SWFs and Private Capital
Over the past few months, Ashby has noted the trend towards some SWFs attracting private capital, and discussed some of the implications this might have, particularly the fact that this has the potential to compromise SWFs’ long-term investment horizon. Concurrently, we’ve been seeing other funds go long – investing in infrastructure, real estate and other illiquid assets, underlining their commitment to their long-term approach to investing.
So why do some SWFs to choose the first option? The major factor arises from the asset base of the SWFs (and divisions of SWFs) are deciding to bring private capital on board. These tend to be operations that have with portfolios with a substantial proportion of real assets: stakes in government-linked companies, joint ventures or fully-owned corporate entities, and real estate holdings. In 2009 and 2010 we’ve seen Temasek, Mubadala, Mumtalakat and Khazanah and CIC’s Central Huijin issue bonds, while Qatari Diar is considering it. Mumtalakat has also offered part of its Bahrain Family Leisure unit for IPO, GIC is looking to do the same for its logistics business and Temasek is planning to float two real estate investment trusts from its Mapletree Investments unit later this year.
These operations have fundamentally sound asset bases, but their illiquid nature means that cash flow is constrained in the wake of the global financial crisis. This has likely been exacerbated by reduced (or complete cessation of) inflows, tight credit conditions and a disinclination to borrow, learning the lessons learned from funds like Istithmar that over-leveraged parts of their portfolios in 2006-08. Consequently, they are taking advantage of the current low-interest conditions to issue debt that will help them maintain their deal flow and investment strategy and provides scope for them to be opportunistic. Bond issuance also enables funds with currently underperforming assets to rebalance their debt repayments from short- to long-term. Additionally, inviting in private capital, either as bond- or equity-holders, may also signal that, in the wake of the issues surrounding Dubai World, governments are encouraging these types of funds to become more independent, thus removing their assets from government balance sheets.
But what impact will this have on the funds’ activities and should those investors interacting with them perceive them in a different light?
Essentially, raising private capital acts as a corporate commitment device, locking the SWF and its private investors into a course of action that they might not otherwise choose, but that produces the desired, required or otherwise beneficial results. In this case, the SWF has to invest to satisfy investors’ expectations, and pay their coupons. This has some effects that are beneficial for the fund; for example, it might act to increase fund managers’ equity share of the fund and thus reinforce capital efficiency and long-term financial discipline by making them more sensitive to profits and thus improving returns.
Conversely, it may also be detrimental by fundamentally altering the fund’s investment strategy. The competitive advantage of SWFs is that they have no liabilities and can thus invest in assets that other institutional investors, such as pension funds, cannot. However, by taking on private investors, SWFs lose this advantage, by altering their liability profile and thus having to be more attuned to the rights, needs and requirements of stakeholders other than the government owner.
Having responsibilities to private investors also forces SWFs to maintain or improve their transparency and reporting standards, as well as corporate governance, as it improves investor confidence (although some SWFs may not see this as a particularly desirable outcome). It also improves its reputation by demonstrating both the apolitical character of its investment strategy and the independence of its management.
Private capital also acts as a commitment device on the side of the investors. By purchasing SWF bonds, they buy into the underlying aims, objectives and aspirations of the fund. This has a substantial upside for the bond issuer, enhancing its domestic legitimacy at a low price: while the bondholders are locked into the aims and objectives of the SWF, they do not have voting rights, and cannot hold management to account. Moreover, in return for a certainty of payment, they forgo the upside of the fund – if returns skyrocket, they do not see the benefits.
The relationship between the fund and its private stakeholders is different when the SWF invites them in as shareholders through an IPO. The directors and officers of the fund are thus bound by fiduciary duties to act in the best interest of the shareholders, subordinating the interests of the government to private investors. Equally, the SWF has to take shareholders’ voting rights into account, which remove its ability to appoint their chosen candidates unilaterally. Consequently, the government loses full ownership of the assets that the fund has accrued using government capital.
These new responsibilities may change the SWFs’ investment behaviour. To date, SWFs have been largely passive shareholders particularly in foreign companies. However, with the new obligations, it might be beholden on SWFs to be more involved in the management of the companies in which they invest and become more activist investors, bringing management to account. This might make them less attractive as investors for companies who want a capital injection but no interference. Equally, it might raise issues of sovereignty, particularly where a SWF holds a significant stake in a foreign company. Such activity might, once more, raise objections to SWF investment abroad.
On the whole, it is probably unnecessary worry unduly about these issues. Most funds that have brought in private investors have limited their capital raising to about five percent of the fund’s AUM, which doesn’t appear to run the risk of fundamentally changing the character of SWF investment. Questions, however, might be asked if the value of private capital was further towards 15 or 20 percent, but it is unlikely we will see that situation in the near future.
