Sovereign Wealth Funds: grown-up investors facing regulatory pressure

@LawAhead

Sovereign wealth funds have begun to play a critical role in the global economy. Maturing investment strategies and increasingly complex relationships between governments have led to challenges in regulation and international investment policy and strategy.

Author: Javier Capapé, PhD, Director of the Sovereign Wealth Research program at the IE Center for the Governance of Change and Adjunct Professor at IE University The newly established Sovereign Wealth Research (SWR) program at the IE University Center for the Governance of Change was developed to explore SWF strategies and the impact these institutions have on a global scale. The SWR program, among its activities, produces an annual report, made in collaboration with ICEX-Invest in Spain.

From unknown to economic powerhouse

Sovereign wealth funds are now commonplace financial institutions. Yet, when we started investigating these investment giants a decade ago, names like Qatar Investment Authority (QIA), Abu Dhabi Investment Authority (ADIA) and China Investment Corporation (CIC) were practically strangers to us all. However, at the close of 2018, these three funds, and 88 others, exceeded 8 trillion dollars in assets under management. To put that into perspective: the GDP of the United Kingdom, France, Canada and Spain together total 8 trillion dollars. The stock market valuation of Apple, Amazon, Google (Alphabet), Microsoft, Alibaba, Tencent, ICBC, China Construction Bank, Berkshire Hathaway, Facebook, JP Morgan Chase, Bank of America, Johnson & Johnson and Exxon together, also total 8 trillion. These once little-known entities were born in geographies far from traditional plazas like Doha, Abu Dhabi, Riyadh, Moscow, Oslo and Beijing, areas which have accumulated unprecedented financial power.

Few funds making a big impact

Most of the visible activity of sovereign funds (that which SWFs do not execute through third-party managed funds) is carried out by a small group of leading funds. 2018 was once again led by two Singapore funds, Temasek and GIC, and two funds from Abu Dhabi, ADIA and Mubadala. Australia’s sovereign fund, known as the Future Fund, and Malaysia’s Khazanah, were also important players. These six funds together held 80% of the value of SWF deals in 2018. Sovereign funds make approximately 180 transactions annually. That calculates to a little over three deals per week. Although it may not seem like many transactions, these investments hold a total deal value of close to $80 billion annually. That’s equal to 2% of all global merger and acquisition deals in 2018. Those $80 billion represent 10% of SWFs total assets under management. So, despite flexibility of asset allocation, many SWFs are already invested, and capital already deployed cannot be moved as freely as some commentators think.

As sovereign wealth funds move away from real estate, they are increasingly drawn to technology and startups. In fact, 2018 marks a historic record for sovereign venture fund deals, sovereign funds that invest as and with venture capital funds.

 

Real estate on the way out?

Real estate has held the lion’s share of sovereign funds’ interest for the last three years. But, large-scale operations in the chemical, consumer and fintech sectors overtook interest in brick and mortar in 2018. The difficulty of finding attractive valuations in the last phase of the cycle, and competition for scarce assets explains the relative decline of interest in real estate. The recent decision of NBIM (Norway’s sovereign fund asset manager) to reduce their target investment in real estate (from 7% to 5%) and to dismantle its unlisted real estate unit, also explains the decline. Although interest in real estate has ebbed, it still attracts investment. Within the real estate sector, SWFs were most attracted to the hospitality sector, illustrated by two big deals made in 2018: GIC joined a group of investors to acquire a majority at AccorInvest—the real estate property unit of Accor, the largest hotel operator in Europe—for more than $5.5 billion; and QIA acquired the iconic The Plaza Hotel in New York City—a $600 million deal.

A move towards tech

As sovereign wealth funds move away from real estate, they are increasingly drawn to technology and startups. In fact, 2018 marks a historic record for sovereign venture fund deals, sovereign funds that invest as and with venture capital funds. In 2018, SWFs invested in 77 investment rounds, more than one per week, representing the crest of a wave building since 2014. In the last five years, sovereign wealth funds participated in 220 startup investment rounds, mostly in the United States and China. SWFs in India, the United Kingdom and Singapore have also been attracted to technology-based companies. Among the most appealing sectors are biotechnology and health, fintech, mobility and agriculture. Startups that develop artificial intelligence, provide cybersecurity or storage and management in the cloud, are also highlighted in the report.

 

The evolution of investment

SWFs appetite for investing in private markets reflects an increasing maturity in asset allocation. Sovereign wealth funds have grown, and this growth has translated into changes in investment strategy. From classic conservative portfolios (60% equities, 40% fixed income), they have moved to portfolios with alternative assets, where private equity, real estate and venture capital hold a place. Another big change observed is the access to deals. Most SWFs use third-party managers to invest in private illiquid assets, through specialized sector and geographic managers. Yet, as SWFs join other private players in the industry, they are beginning to establish their own direct investment units in real estate, infrastructure, private equity and venture.

Regulatory response to SWFs’ new-found power

One of the consequences of this shift to direct deals in private and public markets is regulatory concerns. Old fears about the end goals of SWF investments are reemerging in the US and Europe. In August 2018, reform was made in the Committee on Foreign Investments in the United States (CFIUS), increasing scrutiny of minority positions of foreign SWFs and private equity funds based on national security concerns. This new protectionist approach, and the current trade war between the US and China, may explain why Chinese foreign direct investment in the US is projected to fall by 86% year over year from $29.4 billion to $4 billion. No direct deal made by China Investment Corporation was recorded in the US in the third quarter of 2018, compared to deals valued at $1.2 billion in 2017. These macro tensions came directly following two decisive actions taken by CIC to focus on US markets; in May 2017, CIC opened its North America office in New York, and in August 2018, they closed their first deal with the Cooperation Fund, established with Goldman Sachs, to invest in American companies in the manufacturing, industrial, consumer and healthcare industries with real or potential material business connections to China. These two moves may now be put on hold given the direction of both the political and regulatory decisions being made by the US administration.

One of the consequences of this shift to direct deals in private and public markets is regulatory concerns. Old fears about the end goals of SWF investments are reemerging in the US and Europe.

In Europe, both the European Commission and German and French governments have expressed the need to establish a unit in the EU similar to the CFIUS, with a particular focus on Chinese state-owned enterprises that could affect other state-backed institutions such as SWFs. Germany plans to pass a law that will create a state-owned vehicle for protecting ownership in strategic companies from unwelcome investors.

SWF partnerships in the face of protectionism

These political decisions butt heads with other agreements being made between global players, including a recently signed partnership between CIC and BNP Paribas, which establishes a $1.4 billion private equity fund for investing in French companies with interests in China. It comes after the United Kingdom’s HSBC released a statement about a similar $1.3 billion deal with CIC for investing in British companies with ties to China. The particular use of SWFs as co-investment funds can be understood as a way to channel and accompany foreign, state-owned capital into strategic sectors and help domestic companies in Europe and the US grow in the markets of capital origin. Italy and Ireland, and recently Spain, have signed similar SWF co-investment agreements with SWFs in Kuwait, Qatar, China and Oman. It is still too soon to assess which of these two trends will drive the relationship between state-owned investors and recipient countries in Western economies. On the one hand, there is stronger regulation and scrutiny of SWF investments; on the other, there is an increasing number of partnerships being made between SWFs and EU and US financial institutions to foster business and investment relationships. We will be watching to see the outcome with bated breath.

 

Javier Capapé, Ph.D. is the Director of the Sovereign Wealth Research program at the IE Center for the Governance of Change and Adjunct Professor at IE University. He earned his Ph.D. from ESADE Business School and the University of Illinois (USA). He has been Consultant at the United Nations Environment Program on Sovereign Wealth Funds and Sustainable Development Goals. Since 2012, he is SovereigNET Research Affiliate at The Fletcher School (Tufts University) and Co-Editor of the Sovereign Wealth Funds Reports series, an initiative backed by ICEX-Invest in Spain. He has published in top academic journals such as the Academy of Management Perspectives and Oxford University Press. His research has been regularly cited in international media (including Financial Times, The Economist, Wall Street Journal, Reuters).

Note: The views expressed by the author of this paper are completely personal and do not represent the position of any affiliated institution.