Sovereign funds under scrutiny

Growing pressure on sovereign wealth funds to open their books and enhance transparency may force them to cut their investment horizons short and discourage them from investing in illiquid but higher-yielding assets.

The secretive $3 trillion (Dh15.54trn) industry, which invests national windfalls for future generations, has come under scrutiny as it has replaced crisis-hit private equity firms and hedge funds as the main driver of corporate acquisitions.

But with ever-greater pressure at home to prove their strategies are successful even in the short term, these funds may opt more for relatively safe debt securities over riskier equity stake building that may take years to yield fruit.

Concerns have grown in many Western capitals that state-owned funds are investing with political rather than commercial motives.

These funds have responded by forming working groups, agreeing their Santiago Principles of best practices and releasing details of performance and strategies.

Many welcome these efforts to open up. But the increased transparency has also led to revelations of huge losses incurred by investing in Western banks as the crisis unfolded – sparking public criticism at home. As a result, SWFs have sharply reduced their headline activities and come under pressure to invest in instruments or projects that will give visible and accountable returns, rather than in something which will hopefully yield something in a loosely defined, somewhat "long", investment horizon.

"SWFs are under greater scrutiny than ever before, not least from their domestic audiences," said John Nugee, head of official institutions at State Street Global Advisors. "The level and tone of some of the criticism by national media for high profile losses on selected headline acquisitions might even jeopardise their ability to take the long-term investment positions that have given them such a comparative advantage."


Assets decline

Total assets held by SWFs, many from resource-rich emerging economies, are estimated to have shrunk 15-20 per cent after their $80 billion investment into Western banks turned sour. Currently making up almost a 10th of global stock market capitalisation, SWF assets are expected to more than double in the next 10 years.

Their orthodox mandate is to maximise returns to provide wealth for future generations – thereby allowing them to take a "liquidity premium" and invest in illiquid instruments which will bring higher extra returns in the long term.

However, very few countries spell out the exact objectives of their SWFs, resulting in some governments dipping into their wealth funds to provide fiscal support during the crisis.

Given the shrinking assets and reduced new inflows, SWFs have sharply cut their activity in global corporate takeovers.

According to data from Thomson Reuters, global announced M&A volumes involving state-owned funds, which include pending and completed deals, stood at $30.2bn so far this year. This compares with $53bn in the same nine months in 2008.

Deals are coming back to the market slowly however, with the third quarter registering 29 pending and completed deals worth $18.0bn.


Santiago blues?

Leading sovereign funds formed the International Working Group of Sovereign Wealth Funds in 2008, announcing a set of 24 principles and best practices, known as the Santiago Principles, last October.

The group – whose members include the UAE, Kuwait, Singapore, China, Korea, Russia and Norway – meets once a year to exchange views on issues of common interest and the next gathering is due in October in Baku, Azerbaijan.

Gary Smith, head of central bank, supranational and SWF business at BNP Paribas Investment Partners, warns that an excessive push for transparency, coupled with recent poor performance, could lower the risk appetite of SWFs and encourage them to favour safer instruments such as bonds.

"Following the whole push towards transparency, funds opened themselves up for a monitoring process which did not exist," said Smith.

"We have transparency problems for them. The consequences are that these guys are being marked to market on a daily basis by domestic constituents. It's uncomfortable, particularly when the assets under management shrink."


Need for structure

Sponsoring governments therefore need to spell out the mandate of their SWFs with a clearer investment horizon – thereby allowing them to ride out short-term portfolio fluctuations and protecting them from domestic criticism.

"Obviously we believe transparency is a good thing. The problem of transparency is – daily performance, daily this, daily that – that we create an obsession which often detracts from what you are trying to achieve from a particular portfolio," said John Green, global head of business development at Investec.


- The writer is a Reuters columnist. The views expressed are his own