The Design and Governance of Sovereign Wealth Funds
I’ve come across quite a few new academic papers on SWFs over the past few weeks. The following are those I have not yet already linked to (some may require subscriptions):
Inevitability and Necessity to Develop SWFs in China
Oil Funds: Perils and Opportunities
Opalesque flagged up an interesting article this morning in Emirates Business 24/7 on ‘joint funds’. In short, joint funds are cooperative investment funds that attract two or more SWFs into a new investment fund with a specific focus. The China Dubai Capital joint fund is listed as the primary example.
Whereas I rubbished the idea of mutual wealth funds that recently came to the fore, joint funds could offer considerable benefits. Unlike MWFs, which were presented as a way to facilitate SWF legitimacy and alleviate Western concerns about SWFs, joint funds are presented as institutionalized knowledge transfer. This transfer typically comes in the form of local information about investing in a specific region or industry. Since, past academic research by Coval and Moskowitz has shown that investing locally (within 100 kilometers of the fund’s headquarters) can bump investment returns by over 1% due to information asymmetries, there are clear benefits to having local partners.
In short, joint funds would bring together two or three funds with diverse backgrounds into a single cooperative, entity so as to maximize the effectiveness of the investment function in a specific economic geography (region, industry, asset class, etc.). I expect we’ll see more of these types of funds, since improving the investment function will also facilitate the acceptance of SWFs internationally. The partnership between Mubadala and France’s Strategic Investment Fund is perhaps illustrative of this fact.
Less than two years ago, France was leading the charge against sovereign wealth funds. Recall this statement by President Nicolas Sarkozy in 2007:
“We’ve decided not to let ourselves be sold down the river by speculative funds, by unscrupulous attitudes which do not meet the transparency criteria one is entitled to expect in a civilised world. It’s unacceptable and we have decided not to accept it.”
Things have changed. To begin, France is itself now a sponsor of a SWF. So, it clearly sees the benefit of state run financial institutions. However, given that the new French SWF was designed to thwart the influence of other, foreign SWFs over the French economy, this may not be the best signal that France has accepted the role of SWFs in the global community.
Nonetheless, some new evidence suggests this acceptance is forthcoming. France’s Minister of Economy, Industry and Employment, Christine Lagarde struck a tone recently that signaled a positive outlook about SWFs:
“Of course we welcome those investments. France is very much open to foreign direct investment. It is the second destination for FDI in the world after the United States. So it comes before the UK before Germany. It’s open…Foreign direct investments by sovereign funds are welcome. We’re not afraid. We don’t regard them as a threat.”
Lagarde is in the UAE to sign a cooperation agreement between the Strategic Investment Fund of France and Mubadala. Basically, the two will work together to make investments in France.
In short, it appears that France is comfortable with a model that sees foreign SWFs clubbing with the French SWF on French investments. So, in a matter of two years, France has gone from viewing SWFs as a threat to signing a deal that ensures foreign and domestic SWFs will be key players in France economy.
La France change d’avis comme de chemise…
This is your last chance to participate in the sovereign wealth fund survey co-sponsored by Oxford University and Pensions & Investments. If you have not already done so, please take 15 minutes to register your opinions and experience (just 37 quick questions).
Click here to proceed to survey website.
Sovereign wealth funds’ operations and strategies remain, in many cases, guarded secrets. This survey seeks to fill the information gap through proxy, by canvassing experts about their experience working with SWFs and their opinions on SWF operations. Until such a time that we have reliable, first-hand data, this may help us better understand these important financial institutions
Please forward this invitation on to colleagues whom you feel are also fit to respond. The main results of the survey will be published in Pensions & Investments in July.
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The GAO just released a new report entitled: “Sovereign Wealth Funds: Laws Limiting Foreign Investment Affect Certain U.S. Assets and Agencies Have Various Enforcement Processes.” This report seems to have two main objectives: First, it examines the U.S. laws that affect foreign investment in the United States. Second, it evaluates which agencies enforce them and how they do it.
This report is worth reading; the impetus for producing it was clearly the 2007/2008 concerns many Washington policymakers had about SWFs’ activities. What is ironic then is the fact that the report details the extent to which many sensitive investments in the U.S. by foreign investors, including SWFs, were off limits well before the issue of SWFs cropped up. Will the fears that led to this report be muted by its release?
“…sectors with specific restrictions on foreign investments include transportation, communications, and energy. For example, foreign governments may not be issued radio communications licenses and foreign entities are not allowed to own or control more than 25 percent of the voting interest of any U.S. airline. In other cases, foreign investors can purchase companies or assets in a sector but face restrictions on their activities once they invest. For example, foreign companies can invest in U.S. banks, but if a company’s stake exceeds 25 percent or the company would control the bank, the company must receive prior approval and become regulated by banking regulators and would be limited in the types of nonbanking activities in which it can also invest. Foreign investors can generally invest in U.S. agricultural land, but must disclose purchases above certain thresholds to the Department of Agriculture (Agriculture). In addition, while not specifically a restriction on foreign investment, a recently strengthened U.S. law authorizes interagency reviews of certain foreign investments, potentially in any sector, for national security considerations. Most federal laws limiting foreign investment were put in place decades ago in response to national security or economic concerns at the time. GAO’s analysis of state-level restrictions on foreign investment indicated that some states had restrictions on foreign entities’ ability to invest in real estate, including agricultural land, and some had restrictions on foreign government ownership of insurance companies.”
The oil-rich sultanate Terengganu, within Malaysia, is raising money through the issuance of Islamic medium term notes to fund its new SWF: the Terengganu Investment Authority. Apparently, TIA already has some investments in mind:
“TIA chief executive officer and former executive partner at Accenture, Shahrol Halmi, said the fund had identified several strategic partners and would team up with well-known sovereign wealth funds for these projects, which include regional and international projects that have “positive spillover benefits” to the state.”
Governance issues plagued the process of setting up TIA, as both industry and government stakeholders worried about how such a large sum would be managed and governed. Significantly, it appears these governance issues have been resolved (or at least addressed):
TIA will “incorporate a triple-tier check and balance system comprising the board of directors (representatives from the three stakeholders who cannot hold positions in the Government or occupy any political positions), a board of advisers (to include “international eminent persons”) and a senior management team which will have a “mix of experienced, prominent local and international individuals”.”
Larry Catá Backer has a new paper out entitled “Sovereign Wealth Funds as Regulatory Chameleons: The Norwegian Sovereign Wealth Funds and Public Global Governance Through Private Global Investment.”
This paper is worth reading. In particular, the following quotation struck me as quite insightful:
“SWFs thus proceed from definition to conundrum. If SWFs are grounded in the reality of their formal connection to states, and if states are deemed sovereign in their actions, then it might be reasonable to assume that such funds could not be treated like private investment funds. To bridge that gap, it was necessary to find a way to disconnect SWFs from the state and sovereign activity, and to model private activity in a way that made it possible to construct a set of behavior principles that might produce an equivalence between SWFs and private investment vehicles. The first was accomplished by creating a functional distinction between state and SWF, a distinction unnecessary for traditional sovereign investment. The second was grounded in the presumption that there is a way of distilling the essence of private investment behaviors sufficiently precisely to distinguish those behaviors from sovereign conduct. Both are nicely captured in the Santiago Principles.”
According to an article by Tom Arnold on ArabianBusiness.com, the global economic crisis pushed many Gulf SWFs into a defensive position. They slowed down their rate of investing and became wary of deploying any capital at all. As I have noted several times, many turned inward, changing their investment focus so as to shore up struggling domestic economies and avoid the global uncertainty. While nobody can fault these countries for using their SWFs in times of crisis (so long as that was their purpose), by pulling back they may have missed a unique opportunity to secure future cash flows at a much reduced price. Not all SWFs missed this chance…
Landon Thomas reports in today’s New York Times that Norway (and in particular Kristin Halvorsen) bucked the trend completely, allocating a larger portion of its SWF’s assets to equities in the midst of the economic downturn:
“As investors the world over sold in a panic, she bucked the tide, authorizing Norway’s $300 billion sovereign wealth fund to ramp up its stock buying program by $60 billion — or about 23 percent of Norway ’s economic output.”
This decision reflects: 1) the genius of Norway and 2) the true nature of the institution that is a SWF.
In my view, SWFs should judge their success over time horizons that are much longer than other financial institutions; at least 5 years or more. So, they are the best placed investors (in the world) to snap up “deals” in the global downturn. They simply don’t have pressing liabilities today, tomorrow or even this year, meaning that they can take on illiquid positions or take a long-term bet on the stock market. I also happen to know that the Canada Pension Plan Investment Board (while not really a SWF) took a similar view as Norway. Due to the fact that the CPPIB’s liabilities won’t come due for another decade, it increased its risk as the markets fell (while remaining within its risk budget). In markets where investors are liquidating positions so as to meet capital requirements, SWFs can look beyond the short or even medium term economic turmoil and think about investments five or even ten years out. This is the genius of a truly long-term investor: they smooth out economic and financial volatility.
Karen Remo-Listana of Emirates Business 24 reports that the IMF sees a global role for regional SWFs despite significant losses:
“Deteriorating domestic financial conditions have warranted more prominent roles for SWFs in their home countries…At the same time, SWFs in the region continue to pursue profitable investment opportunities abroad in real estate, retail and finance.”
Nonetheless, the article illustrates the inherent tension between a long term, international focus and a SWFs’ domestic stabilization role:
“The crisis has shown that, notwithstanding their long-term focus, SWFs have a domestic stabilisation role with implications for their investment objectives and strategies, IMF said. In times of financial stress in the domestic economy, SWFs’ domestic investments may temporarily deviate from pure profit maximisation to support broader macroeconomic and financial stabilisation objectives, it added.”
This is a subject of considerable interest for me. In fact, it is the subject of a paper Gordon and I just finished writing. Have a look.
