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June 24, 2008

Sovereign Wealth Funds: The Emerging ‘Supermen’ of Private Equity LPs

By Rajesh Begur, Partner, A.R.A. Law

“A sovereign wealth fund (SWF) is a state-owned fund composed of financial assets such as stocks, bonds, property or other financial instruments.”

While some SWFs have major economic and fiscal importance, others might not have significant role in fiscal management. But the major purpose of SWFs is to maximize long term returns.

Origin: Most of the savings of SWFs originate in accumulated foreign currency reserves. This was done as follows: the reserves used to be earlier held only in gold till the U.S. came up with the Bretton Woods System, where dollars were pegged against gold, which thus lead to dollars (or now, other currencies like Yen or Euro) being used as foreign currency reserves.

Creation: SWFs are typically created when governments have budgetary surpluses and have little or no international debt. It is not always desirable to keep the excess liquidity as money or to immediately use it up in consumption, especially when a nation depends on raw material exports like oil, copper or diamonds. To reduce the volatility of government revenues, counter the adverse effects of the boom-bust cycles' on the national economy or build up savings for future generations, SWFs may be created. Other reasons for creating SWFs may be economical, or strategic.

Investment Strategies: The investment strategies and criteria differ widely for various countries. Theoretically, SWFs are just like any other independent investment funds. Most SWFs do not publicly disclose their investments, making it difficult to get a sense of their assets or their investment strategies. Most SWFs could reasonably be expected to use long-term investment strategies. Also majorly, SWFs are not highly leveraged, which differentiates them from some large hedge funds.

Examples: Several SWFs have gained public attention for specific investments. China’s fund invested in major U.S. financial firms. Temasek Holdings, a fund managed by the government of Singapore, had invested 38 percent of its portfolio in the financial sector as of September 2007. In 2005, a United Arab Emirates-owned company, Dubai Ports World, stirred controversy in the United States by purchasing a British-owned shipping company, thus giving it control over parts of several U.S. port facilities.

Dubai Ports World is a state-owned business, not a sovereign wealth fund, but the concerns provoked by the incident mirror concerns over SWFs purchasing business interests that had formerly been the domain of private companies. Another famous one that rolled the headlines was Singapore’s GIC (Government of Singapore Investment Corporation), the sovereign wealth fund that ploughed $8.9bn (£4.5bn) into Swiss bank UBS and on a spree with a $1.5bn investment in private equity firm TPG's latest $20bn fundraising. Even the world’s number 2 holder of reserves after China, Japan (with $948 billion) has been actively considering establishing an SWF of its own.

Although SWFs have been on a rise, but with emergence of greater number of SWFs, emerge new issues which need to be addressed. SWFs might be highly lucrative for PE setups, but they tend to have greater ramifications on the global front, both political and financial.

Advantages: There have been an entire multitude of opinions which treat SWFs as a positive trend, owing to its “on the face” benefits.

• More efficient government investment potentially means more government money. For the countries making the investments, this would lead to lower taxes, better public works, and stronger state-run businesses.

• SWFs offer a viable mode of sustaining long term capital growth for exporting countries who aim at long term economic viability and stability.

• Even for the companies being invested in and their countries, SWFs lead to greater capital inflows. This would mean more money for research and development, and more money to pay salaries.

• They may have a more stabilizing influence on stock markets because they are generally long term and hold the securities and stay invested for a longer time.

• There is a definite increase in the rate of return which is a result of diversification of holdings and large scale investments.

• One global advantage of SWFs having a non-financial outcome has been the southern shift in economic balance in recent years. The US has been losing its hegemonic role even in financial markets and other players are coming up.

Concerns: SWFs may also pose a danger to the global financial system and otherwise, as has being contemplated in the recent years:

• It is suggested that SWF operations are opaque, i.e., they lack transparency. Very few of them publish information about their assets, liabilities, or investment strategies and this leads to a number of other problems.

• A major concern being expressed is regarding the motives behind these SWFS. It is being apprehended that if guided by political or other considerations, SWFs can have a greater negative impact at the international front. A common example of this may be a government could use SWFs to learn how companies in other countries operate, then use this information to bolster rival state-run enterprises. Or another example, for that matter, can be when the SWFs use their powers as shareholders for political motives.

• Another problem associated with SWFs is that they are not regulated by any single authority, rather are often always regulated by multilateral organizations.

• Another commonly perceived risk of SWFs is the danger of rogue traders, who may take risky positions using their command over Sovereign Wealth Funds.

• It is apprehended that SWFs may encourage capital account protectionism, through which countries pick and choose who can invest in what, in the sense that various countries may try to pick and choose what fund can invest where. This emerges as a main concern while dealing with SWFs.

• Further, there are questions of national sovereignty which relates to interference of one country into the other country’s matters and policies through the channel of financial interests.

• SWFs are a throw-back to the end of the nineteenth century, when large pools of capital moved unregulated around the world generating a global boom, along with a fair number of crises.

• As sovereign funds grow in importance, they may take up the form of an unregulated set of intermediaries which may or may not invest with hedge funds in the future and thus it may become increasingly difficult to regulate them.

Market Response: SWFs being based on current account surpluses, major countries have committed to reducing their current account imbalances. This would limit the growth of sovereign funds. But the world economy evolves continuously in ways that make it hard to be sure current account imbalances will shrink. For example, global growth may accelerate or decelerate, and this is likely to affect commodity prices. But if commodity prices remain high, commodity exporters will have large surpluses for the foreseeable future. If commodity prices fall, the surpluses of Asian countries that export manufactures may increase.

Different countries are expected to respond differently to the growth of SWFs investments in them. For example, recently, the Indian government has made its intention clear that till the time the SWFs investments from abroad do not attain a critical mass and have the potential to abuse their economic strength detrimental to the country’s national interest, there is no need for a fresh capital control measure. India, as on date, therefore, does not recognize SWFs as distinct entities and their investments are governed by the same regulations that address FIIs. Thus, protectionism, as we see, is a highly dynamic concept very specific to the nature and position of the market, as also the country invested in. [Source: “Atithi Devo Bhava: Sovereign Funds Policy won’t build wall”, c.f. The Economic Times, dated May 23, 2008, p.7]

Impacts: Finance ministries in the past typically invested currency reserves in U.S. treasury bills and other risk-free bonds issued by wealthy countries. SWFs provide countries with a broader range of investment options. A shift away from U.S. Treasury-backed bonds as the default option for government currency-reserve investments could hold ramifications for global currency markets. Most notably, the world could be witnessing the end of an age of dollar dominance.

This shift could, in theory, be broadly positive. However, the recent concerns that have been raised regarding SWFs need to be taken into account. Although the concept of countries investing in foreign markets is an age old one, but it taking the form of SWFs and widening the investment horizons is a relatively new phenomenon, the impact of which is still in the speculation stage. Thus, the true impact and response of various economies to SWFs is yet to be observed. However, what comes forth as a certain implication is that SWFs will undoubtedly trigger the protectionism mechanism in various countries owing to the political and sovereignty issues associates with them.

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