one of these institutions – not only are there regulatory hurdles (too large a stake in a bank would turn a sovereign fund into a bank holding company, placing restrictions on its other assets) but equally importantly they might not want to take it on. Sovereign funds have been scaling up managers quickly as they absorb new assets, but they may not have the capacity for such management – leaving aside the regulatory requirements. For them, a good return might involve finding and supporting a good manager - a hard thing to discern in the current climate. While some sovereign investors are active managers, voting their shares and sometimes having board seats, often these roles are not played in the financial sector given concerns about conflict of interest. So if financial institutions are facing such dire defaults that could weaken a string of other financial linkages, then sovereign capital might not be enough.

7. Spending more at home – the governments of sovereign funds are spending more now than they were two years ago on both current and capital spending (though savings are still high). This trend is most noticeable in the commodity exporters who account for around 70%+ of the sovereign funds, but even China might start spending more. The funds themselves may also come under pressure to invest more at home too. Several months ago, booming domestic and regional markets might have seemed attractive. In recent days, officials in both Kuwait and Russia suggested deploying revenues to stem the declines of domestic equity markets. With Russia's RTS falling 17% yesterday and over 50% year to date, the prospect that Russia will spend some of the wealth fund assets at home seems more and more likely. However, doing so might only worsen investors fears about the Russian markets. Asian countries might do the same. And Australia's future fund and the Kazakh fund already provided support to the banking system. Governments trying to maintain domestic liquidity may not

8. Not quite so rich Growth in sovereign wealth funds was based on two trends, the rising in savings of emerging economies (mainly from commodity revenues or accumulated trade surpluses in other goods.) Oil-rich sovereign funds still save a lot even with an oil price of $90 a barrel , but fall in the oil price may mean less money available for investment abroad. Even with spending rising at a fast clip, we are far away from eroding the surpluses but the new funds available may be lower than some commentators imagined. Furthermore, the lending environment is quite different than it was a year ago. These funds too have faced lending issues and like private equity have found it difficult to conclude deals where they need financing . So too the funds they invest in may increasingly be reliant on expensive financing (the recent IMF working group suggest that at least 20% of the 20-some sovereign funds (or 4-5) surveyed participate in leveraged funds. In other words the investment model is changing with higher credit costs, another reason to wait it out, and perhaps take a more defensive approach.

Finally funds are still seeking out other markets. Over the last year, investments in Asia and the middle east are on the rise from all funds. All sort of investors are targetting Asia, and some sovereign funds may start turning their attention to Latin America. Finally GCC governments as a whole are seeking out land to offset their domestic agricultural shortfalls. This means the U.S. and EU may receive a smaller share of sovereign funds.

However, swfs relative absence from the financial sector doesn't mean they are gone. They still have a lot to invest – GCC funds likely have $150 billion to invest in 2008 – more than in 2007 (and that doesn't even include Saudi Arabia. But they may not be stabilizing per se. Norway may be among the rare funds which must rebalance their assets to maintain a set asset allocation - others may have more flexibility and may be accentuating market moves, shifting away from higher risk assets. But others have been buying property, even in the likely to fall markets of New York and London. Sovereign funds though are among the investors that could return – and they still have a lot of money to place. But they could be reinforcing trends rather than offsetting others losses.

Some may be investing indirectly, by providing capital to a range of asset managers (an example is the joint venture between CIC and JC Flowers which was suggested as a possible capital source for BoA in a possible takeover of Lehman. Doing so might provide some political cover at home or abroad and hopefully some asset management expertise – or that is probably the hope. Others might choose to take small stakes, that may be below disclosure requirements. The FT recently provided a list of the equity holdings of the Chinese State Administration of foreign exchange (SAFE) – it included small stakes in a number of UK-based banks. And SAFE may also have small stakes in U.S. equities also. SAFE once aimed to have as much as 5% of its portfolio in equities. That would be $90 billion - or the amount of CIC's initial capital that it plans to invest abroad in equity and fixed income - or more than the equity holdings of the Swiss National bank, the Hong Kong Monetary Authority, many pension funds, and probably the Saudi Arabian monetary agency.

However, the bottom line is that large scale direct investments from sovereign funds may be a thing of the past, particularly given the scale of the shakeup in the financial sector.–Other aquisitions may be more attractive in other sectors as more and more countries create institutions that are sectorally focused and targeted towards partnership with domestic goals.

In fact, in terms of funds, the assets plowed into the US government debt market by sovereign investors are much higher than those that went into recapitalizing the financial institutions. Thus while sovereign funds were on the sidelines – sovereign investors as a whole were not, and contributed to upporting the U.S. financial system. They contributed in particular to the flow of funds into the U.S. treasury and until recently U.S. treasury markets.

Drawing on the TIC data released Sep 16 by the U.S. treasury, total capital flows from China were almost $160 billion in the year ending July 2008 and inflows from Oil exporters in the emerging world were about $150 billion, roughly split between Asian oil exporters (the GCC, which had some equity purchases including the investments in the banks) and Russia. Such inflows might actually be higher as the TIC data regularly understates the investments made by official institutions (mainly because many are made through intermediaries). These inflows, not just the smaller component characterized by the sovereign investments in the banks flowed into the U.S. There is such evidence that such flows may be subsiding somewhat.

The capital flow data (TIC) shows that sovereign investors (and others) finally started to stampede out of U.S. agency bonds in July – with net reductions in holding by private and official investors at least $50 billion. This may be old news given the preliminary data both of the custodial holdings of foreign governments at the federal reserve bank of new York - and from the yields demanded at the August auctions of the GSE's debt.

Furthermore – global reserve growth (a driver of US treasury demand) is slowing. A lower oil price will mean less savings by Saudi Arabia and evidence suggests the hot money inflows into countries like China are slowing (though China's record trade surplus may still point to a significant reserve growth in Q3). Even the GCC which had record reserve growth in 2007 and early in 2008, are no longer attracting speculative capital. Capital inflows to some of the large emerging markets like Russia and Brazil are also reversing. But imbalances won't disappear overnight – and a fall in the oil price could actually pose a reacceleration of China's surplus. Yet oil at $90 still means a lot of savings – somewhat more than in 2007 – and that money still needs to go somewhere. Since it would overwhelm some domestic markets, for now it still might make its way to the U.S. despite the financial turmoil.