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A tsunami of money is set to break over London. Will it nourish the market or enslave it? Simon Keane scans the horizon

They have a huge amount of cash, buy when markets are weak and have the potential to generate massive advisory fees for the City. So why is everyone knocking sovereign wealth funds? At a time when there are few buyers of UK equities, when cash is in short supply and fees are hard to come by, they should be welcomed with open arms.

Analysts predict the sheer weight of money from sovereign wealth funds could drive an epic rerating of equity markets, pushing up share prices by more than 10%. Predictions of $200 billion a year of funds being out-sourced to the world’s major asset management groups could generate hundreds of millions of pounds in City management fees. Sovereign wealth funds are one almighty golden opportunity.

Big and growing fast, they will become an increasingly important player in the UK equity market. In the same way that hedge funds and private equity rapidly went from fringe to mainstream, so too will sovereign wealth funds. Already on the register of some of our leading companies (Standard Chartered, Barclays, the London Stock Exchange, and more recently BP, names such as the Government of Singapore Investment Corporation (GIC), China Investment Corporation (CIC) or the Abu Dhabi Investment Authority (ADIA) will become ever more familiar.

We’ve come to learn the way private equity works with its favoured (albeit it now seriously curtailed) leverage buyout model. Equally, the hedge fund manager’s activist strategy of taking a small stake to launch a well-argued attack on strategy (a 5% holding permits resolutions to be put forward at the AGM) is well known. Sovereign wealth funds, however, are an unknown quantity. Many, including CIC, didn’t exist this time last year so there are very few precedents. When a rumour surfaces that a sovereign wealth fund has bought into blue-chip company X, Y or Z it’s hard to know what to expect next.

Many see stake building in strategic assets such as a banks, infrastructure or energy companies as politically motivated rather than economic (Lawrence Summers, a former US Treasury secretary under Bill Clinton, warns of Chinese or Saudis ‘disabling’ Western companies). These concerns are, however, a red herring to what is really going on and that is oil and trade-rich nations diversifying away from bonds.

A huge positive

Fears of private equity and hedge funds outfits with Chinese and Saudi Arabian masters miss the point which is that most of this money will be run passively as long-only equity portfolios. Fear obscures the fact that sovereign wealth funds are a huge positive for equity markets in general – perhaps boosting share prices by 10% plus – and offer a great opportunity for the financial services sector in particular – fund managers are set to see a windfall of new mandates to manage this new money.

Yes, there are some alternative agendas – think the Qatar Investment Authority’s (QIA) stake in the London Stock Exchange as access to trading platform technology for its own exchange – but they’re not the hidden agendas some, such as Harvard professor Summers, would have us believe. What is going on is more about good old-fashioned portfolio diversification, and the UK equity market, like those in Europe and the US, will be on the right side of a huge wall of money flowing its way right into the 2010s.

Analysts at Morgan Stanley believe the weight of this money with result in a rerating of equities on an epic scale. The broker projects that by 2022 companies may trade on earnings multiples of up to 26.6, about 11% above today’s 23.9 rating. So, all else being equal, share prices will be more than 10% higher. Aside from boosting equity markets, sovereign wealth funds are likely to have a stabilising effect. Without the short-term liabilities of traditional pension or insurance funds, they can afford to take a value approach, buying into dips (think recent stakes in bombed-out American investment banks) and holding for years, perhaps decades.

The growth of the sovereign wealth funds is also potentially a huge boon for the financial services sector, in particular the asset management industry. Many of these new funds will be looking to external managers to run portfolios (CIC began recruitment in December) with estimates of up to a fifth of all assets under management farmed out.

Of the $100 trillion-worth of total financial assets currently in existence (Morgan Stanley estimate) most estimates have sovereign wealth funds holding a relatively small $3 trillion of this (International Financial Services London (IFSL) – $3.3 trillion (March 2008), Morgan Stanley – $2.8 trillion (October 2007), Peterson Institute for International Economics $2.1 trillion (November 2007), although Peterson’s figure does not include the $200 billion added by CIC in September). But the growth of these funds is likely to be rapid, with IFSL and Morgan Stanley expecting them to expand by roughly $1 trillion a year, with respective predictions of their size at $10 trillion and $12 trillion by 2015.

From bonds to equities

The evolution of CIC is a classic example of foreign governments’ desire to diversify from bonds to equities. China’s rapid industrialisation has resulted in a huge current account surplus on the back of export growth to western economies. (Witness China’s huge foreign foreign exchange reserves, which stood at $1.4 trillion at the end of September) Until now much of this surplus has been invested in US treasury bills: the launch of CIC was a conscious decision to seek higher returns offered by equities versus bonds. This switch in focus of traditionally conservative Asian countries is expected to be the biggest single contributor to the growth of the sovereign wealth fund market. Even if the price of oil falls back from the current $100-plus a barrel Asian exporters will pick up the slack.

Most (about 70%, according to Morgan Stanley) of the annual $1 trillion flows from sovereign wealth funds will be managed along traditional lines as practised by the world’s big pension, insurance and mutual funds. What this means for UK equity market watchers is that the next time you see a regulatory news announcement revealing that a sovereign wealth fund has hit a 3% holding in a blue chip, the implications are probably no more significant than, say, had it been Legal & General’s name flashing up on the screen. About 25% or the 70% mentioned above is tipped to go into bonds, with 45% into equities run as conventional long-only, benchmark-constrained portfolios. This is a world away from the unconstrained mandates of the hedge funds where the aim of absolute return, rather than relative performance to a benchmark, fuels the activist approach.

This is not to say that the sovereign wealth funds won’t venture outside the traditional asset management model. About 30% of the $1 trillion annual flows will go into alternative assets, about half of which will be equally split between hedge funds, private equity and direct investment into infrastructure assets. The other half of these flows is tipped to be direct investment into real estate. But, like the pension, insurance, or mutual funds, most of these sovereign wealth investors will be of the silent, passive, variety.

Benchmarks

The latest round of sovereign wealth fund activity was in the US, just ahead of Christmas, when we saw stakes taken in a series of major investment banks mainly via the issuing of convertible stock. In November, ADIA invested $7.5 billion into Citigroup for stock, which, when it converts into shares in 2011, will amount to a holding or ‘no more than 4.9%’. In December, GIC injected $11 billion into UBS (alongside $3 billion from a mystery Middle Eastern investor, reported to be from Saudi Arabia) for convertible stock, which will be swapped for shares in a couple of years.

Shortly after the UBS deal, it was revealed that CIC was to plough $5 billion into Morgan Stanley for what will amount to a stake of ‘9.9% or less’ when its notes convert in 2010. In late December, Singapore’s Temasek paid $4.4 billion for new shares in Merrill Lynch and took an option to purchase an additional $600 million of stock – since exercised – for an ownership position that will ‘at all times represent less than 10%’ of Merrill Lynch.

Those who doubt that sovereign wealth funds will invest along traditional, benchmark-driven lines may well point to these large focussed investments in US banks to prove their point. But Stephen Jen, analyst at Morgan Stanley, believes these stakes were part of an opportunistic phase that won’t be repeated. Clearly the banks, nursing huge sub-prime losses, were desperate for funds. While these investments may represent large capital losses at present, they could turn out to be the buy of the century. As a rule, Jen would ‘normally’ expect these funds to take a top-down approach, that is they will be buying with a benchmark in mind. Portfolios will be well diversified so stakes in an individual company will be relatively small. These funds won’t, in general, be buying strategic stakes in the way that an activist hedge fund might. They won’t, as a general rule, be making outright offers for public companies in the way private equity has.

This view of sovereign wealth funds behaving like traditional pension funds is supported by research from the Peterson Institute for International Economics, which has studied the investment strategies of 28 countries. Of these 28, the institute claims to have ‘reasonably complete information’ about the strategies of 24, of which only eight are planning ‘the acquisition of significant or controlling stakes in companies’. Meanwhile McKinsey & Company, in its recent report The New Power Brokers: how oil, Asia, hedge funds, and private equity are shaping global capital markets concludes: ‘Sovereign wealth funds typically do not make direct investments in companies but rather invest in a diversified portfolio of public equity and debt markets.’

Longer horizons

While sovereign wealth funds will share the benchmark approach of pension, insurance or mutual funds, their investment horizons are longer as they don’t have the same liabilities. They can afford to take stakes in bombed-out stocks and hold for ten or 20 years in the knowledge that members won’t be knocking on the door demanding to cash in policies or redeem units. In this respect these funds may have a stabilising affect by buying when everyone else is selling. The market should perhaps have welcomed Temasek onto the register of British Land. Temasek, which was revealed as a 3% holder in British Land in January, is one of the few buyers in the quoted real estate sector, where shares have just about halved in the past 12 months.

Without doubt, some of the stake building has been about more than just investment returns. The QIA’s 20% position in the LSE (that’s the pre-dilution stake prior to the LSE’s merger with Borsa Italiana) is a clear example of strategic investing. At the time of the investment last September the LSE went on the record to welcome the QIA on to its share register, heralding the start of ‘a long-standing relationship based on plans to develop the Qatar marketplace for regional leadership in financial services.’ The move, coming concurrently with Borse Dubai’s decision to buy most (28%) of Nasdaq’s then 30% LSE stake, ties into reports that Qatar is in a race with Dubai to become the Middle East’s financial centre. Doha’s battle with Dubai would surely be aided by access to the technology underpinning the LSE’s electronic order book. In the same fashion market watchers believe BG Group could be the next strategic target.

‘BG has intellectual property in terms of knowledge of the gas market,’ comments Phil True, head of UK institutional equities at Credit Suisse. ‘I think that’s something that a number of these funds [will] be interested in getting access to. For Asian sovereign wealth funds some of these countries are big buyers of LNG so BG is an interesting hedge.’

About 30% of the annual $1 trillion flows of new money from sovereign wealth funds is expected to go into alternative assets.Of this ‘alternative’ pie, about 6%, or £60 billion, is tipped to be directed at private equity, and approximately 3%, or £30 billion, to hedge funds. It is these pots of money that could cause the political waves, as, combined with leverage, they could be used to take control of public companies or influence strategy. Of course, no-one complains when private equity takes out a public company on a good premium, or the hedge funds boot out ineffective management, but how will private equity/hedge funds with Chinese or Saudi Arabian masters behave?

A lack of transparency from the sovereign wealth funds has given fuel to those who question motives. According to McKinsey & Company none of the Middle Eastern oil funds make public their portfolio allocations and CIC doesn’t even seem to have a website. But things seem to be changing here. In March, current US Treasury secretary Henry Paulson, ADIA executive director Hareb Masood Al-Darmaki and GIC deputy chairman Tony Tan agreed a set of policy principles for sovereign wealth funds. These included the pledge that ‘SWF investment decisions should be based solely on commercial grounds’ and a promise of greater disclosure about ‘purpose, investment objectives, institutional arrangements, and financial information – particularly on asset allocation...’

Separately it has been reported that a sovereign wealth fund is close to signing up to a voluntary code of conduct devised by the British Private Equity and Venture Capital Association (BVCA). Designed to improve transparency in the private equity industry, the new code is in the process of being finalised but will be based on guidelines published in November, which include a requirement for regular reports. Meanwhile a press release on the home page of China’s US embassy quotes vice minister of finance Li Yong as saying: ‘The CIC will want to make things more transparent and learn best practice from other sovereign wealth funds.’

Fund management opportunities

Given the current political sensitivities, when private equity/hedge fund investments are made by the sovereign wealth funds, they are likely to be made via investments in existing private equity firms or hedge funds, says Morgan Stanley’s Stephen Jen: ‘Partly due to the limited administrative capacity for some sovereign wealth funds to be active in the private equity space, and partly due to the desire to duck under the radar of protectionist governments, they have and will continue to buy into private equity companies. For the same reasons they will, in my view, also start to invest in hedge funds themselves.’

CIC’s first investment, made before the fund’s formal unveiling, was in Blackstone. It took a large stake at the point of the private equity group’s flotation in May, via a $3 billion slug of non-voting shares. If Jen is correct, and this form of indirect investment is to be the favoured route, then the shelved approach for Sainsbury (now rumoured to be on the cards again) from the QIA will be the exception to the rule.

One clear reward of the growing sovereign wealth funds sector is likely to be large fund management contracts. Many of these new funds don’t have the in-house knowledge to run large equity portfolios so will need to outsource to third parties. This could potentially create opportunities for the the big UK-quoted groups – Schroders, F&C Asset Management, Henderson Group and Aberdeen Asset Management – and the niche fixed-income managers such as Ashmore and BlueBay Asset Management. Analysts at Morgan Stanley believe up to 20% of all assets under management by sovereign wealth funds will be farmed out to external parties, so if annual flows of about $1 trillion are correct, that’s about $200 billion a year potentially flowing the way of London and other major financial centres. To put that into perspective that’s about equal to all of F&C’s current assets under management each year.

The scare stories about sovereign wealth funds should not distract from what is likely to be a huge opportunity. Opportunity in the sense that this wall of money flowing from oil and trade-rich nations can only support the UK equity market and generate opportunities for the finance sector. Given their poor level of transparency, sovereign wealth funds remain an unknown, but common sense suggests they are not about to destroy our flagship companies. They’re to be welcomed not maligned.

WHAT THE CRITICS SAY

DP World’s acquisition of P&O in 2006 resulted in a political backlash in America because it included a number of US ports. DP World is owned by Dubai World, the state-owned conglomerate of Middle Eastern city state Dubai. American politicians threatened a widespread revolt – members of Congress’s House of Representatives and the Senate warned they would block the takeover on security grounds. In the end DP World agreed to hive off the US ports but similar political concerns have been surfacing again following sovereign wealth funds taking equity stakes in major US investment banks.

In an election year, criticisms from Democrat supporters are coming in thick and fast. Harvard professor Lawrence Summers, a former US Treasury secretary under Bill Clinton, is one of the most vocal opponents of sovereign wealth funds. At January’s annual World Economic Forum in Davos, Switzerland, Summers cautioned of hidden motives. Summers raised, among other scenarios, the prospect of sovereign wealth funds using stakes to destroy companies in competition with their own national businesses.

What if a state proposed an ‘airline to fly to their country, wanted a bank to do business in their country, or wanted a rival to their country’s national champion disabled?’ These were, reportedly, questions posed by Summers to delegates. Since then, fellow Democrat and Indiana senator Evan Bayh has taken to the pages of the Wall Street Journal to criticise sovereign wealth funds. An opinion piece published in February saw Bayh refer to China’s ‘drive for economic advantage – including rampant intellectual property theft, currency manipulation and subsidies for manufacturers and exports.’ Bayh fingered Saudi Prince Alwaleed bin Talal, a 5% shareholder of Citigroup, for being partly responsible for the resignation in November of its former chief executive and chairman Charles Prince.

More recently, according to reports, Germany has passed legislation to set up its equivalent of the US Committee on Foreign Investment in the United States (CFIUS) with the power possibly to block investments by sovereign wealth funds.

EYES ON BRITAIN:

Wealth funds in action

Four active wealth funds in the UK market

Qatar Investment Authority

Has a 14.9% stake in the London Stock Exchange purchase in open market. Rumoured to be preparing a new bid for Sainsbury. Its Delta Two vehicle backed away from a bid last year, triggering a six-month waiting period under UK Takeover Panel rules.

Temasek

Has a 3% stake in British Land acquired in the open market in January. Owns 19% of Standard Chartered much of which was acquired from the estate of billionaire Tan Sri Khoo Teck Puat following his death in 2004. Took a 2.1% stake in Barclays last July following the bank’s fundraising to bolster its failed ABN AMRO bid.

Kuwait Investment Authority

Has a stake in BP, which dates back to the 1980s. The current stake is 1.7%, according to reports.

China Investment Corporation

An unnamed sovereign wealth fund has reportedly taken a 1% stake in BP. Could it be the recently established China Investment Corporation?

NORWAY GOES FOR TRANSPARENCY

The Norwegian Government Pension Fund is said to be the only transparent sovereign wealth fund. This fund is run by Norges Bank Investment Management (NBIM), the investment arm of Norges Bank, Norway’s central bank. The fund has a clearly defined mandate set down by Norway’s Ministry of Finance and elaborated upon on NBIM’s website. As such, analysts have used the fund as a guide to how some of the newer Middle Eastern and Asian sovereign funds may shape up.

Morgan Stanley’s Stephen Jen predicts the new sovereign wealth funds will hold 25% in bonds, 45% in equities and 30% in alternative assets, the later being made up of private equity, hedge funds, real estate, commodities, property and infrastructure assets. In arriving at these numbers, Jen draws inspiration from Norway. The Norwegian fund has to follow a Ministry of Finance defined benchmark of 60% in bonds and 40% in equities – but the mix is changing. The Norwegian government is to increase the proportion of equities to 60% and last week it was reported the fund would move into alternative assets for the first time. With a blessing from the Ministry of Finance, it will make its first foray into alternative assets via real estate.