Sovereign Wealth Funds Fill Gap When Cash is King

MBA (4/2/2008 ) Murray, Michael
Necessary capital infusion into the United States economy and weakness in the U.S. dollar is forming a “perfect storm” for sovereign wealth funds (SWFs) to invest more heavily in U.S. financial institutions and potentially commercial real estate—primarily Class A office and hotel properties.

Jocelyn Cunningham, principal at Deloitte Consulting, New York, said the reason for greater investment in the U.S. by sovereign weal is not so much weakness in the U.S. dollar but in providing fundamental liquidity and capital into organizations.

"It's the need for capital injection into mature markets and these organizations having abundant liquidity," Cunningham said. "They're here to stay. I think their activity will increase, and I think it has everything to do with the current marketplace—a capital injection into the marketplace."

SWFs—wholly-owned government entities—are investment vehicles holding assets with funds in domestic and different reserve currencies, including the dollar, euro and yen. SWFs derive from countries or states with balanced budgets and abundant capital.

SWFs have been in existence for more than 20 years but increased their role significantly in the global economy and U.S. in past two years. Deloitte Research said that since 2006, three of the top 10 SWFs were established and with $3 trillion of SWF assets under management, Deloitte expects them to grow to nearly $10 trillion by 2012.

Oil SWFs account for nearly 75 percent of assets under management but from 2006-2007, SWFs spent $35 billion—$26 billion during the second and third quarters last year—in the financial sector verticals.

"It has a very profound impact, potentially, on the financial market," Cunningham said, adding that SWF investment strategies have shifted from conservative debt market investments to a "much needed" recapitalization of the global banking system.

"It's interesting to note that oil topped $100 per barrel,” said Guy Langford, principal at Deloitte & Touche LLP. When speaking to SWF clients, Langford said they used the term, specifically, the "perfect storm.” “It really has opened up the playing field for low leveraged buyers, such as SWFs," he said.

Abu Dhabi Investment Authority, Kuwait Investment and the Government of Singapore own nearly $17.5 billion in Citigroup; Singapore’s Temasek Holdings, Korean Investment and Kuwait Investment owns nearly $9 billion in Merrill Lynch; China Investment Corp. purchased 9.9 percent of Morgan Stanley for $5 billion; the Government of Singapore purchased 9 percent of UBS in Switzerland for $9.75 billion and Qatar Investment purchased 20 percent of the London Stock Exchange.

"We are seeing an increasing role in the banking system," Cunningham said, adding that SWFs own 9 percent of the U.S. banking sector.

Langford said 19 of 24 SWF funds on Deloitte's list invested in real estate. The decline in the dollar, issuance rates in financing transactions and declining real estate values all contributed to SWF investment.

U.S. commercial real estate, primarily office and hotel properties, found capital primarily from the Government of Singapore; Istithmar (UAE); and Abu Dhabi’s $1.4 billion investment in Related Companies, based on data from Securities Data Corp. and Real Capital Analytics, New York.

Securities Data Corp. and RCA showed the Government of Singapore invested $450 million for the Intercontinental Hotel in Chicago and made an undisclosed investment in the Hyatt Regency La Jolla; Istithmar provided 73 percent investment--$380 million--for the Mandarin Oriental in New York and $300 million for Six Times Square, an office property in New York; Istithmar entered a joint real estate venture with MGM and Kerzver for an undisclosed amount.

"With transparency issues, it's not easy to determine allocation to real estate," Langford said.

Real estate investment trusts, trading at 25-30 percent and discounted net asset value (NAV), also create a buying opportunity for SWFs, Langford added, and if delinquencies remain low for commercial real estate this year and in 2009, tightness in the credit market keeping commercial mortgage-backed securities low could make SWFs a viable force in commercial real estate.

Hybrid debt financing or alternate investment commitments to private equity investors could fill the void created by lack of liquidity from current public and private debt markets, Langford said.

BIHT Ltd. International, a SWF based in the Channel Islands, said it is investing in debt and equity for commercial real estate properties, and views itself more as a mezzanine or bridge lending facility at a maximum term of 36-48 months—until the market recovers—and not above 60 percent loan-to-value. In addition to gap financing, BIHT Ltd. is also looking at “advantage acquisitions,” said Clain Brandt, managing principal at BIHT Ltd. International.

“Sovereign funds like ourselves are involved in doing direct debt but very cautiously,” Brandt said. “It’s the mark-to-market issue.”

"In the last four or five months, sovereign wealth funds have looked at portfolios of trophy hotel properties,” Langford said. “The concept of getting a property that is, perhaps, an irreplaceable location—five star, on the beach."

Securities Data Corp. database and RCA also showed that while China Investment Corp. purchased 8 percent of Blackstone for $3 billion, Mubadala (UAE) purchased 7.5 percent of Carlyle Group for $1.35 billion.

“It’s all about transparency, simplification and accountability,” Brandt said. “These institutions that are relying on sovereign funds have to figure out some way to accomplish those goals while at the same time staying liquid.”

While SWFs are more transparent in Norway; New Zealand; Alaska; Alberta, Canada; and Singapore, less transparent SWFs are from the United Arab Emirates; China; Qatar; Kuwait; Brunei; Venezuela; Taiwan; and Oman, according to Deloitte Research.

"Most are not very transparent," Cunningham said, calling less transparency around allocation of funds and its impact around financial markets a "worrisome trend."

One concern, Cunningham added, are fears that growing SWFs could give possible undue financial leverage for the Middle East, Russia and China. "There is a high level of sensitivity to what the investment strategies are to these sovereign wealth funds," she said.

Deloitte analysts said SWFs are not purchasing controlling interests, based on the data, but Brandt disputed that notion. He said that prior to the liquidity crisis in the capital markets, sovereign funds would not be allowed to provide this capital infusion into U.S. financial institutions.

“These foreign sovereign wealth funds are buying controlling interests,” Brandt said. “They will be dictating policy within these financial institutions on a go-forward basis.”

Political task forces, however, are evaluating the impact of potential regulation as concerns mount on the advancement of political or market agendas; the influence of SWFs within international and monetary markets; and potential for SWFs to control major investment banks and possibly the U.S. economy.

Some host countries—recipients of SWF investments—have put guidelines and restrictions in place, including keeping SWFs from having voting privileges. Potential regulatory changes would have an impact on these funds, but Cunningham said the dire need for capital in the U.S. economy is leaning the U.S. toward not blocking SWFs.

Last month, however, United States Treasury leaders and heads of government from Singapore and Abu Dhabi agreed to a set of principles for sovereign wealth funds to base investment solely on commercial grounds rather than advancement of geopolitical goals of the controlling government and for greater disclosure to reduce financial market uncertainty and build trust in recipient countries while respecting host-country rules and regulatory requirements.

"Singapore and UAE [United Arab Emirates] have long-established, well-respected funds and are showing real leadership by joining with us,” said Treasury Secretary Henry Paulson Jr. “The U.S. welcomes sovereign wealth fund investment and looks forward to continuing to work with these two countries and others to support the initiatives underway at the IMF [International Monetary Fund] and OECD [Organization for Economic Cooperation and Development] to develop best practices for sovereign wealth funds and recipient countries.”

Principles for countries receiving sovereign wealth fund investments included equal treatment of “like-situated investors” without creating protectionist barriers to portfolio or foreign direct investment. Investment framework and rules for recipient countries should also have consistency, predictability and public support and any investment restrictions based on national security reasons should be proportional to genuine national security risks raised by the transaction, the set of principles stated.