A new frontier

Depending on whose views you canvass, sovereign wealth funds (SWFs) are the biggest threat to the capitalist model and political stability since Josef Stalin, or benign state actors in pursuit of no more than a diversified portfolio and stable returns. Reaching a consensus on issues of motivation and regulation is as difficult as finding reliable information on the activities and structures of these elusive players. One thing all commentators seem able to agree on is their longevity and importance – they are in it for the long term. Flush with petrodollars as stocks decline and the price of a barrel nudges $100, oil rich states previously content to avoid credit risk for a stable yet lower rate of return are conscious that future growth will depend on successfully diversifying their investments. Government bonds and US Treasuries in particular have long been a favourite of central banks and SWFs, underpinning the economies of emerging countries when the priority was debt repayment and establishing basic infrastructure – phase one in the program of rapid modernisation. With a number of these countries now sitting atop a huge cash surplus and social, financial and governmental institutions in place, a second phase of development is now under way. This phase involves taking significant minority stakes in listed companies across a range of sectors, as well acquiring chunks of the share capital of banks, asset managers and other investment vehicles in addition to funding and managing ever-more ambitious infrastructure projects.

Qatari assault
Sovereign wealth funds may have hit the headlines in the past few months, thanks largely to the Qatari Investment Authority (QIA) approach (via subsidiary Two Delta) for UK supermarket chain J Sainsbury, but many are old hands when it comes to private equity investing. The likes of the Abu Dhabi Investment Authority (ADIA), the Kuwait Investment Authority (KIA), Government of Singapore Investment Corporation (GIC), and the Norwegian Government Pension Fund have long invested as LPs in private equity funds.

The announcement that Two Delta was in the running for the retail giant sparked debate as it marked a departure from previous SWF investment strategies. Taking on the role of the lead investor is an unusual approach, although for the Qatari’s it is not unknown. In September 2006, Qatari-backed Delta Commercial Property, acquired specialist UK healthcare provider Four Seasons Healthcare from Allianz Capital Partners for £1.4bn and in July another Qatari-backed vehicle, the Delta Fund, bought UK hospital operator Care Principles for £270m from 3i. It also struck a £150m deal for the UK-based specialist school Senad in 2006.

The QIA invests the emirate’s gas reserves and is run by Qatari Prime Minister Sheik Al Thani. The organisation and structure of the fund is as secretive as any of the SWFs, yet the QIA does not shy away from high-profile deals. The fund is estimated to have assets under management of between $50-70bn and recently took stakes of 24% and 10% in the London Stock Exchange and Nordic exchange OMX respectively. Although Delta has proven its ability to lead a deal, it will be some time before it becomes clear whether the fund has the expertise to run a business successfully and generate private equity-like returns. Indeed, some remain sceptical about the ability of SWFs to emerge as genuine challengers for assets because they lack the experience crucial to the success of a leveraged buyout. ‘Sovereign wealth funds will fund it difficult to do direct deals as they do not have the in-house knowledge,’ says Tom Lamb at Barclays Private Equity. One way of ensuring you have the experience is to buy it in. This is the approach taken by the QIA, whose Delta vehicles are advised on their leveraged buyout activities by Paul Taylor, former head of structured finance at NatWest and confidante of property impresarios Robert and Vincent Tchenguiz. Alongside Taylor is another heavy-hitting City bigwig, ex Barclays chairman Sir Peter Middleton, as well as former Ernst & Young chairman Nick Land. The most successful exponent of this model is Dubai International Capital (DIC), which has snared a host of private equity pros to lead its business since its founding in October 2004. (See box)

Teamwork
Interestingly, DIC does not view itself as a sovereign fund, ‘Although we invest the cash of the sovereign we are a private investment arm, not a sovereign wealth fund,’ said a person close to DIC. It would seem clear-cut that where a fund is investing state proceeds rather than raising third party capital and whose ultimate shareholders are the ruling family of Dubai, ‘sovereign wealth fund’ as a description fits the nature of the beast accurately.

Regardless of the term best applied, DIC has shown that it is possible for a vehicle backed by a state to attract the best talent and ready itself for private equity deals, a reality that some in the industry are reluctant to acknowledge. ‘It is comforting for the established private equity houses to believe that sovereign funds do not have the ability to compete or attract the best talent – they do,’ says Ian Bagshaw at Linklaters. However, some question whether the structure of these vehicles will deter private equity deal-doers from making the leap. ‘Sovereign funds may have a problem attracting private equity professionals, with the deal team fearful of a lack of independence when making investment decisions,’ believes Bown.

However, DIC’s investment strategy does differ in comparison with other SWFs and this difference explains DIC’s reluctance to be tarred with the ‘sovereign wealth’ brush. ‘Unlike other sovereign funds where return expectations are often lower and outlook long-term, Delta and DIC have higher return expectations and holding periods similar to a traditional private equity fund,’ says Chris Bown at Freshfields who has advised DIC on a number of deals. Bagshaw agrees: ‘Funds such as the Kuwait Investment Authority and Abu Dhabi Investment Authority have a different investment horizon. They don’t necessarily buy with a view to selling.’

The contenders
Should traditional private equity firms be worried about the threat from sovereign wealth funds? In short – yes. SWFs have the cash to out-spend any buyer and if the asset is right, the inclination to do so as well. They have the ability to hire the most experienced people, as Delta and DIC have both demonstrated and are not bound by the same limited partnership agreements as private equity firms. This flexibility to scour all sectors, size brackets and asset classes presents a significant advantage in times of uncertainty. When private equity firms are under pressure to put cash to work to avoid capital overhang, a problem firms on the fundraising trail feel most keenly, SWFs can take a more considered view, either holding back or pursuing an investment in an area where risk can be measured more accurately. Sovereign funds are also less reliant on leverage. This point can be over-stated, as SWFs take a similar approach to gearing as private equity firms for basic cost of capital purposes, but bank appetite for underwriting debt, and on what terms, will not make-or-break a deal. For a private equity firm, access to debt is the lifeblood of its operation. However, although the resource at the disposal of SWFs may be vast, the death-knell for private equity firms is some way off yet.

The emergence of sovereign wealth funds as genuine contenders in the M&A space is a challenge private equity firms will have to adapt to. Out-spending them is off the table, so private equity firms might consider teaming up as an option to negate their superior firepower. ‘Investing alongside a sovereign wealth fund makes a lot of sense. Apart from the equity ticket they bring to the deal, striking a relationship with a sovereign player opens doors for future investments in difficult to access geographies,’ says one UK-based private equity investor. With deals in the €1bn+ space off-limits for most houses due to tightened liquidity, there is a financing gap to be plugged and SWFs could play a role. ‘Times are changing. The days of four private equity houses co-investing are gone. We moved to equity bridges to plug the gap initially and with this no longer an option, LPs and sovereign wealth funds may step in,’ says Ian Bagshaw at Linklaters.

The enemy within?
The prospect of private equity firms investing on equal terms with SWFs was brought closer this summer with the China Investment Corporation’s acquisition of a 9.9% stake in Blackstone. The sale was criticised by some as motivated purely by profit, whilst others believe there was a more sound logic. ‘It was a smart move by Blackstone, opening up China for inward investment from the firm,’ says Bown. The move has already reaped rewards, with Blackstone investing $600m for a 20% stake in state-owned chemical giant China National BlueStar in October. Less than a month later, Blackstone joined forces with China National Chemical Corporation, of which BlueStar is a subsidiary, in the race for Australian Agro-Chemical firm Nufarm. The deal fell through in December, but revealed how Blackstone is looking to leverage its relationship with the state.

For the Chinese, the acquisition of the stake in Blackstone will allow it to view first-hand the complexities of a private equity deal and potentially accrue enough knowledge to conduct its own direct deals at some point in the future. ‘The people staffing China’s sovereign fund are all highly educated and will be asking themselves “why don’t we go one step further” and lead our own deals,’ says Hasan Sohbi at Taylor Wessing. One private equity lawyer with experience of dealing with SWFs says that having a sovereign investor in your management company is akin to ‘inviting the enemy in. Of course they will try and learn as much as they can and will be competing with you in a few years.’ These fears did not dissuade US firm Apollo from selling a 9% stake in its management company to ADIA in October, while another arm of Abu Dhabi, Mubadala, acquired a 7.5% stake at Carlyle around the same time. At the time of the deal, Carlyle co-founder David Rubenstein stated that co-investment as a result was a possibility. Sovereign funds have also looked to asset managers with expertise in other areas of the financial markets for investments. DIC agreed to pay $1.25bn for a 9.9% stake in hedge fund manager Och-Ziff, and also has stakes in a number of banks including HSBC, Indian bank ICICI and Greek bank Marfin. Temasek Holdings, an investment arm of the government of Singapore, has a 2% stake in UK bank Barclays and owns 17% of Singapore bank Standard Chartered, which was recently the subject of a sovereign wealth tug-of-war. It was reported that China’s three largest banks approached Temasek about buying its stake but were rebuffed by the Singaporean fund.

National insecurity
As well as encroaching on the financial landscape, the emergence of sovereign wealth funds has fuelled a discussion on protectionism and transparency, which has spilled into the political realm. The Dubai Ports World controversy in the US propelled the issue into the public consciousness and the debate has continued, aided in large part by SWFs abandoning their previous strategy of acquiring non-controlling stakes. Leading a deal may allow you to cut out the GP fees and remuneration structures may be more lucrative, ‘but it has to be asked whether acting as a lead investor is a politically astute move. Co-investment or seeding funds attracts less criticism and negative attention,’ says Jenkinson.

Sovereign wealth funds encourage scepticism of their motives by operating opaquely. Although there is little to suggest that their motives are anything other than benign, ‘it is not out of place to have a conversation about sovereign funds. If you believe private equity should be more transparent then you do need to ask whether sovereign funds should be included in this process,’ says Timothy Spangler at US law firm Kaye Scholer. Richard Portes at the London Business School believes it is right that we are having the debate and sounds a more ominous tone regarding the intention of sovereign players. ‘There is a real danger that we allow sovereign funds to operate like any other investor and they nationalise by the back door.’ Although desirable, Portes believes workable regulation would be very difficult to construct. ‘If you don’t have a common policy it is very difficult to work on a country-by-country basis and introduce incentives to restrict investment. The best option would be to go through the OECD (Organisation for Economic Co-operation and Development). Going down this route might get results.’

In many ways, the issue of protectionism is a cultural one, tied into a climate of insecurity, ideology and fears regarding terrorism. In the US, The Dubai Ports World deal was thwarted by the House of Representatives, which voted 62-2 to block the deal in defiance of President Bush. However, with the dollar in decline and a recession creeping closer, the US does not have the luxury of rejecting investment from wealthy financiers, regardless of where the money is coming from. ‘The US needs as much foreign investment as it can get,’ acknowledges Portes.

Similar protectionist impulses have reared their heads in Continental Europe. Following speculation in 2005 that French dairy-product company Danone was a takeover target for a number of US firms, the French government introduced laws protecting a raft of French companies in ‘strategic industries’ from a hostile takeover. In Germany, controversy erupted following the acquisition by US private equity firm One Equity Partners (OPE) of Germany’s largest shipyard, HDW. At issue was OEP’s intention to sell submarine technology to Taiwan, something expressely forbidden by the German government which supports the ‘One China’ policy. Unable to force the government to overcome its opposition to the sale, OEP sold its stake in HDW two years later to rival German shipyard ThyssenKrupp. ‘If you pursue a policy of creating “national champions” then you are bound to view aggressive foreign investment with scepticism and look to curtail it in some cases,’ says Jenkinson. In Germany protectionist impulses continue to thrive. Following the French lead, a law is currently being drafted which would curb foreign investment by protecting ‘strategic industries’, with sovereign wealth funds the explicit target. The bill is expected to pass in the new year following delays over which government ministry should have the final say over investments in sensitive industries.

The story is different in the UK, where the Labour government has made a virtue of its embrace of foreign investment, from the stock exchange, to utility companies and football clubs. ‘The UK has tended to take a more sanguine view of foreign investment. The central question following any takeover approach is whether the investment is in the interest of the shareholders. Regulatory bodies exist to deal with national security issues,’ states Jenkinson.

Transparency divide
‘The question that needs to be asked is how many of the concerns raised are unique to sovereign wealth funds? To what extent is this an “asset problem" shared by private equity funds, for example, and not an "investor problem?” asks Spangler. Those who contend that the problem is an investor one believe that with no stated aims and an ownership structure directly linked to the state, it is right to impose stricter conditions on the terms of entry. As a concession to this point of view, the China Investment Corporation waived its voting rights on agreeing the deal with Blackstone to take a 9.9% stake in the company, as did Mubadala following the purchase of its stake in Carlyle. Until we know more about the aims of sovereign players, a prudent approach is sensible. Lawrence Summers, a Harvard professor, put it most eloquently when he said that the ‘logic of the capitalist system depends on shareholders causing companies to act so as to maximise the value of their shares. It is far from obvious that this will over time be the only motivation of governments as shareholders.’ Perhaps the simplest way of calming such fears would be to introduce a non-executive or advisory figure to oversee investments. ‘Sovereign wealth funds may need to think about improving their public perception, possibly by bringing external advisers on board to allay concerns regarding politically motivated investments,’ believes Spangler.

For private equity, SWFs pose both a threat and an opportunity. They will increasingly challenge for deals, with the infrastructure sector destined to become a key battleground. Sovereign funds taking stakes in private equity firms present an opportunity in the short-term but may in the long-term constitute a threat to deal flow. Transparency will continue to dominate the SWF debate, and for private equity the outcome may be crucial. The Walker Report in the UK has created a new tier of regulation for private equity firms, but makes no mention of sovereign funds. If private equity firms are subject to more punitive transparency codes than their sovereign wealth competitors, this will hand sovereign funds a competitive advantage over private equity firms. The worst case scenario would see acquisition targets choose a sovereign backer over a private equity backer in order to avoid the enhanced disclosure requirements.

Ultimately, SWFs will need to address the transparency issue if they are to compete with private equity whilst continuing along the path of high-profile global acquisitions. Failure to address the concerns will see these funds face greater restrictions from protectionist governments sensitive to charges of compromising not just national security, but national character.

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