The Design and Governance of Sovereign Wealth Funds
This blog has officially moved to its new home over on Institutional Investor. It’s called ‘Avenue of Giants‘, and it will be nothing short of awesome. So check it out.
Thanks again to all those who’ve made this website and project a success. It’s been a ton of fun. But it’s now time to move on…
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I’ve been of the mind that private sector investors are generally shorter term than public sector investors. And it’s simple to see why: a vehicle sponsored by an individual is going to operate according to an individual’s discount rate, while a vehicle sponsored by a government is going to operate according to a government’s discount rate. In theory, the government will consider longer-term factors than its private cousin (if only because the government will go on existing long after the individual has perished).
But the theory breaks down in practice for a variety of reasons. First, while governments may be long-term, the politicians that run governments are not. This is one of the failings of democracy; it’s challenging to deal with intractable problems outside of a given election cycle. In addition, while public pensions or sovereign funds may have inter-generational time horizons, the people that staff these organizations do not. As such, long-term investors often struggle to live up to their moniker.
In order to counter these factors, public funds are often set up with governance procedures that limit the short-term influence of politicians. And, perhaps more importantly, these funds also tend to devise compensation structures that extend the time horizon of their staff (as much as is feasible and possible). For the more sophisticated funds, this may mean establishing long-term incentive plans (LTIPs) that smooth performance compensation over time (e.g. five years). This may also include capping upside compensation to prevent employees from over-reaching. Whatever the case, there are a variety of ways to try to align an individual’s short-term interests with the long-term interests of pensions and sovereigns.
But where all of these public incentives fall short — and where the private sector may actually have a leg up — is on the issue of ownership. By granting an individual some ownership rights over a certain asset, you, in effect, provide that individual with an opportunity to hold that asset for life (and even bequeath that asset on to future generations). Without going into all of the theory here, let’s just agree that ownership is a powerful private sector ‘time-extender’ that is often deployed in non-financial industries through equity stakes, partnerships, or stock options. The idea is really simple: Give employees a stake in the long-term growth and sustainability of the organization so that the individuals will act in the best interests of the company. (There are problems with stock options due to the fact that they reward company-wide rather than individual performance, but I can go into that offline if anybody is interested.)
Anyway, I then started to wonder if there was a way to synthetically provide public sector pension and sovereign fund employees with some notion of ‘ownership’ that could extend their own time horizon for decades. One obvious way is seeding new subsidiaries and then giving staff a small ownership stake in the separate vehicle. While effective, it’s not a scalable solution for the entire organization. So I started thinking about some form of ‘notional ownership credits’ whereby the credits increase in value over time along with the total value of the fund’s assets? It could even be a specific portfolio’s assets. In other words, what if public pension and sovereign fund employees were paid with derivative-like assets that tracked the value of the fund’s portfolio and could be redeemed when the employees wanted? There would be plenty of challenges associated with such a policy (i.e. calculating the liability from outstanding credits), but at least people would be tied to the long-term growth of the fund. And that might drive them to think about the pension’s health in 10 or even 20 years from now. That’s the value of ownership.
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Abu Dhabi in January is outstanding. Seriously. Anyway, here’s some of today’s investment news of note:
This is, literally, the view from my hotel:
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I’m on planes for the better part of two days, as I’m making my way to the other side of the planet. That means I’ll have plenty of time to catch up on my reading. And, so, here are two papers I loaded on my tablet for some ‘in-flight infotainment’:
First, Brad M. Barber and Guojun Wang have a new paper entitled “Do (Some) University Endowments Earn Alpha?” It looks like the answer is ‘Yes’ but it’s almost all due to the asset allocation. Should be interesting.
Second, Eiichi Sekine has a paper out entitled “Moves by China to Improve How It Manages Its Foreign Exchange Reserves.” This looks like one of a number of papers offering details on China’s SWFs. Even if repetitive, there’s usually some interesting nuggets of info.
Anyway, away I go…
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Good morning, London. Here’s our top story this morning:
In other news:
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Michael Nobrega is an interesting personage within the pension community. He’s been the CEO of the Ontario Municipal Employees Retirement System since 2007. And, prior to that, he was the President, CEO (and one might say Founder) of OMERS wholly-owned infrastructure manager Borealis (which he launched in 1998). In short, Nobrega has been an instrumental figure at OMERS during a time period when the Toronto-based pension fund was (as it continues to be) one of the single most innovative pension funds in the world. As you can imagine, then, those of us in the pension community generally pay attention when Mr. Nobrega offers some insight into what he’s thinking and doing. And, significantly, Benefits Canada has just published an interview with, and an article on, the innovative OMERS CEO. So I thought I’d share some of Nobrega’s ‘deep thoughts’ with you here:
The rationale for OMERS shifting its assets into illiquids: “The principal reason it was done was to reduce our exposure to the volatility of the capital markets, especially public equity. The second reason was to acquire assets that would give us as predictable as possible long-term cash returns to fund the pension plan.
The practical challenges of OMERS focus on illiquids: “It’s not an easy exercise. You want assets you can live with for 25 years…To do that, you have to keep your investment criteria in place. It’s easy to go and buy assets, but it’s a question of buying them at the right price, managing them properly and adding value to them later on.”
The importance of talent within a pension fund: “A pension fund makes money in two ways: it leverages its capital, and it leverages its people. And the best leverage is to have people with ownership responsibility [to leverage the capital].”
The importance of local knowledge in making investment decisions: “I think we made a good decision to open our offices in New York and London. That has really helped us in terms of sourcing investments…To get to where we want, we need to do two things: find the right people, and deploy the capital. Those two offices have helped us attract people we couldn’t attract to Toronto, because they want to live in New York or London. And they’re also part of the networks in those locations, which gives us an advantage in getting to the assets.”
Why OMERS is moving into Venture Capital: “It’s our intention to be the parent for some of the serious innovation in the country. And we hope the [venture capital investment] ecosystem will go from $1 billion to $10 billion annually over the next five years. That’s what we need in this country. Our intention in making this step is to encourage others to join us.”
Fascinating stuff!
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And now, the news:
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I’ve been saying this for years now: when it comes to resource rich countries using sovereign wealth funds to successfully manage resource revenues and overcome the resource curse, strong institutions and good governance are indispensable. In short, governments should not be setting up a sovereign fund if they do not already have the necessary institutional ingredients to actually make it work. As evidence of this, I’d like to direct your attention to a neat new paper by Antony Goldman entitled “Poverty and Poor Governance in the Land of Plenty: Assessing an Oil Dividend in Equatorial Guinea”.
The Goldman paper is well worth reading, as it depicts a dire governance situation in Equatorial Guinea and, in so doing, offers a useful case study of a failed (or, at least, failing) sovereign fund. Here’s a bit of background: the country is rich in natural resources — GDP per capita is above $11,000 — but these riches are enjoyed by only a small proportion of the country. Indeed, three quarters of the population apparently live in poverty. Here’s an interesting blurb to describe why this is the case:
“Equatorial Guinea’s management of natural resource revenue has earned it international notoriety. Allegations of a local elite with an apparent taste for multimillion dollar mansions abroad and wasteful spending at home have dominated reporting of the country since the oil boom began…Money is managed by a tight-knit group of family and ethnic group members, but governance is filled with intrigue and unexplained changes…The government has developed a recent track record for savings, but there are no safeguards on those funds or mechanisms to ensure that they last…There is little evidence of what goes into the Malabo government’s plans for managing oil and gas revenues. Neither the President nor the ruling party make substantive public disclosures about the budgeting process.”
That’s pretty bad. But none of the this stopped the country from (or the international community from pushing the country towards) setting up a sovereign fund:
“Equatorial Guinea has a Fund for Future Generations (FFG), but there is little transparency about its management. At its creation, the government pledged to deposit 0.5 percent of annual oil revenues into a special account at the regional central bank, the Banques des Etats de l’Afrique Centrale (BEAC). In 2008, the World Bank confirmed that the government had been following through on its promise (Toto Same 2008), but now the government’s statistics on money held at the BEAC appear to present global figures rather than a breakdown, suggesting that the money could be spent without safeguards – and that the rhetoric behind the initiative is designed to satisfy an external constituency while the substance of policy and practice on the ground effectively remains little changed.”
This was the same problem we saw in Chad — the international community pushed the idea of a sovereign fund to ensure inter-generational savings, but the institutional and governance frameworks required at the local level to make such a policy effective simply did not exist. As we now know, some resource rich countries are so corrupt that setting up a commodity fund for managing resource rents is pointless. So here’s my takeaway from all of this: An SWF isn’t a mechanism to bypass weak institutions and poor governance at the local level. Rather, it should be the manifestation of these effective institutions and good governance.
Anyway, for some more details, here’s blurb from a paper I wrote on this topic:
“One would hope that a SWF could be set up such that it is insulated from instability just as one would hope that the fund could help underwrite political and economic stability. But it is important to reinforce that establishing a SWF and sustaining its capacity over the long term confronts the same problems already constraining economic growth and development. The prevailing institutional and political reality cannot be ignored. For example, political elites and interest groups may try to use the fund for their own gain or clientelistic activities. For resource-rich African countries, the scope of challenges in this regard is wide. Such prevailing conditions may even constrain the establishment of a SWF not to mention the employment of the fund for development goals. For example, the ruling elite may find it useful to establish a SWF, but only as a means of maintaining its power or financing pet projects.”
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Some news of note for your Friday:
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Syria’s President Bashar al-Assad announced yesterday that he will establish a new sovereign wealth fund called the “National Investment Fund”. The objective of the new fund will, apparently, be to support and stabilize the Syrian financial markets through a “long-term investment policy”. The fund will initially have around $40 million and operate under the supervision of the Ministry of Economy and Trade. Minister Nidal al-Shaar apparently said that ‘the Law will positively interfere in the financial market performance through establishing an investment sovereign fund to activate the act of the Securities’ Market.’ Where’s the money coming from for this new SWF? Good question, as the decision by Arab states to turn against Syria is likely having significant economic consequences for the country. Indeed, the same Nidar al-Shaar said late last year that the economy was in a state of emergency. Nonetheless, Syria received an offer of $5 billion in aid from Iran and Iraq back in July. Perhaps that’s the source of funds?
Whatever the source(s), objectives or motivations, the creation of a new sovereign fund in Syria is fascinating. Now I’m not a Syria expert, but I am aware that this country is facing a significant domestic uprising with an increasing likelihood that President Assad will, eventually, fall. So this new SWF is, in all probability, one of the Assad regime’s last ditch efforts to stave off the inevitable. And we shouldn’t be too surprised by this, as there is a growing body of research that shows SWFs to be “autonomy-maximizing institutions”. So let’s revisit some of the SWF basics to try to shed some additional light on Syria’s decision, shall we?
The basics: most SWFs arise out of growing international cooperation and greater integration of nation-states into the global economy. As countries open themselves up to these global forces, policymakers increasingly recognize this opening as a potential threat to their sovereignty and autonomy. The SWF, then, is a part of the give and take between states and markets, sitting at the intersection between the two and acting as a sort of buffer. In this way, you can think of SWFs as a form of self-insurance, a coping mechanism for dealing with the external uncertainties that come with joining global markets. SWFs offer policymakers a chance to make reliable and consistent plans in an environment that is increasingly subject to volatility and market-based short-termism.
How does all this fit in with Assad and Syria? Well, interestingly, it really doesn’t. In fact, it appears (to me) that Assad is setting up his new National Investment Fund for almost the opposite reasons — as the country grows more isolated, the burden of propping up its industry has fallen on the Syrian government. The new fund seems to be a way for Syria to fill the vacuum left by foreign partners leaving. So, then, the question is whether this new fund will achieve its objectives of stabilizing Syria.
Maybe. Here’s an insightful quote from a solid piece of research by Kyle J. Hatton and Katharina Pistor of Columbia University:
“…the internal governance structures of the SWFs themselves ensure that SWF management is directly accountable to the ruling elite in each sponsor country. Consequently, it is unsurprising that SWFs can be, and are, wielded to advance the interests of those elites. First and foremost among these interests is the maintenance of their privileged position…The task of maximizing autonomy is, however, complex. The privileged position of ruling elites in non-democratic countries is dependent on domestic stability, security of the state against foreign rivals, and the maintenance of substantial autonomy relative to superpowers to which they might otherwise be vulnerable. Without domestic stability, elite status is fragile and will last only until the next coup or mass uprising; a foreign invasion would topple existing elites or at least subsume them into a hierarchy with foreigners at the top. Finally, as autonomy relative to superpowers decreases, the ability to direct state action toward benefiting the elite is restricted and domestic legitimacy may be threatened.”
I have to say, I find that a disconcerting conclusion – namely that SWFs are there to keep the ruling elites…well…ruling and elite. But I myself believe that SWFs exist “to preserve local autonomy and state sovereignty.”
In a way, a sovereign fund exists at the most basic level to stabilize and buffer. That’s really it. A SWF can help protect against a commodity price collapse, a mortality improvement, a diminishing tax base, or even a currency crisis (among many other things). In short, SWFs exist to preserve, bolster and sustain existing institutions, orders and regimes. In many countries, especially in democracies, this stability is perceived to be a very good thing because it extends the time-horizon of policymaking and minimizes the impact of short-term economic volatility. However, as it just so happens, that same stability in the case of non-democratic regimes may mean extending the reign of a dictator. And that’s not really a good thing. I’ll be very interested to see what happens in Syria.
