The problem with sovereign wealth funds

The ‘problem’ with sovereign wealth funds is that they do not have to compete for capital. Governments with fiscal or trading surpluses basically give capital (and a lot of it) to their sovereign wealth funds for investment.

It is more complicated for private equity funds. Private equity funds must produce superior risk and liquidity adjusted returns in order to attract capital from limited partners. For leveraged buyouts, private equity funds also have to satisfy their lending banks, which are scrutinizing transactions more and more carefully.

So the principal risk to private equity on the buy-side is that sovereign wealth funds, free from the discipline imposed by limited partners and banks, may be able to pay more than private equity funds for any given business. When a sovereign wealth fund takes an interest in a particular asset, private equity may find it difficult to compete on price. In this respect, sovereign wealth funds are a bigger potential threat than hedge funds which must also compete for capital.

Moreover, sovereign wealth funds may be able to move more quickly than private equity funds. Look for instance at the speed with which the Abu Dhabi Investment Authority recently committed to invest $7.5 billion in Citigroup shares. Saying this, there are a few saving graces for private equity.

First and foremost, there is a limited pool of principal investing talent, and most of that talent currently manages private equity funds. Through vesting and employment related contractual arrangements, the talent at private equity funds is often tied in for long periods of time. To compete effectively with private equity, sovereign wealth funds will need to pry away individuals who can identify and tie down targets, succeed in execution of transactions, and improve the performance of portfolio companies. I think that sovereign wealth funds will find it difficult to extract this talent from private equity firms.

Private equity funds have been unpopular with unions and public shareholders in particular. But this level of unpopularity pales in comparison to the public and political reaction to sovereign wealth fund’s active ownership of certain businesses. This was made abundantly clear in 2005 when political opposition scuttled a bid for Unocal Corp. by a Chinese state-controlled firm and in 2006 when significant delays were caused in the Dubai ports deal.

Since 1988 U.S. legislation has authorized the President to block foreign purchases of U.S. businesses if there is credible evidence that the acquisition would threaten U.S. national security (the Exon Florio Amendment ). In 1993 the legislation was extended to cover purchases by acquirers controlled by a foreign government if the target company’s business could affect the national security interests of the U.S. (the Byrd Amendment).

In the wake of the Unocal and Dubai ports deals, President Bush signed further legislation in July 2007. The new legislation expands and clarifies the definition of national security, makes the government review process more rigorous and in certain cases longer, imposes greater Congressional reporting obligations and for the first time provides for civil penalties for non-compliance. Under the new legislation, one of the factors which the government must consider is the potential for national security related effects from the acquisition of U.S. critical technologies or infrastructure, including energy.

The unpopularity of foreign owners and the heightened regulatory scrutiny of foreign ownership will be a net advantage for private equity funds. Of course on the sell side, the ‘problem’ of sovereign wealth funds becomes an opportunity for private equity. If sovereign wealth funds are awash in capital and willing to overpay, then disposing of portfolio companies may become that bit easier.

Stuart Mills is Chairman of the International Bar Association’s Private Equity Committee.

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