Their wealth has spiked while their numbers have jumped. Sovereign wealth funds have moved into the media spotlight with their recent high-profile investments in Merrill Lynch, Citigroup, Morgan Stanley, UBS and The Blackstone Group, among others. The funds have poured billions of dollars into these and other companies and in some cases securing them from what could have been significant fall-out from losses, especially as a result of the sub-prime mortgage crisis. With less-than-rosy forecasts for many of Wall Street's largest brokerages and banks, large-scale infusions of cash have created a heated debate over whether investments by these increasingly massive funds are a cause célèbre or a cause for concern. Consider this about the growth of these funds. A May 2007 report by Morgan Stanley analyst Stephen Jen predicts that sovereign wealth funds—estimated at approximately $2.3 trillion in mid-2007—could reach $12 trillion by 2015, and is likely to exceed the total size of the world's official reserves by the end of 2011.Moreover, the long-term investing strategies of the funds and the nations behind them are emerging from hard lessons learned three decades ago, according to Van Wood, Ph.D., chair in International Business at Virginia Commonwealth University. "We're seeing these countries with enormous surpluses," Wood says. "The last time around was in the 1970s, when many countries had a big run-up of wealth, and they didn't invest it too wisely, buying weapons and consumer goods. This time, they want to invest for the long-term to accumulate more wealth for the stability of their countries," he says.
Establishing a U.S. Beachhead
The U.S. is an attractive market for many of these funds because of its history of political stability and overall transparency, says George W. Denninghoff, chief financial officer of Vista Research and Management, LLC, a Chappaqua, New York-based mutual fund management firm. In addition, the financial expertise in the U.S. is unparalleled. That, Denninghoff says, makes these funds willing to take on risky investments like financial companies that may still have significant exposure to losses from mortgage-backed securities.
But when foreign nations with governments and ideologies that are very different from Uncle Sam's—and which often operate with little transparency—start buying financial companies, people get nervous.
Singapore's Temasek Holdings recently purchased $4.4 billion of Merrill Lynch common stock with an option to buy $600 million more this year, and Beijing's State Foreign Exchange Investment Company poured $3 billion into private equity giant, The Blackstone Group.
Yet with most of these investors opting out of large-scale investor benefits such as board seats and voting rights, why should Americans be so uneasy? In his paper, Jen cautions that aggressive investment of funds from sovereign nations may spur a wave of economic nationalism, particularly as Western countries become apprehensive about the motivation of sovereign nations investing in their foremost companies.
Indeed, Peter Mandelson, the European Union's (EU) Trade Commissioner, recently spoke out against certain kinds of foreign investment opportunities, such as investing in defense contractors, by sovereign nations. And shortly afterward, the European Commission announced that it would push for a set of principles, but not legislation, relating to sovereign wealth funds investing in European companies, modeling those guidelines after the transparent operations of Norway's Government Pension Fund.
Mitigating Backlash
The U.S. has already had its share of backlash and change surrounding foreign investment. In October 2007, the Foreign Investment and National Security Act of 2007 (FINSA) went into effect, broadening the President's and the executive branch's ability to control foreign investment in the United States. According to a report by Edwin M. Truman, senior fellow at the Peterson Institute for International Economics, this was largely motivated by the controversy surrounding the proposed takeover of Unocal by the state-owned China National Offshore Oil Corporation (CNOOC) in 2005 and the proposed acquisition of the Peninsular and Oriental Steam Navigation Company by Dubai Ports World, a company owned and controlled by the government of the United Arab Emirates.
Truman makes the case that the time has come to create international guidelines that guarantee greater transparency and accountability as sovereign wealth funds continue to invest in U.S. companies. While he is not yet troubled about national security issues related to sovereign wealth fund investing, he points to the potential for economic fallout. "There is a concern about investment in banks and financial institutions in general. They are viewed as quasi-public utilities. With the U.S. government on one side and another government on the other side, that could—at a minimum—have bigger [financial] implications," Truman says.
Truman suggests a set of best practices that addresses four areas, including structure, governance, transparency and accountability, and behavior. Overall, the guidelines would try to guarantee that the countries have clearly stated investment policies and operate according to sound fiscal policies, rather than political motives. Each government's role in the fund, as well as the operations of the investment mechanisms should be clearly stated. Truman is not alone in his opinions that greater oversight in foreign investment is necessary. Sen. Richard Shelby (R-Ala.) of the U.S. Senate Committee on Banking, Housing, and Urban Affairs called on the Government Accounting Office to collect information on which countries have sovereign wealth funds, how large they are, how they are governed, and what reporting they do, among other information. Last October, U.S. Treasury Secretary Henry M. Paulson, Jr. pushed the International Monetary Fund for policies on the increasingly controversial funds. "The United States believes a multilateral approach to [sovereign wealth funds] that maintains open investment policies is in the best interest of countries that have these funds, and countries in which they invest."
Other Options for Control
Not everyone thinks guidelines are necessary. Jaffe says that, if anything, their decision to forego voting rights and board seats might make them too passive. "As large investors, some might argue that they have a responsibility to ensure their investments are run in the proper fashion," he says. As for the potential for political motives? "If these funds begin making investments based on political criteria, as opposed to good financial sense, then I expect the market will punish them, as it would anyone making foolish investments."
Wood says that increasing restrictions could lead to a softening of investment in the U.S. "There's plenty of evidence that when you put up the borders, stop the exchange of ideas, you lose money," he says.
Then there is the issue of who would police the guidelines and what types of enforcement would be possible or realistic. Denninghoff suggests using existing tools to limit the roles of passive investors. "There's a solution in publicly-traded partnerships," he says. "This is a tremendous opportunity for us to use an existing provision to address this issue." Publicly-traded partnerships, also known as master limited partnerships, are limited partnerships that are traded on public exchanges, just like corporate stock. Such partnerships allow a corporation to spin off a group of assets or part of its business into a publicly-traded partnership, limiting the scope of the investment in the company.
With more grim news emerging for U.S. financial institutions and with the enormous riches that these foreign countries have to invest, sovereign wealth funds are going to be a factor on Wall Street for years to come.Click Here for Complete Story
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