The Oxford Handbook of Sovereign Wealth Funds 9780198754800, 0198754809

Table of contents :
Cover
The Oxford Handbook of Sovereign Wealth Funds
Copyright
Contents
List of Figures
List of Boxes
List of Tables
About the Contributors
Part I Size and Governance of Sovereign Wealth Funds
1. Introducing Sovereign Wealth Funds
2. A Financial Force to be Reckoned With? An Overview of Sovereign Wealth Funds
3. Sovereign Development Funds: The Governance and Management of Strategic Investment Institutions
4. From Financialization to Vulture Developmentalism: South-​North Strategic Sovereign Wealth Fund Investment and the Politics of the “Quadruple Bottom Line”
5. Sovereign Wealth Funds and the Resource Curse: Resource Funds and Governance in Resource-​Rich Countries
Part II Political and Legal Aspects of Sovereign Wealth Funds
6. Sovereign Wealth Funds and the Global Political Economy of Trust and Legitimacy
7. Sovereign Wealth Funds and Domestic Political Risk
8. Sovereign Wealth Funds and Foreign Policy
9. Sovereign Wealth and the Extraterritorial Manipulation of Corporate Conduct: A Multifaceted Paradigm in Transnational Law
Part III Investment Choices and Structures of Sovereign Wealth Funds
10. Sovereign Wealth Funds and Private Equity
11. Co-​Investments of Sovereign Wealth Funds in Private Equity
12. The Use of Debt by Sovereign Wealth Funds
13. Sovereign Wealth Fund Investment and Firm Volatility
14. Sovereign Wealth Funds: Investment Choices and Implications Around the World
15. The China Investment Corporation: From Inception to Sideline
16. Investment Terms and Level of Control of China’s Sovereign Wealth Fund in its Portfolio Firms
17. Strangers Are Not All Danger: Sovereign Wealth Fund Investment in the Energy Industry
Part IV Country and Regional Analysis of Sovereign Wealth Funds
18. The Norwegian Government Pension Fund Global and the Implications of its Activities for Stakeholders
19. Sovereign Wealth Fund Investments and Industry Performance: Evidence from Europe
20. Spain and Sovereign Wealth Funds: Four Strategic Governance Types
21. Sovereign Wealth Funds in Central and Eastern Europe
22. Sovereign Wealth Funds in the Persian Gulf States
23. The Australian Future Fund
24. Is it Possible to Avoid the St Augustine Syndrome of Fiscal Procrastination? The Case of Chile
Index

Citation preview

T h e Ox f o r d H a n d b o o k o f

S OV E R E IG N W E A LT H  F U N D S

The Oxford Handbook of

SOVEREIGN WEALTH FUNDS Edited by

DOUGLAS CUMMING GEOFFREY WOOD IGOR FILATOTCHEV and

JULIANE REINECKE

1

3 Great Clarendon Street, Oxford, ox2 6dp, United Kingdom Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries © Oxford University Press 2017 The moral rights of the authors have been asserted First Edition published in 2017 Impression: 1 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by licence or under terms agreed with the appropriate reprographics rights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America British Library Cataloguing in Publication Data Data available Library of Congress Control Number: 2017941536 ISBN 978–​0–​19–​875480–​0 Printed and bound by CPI Group (UK) Ltd, Croydon, cr0 4yy Links to third party websites are provided by Oxford in good faith and for information only. Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work.

Preface DOUGLAS CUMMING, GEOFFREY WOOD, IGOR FILATOTCHEV AND JULIANE REINECKE

Sovereign wealth funds (SWFs) represent both an increasingly important—​and potentially dominant—​category of alternative investor, and a novel form for governments to project their interests both at home and abroad. As such, they represent both economic actors and embody power vested in the financial and diplomatic resources they can leverage. Although at times they have acted in concert with other alternative investors, their intergenerational savings function should, in theory at least, promote more long-​termist thinking. However, they may be impelled toward greater short termism in response to popular pressures, demands from predatory elites and/​or unforeseen external shocks. Of all the categories of alternative investment, SWFs perhaps embody the most contradictory pressures, making for diverse and complex outcomes. The aim of this volume is to consolidate the present state of the art, and advance the field through new applied, conceptual, and theoretical insights. The volume is ordered into chapters that explore thematic issues and country studies—​although all contributions represent fresh work—​incorporating novel insights into the most recent developments in the SWF ecosystem.

Chapter Summaries This handbook is organized into 4 parts and 24 chapters (including the introductory chapter).

Size and Governance of Sovereign Wealth Funds Part I of this handbook provides an overview of SWFs in respect of the size of the market and the governance of SWFs. It comprises four chapters (Chapters 2–​5). Chapter 2 by

vi   Preface Veljko Fotak, Xuechen Gao, and William L. Megginson begins with an excellent overview of SWFs and explains and documents why they are a massive and global financial force. The chapter authors review an extensive literature and a massive amount of data to compare how SWFs allocate funds across asset classes. They point to patterns of investments and returns around the world. Also, they identify unresolved issues in SWF research and suggest directions of inquiry for future scholars. Chapter 3 by Peter Bruce-​Clark and Ashby H. B. Monk studies the structure of SWFs and sovereign development funds (SDFs). Further, the chapter authors show that with proper governance structures, SDFs can offer attractive financial returns. This evidence is counter to the conventional wisdom that predicts SDFs should offer lower returns due to dual, and sometimes conflicting, objectives of financial profit and regional development. The attractive returns to SDFs have given rise to a growing interest and capital allocation to such funds from non-​developmental private investment organizations. Chapter 4 by Daniel Haberly examines the “quadruple bottom line” of SWFs, which includes both state-​and firm-​level objectives of financial returns, strategic national development, political, and social initiatives. Haberly discusses the tension across these differing objectives, and how governance structures deal with these tensions in different parts of the world. Chapter 5 by Jędrzej George Frynas examines the challenges of nations endowed with substantial resources (often dubbed the “resource curse”) and considers whether or not SWFs are an appropriate organizational form with appropriate governance structures to deal with this resource curse. In particular, Frynas examines issues of stabilization and savings in different contexts by SWFs over many countries and decades. After reviewing the literature and econometric evidence, Frynas concludes that SWFs can be an effective mechanism to deal with the resource curse as long as the country-​level societal governance factors are sufficiently sound, governments are accountable and free from corruption, media are independent, and that they operate in a free civil society.

Political and Legal Aspects of Sovereign Wealth Funds Part II of this handbook focuses on political and legal aspects of SWFs, and comprises three complementary chapters (Chapters  6–​9). In Chapter  6, Gordon L.  Clark and Adam D. Dixon explore trust and legitimacy issues from a global political economy perspective. They evaluate whether SWFs primarily constitute mercantilist and diplomatic agents of the state or simply investment vehicles, and the consequences of either orientation. They conclude that the portfolio investment practices of most SWFs broadly corresponds with that of other public institutional investors. Moreover, there has been a global move toward greater transparency, albeit that SWFs from the most authoritarian societies remain more opaque. The decline of primary commodity prices in 2015

Preface   vii and 2016 led to many SWFs making substantial withdrawals from their holdings. Again, Asian economies such as China may place more emphasis on enhancing domestic consumer demand than massive forex savings in the future. Moreover, states have a legitimate interest in their domestic development and may make use of their SWFs in support of this agenda. This may mean that SWFs become more inward-​orientated; while this may reduce their global prominence as a leading category of alternative investor, it will also reduce concerns as to their potential role in projecting national power abroad. Chapter 7 by Paul Rose investigates the relationship between SWFs and domestic political risk. The evidence is consistent with the view that the extent to which political risk is exacerbated by the creation of a SWF depends on the institutional context in which it was created: “an autocracy, a democracy, or something in between” to use the words of Rose. The “something in between” can be measured by indices of “Polity Score” that measures political risk. The evidence and implications are reviewed in detail by Rose, who highlights where SWFs are associated with heightened political risk. Chapter 8 by Kathryn C. Lavelle studies SWFs and foreign policy. That is, SWFs can be an instrument through which a state exercises its foreign policy. Lavelle provides the tools and reviews the evidence on how one can distinguish between economic and political objectives of SWFs and foreign policy. Also, Lavelle shows how these mechanisms can be controlled, and where economic and political risks are more pronounced for home and target investment countries. Chapter 9 by Salar Ghahramani extends the analysis of SWFs into other countries’ legal and norm settings. Ghahramani explains how legal principles can often be grey or open to interpretation, and how SWFs can influence norm setting and hence legal standards. Also, Ghahramani explains that transnational law is without a state, and codes of conduct are established by norm setting, which are in turn dependent on the actions of SWFs. SWFs in effect have a substantial influence on public and private international law.

Investment Choices and Structures of Sovereign Wealth Funds Part III of this handbook comprises eight chapters (Chapters 10–​17) that deal with the investment choices and structures of SWFs. Chapter  10 by Mike Wright and Kevin Amess examines SWF investment into private equity. The chapter authors explain that SWFs may invest directly into private companies, or indirectly into private equity funds that in turn invest in private companies. Wright and Amess examine the trade-​offs with these different investment structures, and explain how SWF investment in private equity has implications for investment performance, risk, and financial regulation. Chapter 11 by Joseph A. McCahery and F. Alexander de Roode similarly studies the direct investments of SWFs into private firms, and the co-​investment of SWFs with

viii   Preface private equity funds. The chapter authors present evidence that the SWF choice for co-​ investment with private equity funds is associated with deal size, risk-​bearing, fees, and returns. Chapter 12 by Fabio Bertoni and Stefano Lugo examines the use of debt by SWFs. The chapter authors provide extensive empirical evidence on the choice of debt financing by SWFs. Also, Bertoni and Lugo examine the relationship between SWF debt use, credit conditions, and a country’s credit risk. Chapter 13 by April Knill and Nathan Mauck investigates the impact of SWF investment on firm volatility. The chapter authors differentiate between systematic (market) risk and idiosyncratic (firm-​specific) risk. Knill and Mauck review evidence and data that show the relationship between SWF investment and firm volatility depends on the investment horizon examined. They explain that the evidence is consistent with the view that the relationship between SWF investment and firm volatility is mainly attributable to idiosyncratic risk. Chapter 14 by Nuno Fernandes examines the relationship between SWFs and investee performance. Fernandes provides extensive empirical data that highlight a positive impact of SWF investment on investee firm performance in terms of firm valuation and operating performance. This evidence is consistent with evidence from Europe in Chapter 16. Fernandes’ evidence supports the view that SWF investment managers improve the governance of investee firms through monitoring and value-​added active advice. Chapter 15 by Christopher Balding and Kevin Chastagner focuses on the process surrounding the establishment of the China Investment Corporation (CIC), its coming of age, and shifting influence. The chapter authors highlight the potential long-​ term challenges facing the Corporation because the role of individual international Chinese-​owned firms has increased in prominence, as Chinse outward FDI has now surpassed inward investment, and given the decline in value of Chinese foreign exchange reserves. Chapter 16 by Jing Li examines the investment terms of SWFs in respect of control rights in investee firms. Li reviews extensive evidence from the China Investment Corporation from 2007 to 2015, and shows that this SWF takes significant equity in investees, but non-​controlling stakes. Also, there are restrictions on SWF voting rights. Through a detailed review of the contractual documents (which is both very unique as well as time consuming to examine), Li considers whether or not it is efficient to restrict SWFs from remaining passive investors, and whether or not SWFs can extract private benefits from their control rights. Li provides an interesting analysis of the trade-​offs associated with different policy and regulatory responses in different settings. Chapter 17 by Di Wang studies SWF investment in the energy industry. Wang examines evidence that shows SWFs from poor countries are more likely to invest in energy sectors. Wang further shows that this energy industry focus of SWFs from poor countries can have negative consequences for bilateral relations. When SWFs invest in other sectors, they are much less likely to face opposition.

Preface   ix

Country and Regional Analyses of Sovereign Wealth Funds Part IV, the final section of this handbook, examines country-​and region-​specific analyses of SWFs and comprises seven chapters (Chapters 18–​24). Chapter 18 by Geoffrey Wood, Noel O’Sullivan, Marc Goergen, and Marijana Baric begins Part IV with an analysis of the world’s largest and most famous SWF—​the Norwegian Government Pension Fund Global. The authors extensively analyse the governance and performance of Norway’s SWF and its investment terms. They discuss implications for its stakeholders, including investors and employees, among other things. They also examine the role of Norway’s SWF in the broader political and economic environment around the world. Chapter 19 by Sophie Béreau, Jean-​Yves Gnabo, Malik Kerkour, and Hélène Raymond studies European-​based SWF investments in ten countries, and industry-​level performance of these investments. The chapter authors provide extensive evidence from Europe that is consistent with that from Chapter 12, namely that SWFs have a positive effect on industry-​level performance. The authors present a rigorous statistical analysis and numerous checks to show that their findings are robust. Chapter 20 by Javier Capapé, Ruth V. Aguilera, and Javier Santiso examines SWF investment in Spain. The authors provide evidence that these investments comprise four governance approaches that involve corporate governance supervision, in-​house capabilities enhancement, international recognition, and developmental learning. Capapé, Aguilera, and Santiso document and explain how these approaches are successfully implemented in Spain. Chapter 21 by Piotr Wiśniewski studies SWF investments in Central and Eastern Europe (CEE). Wiśniewski explains that whereas SWF investments in this region are still scarce, they have substantial positive implications for their targets and CEE economies. Further, Wiśniewski examines ways in which regulations could be changed and governance models improved to further stimulate the positive impact of SWF investments in the CEE region. Chapter 22 by Gawdat Bahgat examines SWF investments in the Persian Gulf States. Bahgat explains that these investments are typically categorized in terms of two sources of funds: those from commodity exports, and those from non-​commodity sources, such as foreign exchange reserves. Bahgat reviews the investments from a number of specific Persian Gulf States, including Kuwait, Qatar, Iran, Bahrain, Oman, Saudi Arabia, and the United Arab Emirates. Bahgat offers insightful evidence from each of these states, summarizes similarities across the funds, and offers suggestions for future directions. Chapter  23 by Xu Yi-​chong documents the establishment and investments of the Australian Future Fund. Yi-​chong explains the objectives and governance of the fund, and key issues that have arisen in its management. Yi-​chong explains that SWFs face different (often favorable) terms in their domestic investments relative to that of other types of investors. Also, Yi-​chong notes how important sovereign immunity is in the governance of SWFs, and explains how this makes a harmonized set of rules for bilateral

x   Preface relations for all SWFs difficult or impossible. Yi-​chong provides specific details on these issues from the point of view of the Australia Future Fund, and provides empirical evidence in terms of its governance and performance. In the final chapter, Eric Parrado explores the Chilean SWFs. Parrado argues that the funds have managed to combine high levels of accountability and transparency with domestic fiscal continence, but this has proved a complex balancing act, from which other SWFs could heed important lessons. This is particularly so because Chile survived a collapse in global copper prices without endangering its SWF; a number of petrostates have failed to attain a similar achievement in the face of the recent (since 2015) decline of oil and gas prices. Parrado links the Chilean experience to the development of the Santiago principles, in whose development he played a leading role. It is perhaps fitting that this collection should conclude with such insights from scholarly practice.

Conclusion These 24 chapters highlight not only the fundamental sets of principles, and the combination of rules and practices that guide specific types of SWFs, but also the speed of change in the SWF ecosystem. Some SWFs are being rapidly dissipated, and others are changing their orientation and focus in the light of recent developments across the world economy. Although it may be desirable to subject SWFs to arms-​length governance, increased macroeconomic instability, the crises of democratic politics and the rise of populist demagogues in some of the mature democracies, as well as the visible senility of some of the dictatorships overseeing SWFs in autocracies, suggest that the boundaries between SWFs, other arms of government, and indeed, the personal finances of ruling elites, are likely to become blurred in many cases. Furthermore, in some cases they already have become so. At the same time, SWFs represent a vital source of capital to many firms worldwide, and an important mechanism for husbanding foreign exchange windfalls for future generations. The former would suggest that, whatever the financial or governance pressures facing SWFs, the cause of anti-​SWF financial protectionism is a lost one. In conceptualizing and theorizing the shifting role of SWFs, a synthesis of insights from finance, political economy, socio-​economics and political philosophy may be in order. It is hoped that this collection represents some of the first steps in this direction.

Contents

List of Figures  List of Boxes List of Tables  About the Contributors 

xv xix xxi xxv

PA RT I   SI Z E A N D G OV E R NA N C E OF S OV E R E IG N W E A LT H  F U N D S 1. Introducing Sovereign Wealth Funds  Douglas Cumming, Igor Filatotchev, Juliane Reinecke, and Geoffrey Wood

3

2. A Financial Force to be Reckoned With? An Overview of Sovereign Wealth Funds  Veljko Fotak, Xuechen Gao, and William L. Megginson

16

3. Sovereign Development Funds: The Governance and Management of Strategic Investment Institutions  Peter Bruce-​Clark and Ashby H.B. Monk

63

4. From Financialization to Vulture Developmentalism: South-​North Strategic Sovereign Wealth Fund Investment and the Politics of the “Quadruple Bottom Line”  Daniel Haberly

87

5. Sovereign Wealth Funds and the Resource Curse: Resource Funds and Governance in Resource-​Rich Countries  Jędrzej George Frynas

123

xii   Contents

PA RT I I   P OL I T IC A L A N D L E G A L A SP E C T S OF S OV E R E IG N W E A LT H  F U N D S 6. Sovereign Wealth Funds and the Global Political Economy of Trust and Legitimacy  Gordon L. Clark and Adam D. Dixon

145

7. Sovereign Wealth Funds and Domestic Political Risk  Paul Rose

159

8. Sovereign Wealth Funds and Foreign Policy  Kathryn C. Lavelle

182

9. Sovereign Wealth and the Extraterritorial Manipulation of Corporate Conduct: A Multifaceted Paradigm in Transnational Law  Salar Ghahramani

208

PA RT I I I   I N V E ST M E N T C HOIC E S A N D ST RU C T U R E S OF S OV E R E IG N W E A LT H  F U N D S 10. Sovereign Wealth Funds and Private Equity  Mike Wright and Kevin Amess

231

11. Co-​Investments of Sovereign Wealth Funds in Private Equity  Joseph A. McCahery and F. Alexander de Roode

247

12. The Use of Debt by Sovereign Wealth Funds  Fabio Bertoni and Stefano Lugo

274

13. Sovereign Wealth Fund Investment and Firm Volatility  April Knill and Nathan Mauck

298

14. Sovereign Wealth Funds: Investment Choices and Implications Around the World  Nuno Fernandes 15. The China Investment Corporation: From Inception to Sideline  Christopher Balding and Kevin Chastagner

322 348

Contents   xiii

16. Investment Terms and Level of Control of China’s Sovereign Wealth Fund in its Portfolio Firms  Jing Li

367

17. Strangers Are Not All Danger: Sovereign Wealth Fund Investment in the Energy Industry  Di Wang

433

PA RT I V   C O U N T RY A N D R E G IONA L A NA LYSI S OF S OV E R E IG N W E A LT H  F U N D S 18. The Norwegian Government Pension Fund Global and the Implications of its Activities for Stakeholders  Geoffrey Wood, Noel O’Sullivan, Marc Goergen, and Marijana Baric 19. Sovereign Wealth Fund Investments and Industry Performance: Evidence from Europe  Sophie Béreau, Jean-​Yves Gnabo, Malik Kerkour, and Hélène Raymond 20. Spain and Sovereign Wealth Funds: Four Strategic Governance Types  Javier Capapé, Ruth V. Aguilera, and Javier Santiso

459

474

519

21. Sovereign Wealth Funds in Central and Eastern Europe  Piotr Wiśniewski

547

22. Sovereign Wealth Funds in the Persian Gulf States  Gawdat Bahgat

595

23. The Australian Future Fund  Xu Yi-​chong

622

24. Is it Possible to Avoid the St Augustine Syndrome of Fiscal Procrastination? The Case of Chile  Eric Parrado

651

Index

679

List of Figures

2.1 SWF investments in OECD and non-​OECD markets (2006–​14) 

43

2.2 Value of direct SWF foreign investments by target region (2006–​14) 

43

2.3 Value of direct SWF foreign investment by target sector (2006–​14) 

45

3.1 Sovereign development fund types 

82

4.1 SWFs by investment orientation (2015) 

91

4.2 Rough typology of strategic South-​North SWF investment by target firm and sector 

97

4.3 Abu Dhabi’s SWF-​led global developmental network (2012) 

102

4.4 The Austro-​Abu Dhabi petrochemicals network (2012) 

106

4.5

110

Mubadala-​GlobalFoundries-​AMD-​IBM network (2016) 

5.1 Association between Truman Scoreboard and societal governance indicators 

135

5.2 Voice and Accountability rating of four selected countries (2000–​14) 

136

7.1 Average Polity IV Project Polity Scores by amount of assets under management  162 10.1 Percentage of SWFs investing in different asset classes 

232

11.1 Stable allocation to direct investments by SWFs 

260

11.2 Co-​investment in direct investments by SWFs 

265

11.3 Sector characteristics of the investment deals and their size 

268

13.1 Graphs for benchmark-​adjusted volatility ratios 

311

15.1 CIC Global Investment Portfolio Distribution: Diversified Equities 

351

16.1 Proportion of SWFs investing in each asset class (2013 vs. 2014) 

371

16.2 Organizational structure of the CIC 

375

16.3 Industry sector distribution of the CIC’s investments 

408

17.1 Industry distribution of SWF investments 

446

17.2 Marginal effects of each type of acquirer relative to EP SWF based on Model 1 

450

17.3 Predictive margins of EP SWFs with 95% confidence intervals 

450

20.1 Strategic governance types of SWFs 

526

xvi   List of Figures 21.1 Prerequisites for SWF launch and maintenance decision 

550

21.2 GPFG’s investment strategy as at October 13, 2014 

561

21.3 GPFG’s strategic asset allocation as at October 13, 2014 

562

21.4 GPFG portfolio: CEE equity, fixed income holdings, and their total (January 1, 2010 to December 31, 2014) (in US$) 

564

21.5 GPFG’s investment allocation by asset class as at December 31, 2014, including all non-​core European property holdings (in US$ and % of the CEE total) 

565

21.6 GPFG’s investment allocation by asset class using global strategic and actual index benchmarking as at December 31, 2014 (in US$ and % of the CEE total) 

565

21.7 GPFG’s investment allocation by asset class assuming equal weights for all non-​core* European property holdings as at December 31, 2014 (in US$ and % of the CEE total) 

565

21.8 GPFG—​CEE equity portfolio composition by target country as at December 31, 2014 (in US$ and % of the CEE total) 

566

21.9 GPFG—​CEE equity portfolio composition by target industry as at December 31, 2014 (in % of the CEE total) 

567

21.10 GPFG—​CEE fixed income portfolio composition by target country as at December 31, 2014 (in US$ and % of the CEE total) 

568

21.11 GPFG—​CEE fixed income portfolio composition by issuer type as at December 31, 2014 (in US$ and % of the CEE total) 

568

21.12 GPFG—​CEE property portfolio composition by target country as at December 31, 2014 (in % of all CEE property projects) 

569

21.13 GPFG’s property holdings (including all non-​core European holdings) as at December 31, 2014 (in US$ and % of the CEE total) 

570

24.1 Fiscal balance and copper price 

661

24.2 Gross debt 

662

24.3 Accumulation rule (% of GDP) 

663

24.4 Corporate governance 

663

24.5 Investment policy 

665

24.6 GDP volatility 

668

24.7 Real exchange rate 

669

24.8 ESSF market value 

670

24.9 PRF market value 

670

List of Figures    xvii A11.1.1 The traditional private equity model 

270

A11.1.2  The co-​investment approach in the private equity model 

270

A21.1.1  The Funding Mechanism of the National Wealth Fund 

574

A21.1.2 National Wealth Fund’s Assets under Management (in US$Billion and as Percentages of Russian GDP) in Febuary 1, 2008–​January 1, 2016 

575

A21.2.1  The Funding Mechanism of the Reserve Fund 

581

A21.2.2 Reserve Fund Assets under Management (in US$ Billion and as Percentages of Russian GDP) in Febuary 1, 2008–​January 1, 2016 

582

List of B oxes

16.1 The China Investment Corporation’s Role in SMIC 

414

16.2 The China Investment Corporation’s Portfolio Construction 

427

List of Tables

2.1 Sovereign Wealth Funds in the Sovereign Investment Laboratory SWF Transaction Database 

19

2.2 Summary of Empirical, Theoretical, and Normative Studies of How Sovereign Wealth Funds Should Select Asset Classes in Which to Invest 

26

2.3 Summary of Empirical Studies of Sovereign Wealth Funds’ Geographic and Industrial Investment Patterns 

33

2.4 Investment Statistics for the Sovereign Wealth Funds in the Sovereign Investment Laboratory’s SWF Database 

41

2.5 Summary of Empirical Studies Examining Impact of Sovereign Wealth Fund Equity Investments on Target Firm Financial Performance 

48

3.1 Governance and Management

69

3.2 Investment Strategy 

73

5.1 Resource Funds and Governance in Resource-​Rich Countries (2013 Data) 

132

7. 1 Political Orientation of Sovereign Wealth Fund sponsor countries of the 15 Largest Funds in the Sovereign Wealth Fund Institute

161

7. 2 Norges Bank Investment Management Formal Shareholder Proposals (2010–​14)

175

8.1 Major Foreign Policy Concerns Associated with Investment by Foreign Sovereign Wealth Funds 

186

8.2 Sovereign Wealth Funds Receiving a Ten on the Linaburg-​Maduell Transparency Index 

193

8.3 Sovereign Wealth Funds in the Middle East Ratings by the Linaburg-​Maduell Transparency Index 

194

11.1 Categories of Sovereign Wealth Funds 

253

11.2 Alternative Tilt of Sovereign Wealth Funds in their Strategic Asset Allocation 

254

11.3 Sovereign Wealth Funds and Transparency Scores 

258

11.4 Two Examples of Deals 

262

11.5 Public Private Equity Deals 

264

11.6 Regional Characteristics of Government Private Equity Deals 

266

xxii   List of Tables 12.1 Sovereign Wealth Funds’ Characteristics and Use of Debt 

278

12.2 Differences between Sovereign Wealth Funds Allowed to and Restrained from Using Debt 

282

12.3 Outstanding Debt and Credit Risk Levered Sovereign Wealth Funds 

289

12.4 Credit Risk Relationship between a Sovereign Wealth Fund and its Government  291 13.1 Funds in Sample 

304

13.2 Data Characteristics 

306

13.3 Difference in Means Tests 

308

13.4 Volatility Ratios 

312

13.5 Volatility Ratios for Sub-​Samples 

316

14.1 The World of Sovereign Wealth Funds 

326

14.2 Descriptive Statistics of the Sovereitn Wealth Fund Ownership Variables 

328

14.3 Sovereign Wealth Fund Holdings by Country 

329

14.4 Descriptive Statistics of Control Variables 

331

14.5 Determinants of Sovereign Wealth Fund Holdings 

334

14.6 Sovereign Wealth Fund Ownership and Firm Value 

337

14.7 Sovereign Wealth Fund Ownership and Firm Value (Excluding Norway and New Zealand) 

340

14.8 Sovereign Wealth Fund Ownership and Firm Value: The Role of Transparency  342 14.9 Sovereign Wealth Fund Ownership and Firm Value: Foreign and Domestic Holdings 

343

16.1 Investment Principles of the China Investment Corporation and its Subsidiaries

376

16.2 Major China Investment Corporation Investments (2007–​15) 

381

16.3 Major China Investment Corporation-​Invested Joint Ventures (2007–​15)

398

16.4 Major China Investment Corporation Investments into Fund Vehicles (2007–​15)

400

16.5 Geography of the China Investment Corporation’s Investments (N=97) 

407

16.6 Overview of the China Investment Corporation’s Ownership and Direct Control Rights in its Non-​Fund and Non-​JV Investments (N=61) 

411

16.7 The China Investment Corporation’s Board Representation vis-​à-​vis its Relative Ownership in Target Firms (N=25) 

412

16.8 Examples of Long-​Term China Investment Corporation–​Target Collaborative Relationship 

416

List of Tables   xxiii 16.9 Huijin’s Direct Investments 

421

17.1 Categorization of Sovereign Wealth Fund Countries 

438

17.2 Number of Deals Acquired by Sovereign Wealth Funds during 1981–​2012 

444

17.3 Summary Statistics of Energy Investments 

447

17. 4 The Logit Estimates of the Likelihood of Energy Investments

451

17. 5 Robustness Checks

452

18.1 NGPFG’s Largest 20 Equity Holdings in Terms of Ownership Stake (% of Firm Equity) and Market Value (Millions of Kroner) as at December 31, 2015 

464

19.1 Descriptive Statistics on the Sovereign Wealth Fund Investments 

485

19.2 Data Description 

489

19.3a Sovereign Wealth Funds’ Investment and Industry Performance 

494

19.3b Sovereign Wealth Funds’ Investment and Industry Performance

497

19.3c Sovereign Wealth Funds’ Investment and Industry Performance

500

19.3d Sovereign Wealth Funds’ Investment and Industry Performance

503

19.3e Sovereign Wealth Funds’ Investment and Industry Performance

506

19.4 Bravais-​Person Correlations Matrix 

510

20.1 Selected Institutional Investors in the Spanish IBEX-​35 

523

20.2 Bankia: The Divestment Process Attracts Foreign Interest 

524

20.3 Top Ten Equity Holdings in Spain by the Government Pension Fund Global 

529

20.4 Top Ten Largest Equity Stages of the Government Pension Fund Global by Voting Rights in Spain 

529

20.5 Government Pension Fund Global Decisions during Annual General Meetings in Spanish Companies 

531

20.6 Ranking of Sovereign Wealth Funds by Labor Intensity 

535

20.7 Most Aggressive Deal Hunters by Transaction Average Value 

537

21.1 Selected Socioeconomic Drivers of Sovereign Wealth Fund Creation in Central and Eastern European Economies (2013–​15) 

552

21.2 Reserves of Foreign Exchange and Gold (in Current US$) and Global Ranks Held by Central and Eastern European Economies as at December 31, 2014 

554

21.3 Selected Socioeconomic Drivers of Sovereign Wealth Fund Maintenance in Central and Eastern European Economies (2013–​15) 

556

xxiv   List of Tables 21.4 Geographical Breakdown of Sovereign Wealth Fund Investments in Central and Eastern Europe by Acquirer Country as at September 30, 2014 

559

21.5 Geographical Breakdown of Sovereign Wealth Fund Investments in Central and Eastern Europe by Target Country as at September 30, 2014 

560

21.6 Industrial Breakdown of Sovereign Wealth Fund Target Investments—​ Globally and in Central and Eeastern Europe (Excluding Investments in T-​bonds) 

560

21.7 Norwegian Government Pension Fund Global’s Strategic and Actual Cross-​Asset Benchmarking as at September 30, 2015 

563

23.1 Annual Real GDP Growth Rate (%) 

626

23.2 Sources of Capital of Australia’s Future Fund 

629

23.3 Australia’s Future Fund Annual Performance Results 

630

24.1 Output Growth and Terms of Trade Volatility 

660

A21.1.1 Limits of the Fund’s Exposure to Various Financial Asset Classes under Russian Budget, Government, and Financial Ministry Rules as at January 1, 2016 

576

A21.3.1 The Fund’s Investment Portfolio Composition as at February 1, 2016 

587

About the Contributors

Ruth V. Aguilera is Full Professor at the D’Amore-​McKim School of Business at Northeastern University and a Visiting Professor at ESADE Business School. She spent the 2014–​2015 academic year as a Visiting Full Professor in the Department of Strategy and Policy at the National University of Singapore Business School. Before going to South East Asia, she was a Professor at the College of Business at the University of Illinois at Urbana-​Champaign—​where she had been since receiving her PhD in Sociology at Harvard University. Ruth’s research interests lie at the intersection of strategic organization and global strategy, specializing in international corporate governance, corporate social responsibility, and internationalization. She is a Senior Editor at Organization Science, an Associate Editor at Corporate Governance: An International Review, a Consulting Editor at the Journal of International Business Studies, and serves on the editorial boards of Strategic Management Journal, Global Strategy Journal, Academy of Management Perspectives and Organization Studies. She has recently been elected to the Board of the Strategic Management Society and the International Corporate Governance Society as well as being inducted as a Fellow of the Academy of International Business. Kevin Amess is Associate Professor at Nottingham University Business School. He is a Fellow of the Centre for Management Buyout Research. For over 20 years Kevin has been conducting research on the consequences of Private Equity acquisitions for portfolio firms. His research has contributed widely to greater understanding of the consequences of Private Equity acquisitions on employees, innovation, and performance through journal publications, which include:  Entrepreneurship Theory and Practice, European Economic Review, and Journal of Industrial Economics. He reports on, and provides advice for, governmental agencies such as the OECD, the US GAO, and UK government, as well as contributing to media debate. Gawdat Bahgat is Professor of National Security Affairs at the National Defense University’s Near East South Asia Center for Strategic Study. He is an Egyptian-​born specialist in Middle Eastern policy, particularly Egypt, Iran, and the Gulf region. His areas of expertise include energy security, proliferation of weapons of mass destruction, counter-​terrorism, Arab-​Israeli conflict, North Africa, and American foreign policy in the Middle East. Gawdat’s career blends scholarship with national security practicing. He has published 11 books and more than 200 articles in scholarly journals.

xxvi   About the Contributors Christopher Balding is Associate Professor Finance and Economics, holding tenure with Chinese characteristics at the HSBC Business School of Peking University Graduate School. A recognized expert in the Chinese economy sovereign wealth funds, he has written a book entitled Sovereign Wealth Funds: The New Intersection of Money and Power, published by Oxford University Press. He is a columnist for Bloomberg View as well as a regular contributor to the Financial Times. His scholarly work has been published in leading journals such as the Review of International Economics, the International Finance Review, and Journal of Public Economic Theory, on such diverse topics as CDS pricing, the WTO, and the economics of adoption and abortion. He received his PhD from the University of California, Irvine and worked in private equity prior to entering academia. Marijana Baric is Lecturer in Organizational Behaviour and Human Resource Management at the University of Buckingham. Broadly, she is interested in social exchange theory and how it can be reconceptualized and used to study a variety of work-​ based and social situations. Although her work focuses mainly on undeclared work and policy, she is also interested in many aspects of organizational behavior and HRM research. Marijana has been involved in research funded by the European Foundation for the Improvement of Living and Working Conditions as well as Marie Curie Industry-​ Academic Partnerships and Pathways. Sophie Béreau is Assistant Professor of Finance at the University of Namur, Faculty Member of CORE (Université Catholique de Louvain), and Consultant at the Banque de France. She holds a PhD in Economics from the Université Paris Ouest. Her research interests lie in international finance, asset pricing, and financial econometrics. Fabio Bertoni, PhD is Professor of Corporate Finance at EMLYON Business School, France. His research focuses on the relationship between financing and firm performance, new listings, sovereign wealth funds, venture capital and corporate governance. He is author of articles in journals including: Journal of Corporate Finance, Journal of Banking and Finance, Research Policy, Small Business Economics, International Finance, and European Financial Management. He has held visiting positions at the Copenhagen Business School, Universidad Computense de Madrid, Centre for European Economic Research (ZEW) in Mannheim, and the University of Oxford—​Saïd Business School. Peter Bruce-​Clark is Director and Co-​Founder of Kalytix Partners, a San Francisco-​ based strategy and management consultancy for institutional investors. Prior to rejoining Kalytix, Peter built an AI-​focused venture capital firm based in California. In addition to his industry experience, Peter has undertaken research at Stanford University. As Research Manager for Investment Innovation at the Global Projects Center, an institute located in the Department of Engineering, Peter focused on the intersection between emerging technology, strategic capital deployment, and private market investment in generating high-​impact outcomes. During his time at the university, Peter ran several impact investment conferences including the Impact Investment Summit held at the University of Oxford in 2014, and Generating Impact Alpha held

About the Contributors    xxvii at Stanford in 2015. Peter’s publications include Reframing Impact Investment (forthcoming, 2017). Peter holds a First Class BA from Queen Mary, University of London, and an MPhil in Business and Financial Management from the Judge Business School, University of Cambridge. Javier Capapé, PhD is the Director at Sovereign Wealth Lab at IE Business School. He earned his PhD at ESADE Business School and is SovereigNET Research Affiliate at The Fletcher School (Tufts University) since 2012. His PhD research was co-​supervised by Javier Santiso (IE Business School) and Ruth V. Aguilera (Northeastern University, Boston, US). He has coordinated the Sovereign Wealth Funds Reports series since 2012, an initiative backed by KPMG and ICEX. He has published in top academic journals such as Academy of Management Perspectives and Oxford University Press. His research has been regularly cited in international media. He also works connecting sovereign wealth funds with start-​ups and venture capital. He has presented his work on sovereign wealth funds at the World Bank (Washington, DC, US); Bank of International Settlements (Basel, Switzerland); Sciences Po (Paris, France); University of Illinois (IL, US); Academy of International Business (Vancouver, Canada) and Economics University (Prague, Czech Republic), and attended conferences or specialized courses at Harvard University, London School of Economics, OECD, Aspen Institute, Qatar Investment Authority, International Forum of Sovereign Wealth Funds, Fondo Strategico Italiano, and Columbia University (New York). He is Manager of Start Up Spain, an initiative representing all actors in the Spanish entrepreneurial ecosystem. He regularly contributes to Spanish media on start-​ups and entrepreneurs. Kevin Chastagner is Assistant Professor of Management at the Peking University HSBC Business School. Kevin’s research interests are in strategy and international business and his current research questions are related to three main areas: cross-​border M&A, political connections, and innovation. Most recently, Kevin’s work on the internationalization of innovation was published in the Journal of International Marketing. Kevin and his wife moved to China in 2012 after he obtained his PhD from Washington State University. Gordon L. Clark is Director of the Smith School of Enterprise and the Environment with cross-​appointments in the Saïd Business School and the School of Geography and the Environment at the University of Oxford. He holds a Professorial Fellowship at St Edmund Hall, Oxford. He is also Sir Louis Matheson Distinguished Visiting Professor at Monash University’s Faculty of Business and Economics (Melbourne) and a Visiting Professor at Stanford University. He is a Fellow of the British Academy. Douglas Cumming, PhD is Professor of Finance and Entrepreneurship and the Ontario Research Chair at the Schulich School of Business, York University. His research covers topics ranging from crowdfunding, securities regulation, stock exchange trading rules, mutual funds, hedge funds, venture capital, private equity, and sovereign wealth funds. Douglas has published over 140 articles in leading refereed academic journals in finance, management, and law and economics, such as the Academy of Management Journal,

xxviii   About the Contributors Journal of Financial Economics, Review of Financial Studies, Journal of International Business Studies, and Journal of Empirical Legal Studies. He is the Founding Editor of Annals of Corporate Governance, and Co-​Editor of Finance Research Letters, and Entrepreneurship Theory and Practice, and has been a guest editor for 12 special issues of top journals, including Corporate Governance: An International Review, Journal of International Business Studies, Journal of Corporate Finance, Journal of Business Ethics, among others. Douglas was recognized in 2015 as a Research Leader by York University and was a recipient of the Schulich School of Business Research Award in 2015. He is the co-​author of Venture Capital and Private Equity Contracting (Elsevier Academic Press, Second edition, 2013), and Hedge Fund Structure, Regulation and Performance around the World (Oxford University Press, 2013). He is the Editor of The Oxford Handbook of Entrepreneurial Finance (Oxford University Press, 2013), The Oxford Handbook of Private Equity (Oxford University Press, 2013), and The Oxford Handbook of Venture Capital (Oxford University Press, 2013). Douglas’ work has been reviewed in numerous media outlets, including The Economist, The Wall Street Journal, The New York Times, Canadian Business, the National Post, and The New Yorker. Adam D. Dixon is Reader in Economic Geography at the University of Bristol. He is also a non-​resident Research Affiliate at Stanford University’s Global Projects Center and IE Business School’s Sovereign Investment Lab in Madrid. He is the co-​author with Jagdeep Singh Baccher and Ashby H.B. Monk of The New Frontier Investors: How Pension Funds, Sovereign Funds, and Endowments are Changing the Business of Investment Management and Long-​Term Investing (Palgrave Macmillan, 2016), author of The New Geography of Capitalism: Firms, Finance, and Society (Oxford University Press, 2014), and co-​author with Gordon L. Clark and Ashby H.B. Monk of Sovereign Wealth Funds: Legitimacy, Governance, and Global Power (Princeton University Press, 2013). Nuno Fernandes is Professor of Finance at IMD (Switzerland), Director of the Strategic Finance program. Fernandes holds a PhD from IESE Business School (Spain). He is a specialist on international financial markets, portfolio management, and emerging market risks. He has published in the leading journals worldwide, including Journal of Financial Economics and Review of Financial Studies. He speaks at business conferences and is a regular contributor to the business press worldwide, including the Financial Times and Wall Street Journal. Fernandes is a member of the Advisory Committee of the World Economic Forum. His works earned some distinguished awards, including the Lamfalussy Fellowship from the European Central Bank, and the Journal of Financial Intermediation’s Best Paper Award for 2014. Igor Filatotchev is Professor of Corporate Governance and Strategy at King’s Business School, King’s College London, and Visiting Professor at Vienna University of Economics and Business. He earned his PhD in Economics from the Institute of World Economy and International Relations (Moscow, the Russian Federation). His research interests are focused on corporate governance effects on entrepreneurship and strategic decisions; sociology of capital markets. He has published more than 130 refereed

About the Contributors    xxix academic papers, in addition to numerous books and book chapters, in the fields of corporate governance, entrepreneurship and strategy, including publications in Academy of Management Journal, Academy of Management Perspectives, Strategic Management Journal, Journal of International Business Studies, Organization Science, Journal of Management and Journal of Corporate Finance. Most recently he co-​edited The Oxford Handbook of Corporate Governance (Oxford University Press, 2013). He is a General Editor of Journal of Management Studies. Veljko Fotak is Assistant Professor of Finance at the University at Buffalo and a Fellow at the Sovereign Investment Lab, Paolo Baffi Centre on Central Banking and Financial Regulation, Bocconi University. Veljko’s research is focused on international corporate finance, with a particular emphasis on state capitalism and sovereign wealth funds. His research has been published in leading academic journals, including Journal of Financial Economics and Review of Financial Studies, and has been cited in The Wall Street Journal, the New York Post, on Bloomberg, and other media outlets. Veljko teaches courses on corporate finance and international financial management for both undergraduate and graduate students. Veljko earned a BS degree in Business Administration, an MBA with a concentration in Finance and an MS in Applied Statistics at the Rochester Institute of Technology, in Rochester, New York and a PhD in Finance at the University of Oklahoma. Jędrzej George Frynas is Professor of CSR and Strategic Management at Middlesex University Business School, UK. For more than twenty years, his empirical research has focused on business, corporate responsibility, and political economy concerns in emerging/​developing countries such as Nigeria and Brazil. He is the author or co-​ author of several books, including Beyond Corporate Social Responsibility—​ Oil Multinationals and Social Challenges (Cambridge University Press 2009)  and Global Strategic Management (Third edition, Oxford University Press, 2014), and has published in leading scholarly journals such as Journal of Management, Strategic Management Journal, International Journal of Management Reviews and African Affairs. Xuechen Gao received his Ph.D. in Finance from the University of Oklahoma’s Michael F. Price College of Business (2017). He also holds an MSc in Finance from the University of Texas at Dallas (2012) and a BSc in Physics from Fudan University, China (2010). Xuechen’s main research interest is corporate finance, including privatization of stateowned enterprises, sovereign wealth funds, government ownership, and Chinese share offerings. His research papers have been presented at several international and domestic elite finance conferences. Xuechen’s teaching interests include corporate finance, financial markets, international finance, and investments. He teaches Financial Intermediaries and Markets and Advanced Corporate Finance at the University of Oklahoma. Salar Ghahramani is Assistant Professor of Business Law and International Law and Policy at the Pennsylvania State University (Abington). He has taught international

xxx   About the Contributors law at the Maastricht Center for Transatlantic Studies in the Netherlands and has led academic programs to the Amsterdam Stock Exchange, the European Commission in Brussels, and the International Court of Justice at The Hague. He has also been a Visiting Researcher at the European University Institute, where he researched the Norwegian sovereign wealth fund, and has served as a Visiting Scholar at the Norwegian Centre for Human Rights at the University of Oslo. Jean-​Yves Gnabo is Professor of Finance at the University of Namur. He has been Visiting Professor at the University of Orléans and worked as a consultant at the OECD. His main research interests lie in sovereign wealth funds as well as in financial econometrics, financial networks, and international finance in general. He has published in academic journals including Journal of Financial and Quantitative Analysis, Journal of International Money and Finance and Journal of Banking and Finance. Marc Goergen holds a Chair in Finance at Cardiff Business School, Cardiff University. His previous appointments include various positions at UMIST and the Universities of Manchester, Reading, and Sheffield. He is a Research Associate of the European Corporate Governance Institute (ECGI). His research interests are in corporate governance and corporate finance, including boards of directors, dividend policy, mergers and acquisitions, initial public offerings, and private equity. He has published extensively, including in the Journal of Finance, Journal of Corporate Finance and Journal of Financial Intermediation. He has also written four books on corporate governance, including a textbook. Daniel Haberly is Lecturer in Human Geography in the School of Global Studies at the University of Sussex, and an Honorary Research Associate in the School of Geography and the Environment at the University of Oxford. His research broadly examines the political and institutional geography of global finance. In addition to National Science Foundation funded research on sovereign wealth funds, his recent work has examined the structure and governance of investment through offshore financial centers. Both areas of research have been published as high-​impact journal articles, which have been cited in US Congressional commission and UNCTAD World Investment reports, and attracted attention from specialist and mainstream media outlets. Malik Kerkour holds a PhD in Economics and Management from the University of Namur and is currently Postdoctoral Researcher in Econometrics at the University of Orléans LEO–​CNRS (France). His areas of interest concern asset allocation, international finance, corporate finance, and financial econometrics. More particularly, his research has dealt with international investments, institutional investors, including sovereign wealth funds, corporate governance, network theory, and spatial econometrics. April Knill is the Gene Taylor/​Bank of America Professor of Finance and the Associate Director of the BB&T Center for Perspectives on Free Enterprise at The Florida State University. She received her PhD from the University of Maryland at College Park in August of 2005. While pursuing her doctoral degree she worked at The World Bank as a

About the Contributors    xxxi consultant. Upon graduation, she went to work at Florida State University. Her research interests are international finance, venture capital/​private equity, and the intersection between law, finance, and politics. She has published in academic journals including (but not limited to) Journal of Business, Journal of Financial and Quantitative Analysis, Journal of International Business Studies, Financial Management, European Financial Management, Journal of Corporate Finance, Journal of Comparative Economics and Journal of Financial Intermediation. Kathryn C. Lavelle is the Ellen and Dixon Long Professor of World Affairs at Case Western Reserve University. Her research explores the exchange between domestic and international politics in finance. She is the author of The Politics of Equity Finance in Emerging Markets (Oxford University Press, 2004), Legislating International Organization:  The US Congress, IMF and World Bank (Oxford University Press, 2011), Money and Banks in the American Political System (Cambridge University Press, 2013). Her articles, book reviews, and chapters appear in International Studies Quarterly, Perspectives on Politics, International Organization, Review of International Organizations, The Journal of Modern African Studies, and Third World Quarterly. She has held fellowships and received grants from the Woodrow Wilson International Center for Scholars, American Political Science Association, and she was the Fulbright Visiting Chair in Global Affairs at the Munk Centre, University of Toronto. Jing Li is Assistant Professor at the Department of Business Law in Tilburg University (the Netherlands). She received her PhD in law from Tilburg University in 2015. Her research interests lie in the legal and regulatory issues related to the alternative investment funds industry and non-​listed business forms in China—​in particular, venture capital/​private equity, sovereign wealth funds, and governance of entrepreneurial firms. She has published in academic journals including (but not limited to) Fordham Journal of Corporate and Financial Law, Michigan Journal of Private Equity and Venture Capital Law, and Asian Journal of Law and Economics. Before joining the academia, she practiced Chinese Law for three years, mainly in the area of cross-​border M&As, joint ventures, and private equity transactions, including with Paul Hastings Beijing Office and the German Chamber of Commerce. Stefano Lugo, PhD is Assistant Professor of Finance and Financial Markets at the Utrecht University School of Economics. His research mainly focuses on sovereign wealth funds and on corporate debt, credit risk, and credit rating agencies. His work has been presented at several conferences, including the EFA annual meetings, and it has been published in academic journals such as the Review of Finance, Journal of Corporate Finance, and Journal of Banking and Finance, among others. He has held visiting positions at the Saïd Business School–​University of Oxford, and at the University of Oklahoma–​Price College of Business. Nathan Mauck is Assistant Professor of Finance at the Henry W. Bloch School of Management, University of Missouri—​Kansas City. Professor Mauck’s research focuses on sovereign wealth funds, mergers and acquisitions, payout policy, corporate finance,

xxxii   About the Contributors and behavioral finance. He has published in Journal of Banking and Finance, Journal of Behavioral Finance, Journal of Corporate Finance, Journal of Financial Intermediation, Journal of Financial Research, Journal of International Business Studies, Journal of Real Estate Finance and Economics, Financial Management, and Review of Quantitative Finance and Accounting among others. He received the Elmer F. Pierson Good Teaching Award (2015), UMKC Chancellor’s Early Career Award for Excellence in Teaching (2015), Bloch Favorite Faculty Member of the Year (2014) at the University of Missouri–​ Kansas City, and the College of Business Doctoral Teaching Award (2010) at Florida State University. Nathan received a BS in Finance from Kansas State University in 2006 and a PhD in Finance from Florida State University in 2011. Joseph A. McCahery is Professor of International Economic Law at Tilburg University Law School and TILEC. He was previously Professor of Corporate Governance and Innovation at the University of Amsterdam and Director of the Financial Markets and Regulation MSc, and Finance and Law LLM program at Duisenberg School of Finance. He has held visiting appointments at Auckland University, Columbia University, Leiden University, Rotterdam School of Management, Solvay Business School, and the University of Pennsylvania. His research interest areas include: banking regulation and supervision, corporate finance, financial market regulation, and corporate law and governance. He has published widely in the top finance and law journals and is author and editor of more than ten books, including; Law, Economics and Organization of Alliances and Joint Ventures (Cambridge University Press, forthcoming); Institutional Investor Activism: Hedge Funds and Private Equity, Economics and Regulation (Oxford University Press, 2015); and Corporate Governance of Non-​listed Companies (Oxford University Press, 2008). He has served as a consultant to publicly traded firms, governmental agencies, investment companies, and law firms. William L. Megginson is Professor and Price Chair in Finance at the University of Oklahoma’s Michael F. Price College of Business. He is also the Saudi Aramco Chair Professor in Finance at King Fahd University of Petroleum and Minerals in Dhahran, Saudi Arabia. Professor Megginson’s research interest has focused in recent years on the privatization of state-​owned enterprises, sovereign wealth fund investments, and investment banking principles and practices. His research has been frequently cited in academic and professional publications, and his articles have been downloaded over 53,000 times from the Social Sciences Research Network, while his books and articles have been cited over 15,600 times (according to Google Scholar). He has served as a privatization consultant for the New York Stock Exchange, the OECD, the IMF, the World Federation of Exchanges, and the World Bank. Ashby H.B. Monk, PhD is the Executive and Research Director of the Stanford Global Projects Center. He is also a Senior Research Associate at the University of Oxford and a Senior Advisor to the Chief Investment Officer of the University of California. Ashby has a strong track record of academic and industry publications. He was named by aiCIO magazine as one of the most influential academics in the institutional investing

About the Contributors    xxxiii world. His research and writing have been featured in The Economist, New York Times, Wall Street Journal, Financial Times, Institutional Investor, Reuters, Forbes, and on National Public Radio among a variety of other media. His current research focus is on the design and governance of institutional investors, with particular specialization on pension and sovereign wealth funds. He received his Doctorate in Economic Geography at the University of Oxford and holds a Master’s degree in International Economics from the Université Paris 1 Pantheon-​Sorbonne and a Bachelor’s degree in Economics from Princeton University. Noel O’Sullivan is Professor of Accounting at the School of Business and Economics, Loughborough University. His main research interest is corporate governance, including boards of directors, the market for non-​executives, mergers and acquisitions, private equity, sovereign wealth funds, and various aspects of auditing. His research has been published in leading journals such as the British Journal of Management, Human Resource Management Journal, International Journal of Management Reviews, Accounting and Business Research, British Accounting Review, European Economic Review, among others. Eric Parrado is Superintendent at Superintendency of Banks and Financial Institutions of Chile and Professor of Economics at Universidad Adolfo Ibáñez. He was the first manager of the Chilean Sovereign Wealth Funds between 2007 and 2010. He was particularly influential in developing and promoting a transparency code for sovereign wealth funds in the world internationally known as the “Santiago Principles.” As a consultant on sovereign wealth fund governance, he has provided advisory services to the governments of Colombia, Mongolia, Nigeria, Panama, and Papua New Guinea. He has a PhD in Economics from New York University. Hélène Raymond is Professor of Economics at the University of Paris Nanterre. Her research interests cover sovereign wealths funds—​on which she has published several papers and book chapters—​and, more generally, international finance, crisis contagion, and financial anomalies. Juliane Reinecke is Professor of International Management and Sustainability at King’s Business School, King’s College London, Visiting Professor at the University of Gothenburg, and member of the Industrial Relations Research Unit and the Global Research Priority in Global Governance (GRP–​GG), University of Warwick. She is also Research Fellow at the Center for Social Innovation, Judge Business School, University of Cambridge, Fellow at the Cambridge Institute for Sustainability Leadership (CISL), University of Cambridge, and Fellow at the World Class Research Environment Responsible Business, Copenhagen Business School. She holds a PhD from the Judge Business School, University of Cambridge. F. Alexander de Roode is Researcher at Robeco’s Investment Research Department where he develops investment portfolio allocation strategies using quantitative methods. In addition, he participates in the design of retirement solutions for institutions and individuals. His other research interests include alternative asset classes, model

xxxiv   About the Contributors uncertainty, and corporate finance. He holds a PhD in Financial Econometrics and an LLM in International Business Law from Tilburg University in the Netherlands. Paul Roseis Associate Dean for Academic Affairs; Bazler Designated Professor in Business Law. He teaches Business Associations, Comparative Corporate Law, Corporate Finance, Investment Management Law, and Securities Regulation. He has written extensively on sovereign wealth funds, corporate governance, and securities regulation, and he has provided guidance and testimony on these topics to numerous regulators and agencies, including the US Senate Committee on Banking, Housing and Urban Affairs; the US Securities and Exchange Commission; the Government Accountability Office; and the Congressional Research Service. He is an affiliate with SovereigNet, a research project at The Fletcher School at Tufts University, a Fellow of the Sovereign Investment Lab, Bocconi University—​BAFFI Center on International Markets, Money, and Regulation, and is a non-​resident Fellow of the IE—Sovereign Wealth Lab at IE Business School. Javier Santiso is Professor at IE Business School and Head of the IE—​Sovereign Wealth Lab by IE Business School. He studied at HEC, Sciences Po, the the University of Oxford, and Harvard University. He holds MA, MBA and PhD degrees. He is a Young Global Leader of the World Economic Forum and in the past has been chief economist for emerging markets at BBVA in Madrid and Indosuez in Paris and Senior Advisor for Amundi and Lazard Frères. He has been also Chief Economist and Director General of the OECD Development Center and Associate Professor at SAIS Johns Hopkins University and ESADE Business School. He has published more than 70 articles and papers and also books with MIT Press, Oxford University Press, and Cambridge University Press, among others. Di Wang, PhD is Lecturer in the Department of Government at the University of Texas at Austin. She received her PhD in Political Science from Texas A&M University. Her primary field of interest is the political economy of international investment and finance. Her dissertation, Leviathan as Foreign Investor: Evidence from Sovereign Wealth Funds, examines how state ownership affects sovereign wealth fund investment abroad by providing a general theoretical framework and a detailed deal-​level analysis. She has published in the International Interactions, World Economics, China and World Economy, Defense Studies, and other outlets. Piotr Wiśniewski, PhD is Associate Professor at the Institute of Finance of the Warsaw School of Economics (Poland). His interests in sovereign wealth funds focus on their performance metrics, their transparency, and the funds’ activity in Central and Eastern Europe (CEE). Piotr brings over two decades of executive experience in the European financial services industry as well as chartered membership of the (British) Chartered Institute for Securities and Investment (CISI). Geoffrey Wood is Dean and Professor of International Business at Essex Business School. Previously he was Professor of International Business at Warwick Business

About the Contributors    xxxv School, UK. He has authored/​co-​authored/​edited 16 books, and over 150 articles in peer-​ reviewed journals. Previously he was Professor of International Business at Warwick Business School, UK. He holds honorary positions at Griffith and Monash Universities in Australia, and Witwatersrand and Nelson Mandela Universities in South Africa. His research interests center on the relationship between institutional setting, corporate governance, firm finance, and firm level work and employment relations. Geoffrey is Editor in Chief of the British Journal of Management, the official journal of the British Academy of Management (BAM). He also serves on the BAM. Council. He is also Editor of the ABS Journal Ranking list. He has had numerous research grants, including funding councils (e.g. ESRC), government departments (e.g. US Department of Labor; UK Department of Works and Pensions), charities (e.g. Nuffield Foundation), the labor movement (e.g. the ITF) and the European Union. Mike Wright is Professor of Entrepreneurship and Founding Director of the Center for Management Buyout Research at Imperial College Business School, Visiting Professor at ETH Zurich, and Fellow of the British Academy. He pioneered research on management buyouts and his current research focuses on entrepreneurial finance (especially private equity, venture capital, business angels and accelerators), as well as entrepreneurial ownership mobility (especially habitual entrepreneurs, returnee entrepreneurs, academic entrepreneurs, and family firms). His books and articles have been cited over 40,000 times (according to Google Scholar). His recent books include The Oxford Handbook of Corporate Governance (Oxford University Press, 2013) and The Habitual Entrepreneur Phenomenon (Routledge, 2016). He is an Editor of Strategic Entrepreneurship Journal, Academy of Management Perspectives and Foundations and Trends in Entrepreneurship. He is a member of the British Venture Capital and Private Equity Association research committee. Xu Yi-​chong is Professor at the School of Government and International Relations, Griffith University, Australia. He is the author of The Sinews of Power (Harvard University Press, 2016), The Politics of Nuclear Energy in China (Palgrave Macmillan, 2010); Electricity Reform in China, India and Russia (Edward Elgar Publishing, 2004); Powering China (Ashgate, Dartmouth, 2002); co-​author of Inside the World Bank (with P. Weller, Palgrave Macmillan, 2009) and The Governance of World Trade, (with P. Weller, Edward Elgar Publishing, 2004); and editor of The Politics of International Organizations (with P. Weller 2015), The Political Economy of State-​owned Enterprises in China and India (Palgrave Macmillan, 2012) and Nuclear Energy Development in Asia (Palgrave Macmillan, 2011) and co-​editor (with G. Bahgat) of The Political Economy of Sovereign Wealth Funds (Palgrave Macmillan, 2010). All the projects were supported by research grants from the Social Sciences and Humanities Research Council of Canada and Australian Research Council (ARC).

Pa rt  I

SI Z E A N D G OV E R NA N C E OF S OV E R E IG N W E A LT H  F U N D S

Chapter 1

In trodu cing S ov e re i g n Wealth Fu nd s Douglas Cumming, Igor Filatotchev, Juliane Reinecke, and Geoffrey Wood

Introduction Sovereign wealth funds (SWFs) represent government owned investment vehicles which have become increasingly prominent in the global financial ecosystem. They have wide ranging and shifting investment priorities; although most have tended to focus on debt and relatively small non-​equity stakes, a significant number of deals involve quite substantial or even controlling shareholding (Butt, Shivdasani, Stendevad, and Wyman 2008; Sauvant, Sachs, and Jongbloed 2012). SWFs have tended to favour diverse portfolio holdings on sectoral and regional lines (Balding 2008). This has led to Beck and Fidora (2008) argueing that they may serve an important role in balancing international capital flows. Although there is little doubt that their holdings are very substantial, inconsistencies in how they count assets in different national contexts, and indirect investments via financial intermediaries, would suggest their size is considerably underestimated (Balding 2008). Although SWFs racked up some heavy losses in the 2008 financial crisis—​some US$14 billion appears to have been lost in 2008 alone (Makhlouf 2010)—​it can be argued that their role in the global financial ecosystem has become even more important as an international source of investment capital (Baker and Boatright 2010). Moreover, SWFs have tended to perform worse than comparable private investments (Bortolotti, Fotak, and Megginson 2015). This may be due to political influence or poor governance (Bortolotti, Fotak, and Megginson 2015; Chhaochharia and Laeven 2008), but could also reflect more diverse agendas, and a greater willingness to sacrifice short term returns for long-​term potential.

4   Introducing Sovereign Wealth Funds

Defining Sovereign Wealth Funds Although in most instances, SWFs manage state revenues from natural resource exports, they may also manage a proportion of returns from the export of manufactured goods, proceeds of privatization, and foreign exchange reserves (Kotter and Lei 2011; Makhlouf 2010). Broadly speaking, they can be divided into commodity and non-​commodity funds; the latter involving interventions on the exchange rate, leading to the issuance of debt to avoid inflation; hence, the latter face interest payments on the debt bonds issued (Blackburn et al. 2008, p. 3). SWFs are managed separately from other government assets, are controlled by national monetary authorities, and typically have global orientation; indeed, some are prohibited from domestic investments (Blackburn et al. 2008; Makhlouf 2010). They are a form of intergenerational savings, designed to husband foreign exchange windfalls. However, they may also function as a stabilization device, helping cushion the parent country against unforeseen shocks to the global economy, as a diplomatic tool, as a mechanism for supporting national industrial development priorities (which can, inter alia, encompass the acquisition of overseas firms with proprietal knowledge), or even as a mechanism for advancing the personal financial interests of ruling clans or families (see Baker and Boatright 2010). They may also help secure foreign assets, and hence advance a resource nationalism agenda (Blackburn et al. 2008). Generational savings vehicles, such as the South African Public Investment Corporation (PIC), strictly speaking fall outside of the definition of an SWF; the PIC, despite being based on public sector pensions savings (in other words, a generational savings device), fulfills some of the other functions of a SWF (see Chapter 10). Blackburn et al. (2008, p. 5) note that primarily future generation orientated funds tend to be quite diversified and hold small stakes, stabilization ones tend to be limited to AAA rated bonds—​with efforts to manage country risk—​while the more opaque funds tend to favor large, but non-​controlling stakes in firms, arguably trying to avoid disclosure requirements. SWFs may benefit the citizens of their parent nation through possible higher return rates, and the political leverage the activities afford (Blackburn et al. 2008). The former is facilitated by the fact that, as they are managed separately from official reserves, there is less pressure to invest in safe and liquid securities (Blackburn et al. 2008; Kotter and Lei 2011). In the case of countries where there are restrictions on offshore investments by citizens, SWFs may be able to secure higher returns than individual investors (Blackburn et al. 2008). Alternatives would include infrastructural spending or simply allowing for lower taxes than would otherwise be the case (Blackburn et al. 2008). The UK represents a good example of the latter; the North Sea oil windfall facilitated tax cuts (although it could be debated whether this in any manner compensated for what could have been saved), helping fuel a volatile economic boom in the late 1980s and 1990s (Chakarbortty 2014). However, any gains seem to have been dissipated, with the country having little in the way of a durable legacy from the North Sea (Chakarbortty 2014); at the same time, the UK has experienced a range of resource curse effects encompassing currency

Douglas Cumming et al.   5 over-​valuation, a decline of traditional areas of the economy and asset bubbles (Ross 1999). Again, tax cuts have tended to be concentrated on the upper income brackets; in other words, the richest have benefited the most, whereas, in ideal terms at least, SWFs treat the well-​being of each citizen equally. A recent trend has been for joint investments between SWFs; examples include Abu Dhabi and Malaysia cooperating in energy, tourism and real estate; France and Abu Dhabi around biotech; and Qatar and Indonesia in natural resource exploitation in Vietnam (Makhlouf 2010). Although it is too soon to draw conclusions from a limited number of cases, it is possible that the shared interests of many SWFs may result in greater cooperation and coordination in the future.

Core Dimensions of Sovereign Wealth Funds Sovererign Wealth Funds as a Diplomatic Tool As arms of national governments, SWFs can serve as a mechanism for advancing parent country diplomatic objectives (Kimmitt 2008). There have been growing concerns as to the political implications of SWF investments, and this has led to firms attracting SWF investment, in some instances coming under intense media scrutiny (Butt, Shivdasani, Stendevad, and Wyman 2008; Gilson and Milhaupt 2007). However, this criticism has become considerably more muted in the aftermath of the 2008 financial crisis (Baker and Boatright 2010) that has made governments of potential investment destinations considerably more tolerant of SWF investments. On the one hand, it has been argued that any restrictions on investors represents a form of financial protectionism (Cohen 2009); in doing so, it restrains the operations of markets (albeit that SWFs are themselves statist), and constrains the ability of firms to attract investment capital. Makhlouf (2010) argues that the political role they have played is minimal; they primarily appear to be a long-​term investment vehicle. Butt, Shivdasani, Stendevad, and Wyman (2008) emphasize the liquidity function of SWFs. Again, their investments may help support existing national industrial paradigms, rather than disrupt individual firms and national systems. For example, Gulf SWF investors in Germany have forged alliances with German industrial families and foundations, which has contributed to the revitalization of the traditional German model of corporate control, helping fend off the demands of activist investors (Haberly 2014). On the other hand, the acquisition of national strategic assets by Middle Eastern SWFs has created disquiet both in the US and the UK (Chijioke-​Oforji 2014). Again, threats by SWF parent governments to cut back on their investments in traditional destinations may exert a chilling effect on host-​country governments. The willingness of the US and UK governments to turn a blind eye to (and even abet through the sale of arms and security

6   Introducing Sovereign Wealth Funds equipment) gross human rights abuses and the funding and arming of Wahabist extremist movements abroad, is at least to some extent impelled by the considerable investments of the Gulf autocracies in their countries (Bronson 2006). Since the onset of the 2008 financial crisis, concerns as to financial protection have become more muted; the increased need for SWF investment, particularly in helping recapitalize the financial services sector, has meant that pragmatism has outweighed expediency. Chhaochharia and Laeven (2008) found a tendency for SWFs to favor certain regions and contexts, and this appeared to suggest that such investments were not strictly driven by profit. Indeed, the long-​term performance of SWFs had tended to be poor, reflecting governance directions and imperfect diversification of portfolios (Bortolloti, Fotak, and Megginson 2015; Bronson 2006).

Sovereign Wealth Funds and National Development Priorities SWFs may also help advance parent country national development through the acquisition of strategic assets, including firms that hold bespoke technology (Reisen 2008). An example of this would be the range of acquisitions of German Mittelstand supported by the Chinese Investment Corporation (see Casaburi and Broggi 2015). While this does open up a new source of investment capital, it may lead to the loss the organization’s unique competitive advantage, and indeed undermine locally based supply chains in favor of those in the SWF country of origin. If an investment is primarily about securing access to technology, it is possible that the target firm may be drained of its knowledge and discarded, with the proprietary know-​how being disseminated to influential firms in the country of origin. SWFs may also help the parent country gain access to mineral or natural resources. Although resource seeking is a pattern of behavior particularly accentuated by Chinese investors abroad (Wood, Mazouz, Yin, and Cheah 2014b), Gulf SWFs have shown a considerable appetite for the purchase of agricultural land in Africa (Cotula, Vermeulen, Mathieu, and Toulmin 2011; Hall 2011). On the one hand, this may enable countries with poor agricultural prospects to ensure against future scarcity or high agricultural prices, through direct ownership in fertile areas abroad. On the other hand, such purchases have, in a number of instances, been associated with the forced expropriation of the indigenous peasantry (Hall 2011; Rahmato 2011). Examples would include Mozambique and lowland Ethiopia. Existing low-​scale resistance, and the proven potential of peasants to wage protracted guerrilla wars might suggest that such SWFs are overestimating the diplomatic clout investment capital brings, and underestimating realities on the ground (c.f. Martin and Palat 2014). Many SWFs are prohibited from investing in their home countries, a notable example being Norway’s Government Pension Fund Global and Botswana’s Pula Fund. In some cases, this restriction is partial. For example, Singapore avoids investing in high profile national firms to escape controversy (Makhlouf 2010). However, a number of other SWFs hold significant investments in their country of origin; indeed, within the China

Douglas Cumming et al.   7 Investment Corporation’s portfolio are what might be considered “typical domestic strategic investments” (Zhang and He 2009, p. 109).

Stabilization Device A further role for SWFs is that of a stabilization device, protecting the parent government against external economic shocks. Funds which prioritize this will accord particular attention to governmental budgetary dynamics; decision making will be also shaped by private capital flows and domestic private debt (Petrova, Pihlman, Kunzel, and Lu 2011). SWFs may smooth out the negative domestic consequences of fluctuations in commodity markets, and help cushion a transition away from a resource driven economy (Fotak, Bortolotti, Megginson, and Miracky 2008). They may also mitigate the effects of unexpected external economic shocks; many countries’ SWFs have been able to smooth out the consequences of such events through relatively modest and rapidly replenished distributions back to the parent country. At the same time, as will become apparent below, no SWF has infinite reserves, and a combination of low oil and gas prices, as well as diminishing natural resources, has placed a severe pressure on many SWFs. Moreover, the possession of an SWF may deter parent governments from making difficult decisions, extending rather than eliminating any day of reckoning when natural resources are depleted.

Intergenerational Savings Intergenerationl savings represent the raison d’etre of many SWFs. All countries experiencing mineral (or indeed, any other foreign exchange) windfalls should, of necessity, make some plan for when such gains are no longer likely to be forthcoming (Helleiner and Lundblad 2008). Typically, governments have two broad options, although they may make use of both simultaneously. The first is to use the gains to fund an active industrial policy, promoting diversification away from oil and gas. The second is the establishment of an SWF; a downside is that SWFs can be dissipated as they are readily available and often opaquely governed assets long before resources are depleted. An example would be Saudi Arabia’s existing quasi-​SWF, the Public Investment Fund, which has been significantly depleted from 2014 up until the time of writing.

Sovereign Wealth Fund Transparency There has been considerable concern as to the relative transparency of SWFs. As Weiss (2008) notes, a lack of transparency may obscure investment patterns (and potentially

8   Introducing Sovereign Wealth Funds hidden diplomatic agendas), governance, and risk management strategies. Drezner (2008) found that there was a close correlation between relative transparency and home country democratic institutions and relative rule of law. In the run up to the financial crisis, growing pressures toward financial protectionism and, above all, unease in the US, encouraged (via first the G-​20, and then the IMF) the development of the 2008 Santiago Principles of best practices, which were drawn up by the IMF and fourteen of the largest SWFs (Norton 2010). In 2009, the International Forum of SWFs was established to develop a self-​regulatory process for implementing, revising and interpreting the Principles (Norton 2010). By 2016, some thirty funds, representing the bulk of SWF assets, had signed up (IFSWF 2016). Following on this, there appears to have been a stronger focus on returns, shorter term time horizons, and a slow move toward greater transparency and clarity in management (Balin 2010). Nonetheless, there persists much diversity in the governance of SWFs, with some remaining quite opaque. Kotter and Lel (2011) found that more transparent SWFs were more likely to provide capital to financially constrained firms and enhance performance; hence, transparency appears to impact both on investment targets and performance.

Sovereign Wealth Funds and Ethical Issues Bearing in mind a significant size and influence of SWFs, they may also play an important role in terms of enforcing principles of ethical investment. However, this aspect of the SWF’s investment policies is rather controversial. For example, the Norwegian oil fund’s decision to dump tobacco companies has cost the world’s largest sovereign wealth fund US$1.9 billion in missed profits over the past decade. The losses have prompted campaigners for ethical investment to admit that the economic arguments for excluding companies like BAT and Imperial Tobacco are rather ambiguous, potentially prompting other big investors to review their exclusion policies. Calpers, the largest US public pension fund, is already reassessing its stance on tobacco after discovering it has suffered around US$3 billion in missed profits as a result of blacklisting the sector in 2000 (FTfm 2016).

Sovereign Wealth Funds and Other Alternative Investors SWFs have exhibited much diversity—​and change—​in their investment strategies and appetite for risk (Butt, Shivdasani, Stendevad, and Wyman 2008). Several—​but with the notable exception of Norway—​have become significant players in the alternative investment ecosystem, with large investments in prominent private equity partnerships and other financial services industry players (Butt, Shivdasani, Stendevad, and Wyman 2008). On the one hand, their longer term horizons may make them more attractive as a source of investment capital than private equity on its own (Butt, Shivdasani, Stendevad,

Douglas Cumming et al.   9 and Wyman 2008). On the other hand, the more transparent SWFs are subject to a high degree of public scrutiny in their country of origin, and this may place pressure on fund managers to maximize returns, even if this involves a greater degree of risk-​taking than may be desirable. Significantly, the Norwegian Government Pension Fund Global has moved into property and is considering moving into private equity. However, although it has been argued that alternative investors share broadly similar agendas and, hence, have increasingly acted in concert, the very different time frames and strategies employed mean that they are often divergent (Wood 2016). Hedge funds may promote share buy backs, which make private equity takeovers more difficult, while SWFs have, at least in formal terms, much longer term agendas than either of the former.

Vanishing Sovereign Wealth Funds? The decline in oil and gas prices in 2015 led to a number of petrostates dipping into their SWFs to fund budget deficits (Blas 2016). For example, the Qatar SWF has quietly sold off some of its shareholdings and its commitments to private equity (Sender 2016). Russia has also significantly dipped into its SWF. Many petrostates—​Equatorial Guinea and Saudi Arabia being two of the most extreme examples—​have failed to successfully diversify away from oil and gas, making the economic consequences of falling oil revenues particularly severe. In the case of Saudi Arabia, the government has bought domestic stability through the continuing lavish funding of Islamist extremism abroad, and has become embroiled in a costly and open-​ended military adventure in Yemen; it has only limited room for maneuver in cutting domestic spending given the omnipresent threat of political disorder at home (Simons 2016). The Saudi Public Investment Fund is a quasi-​SWF in that it is a ministry owned public investment company with a large domestic portfolio, but also has significant foreign investments (Cotterill 2016). Meanwhile, Saudi Arabian Monetary Agency (SAMA) technically forms part of the tyranny’s monetary policy (Cotterill 2016), again placing it in the quasi-​SWF category. Declining oil revenues have led to a large-​scale sell-​off of foreign equities (some estimates suggest the sales were so large as to cause a decline in the Japanese stock exchange in early 2016) and the cashing in of managed bank accounts (Sender 2016). All these demands have led to the decline of the country’s foreign exchange reserves by US$100 billion in the second half of 2015 alone to US$635 billion (Blas 2016). In response, the Saudi government has called for the transfer of government assets to the Public Investment Fund, with further funds to be released through the partial privatization of Aramco, the state oil and gas company; the ambition of Deputy Crown Prince Mohammed is that there “will be no investment, movement or development in any region of the world without the vote of the Saudi sovereign fund” (Bianchi 2016). This represents a departure from the established model of directly funding SWFs through natural resource windfalls; rather, it represents the transfer of existing oil and gas funded assets into a more liquid form. As such, it would give the Saudi government renewed clout abroad, at the same time as its capacity to deploy Aramco to suit domestic developmental objectives would be accordingly

10   Introducing Sovereign Wealth Funds weakened. Given very high levels of corruption, it could provide new opportunities for princely clans to capture rents and, indeed, it could serve as a life raft for the same in the event of a major domestic disturbance (c.f. Simons 2016). An even more extreme example would be Equatorial Guinea; despite its African locale, this former Spanish colony represents an example of a traditional Latin American family dictatorship, with close parallels to Samoza’s Nicaragua, Batista’s Cuba, and above all, Papa Doc’s Haiti (Wood 2004). The diversion of oil and gas revenues into a personal bank account held by members of the Nguema family (the Riggs Bank scandal) does not seem to have diminished the appetite of family members and their extended networks for a range of other activities for personal enrichment, including the alleged acceptance of nuclear waste, drug and human trafficking, pirate fishing, general corruption and petty extortion (Frynas 2004; Wood 2004). Despite experiencing oil and gas fueled phenomenal growth in the early 2000s, the overwhelming majority of the population remained deeply impoverished (Appel 2012; Okenve 2009). Rather than promoting sustainable diversification, oil and gas funded domestic spending was concentrated on elite housing, government buildings and other vanity projects (Appel 2012; Blas 2014). Rapid over exploitation of ultra deep water oil finds led to a drop in oil and gas extraction at the same time as the global oil price declined. The country has now entered a deep recession, and the SWF is accordingly being drained. This unhappy story highlights the fact that the mere possession of an SWF does not mean that intergenerational savings are secured, nor that the negative effects of a chronic resource curse and a criminal state may in some manner or other be offset; what matters is the governance of the SWF and its country of origin. These trends emphasize the extent to which SWFs may provide readily available capital, which may be used to cushion parent countries against unforeseen developments in the global capitalist ecosystem; but which may also be used, in extreme cases, by feckless elites to secure their continued personal enrichment and/​or their foreign policy adventures. In such circumstances, the intergenerational savings function may be lost.

Sovereign Wealth Funds and Institutions The literature on comparative institutional analysis—​be it orthodox or heterodox—​that focuses on the effects of institutions on firm practices and vice versa, has tended, up until recently, to neglect the role of international players other than at the formal structural level. However, recent work in the Business Systems theory literature has focused on the extent to which Multinational Enterprises (MNEs) straddle institutional domains and, as such, are subject to weaker pressures to conform in each (Morgan 2012). As MNEs seek to gain access to the unique advantages specific settings confer, they have some incentives to fit into local rules and conventions (Morgan 2012; Morgan and Kristensen 2006). SWFs and other alternative financial actors may thus act to buoy up and reinforce locally dominant models of corporate control and associated firm level practices (Haberly 2014). However, this is only likely to be the case in mature institutional settings

Douglas Cumming et al.   11 where complementarities are relatively advanced (Hall and Soskice 2001; Hancké 2009; Wood, Dibben, and Ogden 2014a). In emerging markets, there will be fewer incentives to support dominant local production regimes, and, in any event, regulatory oversight will be weaker. Further, in many instances, politicians more pliable, allowing considerably more room for innovation or departure from local norms. Examples of this would include numerous Chinese and Gulf SWF funded investments in Africa. Examples of the former would include the wholesale import of semi-​skilled and unskilled labor from China in place of local workers (Mohan and Power 2008), and the above-​mentioned purchase of agricultural land in the case of the latter. Again, the literature on comparative institutional analysis has tended to focus on the causes and effects of government decision making within the confines of the nation state. However, SWFs represent an example of a transnational alternative investor that, in some manner or another, serves the interests of the parent country government, and whose actions may impact on different institutional settings. Even the Norwegian Government Pension Fund Global, which is often held up as a model of a transparent investor that has to directly account to the Norwegian public for its financial performance, has in its brief a responsibility to promote Norwegian values in the world at large, and it seeks to do so through promoting ethical investor behavior (see Chapter  17). While other, more opaque, SWFs may have little concern for human rights—indeed, a number of prominent land deals in Africa appear to involve gross human rights violations (Hall 2011; Rahmato 2011)—​they do nonetheless represent a mechanism for promoting national specific concerns abroad in a manner that may have significant impact for host country institutions and informal regulatory devices. In a recent Academy of Management Perspectives article, one of the editors of this book (with Mike Wright), argued that there was significant evidence within Liberal Market Economies (LMEs) of a drift toward greater statism (Wood and Wright 2015). More optimistic interpretations of Polanyian double movements suggest that when market excess has exhausted itself, there is an inevitable move toward greater state mediation. However, Wood and Wright (2015) argue that the “new statism” is characterized by greater state involvement, but in novel forms; this echoes the view of Polanyi (1944) that statism is not always benign, nor does it represent a return to previous familiar forms thereof. Rather, the kind of statism encountered in LMEs is characterized by heavily interpenetrated and burgeoning military-​industrial, security and penal complexes, and an ecosystem of firms that, rather than competing in open markets, occupy oligopolistic positions in tendering for and performing outsourced public services (Wood and Wright 2015). Although there is much diversity in the national level institutions of governments holding SWFs, this also represents a novel form of statism in an age of privatization; it represents national governments taking into at least partial state ownership key firms in strategic or potentially lucrative industries. However, a key distinction between this and traditional nationalization policies is that SWFs transcend national boundaries and, indeed, in a number of key instances are barred from investing in their home country. This book highlights the extent to which such investments may serve complex and sometimes contradictory objectives, but at the same time constitute part

12   Introducing Sovereign Wealth Funds and parcel of shifting—​but not always diminishing—​patterns of state intervention in markets.

Conclusion Sovereign wealth funds represent not only an increasingly frequent player in the alternative investor ecosystem, but also a novel mechanism through which governments may project their power, and serve geopolitical and strategic interests abroad. There is a body of existing literature that suggests that the directly observable political effects of SWF activity are very limited (Butt, Shivdasani, Stendevad, and Wyman 2008; Makhlouf 2010). However, the ability of national governments to dispense, withdraw or withhold capital represents an important dimension of soft power abroad, and there is considerable evidence that the indirect effects of SWF investments may have considerable wider political, social and economic effects, as outlined in the various chapters in this book. At a theoretical level, the growing body of evidence on the consequences of SWF activities highlights the need to develop and extend existing theories of institutions and the state, and the role of alternative investors as transnational actors; they also call for more nuanced understandings of how we understand agency and the ways in which owner agendas may be advanced. At an applied level, the book brings to bear new evidence on SWFs from around the world. At the same time, it is hoped that the book will encourage further studies on little known SWFs, such as the Equatorial Guinean Fund for Future Generations, and on quasi-​SWFs, such as the South African Public Investment Corporation (as the latter is a vehicle for holding public sector pensions assets, it is a generational, rather than intergenerational savings vehicle).

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14   Introducing Sovereign Wealth Funds Hall, R. (2011). Land Grabbing in Southern Africa:  The Many Faces of the Investor Rush. Review of African Political Economy, 38(128), 193–​214. Hall, P.A. and Soskice, D. (2001). Introduction. In:  Varieties of Capitalism. Oxford:  Oxford University Press. Hancké, B. (ed.) (2009) Introduction. In: Debating Varieties of Capitalism: A Reader. Oxford: Oxford University Press, pp. 1–​20. Helleiner, E. and Lundblad, T. (2008). States, Markets, and Sovereign Wealth Funds. German Policy Studies, 4(3), 59. IFSWF (International Forum of Sovereign Wealth Funds). (2016). Santiago Principles. Available at http://​w ww.ecgi.org/​codes/​documents/​iwg_​santiago_​principles_​oct2008_​ en.pdf [accessed December 1, 2016]. Kimmitt, R.M. (2008). Public Footprints in Private Markets: Sovereign Wealth Funds and the World Economy. Foreign Affairs, 87(1), 119–​30. Kotter, J. and Lel, U. (2011). Friends or Foes? Target Selection Decisions of Sovereign Wealth Funds and their Consequences. Journal of Financial Economics, 101(2), 360–​81. Makhlouf, H. (2010). Sovereign Wealth Funds. International Journal of Governmental Financial Management, 10(1), 35–​41. Martin, W.G. and Palat, R.A. (2014). Asian Land Acquisitions in Africa:  Beyond the “New Bandung” or a “New Colonialism?” Agrarian South: Journal of Political Economy, 3(1), 125–​50. Mohan, G. and Power, M. (2008). New African Choices? The Politics of Chinese Engagement. Review of African Political Economy, 35(115), 23–​42. Morgan, G. (2012). “International Business, MNCs and National Systems”. In: Demirbag, M. and Wood, G., eds, Handbook of Institutions and International Business. Cheltenham: Elgar, pp. 18–​40. Morgan, G. and Kristensen, P.H. (2006). The Contested Space of Multinationals: Varieties of Institutionalism, Varieties of Capitalism. Human Relations, 59(11), 1467–​90. Norton, J.J. (2010). The “Santiago Principles” for Sovereign Wealth Funds: A Case Study on International Financial Standard-​Setting Processes. Journal of International Economic Law, 13(3), 645–​62. Okenve, E.N. (2009). Wa Kobo Abe, Wa Kobo Politik: Three Decades of Social Paraylsis and Political Immobility in Equatorial Guinea. Afro-​Hispanic Review, 28(2), 143–​62. Petrova, I., Pihlman, J., Kunzel, M.P., and Lu, Y. (2011). Investment Objectives of Sovereign Wealth Funds: A Shifting Paradigm. Washington: International Monetary Fund. Polanyi, K. (1944). The Great Transformation: The Political and Economic Origins of Our Time. Boston: Beacon Press. Rahmato, D. (2011). Land to Investors: Large-​Scale Land Transfers in Ethiopia. Addis Abbaba: African Books Collective. Reisen, H. (2008). How to Spend It: Commodity and Non-​Commodity Sovereign Wealth Funds. Geneva: OECD. Ross, M.L. (1999). The Political Economy of the Resource Curse. World Politics, 51(2), 297–​322. Sauvant, K.P., Sachs, L.E., and Jongbloed, W.P.S. (2012). Sovereign Investment: Concerns and Policy Reactions. Oxford: Oxford University Press. Simons, G. (2016). Saudi Arabia: The Shape of a Client Feudalism. Frankfurt: Springer. Sender, H. (2016, March 22). “Lower Oil Tests Sovereign Wealth Funds.” Financial Times. Available at http://​www.ft.com/​cms/​s/​0/​ecf838cc-​ef61-​11e5-​aff5-​19b4e253664a.html#axzz4 EvLeNKfC [accessed December 1, 2016].

Douglas Cumming et al.   15 Weiss, M.A. (2008). Sovereign Wealth Funds:  Background and Policy Issues for Congress. Washington: Congressional Research Service, Library of Congress. Wood, G. (2004). Business and Politics in a Criminal State: the Case of Equatorial Guinea. African Affairs, 103(413), 547–​67. Wood, G. (2016). Private Equity at Work: Review Symposium. Socio-​Economic Review, 13(4), 813–​20. Wood, G., Dibben, P., and Ogden, S. (2014a). Comparative Capitalism Without Capitalism, and Production Without Workers: The Limits and Possibilities of Contemporary Institutional Analysis. International Journal of Management Reviews, 16(4), 384–​96. Wood, G., Mazouz, K, Yin, S., and Cheah, J. (2014b). Foreign Direct Investment from Emerging Markets to Africa: The HRM Context. Human Resource Management, (US, Wiley), 53(1), 179–​201. Wood, G. and Wright, M. (2015). Corporations and New Statism:  Trends and Research Priorities. Academy of Management Perspectives, 29(2), 271–​86. Zhang, M. and He, F. (2009). China’s Sovereign Wealth Fund: Weakness and Challenges. China and World Economy, 17(1), 101–​16.

Chapter 2

A F i nancial F orc e to be Reckoned W i t h ? An Overview of Sovereign Wealth Funds Veljko Fotak, Xuechen Gao, and William L. Megginson

Introduction What Are Sovereign Wealth Funds and Why Do We Care? Sovereign wealth funds (SWFs), as a new form of investment organizational structure, have received extensive attention from practitioners, academics, and policymakers in their short history. One important reason that SWFs provoke widespread concern is due to their unique characteristic as state-​owned investment vehicles, since government ownership implies potential political interference in target firm affairs, and passivity regarding corporate governance. SWFs’ lack of liabilities and lack of need for short-​term liquidity could also potentially make their investment behavior different from other international institutional investors. The other, equally important reason why SWFs have attracted research interest is the astonishing speed at which they have grown. By the end of 2014, SWFs had over S$5.5 trillion assets under management (AUM) and they were undoubtedly a financial force to be reckoned with in international financial markets. However, when we look at their size in 2015–​16, some new trends emerge. Major oil producers and consistent export-​surplus countries, traditionally the principal sponsors of SWFs, face massive problems due to the prolonged oil price slump from the second half of 2014 to present and the slowdown of economic growth in emerging economies, and these facts dramatically impact the level of SWF assets. We observe a significantly lower growth rate, or even a decline, in total SWF AUM values since the beginning of 2015, which raises doubts about the future of SWFs in the new economic environment.

Veljko Fotak, Xuechen Gao, and William L. Megginson    17 When SWFs change from asset accumulators to asset managers and trust funds, whether they can still remain a growing financial force and maintain their relative fraction of global financial assets seems questionable. In addition, SWFs may change their investment behavior and monitoring role in corporate governance under the new economic environment as a reaction to the reduction of oil export revenues and declining trade surpluses. Funds also face political pressure to support domestic fiscal budgets. Adjusting investment strategies to chase for higher returns while simultaneously satisfying domestic fiscal needs will doubtless pose a major challenge for SWFs. In this chapter, we use the most up-​to-​date data to document UM trends through February 2016, and trace the new investment patterns up to year-​end 2014. We also describe several recently published articles to present a comprehensive survey of SWFs. There is no consensus, in either the academic or practitioner literature, on the definition of a “sovereign wealth fund.” However, most researchers agree that SWFs are government-​owned investment vehicles that invest domestically or internationally to seek commercial profits (Alhashel 2015; Chwieroth, 2014).1 Some definitions are broader than this, as in Truman (2008), who defines an SWF as “a separate pool of government-​ owned or government-​controlled financial assets that includes some international assets.” Balding (2008) shows that an expansive definition encompassing government-​ run pension funds, development banks, and other investment vehicles would yield a truly impressive total value of “sovereign wealth.”2 In this chapter, we use the definition of an SWF employed by the Sovereign Investment Laboratory:  (1)  an investment fund rather than an operating company; (2) that is wholly owned by a sovereign government, but organized separately from the central bank or finance ministry to protect it from excessive political influence; (3) that makes international and domestic investments in a variety of risky assets; (4) that is charged with seeking a commercial return; and (5) which is a wealth fund rather than a pension fund—​meaning that the fund is not financed with contributions from pensioners and does not have a stream of liabilities committed to individual citizens.3 While this

1 

Most definitions also exclude funds directly managed by central banks or finance ministries, as these often have very different priorities, such as currency stabilization, funding of specific development projects, or the development of specific economic sectors. 2  In ongoing research employing the Thomson Reuters Securities Data Corporation Mergers and Acquisitions database and other databases, we identify over 12,100 investments, worth over $1.67 trillion, just in listed-​firm stocks by state-​owned investment companies, stabilization funds, commercial and development banks, pension funds, and state-​owned enterprises. If we add state purchases of government and corporate bonds, plus SWF holdings and foreign exchange reserves of roughly $12 trillion, the total value of state-​owned financial assets may already exceed $25 trillion. David Marsh writes that global public investors owned about $30 trillion of assets worldwide. See David Marsh, “Sovereign-​wealth funds must move out of shadows,” MarketWatch (March 10, 2014, http://​www. marketwatch.com/​story/​sovereign-​wealth-​funds-​must-​move-​out-​of-​shadows-​2014-​03-​10). 3  For a comparison of SWFs with state-​run pension funds, see Blundell-​Wignall, Hu, and Yermo (2008).They conclude that SWFs and public pension reserve funds (PPRFs) are similar in some ways, but differ significantly with respect to objectives, investment strategies, sources of financing, and transparency requirements.

18    A Financial Force to be Reckoned With? sounds clear-​cut, ambiguities remain. Several funds headquartered in the United Arab Emirates are defined as SWFs, even though these are organized at the Emirati rather than the federal level, because the emirates are the true decision-​making administrative units.4 Table 2.1 presents the 34 SWFs that meet these criteria, the countries that sponsor the funds, their year of inception, their principal source of funds, and estimates of the value of AUM as of February 29, 2016. We also include Saudi Arabian Monetary Agency (SAMA) in this listing, since the Saudi government announced in June 2014 that it would establish a large SWF, partly encompassing SAMA’s foreign assets. There is some controversy regarding which is the largest SWF. Historically, the Abu Dhabi Investment Authority (ADIA) has been awarded that title, but that is mainly because the fund has never reported its AUM, and commentators assume that Abu Dhabi’s massive oil export revenues must translate into an equally massive fund, with AUM estimates often exceeding $800 billion. The Sovereign Wealth Fund Institute (http://​w ww.swfinstitute.org/​s overeign-​w ealth-​f und-​r ankings/​) estimates that ADIA has AUM of about $773 billion, which places it second in size behind Norway’s Government Pension Fund Global (GPFG). Although the GPFG is the largest SWF on our list, it is worth mentioning that its size, unlike the previous rapid growing pattern, has actually declined since year-​end 2014. The GPFG has AUM of $855.8 billion as of December 31, 2014, but this dropped to $844.2 billion by the end of 2015 and fell further to $824.9 billion in February 2016 (http://​www.nbim.no/​en/​the-​fund). The China Investment Corporation (CIC) ranks in third place with $746.7 billion AUM. If the SAMA is re-​classified as a SWF, it would be the fourth largest, with total foreign assets of $632.3 billion as of February 2016. Similar to the GPFG, the SAMA’s assets have shrunk more than $115 billion since 2015, largely because Saudi Arabia has been drawing down foreign assets after oil prices crashed to help close a budget deficit equaling 15% of GDP. As the oldest SWF, having been founded in 1953,5 Kuwait Investment Authority (KIA) is now the fourth largest SWF, as defined by the Sovereign Investment Laboratory. Its estimated AUM is around $592.0 billion as of February 29, 2016 (http://​ www.swfinstitute.org/​sovereign-​wealth-​fund-​rankings/​). Amazingly, the small city state of Singapore itself sponsors the fifth and eighth largest SWFs, the Government of Singapore Investment Corporation (GIC, estimated AUM of $344.0 billion (http://​ www.swfinstitute.org/​sovereign-​wealth-​fund-​rankings/​)), which is charged primarily with international investing, and Temasek Holdings (AUM of $193.6 billion in February 2016 (http://​www.swfinstitute.org/​sovereign-​wealth-​fund-​rankings/​)), which focuses 4  The sub-​national UAE funds included in our list are the Abu Dhabi Investment Authority (the world’s second-​largest SWF), the Investment Corporation of Dubai, Istithmar World, the Mubadala Development Company, the International Petroleum Investment Corporation (IPIC), and the Ras Al Khaimah Investment Authority. 5  The Kuwaiti SWF is also unusual among large funds in that it is funded based on a formulaic percentage of the sales of Kuwait National Oil Company. The fund is automatically granted 10% of the oil revenues of the state, and the finance ministry recently approved increasing the allocation to 25%. See Henny Sender, Kuwait Investment Authority, “Integrity and caution are no handicap,” Financial Times (April 24, 2013).

Veljko Fotak, Xuechen Gao, and William L. Megginson    19 Table 2.1 Sovereign Wealth Funds in the Sovereign Investment Laboratory SWF Transaction Database Source of Funds

Total Assets US$ Billion

Government Pension Fund Global 1990

Commodity (Oil)

824.9

UAE-​Abu Dhabi

Abu Dhabi Investment Authority

1976

Commodity (Oil)

773.0

China

China Investment Corporation

2007

Trade Surplus

746.7

Saudi Arabia

Saudi Arabian Monetary Agency Foreign Assets

1963

Commodity (Oil)

632.3

Kuwait

Kuwait Investment Authority

1953

Commodity (Oil)

592.0

Singapore

Government of Singapore Investment Corporation

1981

Trade Surplus

344.0

Qatar

Qatar Investment Authority

1974

Commodity (Oil)

256.0

China

National Social Security Fund

2000

Trade Surplus

236.0

Singapore

Temasek Holdings

1974

Trade Surplus

193.6

UAE-​Dubai

Investment Corporation of Dubai

2006

Commodity (Oil)

183.0

Russia

National Wealth Fund and Reserve Fund

2006

Commodity (Oil)

139.2

UAE-​Abu Dhabi

Abu Dhabi Investment Council†

2005

Commodity (Oil)

110.0

Australia

Australian Future Fund

2006

Non-​Commodity

95.0

Republic of Korea

Korea Investment Corporation

2006

Government-​ Linked Comps

91.8

Kazakhstan

Kazakhstan National Fund

1983

Commodity (Oil)

77.0

UAE-​Dubai

International Petroleum Investment Company

1984

Commodity (Oil)

66.3

UAE-​Abu Dhabi

Mubadala Development Company PJSC

1993

Commodity (Oil)

66.3

Libya

Libyan Investment Authority

2003

Commodity (Oil)

66.0

Malaysia

Khazanah Nasional Berhard

2000

Government-​ Linked Firms

41.6

Brunei

Brunei Investment Agency

1983

Commodity (Oil)

40.0

Azerbaijan

State Oil Fund of Azerbaijan

1999

Commodity (Oil)

37.3

Oman

State General Reserve Fund

1980

Commodity (Oil & Gas)

34.0

Ireland

Ireland Strategic Investment Fund 2014

Non-​Commodity

23.5

Country

Fund Name

Norway

Inception Year

(Continued)

20    A Financial Force to be Reckoned With? Table 2.1 (Continued) Source of Funds

Total Assets US$ Billion

New Zealand Superannuation Fund 2001

Non-​Commodity

20.2

East Timor

Timor-​Leste Petroleum Fund

2005

Commodity (Oil & Gas)

16.9

UAE

Emirates Investment Authority

2007

Commodity (Oil)

15.0

UAE-​Dubai

Istithmar World†

2003

Commodity (Oil)

11.5

Bahrain

Mumtalakat Holding Company

2006

Government-​ Linked Firms

11.1

Oman

Oman Investment Fund

2006

Commodity (Oil & Gas)

6.0

Angola

Fundo Soberano de Angola

2012

Commodity (Oil)

5.0

Nigeria

Nigerian Sovereign Investment Authority

2012

Commodity (Oil)

1.4

UAE-​Ras Al Khaimah

Ras Al Khaimah Investment Authority

2005

Commodity (Oil & Gas)

1.2

Kiribati

Revenue Equalization Reserve Fund

1956

Commodity (Phosphates)

0.6

Vietnam

State Capital Investment Corporation

2005

Government-​ Linked Firms

0.5

São Tomé & Principe

National Oil Account†

2004

Commodity (Oil)

0.00063

Country

Fund Name

New Zealand

Inception Year

Total, 23 oil-​based funds (US$ billion)

$3,954.3

Total, 12 non-​oil based funds (US$ billion)

$1,804.6

Total, all 35 funds (US$ billion)

$5,758.9

†

Sovereign Investment Laboratory estimate of assets under management (AUM).

This table lists the 34 funds that meet the Sovereign Investment Laboratory definition of a sovereign wealth fund (SWF), plus the Saudi Arabian Monetary Agency’s foreign assets, and offers information regarding country of origin; fund name; the year in which the fund was established; the principal source of funding for the fund; and estimated total assets under management in US$ billions as of February 29, 2016. Unless indicated as being Sovereign Investment Laboratory estimates, data are mainly obtained from the Sovereign Wealth Fund Institute.

on domestic and regional investments. The UAE alone account for six of the 34 SWFs on this list, and other Arabian Gulf states account for another four. Only four funds are from western-​style democracies (Norway, Australia, New Zealand, and Ireland), though many others are sponsored by countries meeting most definitions of being democratic

Veljko Fotak, Xuechen Gao, and William L. Megginson    21 (Korea, Malaysia, Singapore, Russia).6 No fewer than 21 of the 34 funds have been launched since January 2000. The newest SWFs in our database are the Fundo Soberano de Angola (FSDEA) and the Nigeria Sovereign Investment Authority (NSIA). Both of them were established in 2012 to increase transparency and ensure that the nation’s resource wealth would not be misappropriated. Countries in Africa have a clear pattern to start relatively small SWFs in recent years in order to better manage their oil revenues. Most SWFs are sponsored by one of two types of channels: the revenue from the sale of natural resources, such as oil, natural gas, and coal; and the accumulated foreign currency reserves from persistent and large net exports. Since the ultimate owners of SWFs are governments, they usually have no explicit short-​term liabilities and intend to make long-​term investments. However, Bertoni and Lugo (2015) document a third, still relatively rare, but growing source of SWF financing—​the use of debt. They find that non-​ commodity-​based SWFs are more likely to use debt as an alternative way to increase the size of their AUM when they cannot receive stable capital injections from the governments. In addition, SWFs in the countries with underdeveloped bond markets have more incentive to use debt in order to facilitate the development of these markets. Last, SWFs with strategic investment styles tend to use debt because it can provide them more financial flexibility and help them optimize the cost of financing. The use of debt is still an uncommon and under-​researched phenomenon in the SWF literature. As of February 29, 2016, the 23 SWFs that are financed principally from oil revenues have combined AUM of $3.954 trillion—​or 68.7%—​of the $5.759 trillion total for all funds, while trade-​surplus-​financed SWFs account for most of the rest. It should be noted that this fairly restrictive definition of SWFs yields a smaller number and total AUM value than do most other classifications. For example, the Sovereign Wealth Fund Institute (SWFI) listed 79 SWFs with AUM of $7.088 trillion on February 29, 2016. However the definitions of SWF may vary, these fund totals show similar time trends. They had been growing much more rapidly over the past several years than had hedge funds, pension funds, and other private institutional investors. But this fast-​ growing pattern halted and the total AUM value declined during 2015 (this statement is made based on the SWFI’s definition of SWFs. With our restrictive definition, the total AUM still increased during 2015, but the growth rate was much lower than in previous years). Nearly all oil-​funded SWFs are affected by the oil price declines. At this point, it is important to assess what a stable, low oil price truly portends for the future of SWFs. In terms of total size, we believe SWFs face a dismal future, unless oil prices rebound sharply and permanently, with their size staying about the same or falling a 6 

It is perhaps no surprise that so many oil-​funded SWFs are from non-​democratic countries, since it is well established that abundant oil reserves (which promote large SWFs) and the evolution of democratic societies are natural enemies. (Tsui 2010) finds that discovering 100 billion barrels of oil (approximately the initial endowment of Iraq) pushes a country’s democracy level almost 20 percentage points below trend after three decades. Wolf (2009) and Wolf and Pollitt (2008) also show clearly that national oil companies are significantly less efficient and innovative than privately owned international oil companies—​and thus document the scale of value-​destruction associated with state ownership/​ control of petroleum reserves and production.

22    A Financial Force to be Reckoned With? bit in absolute value due to net withdrawals by cash-​strapped governments. SWFs have changed from asset accumulators to cash dispensers for sponsor governments and their AUM will probably decline in relative terms as a fraction of global financial assets. Although the term “sovereign wealth funds” was coined by Andrew Rozanov in 2005,7 the funds themselves are not a new invention. The first SWF was founded by the government of Kuwait in 1953. Most of the well-​established SWFs evolved from commodity stabilization fund precursors. The main purpose of a stabilization fund is to promote local economic development by minimizing the volatility of revenues due to the fluctuation of commodity prices or production levels, therefore smoothing government finances.8 Most such funds are employed by countries whose budgets are highly dependent on natural resources, such as oil, copper, diamonds, or other commodities, and they usually choose domestic investment targets. However, the disadvantages of stabilization funds are apparent. Poor management and political interference have negatively impacted fund efficiency, thereby motivating the evolution from stabilization to SWFs (Balding 2012). Unlike stabilization funds, which are tightly controlled and managed by the central bank and Finance Ministry, SWFs are intentionally separated—​either legally or operationally, or both—​from other ministries and agencies in order to shield the funds’ managers from direct political pressure. In term of goals, instead of aiming at promoting local development, SWFs pursue commercial profits, and as a consequence, they attempt to diversify revenue streams by investing mostly abroad. However, we should also note that many of the modern SWFs, implicitly or explicitly, carry at least a partial stabilization mandate as the domestic financial-​sector recapitalizations seen in 2008 and 2009, and Russia’s tapping of its SWFs in 2015, all attest. The defining characteristic of SWFs is their state ownership, which makes them different from other large, internationally active institutional investors. Governments often have broader goals than simple wealth maximization at the firm level—​for example, the maximization of employment levels and promotion of broad national industrial interests—​imposing on enterprises multiple, often conflicting objectives. In addition to social-​welfare concerns, politicians might distort priorities through their rent-​seeking influence. As state-​owned actors, SWFs might suffer from such deviations from the set of objectives normally associated with private-​sector investors, and this, in turn, might translate political influence onto their investment targets. In this sense, SWFs investments suffer from the same problems of “multiple principals” and cognitive dissonance described in the “mixed ownership” model of Boardman and Vining (1989; 2012) and Vining, Boardman, and Moore (2014). Yet, while many other examples of mixed ownership result in opaque entities, SWFs often apply mixed ownership to publicly traded, and hence transparent, firms allowing for a more data-​rich investigation of the impact 7 

The slow take-​up of “sovereign wealth fund” is illustrated by noting that the Financial Times first used the term on May 17, 2007, two years after Rozanov’s article was published. Once the phrase reached a critical mass of usage—​and the Financial Times began employing the term—​usage quickly became universal, to the point where a search of the Financial Times website (www.ft.com) on March 19, 2016, yielded 6,516 hits for “sovereign wealth fund.” 8  Commodity stabilization funds are discussed and analyzed in Arrau and Claessens (1992) while the US equivalent, state “rainy day” funds, are described in Douglas and Gaddie (2002).

Veljko Fotak, Xuechen Gao, and William L. Megginson    23 and efficiency of government investments. Whether this mixed ownership, as Vining, Boardman, and Moore (2014) put it, results in the “best of both worlds”—​merging government’s concern for social welfare with private sector efficiency—​or the “worst of both worlds” (crony capitalism) is one of the lessons we can draw by investigating the impact of SWFs on their investment targets. Another important characteristic of SWFs is the small size of their staffs. The number of SWF employees is, on average, much smaller than comparable privately owned mutual funds. This requires most SWFs to employ external managers to actually invest the funds’ money and oversee segments of their portfolios, as described in Al-​Kharusi, Dixon, and Monk (2014), Clark and Monk (2009), and Dixon and Monk (2013).9 This external mandate has the additional benefit of further insulating SWF assets from political interference. In addition, because of the limited number of employees, it is impossible for most SWFs to assign staff to sit on the board of every investee firm or interact intensively with investee firm managers. As Bortolotti, Fotak, and Megginson (2015) point out, SWFs acquire seats in only 53 of 355 cases (14.9%) where director identities of investment targets could be verified, and most of these were domestic companies. Even in those cases, the funds are much more likely to nominate an employee of a subsidiary (state-​owned enterprise or investment vehicle) than from the parent fund itself. On the other hand, Bortolotti, Fotak, and Megginson (2015) claim that SWFs could potentially become the highly effective monitors described in the institutional investors’ literature in target firms because they usually make long-​term investments and have no short-​term liabilities or liquidity requirements. However, due to the limited number of employees and political constraints, whether SWF investments can significantly improve the target firm governance becomes an intriguing empirical question. In the early days, cross-​border SWF investments were viewed as a threat by the recipient-​country governments. The major concerns, plausible or otherwise, that have been voiced include: (1) the possibility that their capital could be used to further political objectives and to acquire stakes in strategic industries; (2) the risk of equity price bubbles due to the sheer size and past rapid growth rate of their investments; (3) the risk of an increase in volatility of financial markets; (4) the possibility that SWFs might have a detrimental effect on corporate governance because of political motives or lack of sophistication; (5) the risk of the emergence of a new form of financial protectionism as a reaction to SWFs; (6) the lack of transparency by SWFs; and (7) the fear that SWFs would not act as strictly commercially-​minded investors, seeking only the highest possible financial return, but would instead be forced to invest strategically by home-​country governments seeking political influence or access to foreign technology. Empirical research has largely shown all but the last two concerns to be groundless, as there have been no major 9 

Al-​Kharusi, Dixon, and Monk (2014) and Dixon and Monk (2013) also describe why many SWFs in distant (from major financial centers) regions might choose to set up satellite offices in financial centers or establish formal ties with asset managers located therein. Dixon and Monk note that many SWFs have grown disillusioned with paying high fees for mediocre returns; in their delicious phrase (page 42), “they [SWFs] were, and in most cases still are, paying for alpha but only receiving beta returns.”

24    A Financial Force to be Reckoned With? documented cases of SWFs investing abroad as political agents of home-​ country governments. Quite the reverse—​Bortolotti, Fotak, and Megginson (2015) find that SWFs have proven to be passive and non-​confrontational with target firm managers almost to a fault. As foreign, state-​owned investment funds, any posture that SWFs take other than being purely passive investors might generate political pressure or a regulatory backlash from recipient-​country governments (Dinç and Erel 2013).10 Even when SWFs do take majority stakes—​which Miracky et al. (2008) show occurs almost exclusively when SWFs invest in domestic companies—​the funds rarely challenge incumbent managers (Mehropouya, Huang, and Barnett 2009). English, Smythe, and McNeil (2004) and Woidtke (2002) find similar behavior by US public-​sector pension funds and by California Public Employee Retirement System (CalPers) managers, respectively. With most of the fears being lifted, governments’ attitudes toward SWFs have gradually become more positive. In addition, SWFs provided invaluable liquidity to both global and domestic capital markets during the Financial Crisis of 2008–​09. Since then, most governments have actively courted SWF investment, with Britain being the most successful by far. However, with the widespread acceptance of SWFs, the downside of SWF investments cannot be ignored. As Bortolotti, Fotak, and Megginson (2015) point out, politicized SWFs are subject to the oversight of their parent-​country governments. The sponsoring governments may impose political objectives on SWFs and drive them away from profit maximization goals. In their article, Bortolotti, Fotak, and Megginson find empirical evidence that SWFs that are not insulated from political interferences negatively affect target firm value. They document a significant “SWF discount” on the short-​ term abnormal return following SWF investments, and show deterioration of long-​term target firm operating performance. In addition, the SWF divestment trend over the past two years also draws our attention. For example, Norway’s GPFG sold off more than $8 billion coal related investment, and the Qatar Investment Authority (QIA) and the Abu Dhabi Investment Authority divested their real estate properties in London. Although SWF divestment is not yet on a massive scale, it is, to some extent, a source of anxiety for some investors and governments that previously sought large SWF investments.

How Sovereign Wealth Funds Make Target Selection and Portfolio Allocation Decisions With over $5.5 trillion worth of capital to invest, and a mandate to invest a large chuck of that cash internationally, it is unsurprising that many researchers have examined 10 

Active foreign government involvement in a domestic target is usually met with significant public opposition, so governments often choose to be passive investors, especially in their foreign holdings. Jackson (2014), Masters (2013), and Prabakhar (2009) all show that involvement of a foreign state-​owned entity in a large acquisition of a US company is certain to prompt scrutiny by the Committee on Foreign Investment in the US (CFIUS).

Veljko Fotak, Xuechen Gao, and William L. Megginson    25 how SWFs allocate their investment dollars. This section surveys the academic and professional research examining how SWFs should allocate funds across different asset classes—​based on the funding source and sponsor-​country economic, financial and political characteristics—​and then summarizes the research examining the asset allocations that SWFs actually do make.

Normative Assessments of How Sovereign Wealth Funds Should Invest Many authors have presented normative, theoretical or empirical studies prescribing how SWFs should allocate their funds across asset classes. Twelve such articles are summarized in Table 2.2. Four of these papers (Bodie and Brière 2014; Martellini and Milhaup 2010; Sá and Viani 2011; Schena and Kalter 2012) describe optimal asset allocation models for SWFs based on general financial and economic principles relating to global investor preferences, contingent claims models of sovereign government funding sources and spending obligations, and/​or the sponsoring nation’s sensitivity to commodity price variability. The next three articles (Balding and Yao 2011; Bertoni and Lugo 2013; Scherer 2009) focus on oil-​financed SWFs and examine how this funding model should influence the asset allocation decisions of such funds. Two more studies describe the optimal investment policy followed by Norway’s GPFG and assess whether the fund’s actual asset allocations are consistent with the optimal design (Ang, Goetzmann, and Schaefer 2009; Chambers, Dimson, and Ilmanen 2012). Finally, three studies present, first, a policy-​oriented description of the “benchmarks” governments should take into account when establishing an SWF (Ang 2012); second, an assessment of whether SWFs are and should be domestic “investors of last resort” (Raymond 2012); and, third, a discussion of whether SWFs should promote domestic economic development by financing infrastructure investments in developing countries (Gelb, Tordo, and Halland 2014).

Financial and Macroeconomic Influences on Optimal Sovereign Wealth Fund Investment Policies A second group of studies extends existing quantitative financial models to incorporate SWF specificities. Martellini and Milhaup (2010) propose a quantitative dynamic asset allocation framework for SWFs, modeling them as large long-​term investors that manage fluctuating revenues typically emanating from budget or trade surpluses in the presence of stochastic investment opportunities. They show that the optimal asset allocation strategy should account for stochastic features of the SWF endowment process (where money comes from) and the SWF’s expected liability value (what money will be used for). SWFs should make state-​dependent allocations to: (1) a performance-​seeking portfolio, often heavy with equities; (2)  an endowment-​hedging portfolio; and (3)  a liability-​hedging portfolio heavy with bonds to mitigate interest rate and inflation risks. Sá and Viani (2011) develop a dynamic general equilibrium model to analyze the effects of a shift in portfolio preferences of foreign investors on target country interest rates, asset prices, investment, consumption, real output, exchange rates, and current

26    A Financial Force to be Reckoned With? Table 2.2 Summary of Empirical, Theoretical, and Normative Studies of How Sovereign Wealth Funds Should Select Asset Classes in Which to Invest Study

Research Question and Methodology

Summary of Empirical or Theoretical Findings and Conclusions

Gelb, Tordo, and Assess whether SWFs should be used Halland (World Bank to fund the infrastructure financing Working Paper 2014) gap in developing countries. Propose a system of checks and balances to ensure SWFs do not undermine macroeconomic management or make politicized investments.

Conclude that a well-​governed SWF can improve the quality of a nation’s public investment program, but the critical issue will always be limiting the SWF’s investments to those proper for a wealth fund and not to supplant infrastructure investment that should come from other state agencies.

Bodie and Brière (Journal of Investment Management 2014)

Set out a new approach to sovereign wealth and risk management, based on contingent claims analysis (CCA). Note that state must solve an asset-​ liability management (ALM) problem between income and expenditures, and present applications for SWFs.

Propose analytical framework for optimal ALM based on analysis of sovereign balance sheet and extending CCA theory to sovereign wealth. Suggest using broadest possible definition of “sovereign entity” and specifically accounting for nation’s financial, human, and resource wealth—​ and for risks of assets and liabilities. Apply model to Chile’s SWF.

Schena and Kalter (Euromoney Books 2013)

Ask whether it is time to rethink the “Endowment Model” of sovereign investment to focus on less liquid and relatively higher return assets, as do many university endowment funds.

Acknowledge endowment model’s attractiveness, but stress the need for SWFs to consider how the “three Ls” of liabilities, liquidity, and definition of long-​term impact the fund’s specific needs and goals.

Chambers, Dimson, and Ilmanen (Journal of Portfolio Management 2012)

Discuss the management, investment policies, and transparency of the Norwegian Government Pension Fund Global (GPFG) and assess whether the fund has successfully achieved objectives. Assess how fund’s strategy derives from Norwegian government’s directives and examine fund’s long-​term investment performance.

Conclude that the GFPG is one of the best-​managed large pension fund operating today, and that “the Norway Model” of investing only in listed debt and equity securities worldwide using in-​house staff is both successful and is the antithesis of the “Yale Model” of investing in alternative assets and private equity through external managers.

Bertoni and Lugo Using a mean-​variance framework, (Working Paper 2012) develop a model of the optimal strategic asset allocation for stabilizating SWFs (funded by oil revenues). Then derive three sets of parsimonious tests to compare actual SAA of Norway’s GPFG to its theoretical optimum.

Find that optimal SAA for an oil-​funded SWF will deviate significantly from that of a general wealth-​maximizing investor, and confirm that the static and dynamic deviations of the GPFG’s SAA from the market equity portfolio are consistent with their theoretical predictions.

Veljko Fotak, Xuechen Gao, and William L. Megginson    27 Table 2.2 (Continued) Study

Research Question and Methodology

Summary of Empirical or Theoretical Findings and Conclusions

Sá and Viani Develop dynamic general equilibrium (Working Paper 2011) model to analyze the effects on target-​country real and financial variables of a shift in portfolio preferences of foreign investors, and then calibrate model to examine increasing tendency of central banks to channel “excess reserves” into SWFs for investments seeking commercial returns.

Derive two separate diversification paths for switching reserves into SWFs. One keeps the same asset allocation as central banks, other keeps the same currency allocation. USD depreciates in both cases, but US net debt position differs. Both cause reduction in “exorbitant privilege” wherein US receives excess returns on its assets over what it pays for liabilities.

Balding and Yao (Institutional Investors in Global Capital Markets 2011)

Account for the fact that most SWFs depend heavily on oil revenues to increase their funding base by developing a dynamic portfolio risk-​ adjusted return maximizing model across many assets, accounting for continual depletion of natural resources.

Find that, given the high volatility and continuous depletion of oil as a portion of national wealth, SWFs should invest in low volatility liquid fixed income and indexed assets to balance their portfolios. Even then, find returns only maximized when oil drops to about 50% of national wealth.

Ang (Working Paper 2010)

Presents policy-​oriented description of the four “benchmarks” a nation should take into account when creating a SWF and defines the role it should play in overall national policy. These are the benchmarks (B/​Ms) of legitimacy, integrated policy, performance and long-​run equilibrium. States the essence of a SWF is as a vehicle for transferring sovereign wealth into the future.

Find that the legitimacy B/​M is the most important, and ensures fund’s capital is not immediately spent. Integrated policy B/​M accounts for broader policy environment in which SWF operates. Performance B/​M implies fund’s managers should be held accountable for maximizing risk-​adjusted returns. Long-​run equilibrium B/​M ensures well-​ functioning capital markets, free cross-​border capital flows and good corporate governance.

Raymond (Economie Internationale 2012)

Analyze whether SWFs are and/​or should be domestic investors of last resort (ILR) during financial crises. Shows that such SWF interventions occurred frequently after the 2008–​09 Global Financial Crisis, and discusses SWFs’ role as insurance funds against major crises.

Find that Gulf SWFs’ interventions exerted a stabilizing short-​term effect on local stock markets, though long-​ term impact much less obvious. Note that SWFs, contrary to central banks, can easily provide medium-​to long-​ term financing to banking systems. SWFs may also be used for government spending during crises or to negate speculative financial attacks.

(Continued)

28    A Financial Force to be Reckoned With? Table 2.2 (Continued) Study

Research Question and Methodology

Summary of Empirical or Theoretical Findings and Conclusions

Martellini and Propose quantitative dynamic Milhaup (EDHEC-​Risk asset allocation framework for 2010) SWFs, modelled as large long-​term investors that manage fluctuating revenues typically emanating from budget or trade surpluses in the presence of stochastic investment opportunities. Suggest what optimal asset allocation should be.

Find that optimal asset allocation strategy should account for stochastic features of SWF endowment process (where money comes from) and the SWF’s expected liability value (what money will be used for). Should make state-​dependent allocations to (1) a performance-​seeking portfolio, often heavy with equities; (2) an endowment-​ hedging portfolio; and (3) a liability-​ hedging portfolio heavy with bonds to mitigate interest rate and inflation risks.

Scherer (Financial Market Portfolio Management 2009)

Extend existing portfolio choice theories to SWFs in a strategic asset allocation model. Changing the existing analyses from single to multi-​period framework allows for three-​fund separation.

Find that optimal SWF portfolio should be split into speculative demand as well as demand against oil price shocks and short-​term risk-​free rate. All model terms also depend on investor’s time horizon. Oil-​rich countries should hold bonds and SWFs should determine and act on long-​run covariance matrices that differ from correlation inputs that one-​period investors use.

Ang, Goetzmann, and Schaefer (Norges Bank Investment Management 2009)

Evaluate the role of active management by the Norges Bank Investment Management (NBIM) of the Norwegian GPFG over the period from inception in 1998 through early 2009. Also present review of efficient market hypothesis and apply lessons to evaluating GPFG’s performance.

Find that active management has played a very small role in NBIM’s superior long-​term investment performance. Instead, a significant fraction of performance is explained by exposure to systematic factors that fared poorly during Crisis. They believe that exposure to such systematic factors is appropriate for a long term investor that can harvest illiquidity and other factor risk premiums over time.

This table summarizes the findings, predictions and/​or prescriptions of several recent empirical, theoretical and normative studies of how SWFs should allocate funds to different asset classes.

account balances. They then calibrate this model to examine the increasing tendency of central banks to channel “excess reserves” into SWFs to make investments seeking commercial returns, and derive two separate diversification paths for switching reserves into SWFs. One keeps the same asset allocation as central banks, but moves fund flows away from dollar-​denominated assets; the other keeps the same currency allocation but shifts investments from US bonds to US equities. The dollar depreciates in both cases, but the

Veljko Fotak, Xuechen Gao, and William L. Megginson    29 US net debt position differs. Both cause reduction in the “exorbitant privilege” through which the US government receives excess returns on its assets over what it pays for its liabilities. Schena and Kalter (2012) take a different tack and ask whether SWFs should continue pursuing the “Endowment Model” of investment, which was popularized by David Swensen, Yale University’s Chief Investment Officer (Ferri 2012; Lerner 2007) and has been followed by many US private university endowments. This emphasizes investing in less liquid and relatively higher return assets rather than publicly traded stocks and bonds. The alternative would be to switch to the classic foundation model of investment in listed securities that Norway’s GPFG has pursued so successfully. The authors acknowledge the endowment model’s attractiveness, but conclude that the foundation model may be better for large institutional investors operating in today’s environment of low risk-​free returns, increased volatility, and higher return covariance across markets. Schena and Kalter (2012) particularly stress the need for SWFs to consider how the “three Ls” of liabilities, liquidity, and definition of long-​term impact the fund’s specific needs and goals. Finally, Bodie and Brière (2014) develop a new approach to sovereign wealth and risk management, based on contingent claims analysis (CCA). They show that it is essential to analyze a sovereign’s balance sheet, since the government must solve an asset-​liability management (ALM) problem between income and expenditures. They present applications for SWFs and propose an analytical framework for optimal ALM based on analysis of the sovereign’s balance sheet and extending CCA theory to sovereign wealth. Bodie and Brière (2014) suggest using the broadest possible definition of the “sovereign entity” and specifically accounting for a nation’s financial, human, and resource wealth—​and for the risks of the nation’s assets and liabilities. They conclude by applying their model to Chile’s SWF.

How Oil Revenue Funding Impacts a Sovereign Wealth Fund’s Optimal Asset Allocation Policies As noted earlier, the major SWFs are all funded in one of two ways, either through revenues from exports of oil (or other commodities, including natural gas) for the Middle Eastern SWFs and Norway’s GPFG, or through fiscal transfers from governments of mostly Asian countries that run persistent current account surpluses. Commodity-​ based funds are more common, both in terms of number of SWFs and aggregate size. Two papers explicitly analyze how this impacts optimal fund asset allocation. Scherer (2009) extends existing portfolio choice theories to SWFs in a strategic asset  allocation model. In the model, changing the existing analyses from a single to a multi-​ period framework allows for three-​fund separation; all model terms further depend on the investor’s time horizon. The resulting optimal SWF portfolio should be split into a speculative component as well as a hedging component aimed at offsetting oil price shocks and short-​term risk-​free rate shocks. Oil-​rich countries should hold bonds and SWFs should determine and act on long-​run covariance matrices that differ from the correlation inputs that a one-​period investor would use. Scherer also notes that SWFs

30    A Financial Force to be Reckoned With? seem ill-​prepared for an oil price drop that would shrink the value of national cash inflows and increase the importance of the contribution SWF asset returns make to national income. Balding and Yao (2011) suggest a better asset  allocation policy for oil dependent SWFs than the one currently being followed. They account for the fact that most SWFs depend heavily on oil revenues to increase their funding base by developing a dynamic portfolio risk-​adjusted return maximizing model across many assets, accounting for continual depletion of natural resources. Balding and Yao (2011) find that, given the high volatility and continuous depletion of oil as a portion of national wealth, SWFs should invest in low volatility, liquid, fixed-​income instruments and indexed assets. Even then, they find returns are only maximized when oil drops to about 50% of national wealth. Bertoni and Lugo (2013) use a mean-​variance framework to develop a model of the optimal strategic asset allocation for stabilizating SWFs funded by oil revenues. They derive three sets of parsimonious tests to compare the actual allocation of Norway’s GPFG to its theoretical optimum. They find that the optimal allocation for an oil-​funded SWF will deviate significantly from that of a general wealth-​ maximizing investor, and confirm that the static and dynamic deviations of the GPFG’s portfolio from the market equity portfolio are consistent with their theoretical predictions.

The Norway Model of Asset Allocation Norway’s GPFG, with over $850 billion assets under management, is the largest SWF and the second largest pension fund in the world (after Japan’s Government Employees Pension Fund). The GPFG has long pursued an asset allocation policy akin to the classic foundation model of investing in publicly traded stocks and bonds, as opposed to the more recently developed endowment model of allocating fund resources much more toward illiquid/​unlisted stocks and bonds, real estate, private equity, and alternative and absolute return investments. In addition to the aforementioned test by Bertoni and Lugo (2013)—​who developed a generalized model but tested it on GPFG’s portfolio—​two studies focus explicitly on the optimal and actual asset allocations of the GPFG. Ang, Goetzmann, and Schaefer (2009) present a report commissioned by the Norwegian government evaluating the role of active management by the Norges Bank Investment Management (NBIM) group over 1998 through early 2009. They show that active management has played a very small role in NBIM’s superior long-​term investment performance. Instead, a significant fraction of performance is explained by exposure to systematic factors that performed well in the past, but fared poorly during the global financial crisis of 2008–​09. Approximately 70% of all active returns on the overall fund can be explained by exposure to systematic factors—​and the authors believe that the fund should adopt a top-​down, intentional approach to strategic and dynamic factor exposures. They conclude that the fund should provide volatility insurance to other investors and harvest volatility premiums as compensation. The key features of the GPFG that should influence deviation from market weightings are the fund’s absence of

Veljko Fotak, Xuechen Gao, and William L. Megginson    31 any need for liquidity, its long-​term investment horizon, and its freedom from explicit fund liabilities. The article by Chambers, Dimson, and Ilmanen in the Journal of Portfolio Management (2012) has proven highly influential, since it analyses whether the “Norway Model” of investment has proven superior to the “Endowment Model” of investment followed by US private university endowments. As discussed earlier, the Endowment Model emphasizes investing in alternative assets and private equity through external managers, whereas the Norway Model is virtually its antithesis—​ and instead mirrors the classic foundation investment approach of investing in publicly traded stocks and bonds, with a small allocation to real estate and other illiquid assets. The authors discuss the management, investment policies, and transparency of the GPFG and assess whether the fund has successfully achieved its objectives. They also assess how the fund’s strategy derives from the Norwegian government’s directives and examine the fund’s long-​term investment performance. They conclude that the GFPG is one of the best-​managed large pension funds operating today, and argue that the Norway Model is a much more appropriate investment strategy for SWFs. In their detailed analysis of the GPFG’s performance, Chambers, Dimson, and Ilmanen point out that the fund resembles an index fund far more than one that is actively managed, and it relies on beta returns—​reflecting exposure to systematic risk factors—​rather than alpha returns resulting from superior stock picking (Dixon and Monk 2013). They point out that six factors should and do drive the GPFG’s investment strategy: (1) The fund has a long-​term horizon and little need for liquidity; (2) this long-​term horizon makes the fund more tolerant of return volatility and short-​term capital flows than most institutional investors; (3) the fund’s size makes exploiting liquidity and volatility risk premiums impractical; (4) capacity issues, such as a small staff, favor benchmarks that are at least loosely linked to market capitalization; (5) the fund may most effectively earn liquidity and other premiums by serving as an opportunistic liquidity provider purchasing unpopular assets in illiquid markets; and (6) as long as oil remains a significant underground resource, the fund has less need for inflation hedging than most investors. It is worth noting that many SWFs, especially the larger ones, share all or most of these same features.

Other Assessments of Optimal Sovereign Wealth Fund Investment Policy What other aspects of SWF establishment, funding, and asset allocation have researchers considered normatively? Ang (2012) presents a policy-​oriented description of the four “benchmarks” a nation should take into account when creating an SWF and defining the role it should play in overall national policy. These are the benchmarks (B/​Ms) of legitimacy, integrated policy, performance and long-​run equilibrium. Ang (2012) states the essence of a SWF is as a vehicle for transferring wealth into the future, and concludes that the legitimacy B/​M is the most important, since this ensures the fund’s capital is not immediately spent. The integrated policy B/​M accounts for the broader policy environment in which an SWF operates, and the performance B/​M implies a fund’s managers

32    A Financial Force to be Reckoned With? should be held accountable for maximizing risk-​adjusted returns. The long-​run equilibrium B/​M ensures well-​functioning capital markets, free cross-​border capital flows, and good corporate governance. Raymond (2012) assesses whether SWFs are and/​or should be domestic investors of last resort (ILR) during financial crises. She documents that such SWF interventions occurred frequently after the 2008–​09 financial crisis, and discusses SWFs’ role as insurance funds against major crises. The author finds that Gulf SWFs’ interventions exerted a stabilizing short-​term effect on local stock markets during the global financial crisis, though the long-​term impact has been much less obvious. She notes that SWFs, contrary to central banks, can easily provide long-​to medium-​term financing to banking systems, and concludes that SWFs may also be used to supplement government spending during crises or to negate speculative financial attacks. In summary, Raymond concludes by answering her own question whether SWFs should be investors of last resort in domestic markets with a definitive “perhaps.” Finally, Gelb, Tordo, and Holland (2014) assess whether SWFs should be used to fund the infrastructure financing gap in developing countries. They propose a system of checks and balances to ensure SWFs do not undermine macroeconomic management or make politicized investments. They conclude that a well-​governed SWF can improve the quality of a nation’s public investment program, but the critical issue will always be limiting the SWF’s investments to those proper for a wealth fund and not to supplant infrastructure investment that should come from other state agencies.

Asset Allocations and Portfolio Selections Observed in Practice While one set of academic studies examines how SWFs should invest, another stream of research documents and analyzes how funds actually do invest. Table 2.3 summarizes thirteen such papers. Four of them (Avendaño 2012; Chhaochharia and Laeven 2009; Dyck and Morse 2011; Karolyi and Liao 2015) document the actual portfolio decisions of SWFs using large samples of investment observations, examine what factors might be driving these decisions, and ask whether SWFs differ significantly from other large international investors with respect to how and in which types of companies they invest. The largest samples used in any type of SWF empirical studies are observed here. The next five articles (Avendaño and Santiso 2011; Candelon, Kerkour, and Lecourt 2011; Ciarlone and Miceli 2014; Knill, Lee, and Mauck 2012b; Murtinu and Scalera 2016) assess whether political and macroeconomic factors significantly influence observed SWF investment decisions. Heaney, Li, and Valencia (2011) examine how SWFs select specific companies into which to invest and which factors influence that decision. Finally, two studies (Bernstein, Lerner, and Schoar 2013; Johan, Knill, and Mauck 2013) measure how much SWFs invest in private equity (PE) worldwide, and assess why these funds seem to allocate less to PE than do other internationally active institutional investors.

Veljko Fotak, Xuechen Gao, and William L. Megginson    33 Table 2.3 Summary of Empirical Studies of Sovereign Wealth Funds’ Geographic and Industrial Investment Patterns Study Murtinu and Scalera (Journal of International Management 2016)

Sample Description, Study Period, and Methodology

Summary of Empirical Findings and Conclusions

With a sample of 716 investments made by 22 SWFs from 13 countries over the period 1997-​2013, they study whether the use of investment vehicle is influenced by SWF opacity and the presence of political ties between the SWF’s and the target country.

Find that SWF opacity positively impacts the use of vehicles, regardless the type of vehicle used. Bilateral political ties negatively impact only the use of corporate vehicles and increase the likelihood that SWFs invest through vehicles not located in the target country.

Ciarlone and Miceli Use a specifically built proprietary (Working Paper 2014) dataset encompassing 1,903 equity acquisitions made by 29 SWFs over the period 1995-​2010 to study the determinants of SWF investment choices at macro level, with special emphasis on the possible reaction to a financial crisis in a potential target economy.

Find that SWFs prefer to invest in countries with higher degree of economic development, larger and more liquid financial markets, better protection to investors, and more stable macroeconomic environments. SWFs seem to engage in a “contrarian” behavior by increasing their acquisitions in countries hit by crises. They play a stabilizing role on local markets during periods of financial turmoil.

Bernstein, Lerner, and Schoar (Journal of Economic Perspectives 2013)

Use sample of 2,662 direct private equity (PE) investments worth $198 bn made by 29 SWFs over 1984-​2007 to analyze whether there exist differences in investment strategy and performance across funds regarding PE investing.

Find that SWFs seem to engage in trend chasing, since they are more likely to invest in PE at home when domestic equity prices are higher, and invest abroad when foreign prices are higher—​but SWFs invest at lower overall P/​E ratios domestically. SWFs where politicians are involved are much more likely to invest at home than are SWFs with external managers.

Johan, Knill, and Mauck (Journal of International Business Studies 2013)

Examines empirically investments of 50 SWFs in 903 public and private global firms to see whether these funds are less likely to invest in private equity (PE) than other large institutional investors.

Find that SWFs are less likely to invest in PE than are other investors, but economic significance surprisingly low. Find some evidence that SWFs invest internationally with political motivations in mind, perhaps to gain politically from corporate governance conflicts.

(Continued)

34    A Financial Force to be Reckoned With? Table 2.3 (Continued) Sample Description, Study Period, and Methodology

Summary of Empirical Findings and Conclusions

Avendaño (Working Paper 2012)

Using sample of over 14,000 individual holdings of 22 SWFs in almost 8,000 target firms in 65 countries over 2006-​ 09, studies how differences in funding source (commodity/​non-​commodity), investment guidelines (OECD/​non-​OECD), and investment destination (foreign/​ domestic) impact SWF investment decisions.

Finds that SWFs prefer to invest in larger and internationally active firms, but OECD-​based and non-​OECD-​based funds differ in their preferences about target-​firm leverage, degree of internationalization, and profitability. SWFs prefer larger, more levered firms in foreign vs domestic investments, and find some evidence SWF ownerships positively impacts target’s value. Home-​country natural resource endowments help explain whether SWFs prefer to make foreign investments in these industries.

Knill, Lee, and Mauck (Journal of Corporate Finance 2012)

Use sample of over 900 acquisitions of public and private target firm stock by SWFs over 1984-​2009 to test whether bilateral political relations significantly influence SWF investment decisions. Use Cragg Model to test whether political factors impact both decisions whether SWFs will invest and how much.

Find that political relations are an important factor in where SWFs invest, but matter less in determining how much. SWFs are more likely to invest in countries with which they have weaker political relations, contrary to the predictions of the FDI literature, suggesting that SWFs use—​at least partially—​non-​ financial motives in investment decisions.

Avendaño and Santiso (Book, 2011)

Examine whether SWF investments are politically biased by comparing almost 14,000 shareholdings of 17 SWFs to 11,600 shareholdings of the 25 largest mutual funds during 4Q2008. Ask whether SWF holdings show greater political influence than those by privately owned mutual funds.

Find that SWF investment decisions do not differ greatly from those of privately owned mutual funds, and conclude that the fear that sovereigns with political motivations will use their financial power to secure large stakes in Western companies is unfounded. Argue that double standards for SWFs and private institutional investors should be avoided.

Study

Veljko Fotak, Xuechen Gao, and William L. Megginson    35 Table 2.3 (Continued) Sample Description, Study Period, and Methodology

Summary of Empirical Findings and Conclusions

karolyi and Liao (Journal of Corporate Finance 2015)

Study 4,026 cross-​border acquisitions over 1998-​2008, worth $434 bn, that were led by government-​controlled acquirers, and compare to 127,786 similar acquisitions worth $9.04 tr made by private acquirers and 733 deals worth $158 bn made by SWFs and other state-​owned funds. Test whether state-​controlled acquirers and SWFs/​ other funds selected targets in different industries or with different firms characteristics than did private acquirers.

Find surprisingly small, though often significant, differences between state-​ controlled acquirers’ and private acquirers’ investment patterns and preferences, but find somewhat larger differences with SWFs/​ other state funds. SWFs/​other state funds pursue larger targets with higher growth options, and are more deterred by high insider or institutional share ownership. Conclude there is little reason for target-​country policy-​makers to discriminate against state-​owned vs private acquirers.

Dyck and Morse (Working Paper 2011)

Use sample of share holdings in 2008 by 20 SWFs in over 26,000 companies worth $2.04 tr to document SWF portfolio holdings and analyze objectives underlying observed investments. Also test whether SWF investments motivated by home-​country portfolio diversification or industrial planning objectives.

Find SWF allocations are balanced across risky asset classes, very home-​region biased, and biased toward the financial, transportation, energy, and telecommunications industries (especially finance). Measures capturing portfolio diversification and industrial planning objectives explain 14.4% of SWF portfolio variation; industrial motives account for 45% of this.

Candelon, Kerkour, Using sample of 1123 equity investments and Lecourt (Working (849 foreign, 274 domestic) by SWFs in Paper 2011) 73 countries over 1989-​2011, examine whether and how macroeconomic factors influence SWFs’ foreign and domestic equity investments. Also test whether decisions are based exclusively on profit-​maximizing motives.

Find macroeconomic factors are important influences on SWFs’ investing decisions. SWFs largely invest to diversify away from industries at home, but do so mostly in countries with economic and institutional stability. Use different criteria to decide on investments in OECD vs non-​OECD countries, and tend to re-​invest in a country once initial investment made.

Study

(Continued)

36    A Financial Force to be Reckoned With? Table 2.3 (Continued) Study

Sample Description, Study Period, and Methodology

Summary of Empirical Findings and Conclusions

Heaney, Li, and Valencia (Australian Journal of Management 2011)

Document and analyze investments made by Temasek Holdings (TH) in 150 publicly listed Singaporean companies over the period 2000-​04.

Find that TH prefers to invest in companies that are relatively large, with lower systematic risk, that have few director block-​holders, and use stock-​based incentive compensation schemes.

Chhaochharia and Laeven (Working Paper 2010)

Use a sample of 29,634 equity investments made by 27 SWFs and 38,880 stock investments made by public pension funds in firms from 56 countries over 1996-​2008 to test whether SWFs show systematic investment biases compared to other large global investors.

Find SWFs do show strong biases vs other investors. They tend to chase past returns and hold conservative portfolios that are poorly diversified both geographically and across industries (SWF portfolios are heavily overweight oil companies). Biases are more pronounced for SWFs that are more activist, less transparent, and from less democratic countries. SWFs prefer to invest in countries with strong legal institutions.

This table summarizes the findings of several recent empirical studies examining how SWFs allocate funds to different countries and different industries.

Documenting Sovereign Wealth Fund Portfolios and Assessing Factors Influencing Investment Decisions The studies surveyed here employ large samples to document actual SWF portfolios and assess which factors significantly influence fund investment decisions. Chhaochharia and Laeven (2009) use a sample of 29,634 equity investments made by 27 SWFs and 38,880 stock investments made by public pension funds in firms from 56 countries between 1996 and 2008 to test whether SWFs show systematic investment biases compared to other large global investors. They find that SWFs show strong biases and specifically that: (1) SWFs tend to invest in countries that share a common culture, particularly religion; (2) this bias is more pronounced in SWFs than in other internationally active institutional investors; (3) this cultural bias disappears with repeated investments; (4) SWFs display industry biases, investing a disproportionally large fraction of their portfolios in oil company stocks; and (5) they tend to invest mostly in large capitalization stocks. These biases are more pronounced for SWFs that are more activist, less transparent, and from less democratic countries. SWFs tend to chase past returns and hold conservative portfolios that are poorly diversified, both geographically and across industries, and they prefer to invest in countries with strong legal institutions.

Veljko Fotak, Xuechen Gao, and William L. Megginson    37 Dyck and Morse (2011) similarly use a large sample to document SWF portfolio holdings and analyze the objectives underlying these observed investments. Their sample captures holdings in 2008 by 20 SWFs in over 26,000 companies, with an aggregate value of $2.04 trillion. They find that SWF asset allocations are balanced across risky asset classes, are substantially home-​region biased, and are very biased toward the financial, transportation, energy, and telecommunications industries—​particularly finance (SWFs owned 4.8% of the world’s listed financial company stocks in 2008). SWFs invest actively (with control rights) in both public and private sectors, but mainly exercise control in their home regions. Dyck and Morse also test whether SWF investments are motivated by home-​country portfolio diversification or industrial planning objectives, and find that measures capturing portfolio diversification and industrial planning objectives explain 14.4% of SWF portfolio variation; industrial motives account for 45% of this. Karolyi and Liao (2015) employ a large number of cross-​border equity investment observations to determine whether state-​controlled investors have a greater differential valuation impact on acquisition targets than do private, corporate acquirers. They study 4,026 cross-​border acquisitions between 1998 and 2008, worth $434 billion, that were led by government-​controlled acquirers, and compare these to 127,786 similar acquisitions worth $9.04 trillion made by private acquirers, and 733 deals worth $158 billion made by SWFs and other state-​owned funds. They test whether state-​controlled acquirers and SWFs select more targets in different industries or with different firm characteristics than do private acquirers. They find surprisingly small, though often significant, differences between state-​controlled acquirers’ and private acquirers’ investment patterns and preferences, but find somewhat larger differences with SWFs and other state funds. SWFs and other state funds pursue larger targets with higher growth options, and are more deterred by high insider or institutional share ownership. Karolyi and Liao (2015) conclude there is little reason for target-​country policy-​makers to discriminate against state-​owned versus private acquirers. Avendaño (2012) uses a sample of over 14,000 individual holdings of 22 SWFs in almost 8,000 target firms in 65 countries between 2006 and 2009 to study how differences in funding source (commodity and non-​commodity), investment guidelines (OECD and non-​OECD), and investment destination (foreign and domestic) impact SWF investment decisions. He finds SWFs prefer to invest in larger and internationally active firms, but OECD-​based and non-​OECD-​based funds differ in their preferences about target-​firm leverage, degree of internationalization, and profitability. SWFs prefer larger, more levered firms in foreign versus domestic investments, and Avendaño finds some evidence that SWF ownership positively impacts the target firm’s value. Home-​ country natural resource endowments help explain whether SWFs prefer to make foreign investments in these industries. With over $5.5 trillion of assets under management, it is natural that most SWF research has focused on industrial and national influences in their investments, but Heaney, Li, and Valencia (2011) focus on the investments made by a single (albeit very important) fund—​Singapore’s Temasek—​with a focus on firm selection criteria. They document and analyze investments made by Temasek Holdings in 150 publicly listed

38    A Financial Force to be Reckoned With? Singaporean companies over the period 2000–​04, and find that Temasek prefers to invest in companies that are relatively large, with low systematic risk, that have few director block-​holders, and use stock-​based incentive compensation schemes.

Do Political and Macroeconomic Factors Influence Sovereign Wealth Fund Asset Allocation Policies? One of the great fears surrounding SWF cross-​border investments is that these will be made for non-​commercial reasons and that political or macroeconomic forces will instead prove decisive. Five studies assess whether these fears are justified. Candelon, Kerkour, and Lecourt (2011) employ a sample of 1,123 equity investments (849 foreign, 274 domestic) by SWFs in 73 countries between 1989 and 2011 to examine whether and how macroeconomic factors influence SWFs’ foreign and domestic equity investments. They also test whether decisions are based exclusively on profit-​maximizing motives. They find that macroeconomic factors are important influences on SWFs’ investing decisions and that SWFs largely invest to diversify away from industries at home, but do so mostly in countries with economic and institutional stability. SWFs use different criteria to decide on investments in OECD vs. non-​OECD countries, and tend to re-​invest in a country once an initial investment has been made. Ciarlone and Miceli (2014) also study how macroeconomic factors affect SWF asset allocation. With a proprietary dataset of 1,903 acquisition deals made by 29 SWFs during the period 1995–​2010, they find that SWFs tend to invest in the countries with more developed financial markets, more stable macroeconomic environments, and better protection for investors. Unlike most of the institutional investors that divest from the countries being hit by crisis, SWFs show a “contrarian” behavior by increasing their acquisitions in the crisis trapped countries. Therefore, the authors claim that SWFs play a role to stabilize the target country financial markets during the period of crisis. Avendaño and Santiso (2011) examine whether SWF investments are politically biased by comparing almost 14,000 shareholdings of 17 SWFs to 11,600 shareholdings of the 25 largest mutual funds during the fourth quarter of 2008. They ask whether SWF holdings show greater political influence than stakes held by privately owned mutual funds. The authors find that SWF investment decisions do not differ greatly from those of privately owned mutual funds, and conclude that the fear that sovereigns with political motivations will use their financial power to secure large stakes in western companies is unfounded. They argue that double standards for SWFs and private institutional investors should be avoided. Knill, Lee, and Mauck (2012b) use a sample of over 900 acquisitions of public and private target firm stock by SWFs between 1984 and 2009 to test whether bilateral political relations significantly influence SWF investment decisions. They find that political relations are an important factor in where SWFs invest, but matter less in determining the size of the investment. SWFs are more likely to invest in countries with which they have weaker political relations, contrary to the predictions of the foreign direct investment literature, suggesting that SWFs use—​at least partially—​non-​financial motives in investment decisions.

Veljko Fotak, Xuechen Gao, and William L. Megginson    39 Murtinu and Scalera (2016) study how fund opacity and political ties between the SWF’s country and the target’s country affect the use of intermediate investment vehicles. They build a sample with 716 investments (474 cross-​border investments) made by 22 SWFs from 13 countries over the period 1997–​2013 and find that low transparency SWFs have a greater incentive to use investment vehicles to avoid potential hostility from the target country government. However, the stronger bilateral political ties can partially alleviate the concerns of target country governments toward SWF investments, and thus lower the likelihood for SWFs to invest through corporate vehicles.

Do Sovereign Wealth Funds Invest In and Through Private Equity? Many commentators, noting the political difficulties SWFs often encounter when purchasing larges share blocs in publicly traded companies, have suggested that SWFs should invest indirectly instead, by channeling their assets through private equity funds. Two studies assess whether SWFs in fact do this. Bernstein, Lerner, and Schoar (2013) use a sample of 2,662 direct private equity (PE) investments worth $198 billion made by 29 SWFs between 1984 and 2007 to analyze whether there exist differences in investment strategy and performance across funds regarding PE investing. They find SWFs seem to engage in trend chasing, since they are more likely to invest in PE at home when domestic equity prices are higher, and invest abroad when foreign prices are higher—​but that SWFs invest at lower overall price-​to-​earnings ratios domestically. SWFs, where politicians are involved, are much more likely to invest at home than are SWFs with external managers, but greater domestic investment is a symptom of poor investment decision-​ making, since the funds are prone to home bias or have decisions distorted by political or agency considerations. Johan, Knill, and Mauck (2013) examine investments made by 50 SWFs in 903 public and private global firms to see whether these funds are less likely to invest in private equity (PE) than are other large institutional investors. They find that SWFs are less likely to invest in PE than are other investors, but the economic significance of this is surprisingly low. The authors find some evidence that SWFs invest internationally with political motivations in mind, perhaps to gain politically from corporate governance conflicts or to avoid the intense scrutiny and criticisms of the public faced by Dubai World Ports and other investors caught up in controversial cross-​border acquisitions (Dinç and Erel 2013).

Geographical and Industrial Distribution of Sovereign Wealth Fund Investments In this section, we use the empirical data from the Sovereign Investment Laboratory (SIL) database to present SWF investment patterns across countries and industries. Due to the low transparency of SWFs, it is not feasible to identify all types of investments; debt holdings, both corporate and government-​issued, are particularly difficult to track. In the following discussion, we mainly focus on SWF equity investments

40    A Financial Force to be Reckoned With? in publicly traded firms, because only this information is usually disclosed publicly. Table 2.4 presents summary statistics on the investments by 29 SWFs documented in the SIL database over the period 2000 to 2014. A total of 1,379 transactions include investments in listed stock, real estate, and private equity. The total investment value of all SWFs in this period is $632 billion. The Qatar Investment Authority (QIA) has the largest aggregate investment value of $123.5 billion, with investments mainly concentrated in the real estate sector. In second place is the CIC, with $111.3 billion investment in 116 deals. But this total is highly impacted by a handful of very large domestic investments aimed at recapitalizing several state-​owned banks in preparation for their partial privatization. In addition, the $20 billion investment made in the China Development Bank in 2007 is the largest deal in our database. The two Singaporean SWFs—​GIC and Temasek—​are ranked third and fourth, respectively, by value of investments. In total, they made 602 deals worth almost $170 billion—​which puts Singapore ahead of all other countries. We track nine UAE-​based funds, with more than $130 billion invested in 218 deals. Columns 5 and 6 of Table 2.4, referencing the fraction of deals that were cross-​border (foreign) rather than domestic, clearly support the common perception that SWFs target the vast bulk of their investments outside of their home markets (Megginson, You, and Han 2013). Foreign investments represent 84.1% of all SWF investments by number and 74.9% by value over 2000–​14. Many commentators have noted that SWFs tend to make more foreign than domestic investments and that domestic investments differ quite dramatically from the international investments these same funds typically make. Although this seems quite logical at first glance, such a pattern is actually well outside the norm of institutional investment long observed in western economies, which invariably shows a decided “home equity bias” disproportionately favoring the stocks of companies headquartered in the same country (Bekaert and Wang 2009; Hau and Rey 2008). This literature shows that, apart from specialist investment vehicles, such as “emerging market” or “global growth” funds, the typical US or European pension fund or mutual fund invests two to four times as much in their home equity markets as a portfolio diversification, risk-​adjusted return maximizing strategy indicates they should. Although the motivations underlying SWFs’ domestic versus international investment choices have not yet been fully examined empirically, the funds invest the majority of their capital internationally, for two principal reasons. First, as wealth funds they are attempting to invest for the long term in financial assets with more different macroeconomic and political exposures than their domestic economies, and the best way to achieve this is to invest in global equities—​especially those of developed economies. Second, since many SWFs are very large funds based in relatively small economies, they are forced to invest abroad in order not to engender asset price bubbles that would result from channeling investments into domestic stocks, bonds, and real estate. Figures 2.1 and 2.2 show the geographical distribution of SWF investments. Developed economies, such as Europe and North America, maintain a strong attraction for SWFs. In Figure 2.1, we can observe an apparent trend of SWFs targeting their

Table 2.4 Investment Statistics for the Sovereign Wealth Funds in the Sovereign Investment Laboratory’s SWF Database

Country

Fund Name

# of Value of Fraction of Deals Deals, $Mn Foreign Deals By $ value

Qatar

Qatar Investment Authority

153 $123,480.38

84.97%

79.39%

40.82%

$13,260.00

$807.06

$245.00

China

China Investment Corporation

116

111,320.74

58.62%

49.96%

15.27

20,000.00

959.66

248.50

Singapore

GIC Pte Ltd

326

94,107.57

98.16%

99.46%

30.93

10,339.20

288.67

97.00

Singapore

Temasek Holdings Pte Ltd

276

75,588.83

85.51%

90.71%

18.75

5,671.73

273.87

51.23

UAE-​Abu Dhabi

International Petroleum Investment Company

44

38,079.68

81.82%

71.08%

32.61

8,000.00

865.45

230.00

UAE-​Abu Dhabi

Mubadala Development Company PJSC

56

36,742.67

71.43%

69.37%

33.95

4,000.00

656.12

380.00

UAE-​Abu Dhabi

Abu Dhabi Investment Authority

77

26,026.74

97.40%

99.88%

33.71

7,500.00

338.01

140.60

Kuwait

Kuwait Investment Authority

55

24,563.42

89.09%

82.48%

37.49

3,000.00

446.61

250.00

UAE-​Abu Dhabi

Abu Dhabi Investment Council

22

14,043.53

72.73%

32.71%

48.28

8,000.00

638.34

154.78

Ireland

National Pension Reserve Fund

4

13,239.35

25.00%

0.09%

97.37

7,264.00 3,309.84

2,981.42

Malaysia

Khazanah Nasional Bhd

56

12,375.39

64.29%

82.21%

44.39

2,786.65

220.99

61.84

Norway

Government Pension Fund—​Global

20

10,651.80 100.00% 100.00%

58.19

1,500.00

532.59

490.25

China

National Social Security Fund

10

5.98

2,200.00

950.56

819.57

UAE-​Dhabi

Investment Corporation of Dubai

3,396.80 1,314.50

1,182.80

Australia

Future Fund

UAE

Emirates Investment Authority

Libya

Libyan Investment Authority

South Korea

Korea Investment Corporation

5 17

9,505.61

20.00%

2.68%

6,572.48 100.00% 100.00%

31.6

6,431.52

34.67

2,081.00

378.32

224.00

5,658.85 100.00% 100.00%

53

5,658.85 5,658.85

5,658.85

35

5,470.19

72.58%

38.99

1,200.00

156.29

99.84

16

3,653.95 100.00% 100.00%

29.21

2,000.00

228.37

102.00

1

58.82% 94.29%

46.64%

(Continued)

Veljko Fotak, Xuechen Gao, and William L. Megginson    41

By # deals

Average Stake Average Median Purchased Largest Deal Size, Deal Size, (%) Deal, $Mn $Mn $Mn

Country

Fund Name

# of Value of Fraction of Deals Deals, $Mn Foreign Deals By # deals

Average Stake Average Median Purchased Largest Deal Size, Deal Size, (%) Deal, $Mn $Mn $Mn

By $ value

UAE-​Dhabi

Dubai International Financial Center

11

2,867.05

54.55%

98.15%

Oman

Oman Investment Fund

21

2,458.99

71.43%

88.45%

28.04

719.51

117.09

50.00

Azerbaijan

State Oil Fund of the Republic of Azerbaijan

2,016.71 100.00% 100.00%

83.82

500.00

252.09

232.19

1,940.00 1,940.00

1,940.00

8

38.75

1,825.18

260.64

22.96

Russia

National Wealth Fund

1

1,940.00

0.00%

0.00%

n/​a

New Zealand

New Zealand Superannuation Fund

12

1,868.05

50.00%

36.50%

28.15

626.44

155.67

93.00

Oman

State General Reserve Fund

20

1,786.20

95.00%

94.40%

41.46

900.00

89.31

26.42

Brunei

Brunei Investment Agency

12

1,043.99

91.67%

99.62%

50.45

300.80

87.00

68.94

UAE-​Dhabi

Istithmar

1

250.00

0.00%

0.00%

50

250.00

250.00

250.00

Bahrain

Bahrain Mumtalakat Holding Company

1

170.18

0.00%

0.00%

170.18

170.18

170.18

Vietnam

State Capital Investment Corporation

2

25.03

0.00%

0.00%

25.00

12.51

12.51

UAE-​Ras Al Khaimah

RAK Investment Authority

1

11.64 100.00% 100.00%

11.64

11.64

11.64

$20,000.00 $458.27

$120.17

Total, All Funds

1379 $631,950.54

84.12%

74.94%

6.67 17 n/​a 32.05%

This table describes the number and total value of investments made by the SWFs in the SIL database from 2000–​2014, as well as the fraction of those deals (by number and value) that are foreign rather than domestic, the average percentage stake purchased, the largest single investment for each SWF, and the average and median size investment documented for each fund.

42    A Financial Force to be Reckoned With?

Table 2.4 (Continued)

Veljko Fotak, Xuechen Gao, and William L. Megginson    43 100.0%

25.2

77.7

111.7

88.2

47.6

82.6

58.4

49.3

68.6

29.3

40.2

34.0

50.2

50.0

47.6

41.0

35.1

45.3

70.7

59.8

66.0

49.8

50.0

52.4

59.0

64.9

54.7

2006

2007

2008

2009

2010

2011

2012

2013

2014

90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0%

OECD

Non-OECD

Figure 2.1  SWF Investments in OECD and non-​OECD Markets (2006–​14) Source: Sovereign Investment Laboratory (2015).

120

111.7

100 88.2

82.6

77.7

80

68.6 58.4

60

49.3

47.6 40 25.2 20

0

2006

2007

2008

2009

2010

2011

North America

Sub-Saharan Africa

Latin America

MENA

Asia-Pacific

Europe

2012

2013

2014

Non-Pacific Asia

Figure 2.2  Value of direct SWF foreign investment by target region (2006–​14) Source: Sovereign Investment Laboratory (2015).

44    A Financial Force to be Reckoned With? geographical allocation toward OECD countries. However, starting from 2014, the regional distribution of investments shows different patterns. Due to the drop in oil prices and the slowdown of global economic growth, SWFs reduced their investment proportions in developed economies and turned their attention to domestic markets. As a consequence, the proportion of domestic investments increased by 3% and the proportional investments in OECD countries decreased by 10% compared to 2013. Europe has been the largest target region for SWF investments since 2011. However, due to the shift to domestic investments in 2014, the SWF investment value in Europe declined by more than 10% compared to 2013, and Europe was ranked as the second largest target region with an investment of $16.5 billion from SWFs in 2014. In the US, SWFs increased their investment from $7.5 billion in 2013 to $14.7 billion in 2014, but they changed their asset allocation preference from the financial to the real estate sector. It is also worth mentioning that the SWF investments in both the Asia-​Pacific and the Middle East and North Africa (MENA) regions were increased significantly. However, the investments in the two areas show some different characteristics. In the Asia-​Pacific region, most of the deals are cross-​border investments and China is the major beneficiary country. In the MENA region, the investment increase is mainly contributed by their local SWFs. They gave support to their domestic economy and helped alleviate the financial difficulties. Finally, Figure 2.3 summarizes the industrial allocation of SWF investments over 2006–​14. The most obvious trend in this figure is the shift to real estate investments. This pattern is particularly evident in 2014. The 32 publicly reported investments in real estate account for 24% of all deals by number, but the combined investment value ($31.5 billion) represents 46% of the total investment value in 2014. This shift to real estate investments can be explained by the low interest rates all over the world, pushing SWFs to look for alternative asset classes. It is also worth mentioning that the large real estate investments by SWFs are mainly concentrated in commercial property in the UK and US, while emerging economies have received significantly less attention in the past two years. Investments in the financial sector continuously shrank over the past four years and reached their lowest historical point in 2014. We observe a total of 14 deals in the financial sector in 2014, worth $6.9 billion, only 10.5% of the total investment value. Other industries attracting significant SWF investment are oil and gas producers, transportation, chemicals, and other industrials.

Recent Trends in Sovereign Wealth Fund Investments In this section, we highlight other key trends that have recently emerged regarding SWF investment patterns. These trends include the following:  (1)  Joint ventures and co-​investing have increased in importance and attractiveness. This allows SWFs to directly invest in high-​quality, big-​ticket deals with western investment funds and

Veljko Fotak, Xuechen Gao, and William L. Megginson    45 120

111.7

100

88.2

82.6

77.7

80

68.6 58.4

60

49.3

47.6

40 25.2 20

0

2006 Other

2007

2008

2009

Restaurants, Hotels, Motels

2010

2011

Communications

Infrastructure & Utilities

Precious Metals, Non-Metallic, and Industrial Metal Mining

Petroleum & Natural Gas

Real Estate

2012

Retail Chemicals

2013

2014

Aircraft, Autos, Ships & Trains Transportation

Banking, Insurance, Trading

Figure 2.3  Value of direct SWF foreign investment by target sector (2006–​14) Source: Sovereign Investment Laboratory (2015) Sovereign Wealth Fund Annual Report 2014.

developers at less risk than going-​it-​alone and with lower fees than fully out-​sourcing investments. (2) With reduced interest in the finance sector, there is growing interest in allocating funds to private equity. This has long seemed to be a logical target as it finesses political problems with state-​owned funds investing directly, while still accessing the best deal flow. Besides that, SWFs also target foreign banks in emerging economies, hoping to benefit from their recovery and development. (3) All large funds are bringing asset management in-​house by building up internal analyst teams and bulking up with domestic or expatriate specialists. Some, especially GPFG, are much further along than others, though even ADIA now manages one-​third of new investments in-​house. (4) The Norway Model (the classic foundation model) of investment, or variants thereon, is fast becoming the industry standard. This involves investing in mostly public equities (60–​65%), traded fixed income (30–​35%) and, increasingly, real estate (1–​5%) and some alternative assets such as private equity. This involves mostly index-​ oriented, low cost investing rather than large direct stake purchases. Norway’s managerial structure and internal governance are also becoming the model to emulate, especially for newly created funds. (5) There has been major growth—​albeit from a small base—​ in SWF funding and investment in sub-​Saharan Africa. This is now the world’s fastest growing continent and several countries there are launching new funds to protect resource endowments, all based to one degree or another on the Norway model.

46    A Financial Force to be Reckoned With?

The Impact of Sovereign Wealth Fund Investments on Target Firms How State Ownership Itself Should Impact Firm Values A large literature examines empirically whether state ownership of domestic corporate equity is associated with increased or reduced firm value, and most of these studies conclude that government stockholdings tend to correlate with lower firm market values (Boubakri and Cosset 1998; Chen et al. 2012; Lin and Bo 2012). The findings of this literature offer more support for the “political view” that state ownership is engineered to redistribute corporate wealth to connected groups and individuals (Avsar, Karayalcin, and Ulubasoglu 2013; Dinç 2005; Iannotta, Nocera, and Sironi 2013; Megginson, Nash, and Randenborgh 1994; Sapienza 2004) than the competing “social view,” which attributes socially benign intentions to state investors.

Evidence on Different Types of State Owners There is as yet surprisingly little research examining whether all types of state owners have the same impact on target firm value, even though logic suggests a nation’s finance ministry will have different motivations, capabilities, and effects than state-​controlled investment vehicles or state-​owned enterprises. Extant research examining the differential effect of various state actors has focused mostly on Chinese publicly traded companies. Berkman, Cole, and Fu (2010), Chen, Firth, Yu, and Xu (2008), Chen, Firth, and Xu (2009), Houston et al. (2010), Jiang, Lee, and Yue (2010) and Lin and Su (2008) and all examine whether share ownership (or transfers from state to private ownership) by state ministries, state asset management bureaus, and state-​owned enterprises are associated with differential impacts on target firms. These studies generally conclude that SOEs connected with the national government, or which have substantial private ownership, are associated with higher valuations than are shareholdings of, and ownership transfers to, asset management bureaus, local and regional governments, and SOEs affiliated with local and regional governments. We are aware of only five non-​Chinese empirical studies examining the valuation impacts of different types of state ownership, or comparing the effects of comparable state and private investors. Woidtke (2002) shows that stock ownership by private, unaffiliated US pension funds enhances target firm values, whereas investment by public and affiliated pension funds do not. Gianetti and Laeven (2009) find that size and independence of Swedish pension funds seems to matter more than does a simple state-​versus-​private dichotomy, as only large, unaffiliated public and private funds are associated with value creation. Karolyi and Liao (2015) reach a similar conclusion in their study of cross-​border stock acquisitions by state-​owned entities and corporate acquirers; both are associated with nearly identical announcement periods and long-​ term target stock returns, though state-​owned investment funds are associated with

Veljko Fotak, Xuechen Gao, and William L. Megginson    47 significantly less positive target firm stock returns. Lin et al. (2011) differentiate between four types of stockholders in their study documenting that a large control-​cash flow wedge has a less substantial valuation impact for state controlled firms than for those controlled by families or for widely held companies. The fifth paper, by Oum, Adler, and Yu (2006) examines the impact of multiple (six) types of majority-​state ownership and mixed state and private ownership on the operating and financial performance of major airports in North America, Asia, and western Europe. They find that airports run by majority-​private entities are the most efficient, whereas those run by multiple levels of governments and mixed majority-​state/​minority-​private entities are the least efficient. To summarize, while empirical evidence strongly suggests that private ownership should generally be considered superior to state ownership, little existing research can guide our predictions of how different types of state owners might impact target firm value differentially. Some classes of government entities are more likely to be involved in the management and monitoring of their acquisition targets than are others. In particular, government entities such as SOEs are often more closely involved in the management of investment targets than are pure state actors, such as the central government or local/​regional governments. To date, however, only the papers described below have studied the effect of SWF investment on target firms, and only two of these (Bortolotti, Fotak, and Megginson 2015; Karolyi and Liao 2015) compare the impact of SWF investments to those of comparable privately owned investors.

The Impact of Sovereign Wealth Funds on Target Firm Financial Performance and Value In this section, we survey fourteen academic articles which study the impact of SWF investments on target firms’ financial and operating performance, corporate governance, valuation, credit risk, and stock return volatility. The empirical data, methodologies, and findings of the twelve articles are summarized in Table 2.5. We logically divide our discussion into three subsections: market reaction; operating performance and governance; and valuation, credit risk, and stock return volatility.

Event Studies of the Short-​and Long-​Term Stock Price Effects of Investment in Listed Targets First, we discuss the target firms’ short-​and long-​term market performance following the SWF investments. The evidence for the short-​run market reaction is highly consistent. Six papers (Bortolotti, Fotak, and Megginson 2015; Dewenter, Han, and Malatesta 2010; Hua 2015; Karolyi and Liao 2015; Kotter and Lel 2011; Sojli and Tham 2011) all use standard event study methods and find that the short-​term reaction to an announced SWF equity investment in a listed company yields significant positive announcement-​ period excess returns of 1–​3%. However, the findings for the long-​term reaction are less conclusive. Dewenter, Han, and Malatesta (2010) document significantly negative median one-​year cumulative market-​adjusted excess returns (–​4.5%), but significantly

48    A Financial Force to be Reckoned With? Table 2.5 Summary of Empirical Studies Examining Impact of Sovereign Wealth Fund Equity Investments on Target Firm Financial Performance Sample Description, Study Period, and Methodology

Summary of Empirical Findings and Conclusions

Bortolotti, Fotak, and Megginson (Review of Financial Studies 2015)

Construct a dataset of 1,018 investments by SWFs (or by SWF-​owned investment subsidiaries) in publicly traded firms completed over the 1980–​November 2012 period. Generate a “benchmark” control sample of stock purchases by financial investors from the same home countries as sample of SWFs, targeted at firms headquartered in the same countries as SWF investment targets, and executed over the same time period.

Find that announcements of SWF investments are associated with significant mean abnormal returns of 0.9% over (–​1,+1), including investments by Norway’s GPFG, and 2.45% without Norway. However, these are significantly lower than the 5.02% mean abnormal returns generated by the private benchmark investors, implying the existence of a sovereign wealth fund “discount” due to their government ownership.

Hua (Working Paper 2015)

Use a sample of 450 SWF investment transactions among 340 unique firms from 1987 to 2012 to investigate the effect of SWF investment on medium-​ and long-​term performance of target firms through a liquidity channel.

Find that SWFs tend to invest in firms which have poor financial performance and underperform the market. The target firms’ performance in medium and long run is not significantly changed after SWF investments. Attribute the results to a liquidity channel which is caused by the intractable information of SWFs.

Murtinu and Scalera (Rivista Internazionale di Scienze Sociali 2015)

Assemble a dataset with 270 investments made by 23 SWFs from 15 countries over the period 1997–​2013 to investigate whether stock prices of SWF-​backed target companies are influenced by investment geography (domestic versus cross-​border) and target industry (strategic versus non-​ strategic industries). An IV regression is run to control for the endogeneity of the location and target industry choices.

Find that on a 50-​day window around the SWF investment, cross-​border investments have an average higher increase in stock price than domestic SWF investments. While, on the same time window, SWF investments in strategic industries show a higher drop in stock price than SFW investments in non-​ strategic industries. In addition, show that the higher is the politicization of the fund, the larger is the stock price drop.

Borisova, Fotak, Holland, and Megginson (Journal of Financial Economics 2014)

Use a sample of 6,671 credit spreads from 1,723 bonds issued by 244 firms from 43 countries over 1991–​2010, to examine the impact that state ownership (including 1,060 firm-​years with SWF investment) of a firm’s stock has on that company’s cost of debt, as measured by the yield spread above treasuries. Examine for full sample period and after 2008 Financial Crisis.

Find that, in the full 1990–​2010 sample, state ownership (0/​1) is associated with significantly higher (40 bp) cost of debt, and this is even larger during pre-​ crisis period, 1990–​2007. From 2008 on, basic cost of debt rises sharply, and state ownership becomes associated with significantly lower (18bp) cost of corporate debt. SWFs specifically are associated with a higher cost of debt both before (46.7 bp) and after (26.1 bp) the Crisis begins.

Study

Veljko Fotak, Xuechen Gao, and William L. Megginson    49 Table 2.5 (Continued) Study

Sample Description, Study Period, and Methodology

Summary of Empirical Findings and Conclusions

Fernandes (Journal of Applied Corporate Finance 2014)

Use sample of 8,000 SWF share holdings in 58 countries over 2002–​07 to test whether and how SWFs investments create value for target firms.

Find that SWF investments are associated with a value (Tobin’s q) premium of more than 15%, and that SWFs also positively impact target firm return on assets, return on equity, and net profit margin.

Bertoni and Lugo (Journal of Corporate Finance 2014)

Study the impact of SWF investments on the credit risk of their target companies by examining the evolution of credit default swap spreads (CDS) after 391 SWF investments over 2003–​10.

Find target company’s credit risk decreases significantly after SWF investment. Suggests market perceives SWFs as investors that may protect target companies from bankruptcy risk.

Del Giudice, Marinelli, and Vitali (Journal of Financial Management, Markets and Institutions, 2014)

Employ network analysis to investigate whether the connection between target firms created by SWFs positively influence the operating performance of these target firms. Their sample includes 507 SWF acquisition deals in the time span between 2000 and 2011.

Find that highly central firms in the target firm network enjoy higher operating performance. In addition, the target firm operating performance is higher if the stake acquired is larger, the investment is direct and domestic, or the SWF is run by a politician. There is a concave relationship between the number of SWFs investing in the firm and the target firm operating performance.

Gagliardi, Gianfrate, and Vincenzi (Working Paper 2014)

Construct a sample of 113 SWF investments over the period 1998–​2011 to analyze the market reaction to SWF investments from the target firm bondholders’ perspective.

Find that target firm bondholders experience significantly positive abnormal returns both in the short run (+0.32%) and in the medium run (+2.67%). Excess returns are higher when the target is a non-​financial or a non-​strategic firm. Positive bond price performance is positively related to cash flows and earnings of the targets, and negatively related to their credit rating and outlook.

Knill, Lee, and Mauck (Journal of Financial Intermediation 2012)

Use sample of 231 SWF acquisitions of listed firm stock over 1984–​2009 to examine whether this investment significantly impacts the return-​to-​risk performance of target firms.

Find that target firm raw returns decline following SWF investment. Though risk also declines, find a net reduction in the compensation for risk assumed over five years after investment, suggesting SWFs may not provide monitoring benefits for targets offered by other institutional investors.

(Continued)

50    A Financial Force to be Reckoned With? Table 2.5 (Continued) Sample Description, Study Period, and Methodology

Summary of Empirical Findings and Conclusions

Kotter and Lel (Journal of Financial Economics 2011)

Use sample of 417 SWF investments into listed firms over 1980–​February 2009 to examine the effect of SWF investment on the short-​and long-​term valuation and performance of target firms. Also study which types of target firms attract SWF investment.

Find that SWFs prefer large, poorly performing companies facing financial difficulties, and news of their investments yields significantly positive initial returns (+2.25%) that are higher for more transparent funds. Mean long-​term stock returns after investment are insignificantly positive (three-​year significant); median returns insignificantly negative. Conclude SWFs are generally passive shareholders.

Sojli and Tham (Book 2011)

Examine the short-​and long-​term performance impact of 66 SWF investments in US listed companies by comparing SWFs deals documented with 13D and 13G filings over 1997–​2008 to a similar sample of investments made by US institutional investors.

Find that these large investments by SWFs where they plan to take active roles in target firm management yield significantly positive short and long-​term stock returns and financial performance. Find the increase in target’s Tobin’s q post-​deal results from the provision of government contracts.

Karolyi and Liao (Journal of Corporate Finance 2015)

Study 4,026 cross-​border acquisitions over 1998–​2008, worth $434 billion, that were led by government-​controlled acquirers, and compare to 127,786 similar acquisitions worth $9.04 trillion made by private acquirers and 733 deals worth $158 billion made by SWFs and other state-​owned funds. Test whether investments by state-​controlled acquirers and SWFs/​other funds yield different short-​and long-​run target firm stock returns from acquisitions by private companies.

Find that announcement period (–​5,+5) return for acquisitions by private companies (5.0%) is significantly higher than that for state-​controlled acquirers (2.8%), and that the (–​5,+5) return around SWF/​other funds investment announcements (0.8%) is materially and significantly smaller than either. Also find the three-​year mean and median buy-​and-​hold excess returns for SWFs/​other funds (–​50.3%; –​62.8%) are significantly lower than for private acquirers (–​9.4%; –​40.3%) and state-​ controlled acquirers (–​7.6%; –​30.6%), though L-​T excess returns post-​deal are significantly negative for all groups over all time frames (one, two and three years).

Study

Veljko Fotak, Xuechen Gao, and William L. Megginson    51 Table 2.5 (Continued) Sample Description, Study Period, and Methodology

Summary of Empirical Findings and Conclusions

Bertoni and Lugo (Journal of Corporate Finance 2014)

Analyze the certification effect of SWF stock purchases on the credit risk of target firms by computing an adjusted measure of credit default swap (CDS) spread decrease (ADS) for one-​year and five-​year CDS for a sample of 391 direct SWF investments between 2003 and 2010.

Document a significant decline in target firm credit risk following SWF investments, especially for the one-​year maturity CDS, even when investment is purely secondary (no new capital injected into target). Results consistent with market interpreting SWF investment as providing target with implicit insurance against short-​term liquidity shocks.

Dewenter, Han, and Malatesta (Journal of Financial Economics 2010)

Analyze the short-​and long-​term impact of SWF investments on target firm values using a sample of 227 stock purchases and 47 SWF stock sales over January 1987–​April 2008. Try to determine whether there is a trade-​off between SWF monitoring and lobbying benefits and tunneling and expropriation costs.

Find significant announcement period (–​1,+1) excess returns for SWF stock purchases (+1.52%) and divestments (–​1.37%). Document significantly negative median one-​year cumulative market-​adjusted excess returns (–​4.5%), but significantly positive median three-​year (+7.3%) and five-​year (+31.2%) returns for target firm stocks after SWF investments. Also find SWFs are active monitors, with over half of target firms experiencing one or more events indicating SWF monitoring or influence.

Study

This table summarizes several recent empirical studies examining how SWF stock purchases impact the short-​and long-​term stock return and financial performance of investee companies.

positive median three-​year (+7.3%) and five-​year (+31.2%) returns for target firm stocks after SWF investments. They attribute their findings to the outcome of a trade-​off between SWF monitoring and lobbying benefits and tunneling and expropriation costs. Karolyi and Liao (2015) confirm that the one-​year excess returns after SWF investment are significantly negative. However, unlike Dewenter, Han, and Malatesta (2010), they find that the excess returns stay negative even if the time window is extended to two or three years. Both Hua (2015) and Kotter and Lel (2011) and show that the abnormal stock returns after SWF investments are not statistically significant from zero in the long run. Kotter and Lel (2011) believe that shareholder activism is not common among SWFs. However, Hua (2015) explains her results from a different perspective, suggesting the insignificant long-​run reaction is the consequence of the interaction of two opposing factors—​the low target firm stock liquidity caused by the intractable information of

52    A Financial Force to be Reckoned With? SWFs, and the benefit from SWF monitoring and certification. Sojli and Tham (2011) find that the large investments by SWFs, where they plan to take active roles in target firm management, yield significantly positive long-​term stock returns. Dewenter, Han, and Malatesta (2010) also mention that the market reaction is related to the size of the stakes purchased by SWFs. They find a non-​monotonic relationship between the two variables. The abnormal returns first rise with the ownership of SWFs and then decline when the SWF ownership reaches a certain extent. Kotter and Lel (2011) examine which types of the target firms attract SWF investments. They find SWFs tend to choose large, financially constrained, and poorly performed firms. And the market reaction is more positive for the SWFs with higher transparency. Their result is also supported by Hua (2015). Karolyi and Liao (2015) and Bortolotti, Fotak, and Megginson (2015) explicitly test whether the average stock price reaction to news of an SWF investment is significantly different to the average reaction following announcements of investments in listed firms made by otherwise similar privately owned institutional and corporate investors. Karolyi and Liao (2015) use the cross-​border acquisition transactions between 1998 and 2008 to study the target firm announcement period returns. They divide their data into three groups based on the different types of acquirers—​government controlled acquirers, private acquirers, and SWF/​other state-​owned fund acquirers. They find that the private acquirer group has the highest announcement period return (5.0%) which is almost twice the return for the government controlled acquirer group (2.8%). The SWF/​ other state-​owned fund acquirer group has the lowest announcement period return (0.8%) which is far below the other two groups. Bortolotti, Fotak, and Megginson (2015) document a “sovereign wealth fund discount” in their study. They compare the valuation impact of SWF investments with those of comparable private investments and find that the market reaction to SWF investment (0.9% announcement period abnormal return including the investment by Norway’s GPFG, and 2.45% without Norway) over a three-​ day event window (–​1,+1) is significantly lower than that of comparable private-​sector investments (5.02% announcement period abnormal return). They attribute this SWF discount to the inconsistency between political objectives and profit maximization.

Impact of Sovereign Wealth Fund Investment on the Operating Performance and Governance of Target Firms A second group of papers focused on the impact of SWF investment on the target firm operating performance and corporate governance. Fernandes (2014) studies the impact of SWF investments on the value and operating performance of firms in which SWFs invest and finds both a significant increase in firm value as well as significant improvements in operating performance, as measured by returns on equity, returns on assets and operating returns. The author further identifies the source of value provided by SWFs as originating from stronger monitoring, better access to capital, and improved access to foreign product markets. The findings of stronger monitoring are consistent with the results of Dewenter, Han, and Malatesta (2010), who believe that SWF investment may increase the target firm value by providing valuable monitoring

Veljko Fotak, Xuechen Gao, and William L. Megginson    53 or lobbying services. They examine the behavior of target firms and find that over half of the targets experienced one or more event indicating SWF monitoring or influence. They further discuss the role of SWFs in managerial turnover, but also in the creation of valuable network effects. Sojli and Tham (2011) similarly attribute the improved performance of SWF investment target in the US to, among other things, improvements in governance. As an extension of Dewenter, Han, and Malatesta (2010), Del Giudice, Marinelli, and Vitali (2014) study whether the network created by SWF investments can positively affect operating performance and create benefits to the better connected target firms. With a network analysis, they find that the highly central firms in the SWF-​target network tend to have better operating performance due to better access to information. They also point out that an SWF run by politicians, a direct and domestic investment, and a larger investment size are all related to better target firm operating performance. Rose (2013) describes in detail how SWFs tend to be disengaged from corporate governance matters in US firms, as a reaction to regulatory and media opposition to their investments. Yet, as he discusses, this passivity has a dark side and it could have a negative impact on firm value by replacing other, potentially more engaged, shareholders. In contrast to the other studies which document the improvement of operating performance, Bortolotti, Fotak, and Megginson (2015) find evidence of declining return on assets, sales growth, and market-​to-​book ratios over the three years following SWF investments.

Impact of Sovereign Wealth Fund Investment on Target Valuation, Credit Risk, and Stock Return Volatility Six studies examine how SWF equity investments impact the valuation, credit risk, and/​ or financial return volatility of target firms post-​investment. Since these studies employ differing methodologies and samples, and examine different performance metrics, it is harder to draw general conclusions regarding their findings, except to say that two of these studies (Bertoni and Lugo 2014; Fernandes 2014) find that SWF investments generally increase target firm value and/​or reduce the target’s credit risk, while (Knill, Lee, and Mauck 2012a) find that both the risk and return of target firms’ stocks decline following SWF investments. Murtinu and Scalera (2015) find that target firm value is higher if SWFs make cross-​border investments in non-​strategic industries. Borisova, Fotak, Holland, and Megginson (2015) document that SWF investment in target firms’ stock is associated with an increase in those firms’ bond yield spreads—​and thus their cost of debt financing, while Gagliardi, Gianfrate, and Vincenzi (2014) show a positive short-​run and medium-​run market reaction for target firm bondholders. Fernandes (2014) examines a sample of 8,000 SWF share holdings in 58 countries over 2002–​07 to test whether SWFs investments create value for target firms. He finds that SWF investments are associated with a value (Tobin’s q) premium of more than 15%, and that SWFs also positively impact target firm return on assets, return on equity, and net profit margin. It should be pointed out that no other SWF empirical study finds a positive valuation impact anywhere near that large, although most do find that

54    A Financial Force to be Reckoned With? announcements of SWF stock purchases are associated with significantly positive returns in the 1–​3% range. Bertoni and Lugo (2014) study the effect of SWF stock purchases on the credit risk of target firms. The authors compute and analyze changes in credit default swap (CDS) spreads for a sample of 391 direct SWF investments over 2003–​10. They find the target company’s CDS spreads decrease significantly after SWF investment and that the results are stronger when the SWF originates from a politically stable non-​democratic country. The authors interpret the results as suggesting that creditors expect SWFs to protect target companies from bankruptcy. Knill, Lee, and Mauck (2012a) use a sample of 231 SWF acquisitions of listed firm stock between 1984 and 2009 to examine whether these investments significantly impact the return-​to-​risk performance of target firms, and find that target firm raw returns do indeed decline following SWF investment. Though risk also declines, they document a net reduction in the compensation offered to investors for the risk they assume over five years after investment, suggesting that SWFs may not provide the same monitoring benefits for targets offered by other institutional investors. Murtinu and Scalera (2015) study how SWF investments affect the market value of target firms over a 50-​day window. They build a sample with 270 investments by 23 SWFs from 15 countries over the period 1997–​2013 and find that: (1) compared to domestic investments, SWF cross-​border investments generate a larger, more positive effect on target firms’ market value; (2) SWF investments in strategic industries have a negative effect of greater magnitude on the market value of target firms than comparable investments in non-​strategic industries; (3) the level of SWF politicization is negatively related to the market value of target firms. Borisova et al. (2015) examine the impact that state ownership has on a company’s cost of debt using a sample of 6,671 credit spreads from 1,723 bonds issued by 244 companies from 43 countries between 1991 and 2010 (including 1,060 firm-​year observations with SWF ownership). The authors hypothesize that, on one hand, state ownership provides domestic companies an implicit guarantee on the debt of the firm and therefore might reduce the cost of debt. On the other hand, state ownership may have a negative effect on a firm’s cost of debt due to the inconsistent goals between the government and regular for-​profit investors. Borisova et al. (2015) show that, during normal times, state ownership is associated with an increase in the cost of debt. However, during financial crisis, the benefit of an implicit government guarantee is more pronounced and state ownership is associated with lower spreads. Further, SWF ownership is linked to a higher cost of debt compared to ownership by central banks, the national treasury, and state-​owned non-​financial enterprises in both normal times and during the financial crisis. Along the same lines as Borisova et  al., Gagliardi, Gianfrate, and Vincenzi (2014) study the impact of SWF investments on the value of target firm bondholders. With a sample of 113 investment deals over the period 1998–​2011, they document a positive short-​run abnormal return (+0.32%) for bondholders over a three-​day window and also a positive medium-​run abnormal return (+2.67%) for bondholders over a 47-​day window. The abnormal returns of non-​strategic and non-​financial target firms are

Veljko Fotak, Xuechen Gao, and William L. Megginson    55 significantly higher than in strategic and financial targets. Finally, bondholders of targets with poor credit rating or negative outlook experience a larger, positive valuation effect following SWF investments.

Conclusion We conclude by discussing where we think SWF research is heading and what critical questions need to be addressed by the next group of researchers in the future. SWFs are at a crucial transitional period. As discussed earlier, the two principal SWF financing channels are revenue from the sale of natural resources and foreign exchange reserves from net exports. However, crude oil prices have been falling since June 2014, and by early 2015 oil prices were below $50 per barrel. Then prices rebounded slightly for several months but dropped sharply again from almost $60 per barrel in May 2015 to $27 per barrel in February 2016. The prolonged slump in oil prices seriously hurts revenues from energy sales. In addition, due to the slowdown of economic growth in emerging markets, we can predict that the injection of foreign exchange reserves in exporting countries will be significantly reduced. Under this circumstance, it is interesting to check how SWFs adjust their asset allocation strategies to minimize the impact of the revenue reduction. Furthermore, it is also important to look at the channels that parent-​country governments use to explicitly/​implicitly force SWFs to support their domestic financial budgets, and to study how political pressure from domestic governments will affect SWF investment strategies. Far too little is known about the details of SWF investments, with the notable exception of the activities of Norway’s Government Pension Fund Global. Extant research has offered insights—​and even those, incomplete—​into investments in publicly traded firms and some glimpses into disclosed real estate and unlisted equity investments. The substantial fraction of SWF investments in bond markets has so far defied analysis and remains opaque. While little is known about the returns achieved by SWFs in their international equity and debt investments, even less is known about their domestic asset returns. This is partly because of inherently restricted information disclosure and partly because SWFs are often used to rescue local firms and industries during financial crises and recessions. SWFs can be employed as tools of domestic development far more easily than they can be used in such a way in cross-​border deals. The lack of information and opaque nature of SWFs is, of itself, deserving of study. We strongly suspect that the secrecy surrounding most SWFs has actually been self-​ defeating, stoking the flames of those who view foreign government investors with suspicion. Yet, there are perhaps valid reasons (domestic political short-​term pressures but also the need to protect investment strategies) for opacity; it would be interesting to see what the optimal level of disclosure is and whether such heterogeneity among funds has rational justifications. Despite the lack of truly comprehensive data, extant research has gained some insights into the performance of SWF investment portfolios. Most of this evidence indicates that

56    A Financial Force to be Reckoned With? the claimed returns of all but the most transparent funds are probably over-​stated, perhaps wildly so. Yet this research relies on incomplete and certainly biased data—​as it is the most transparent funds based in western countries that are most likely to provide sufficient disclosure, but those funds are also, on an average, the most sophisticated investors amongst their peer group. Extant research on the impact of SWFs on target firm value has mostly relied on analysis of announcement-​period abnormal returns—​and found positive abnormal returns over short-​term windows. However, a large literature documents the market reaction to investments by western mutual funds, pension funds, and other types of institutional investors and also finds positive abnormal returns. Yet, despite the abnormal performance of investment targets documented in this literature, most of the (to start with, scant) research on SWF performance has failed to compare the performance of SWF investment targets to that of a comparable, private-​sector benchmark. Bortolotti, Fotak, and Megginson (2015) have offered a first attempt at constructing a benchmark of comparable private-​sector investments and, while confirming that SWF investments are associated with positive abnormal returns, they have also shown that such returns are smaller than those to private-​sector investment announcements. This “SWF discount” has thus been documented, yet it has not been fully explained. Is the market reaction a rational response to the expectation of political interference by SWFs or is it perhaps a reaction to the stigma associated with the sovereign nature of these investors? A related unanswered question is one of long-​term impact. Empirical corporate finance research has come to rely on short-​term market reactions, under an assumption of market efficiency, to make inferences about the long-​term value impact of corporate events—​in this case, to make inferences about the long-​term value impact of SWF investments in publicly traded firms. Yet is it reasonable to expect markets to efficiently and accurately assess the value impact of investments which are kept intentionally opaque by a group of funds that are, in the first place, little understood? Or is there perhaps more insight to be gained by long-​term analysis of operating performance of investment targets, despite the added noise and econometric challenges inherent in long-​term analyses? In some sense, extant research has failed to provide answers to some of the most fundamental, and most important, questions surrounding SWFs. Foremost is the question as to whether SWFs can truly become vehicles financing economic development, to the benefit of the populations of the sponsoring countries. Of course, the evidence so far suggesting that SWF capital flows are mostly directed to the financial industry in developed, western countries seems to reinforce the view of SWFs perpetuating Lucas’ (1990) paradox (the observation that, contrary to expectations, capital tends to flow from developing countries to developed ones) and diverting resources that could perhaps be employed for domestic investments in countries often lacking infrastructure. Yet, such a view hinges on scant evidence: it is hard to draw any conclusion on the impact of SWF investments when their allocations, as previously discussed, are only partially known. There are other related, specific, unanswered questions. Have SWFs strengthened the influence of government on their domestic economies—​by virtue of direct asset acquisitions—​or have they actually weakened such impact, by insulating those same

Veljko Fotak, Xuechen Gao, and William L. Megginson    57 assets from political interference? Have SWFs helped or hindered domestic financial and industrial development? While data constraints are one of the reasons for lack of clear answers, a contributing factor has been a “western bias” in most of the related research—​as western economists have been more interested in analyzing how SWFs impact target firms and target-​firm economies, rather than questioning the rationale for SWF existence in the first place. Finally, a critical issue is whether countries should set up SWFs in the first place—​ and, even more, whether there are certain countries for which a SWF is more appropriate. Should countries with large, and perhaps temporary, excess cash flows allocate a portion of these funds to an SWF? Should countries excessively dependent on a single commodity use an SWF to diversify their economic exposure? Should countries with aging populations use SWFs as a tool for intergenerational wealth transfer? We hope our research colleagues will vigorously pursue these issues going forward.

Acknowledgments We thank Tor Bakke, Vee Barbary, Joka Kusjlic, Hui Li, Valentina Milella, Laura Pelizzolla, Armando Rungi, Elizabeth Scheer, Blaine Stansel, and Timothée Waxin for research assistance with this project and an earlier survey article published in the Journal of Economic Surveys (2015). We also benefited from comments offered by Mohammed Alzahrani, Chris Balding, Ginka Borisova, Bernardo Bortolotti, Narjess Boubakri, Marie Brière, Craig Brown, Gilles Chemla, Rebel Cole, Serdar Dinç, Elroy Dimson, Mandy Duan, Louis Ederington, Nuno Fernandes, Chitru Fernando, Edith Ginglinger, Janya Golubeva, Kate Holland, Jason Kotter, Carl Linaburg, Stefano Lugo, Stefanie Kleimeier, April Knill, Ugur Lel, Diego Lopez, Stefano Lugo, Nathan Mauck, Aline Muller, Matthias van Randenborgh, Jay Ritter, Patrick Schena, Samer Sourani, Manuchehr Sharokhi, Aidan Vining, Vincenzo Verdoliva, Pradeep Yadav, two anonymous referees and the editor, Iris Claus. We also thank participants in the 2013 ECCE-​USB Financial Globalization and Sustainable Finance conference in Cape Town, South Africa (keynote speech), the 2014 Global Finance Conference in Dubai (keynote speech), the 2014 Sovereign Investment Laboratory Sovereign Wealth Fund Conference (Florence), and seminar presentations at Université Paris Dauphine, Saudi Aramco headquarters (Dhahran, Saudi Arabia), King Fahd University of Petroleum and Minerals, the University of Liege, Università degli Studi di Napoli, and the European School of Management and Technology (Berlin).

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Chapter 3

Sovere i g n Devel opm en t  Fu nd s The Governance and Management of Strategic Investment Institutions Peter Bruce-​C lark and Ashby H.B. Monk

Introduction The global financial crisis and ensuing economic slowdown have undercut investor confidence in traditional financial markets and products (Awrey 2012). In response, the community of long-​term investors (LTIs), such as insurance companies, sovereign funds, pension funds, and endowments, have started to reconsider the efficacy of conventional investment strategies and models, as well as the ways in which they organize themselves (Clark and Monk 2013). In part, LTIs have refocused their efforts and reoriented their organizations toward private, and at times nascent, markets, either via third-​party funds (external asset managers) or private placements (direct investment). The hope is that these strategies will provide a level of performance consistent with the needs and expectations of their public and private sponsors. In contemplating new strategies of this sort, one source of inspiration for LTIs has come from an unconventional place: sovereign development funds (SDFs). An SDF is a government-​sponsored investment vehicle that has dual objectives; it seeks to realize developmental objectives, while delivering competitive financial performance. Conventional wisdom would suggest that these objectives are contradictory, but some SDFs have been very successful on both counts, delivering high investment returns alongside development objectives. As such, a growing number of governments have taken to setting up SDFs of their own, while traditional LTIs are looking to SDF strategies for inspiration. Over the last 25  years or so, governments have established a variety of for-​profit investment vehicles to take advantage of global economic and financial integration.

64   Sovereign Development Funds These funds, generally referred to as sovereign wealth funds (SWFs), were often set up to absorb the growing resource wealth from the margins of the global economy. SWFs tended to mimic the governance and management practices of large western institutional investors. In doing so, they claimed legitimacy at home and abroad by adopting governance and management practices deemed to be proper in the west, all the while pursuing investment strategies anchored in western financial markets. Prior to the 2008 financial meltdown, it was common to suppose that SWFs could and should model themselves entirely on western financial institutions, such as pension funds (e.g. CalPERS) or endowments (e.g. Yale). In part, the international acceptance of SWFs was owed to their agnosticism over the source of their investment returns—​that is, they were comfortable trading in western financial securities without regard to their origin or their purpose. Underwriting these SWFs’ strategy was often a concomitant commitment to the principles and practices of modern portfolio theory—​that is, investment via large portfolios of traded stocks rank-​ordered in accordance with their relative market value (Merton and Bodie 1995, 2005). With the most recent set of global financial crises, however, a new form of sovereign investment vehicle, the sub-​category of SWFs referred to as SDFs, has emerged as a viable alternative to the traditional western mode of institutional investment. In contrast to a traditional LTI, an SDF holds a more concentrated investment portfolio and tends to invest and hold local, untraded securities and/​or large projects. In this chapter, we suggest that the type of investment strategy pursued by an SDF is more like the strategies of private equity groups (although certainly not the business models of private equity groups) than it is like the widely and globally diversified investment strategies of traditional LTIs. Government sponsors use SDFs as a way to mobilize scarce financial resources, specifically to promote industrial development in a manner that also creates financial profits, and these profits can then be recycled back into the economy. In this respect, the sponsors of SDFs often obtain legitimacy for such organizations not by their links to western models and practices but, rather, by promoting the economic development of their nation-​states and, at the same time, generating high investment performance. Governments typically create SDFs when domestic financial markets are underdeveloped and/​or capital starved. For example, local financial markets may be ‘incomplete’ in that they do not have the range of financial products or intermediaries necessary to sustain economic development or the density of financial intermediaries to ensure effective competition between external providers of financial services (see Staum 2007). The academic literature on the relationship between the financial infrastructure of countries and their economic development trajectories is unequivocal as to the important role that finance plays in facilitating and deepening economic development (see King and Levine 1993a, 1993b; Mayer and Vines 1993). Unlike many western-​inspired SWFs, SDFs are typically more closely aligned with and linked to their government sponsors. That said, they must still operate at arm’s length given the distinctive capabilities and resources needed to be an effective investor. In this respect, SDFs are different from, and have different responsibilities to, more traditional government-​linked investors. Arguably, the biggest challenge facing SDFs relative to traditional financial institutions—​that is, their

Peter Bruce-Clark and Ashby H.B. Monk    65 dual-​objective function—​is also their biggest advantage: they have a license to innovate. Because there are few if any “off the shelf ” products for an SDF to invest in, they are obligated to develop novel skills and expertise. This requirement then helps them justify the development of internal expertise, which, in turn, helps them realize investment returns from proprietary knowledge of local opportunities, privileged access to those opportunities, and trusted relationships with other investors. In other words, the development objective justifies an innovative posture, and it’s this innovation that serves as a source of return underappreciated by broader markets. This chapter has three objectives. First, in keeping with the objectives of this book, we introduce the reader to the world of SDFs, including reference to the driving forces behind their establishment. Second, we focus on their governance and management, illustrating the diversity of SDFs in this regard and also the principles and policies that underwrite the legitimacy of these types of organizations. We draw upon our research program on the design and governance of financial institutions, explicating key insights and implications from the research program for understanding the structure and organization of SDFs (see, for example, Clark and Urwin 2008; Clark, Monk, Orr, and Scott 2011; Dixon and Monk 2012). Third, we develop an analytical framework through which to understand SDFs, recognizing that the theoretical foundations for this framework can be found in our previous work and in the seminal contributions of organization theorists such as March and Simon (1958), Cyert and March (1963), Scott (2008), and more specifically Morrison and Wilhelm (2008). Like a number of economic theorists (see Coval and Moskowitz 1999, 2001; Grossman and Stiglitz 1980), it is assumed that information about investment opportunities is often imperfect and that well-​placed financial agents can take advantage of those asymmetries. We also acknowledge that realizing those advantages depends upon being well managed with respect to both the short term and the long term. While not prescriptive, the authors believe that the governance and management framework developed in this paper can provide academics and policymakers with a deeper understanding of the potential for, and limitations of, SDFs. Our framework is based upon primary and secondary sources, including interviews with leading SDFs and their stakeholders, as well as a series of in-​depth case studies that draw upon publicly available data and non-​public sources of information. These case studies, and an extended commentary on specific SDFs, are available at www.ssrn.com. Finally, it is hoped that our focus on SDFs and their particular circumstances will augment existing research on SWFs and institutional investors broadly. Indeed, the high relative performance of some SDFs may offer inspiration for a whole range of LTIs facing the prospects of anemic market returns combined with high return targets from plan sponsors. In this chapter, we situate the growth and development of SDFs in the context of the rise of SWFs. Thereafter, we explore the increasing significance of SDFs, emphasizing the factors driving the most recent wave of SDF establishment. The following section synthesizes our research on the governance and management of SDFs, which is then followed by a section devoted to the investment management of these funds. The penultimate section of the chapter brings together insights on SDF best practice, while the last section summarizes and identifies a series of challenges that all SDFs face. The chapter

66   Sovereign Development Funds concludes by stressing the importance of certain baseline principles and policies of organizational design and investment management in the success of any SDF. We highlight the finding that any investment institution mandated to achieve objectives above and beyond market returns also requires innovative organizational strategies and management solutions that are tailored to sponsoring countries’ idiosyncrasies.

Emergence of Sovereign Development Funds Most practitioners in the investment management world, and those academics studying the investment industry, are familiar with SWFs (see Dixon and Monk 2011). Weighing in at approximately $6 trillion of the $100 trillion global institutional investor community (Prequin 2015), SWFs are special purpose investment funds or arrangements that are owned by a government. Created by national or sub-​national governments for macroeconomic purposes, SWFs hold, manage, or administer assets to achieve financial objectives. SWFs generally source their capital from balance-​of-​payments surpluses, official foreign currency operations, the proceeds of privatizations, fiscal surpluses, and/​ or the receipts resulting from commodity exports. In the same way that SWFs derive their capital from a variety of sources, they also adopt different investment approaches—​ often related to their intended purpose. Broadly speaking, some SWFs are risk-​averse and short-​term oriented (e.g. stabilization funds), whereas others will consider investing in intergenerational and long-​term assets (e.g. permanent or saving funds). The International Monetary Fund (IMF) categorized SWFs into five broad types according to their purpose (2008). These include: (1) Stabilization Funds, which insulate governments’ budgets against commodity price fluctuations (volatility); (2) Savings Funds, which seek to convert nonrenewable assets (such as hydrocarbons, minerals or metals) into a diversified portfolio of assets that can be held offshore to mitigate the effects of Dutch Disease (see Corden and Neary 1982); (3) Reserve Investment Corporations, which invest excess foreign exchange reserves in riskier assets to bolster the return on reserves; (4) Pension Reserve Funds, which seek to manage contingent pension liabilities on a government’s balance sheet via the investment of budget surpluses in global markets; and (5) Development Funds, which finance socioeconomic projects and promote industrial policies. Sorting these funds by their intended policy-​related purpose is useful, as it underlines the diversity of objectives and hints at the idiosyncratic features of each sub-​class of SWF. So, while most SWFs are, in effect, neo-​mercantilist in operation (Clark, Dixon, and Monk 2013), they reflect in their objectives different operating models. In this regard, SDFs are fundamentally different to the other four types of funds. Although a version of SDFs existed in the late 20th century, namely the national development vehicles of communist governments in the 1970s, it was only in the 21st century that SDFs were recognized as modern development investment vehicles (Dixon

Peter Bruce-Clark and Ashby H.B. Monk    67 and Monk 2014). In addition to pre-​existing funds, which were restructured at the turn of the century—​such as Singapore’s Temasek or Malaysia’s Khazanah—​SDF creation has significantly increased since the global financial crisis. How can we account for the recent emergence of SDFs, and why should one pay attention to their investment activity? Clearly one could point to resource over-​dependency and industrial under-​ development, either in combination or isolation, as key drivers for countries to establish SDFs. Another explanation, however, is that Western banks and related financial institutions reined in their global presence after the financial crisis, leading national governments to turn to SDFs as a way to fill financing gaps. Unlike western economies, which view themselves as “developed” countries with existing SDFs, or those intending to establish SDFs, do so within the context of broader economic development policies (see case studies at www.ssrn.com). While western governments continue to implement short-​term austerity measures consistent with liberal economic concepts and measures, whereby the role of the government is limited and fiscally constrained, they also present themselves as unwilling to invest in their domestic economies for the long term. Against this, countries that believe in a higher level of state control and intervention—​such as China, Singapore, and Malaysia—​have long term economic development agendas. These agendas are geared to realize long term economic growth (e.g. greater employment, income, and innovation), and are set forth by proactive policies which encourage perpetual investment in their economies. Created by way of government legislation, SDFs are evidently economic development policy tools and part and parcel of long-​term economic initiatives. An SDF that exemplifies this commitment to economic development is Malaysia’s Khazanah Nasional Berhad (“Khazanah” or the “Fund”). Established originally in 1993 to hold state-​owned and structurally significant Malaysian companies, the Fund was transformed into an active development investment vehicle in 2004. Its objective was to assist in Malaysia’s plan to become a developed, self-​sufficient, and globally competitive country by 2020. As a strategic and tactical investor, Khazanah’s goal was and is to help graduate state-​owned companies into globally competitive private ones that are moving toward partial or full public offerings. To do this, Khazanah provides its investees with governance and management assistance, as well as access to resources and capabilities at the Fund’s disposal. In this way, Khazanah is a catalytic policy tool designed to assist the Malaysian economy’s transition from an emerging capitalist nation to a developed, globally competitive society, while participating in the (often lucrative) financial upside of economic development.

Sovereign Development Funds—​ Governance and Management In this section, we consider the governance and management of some of our SDF case studies, highlighting similarities and differences on issues such as legal status, board

68   Sovereign Development Funds structure, oversight, objectives, and investment management. Understanding what is distinctive about each fund, and what is shared among funds, is an essential step in producing the principles and policies underpinning the governance and management of these types of sovereign funds. SDFs are typically sponsored by their nation-​states. But there are exceptions (see Table 3.1). For example, the Russian Direct Investment Fund (RDIF) is wholly owned by Russia’s State Development Bank. Singapore’s Temasek Holdings is sponsored by the Ministry of Finance, as is South Africa’s Public Investment Corporation. This is, perhaps, a subtle distinction more about form than function (Dixon and Monk 2012). However, if the Ministry of Finance is the sponsor of a fund rather than the government per se, it is likely that its development activities are subject to ministry requirements rather than having a broad range of unrestricted activities. We have shown elsewhere that finance ministries tend to narrow the scope of public investment institutions, containing rather than allowing these organizations discretion in their chosen range of commitments (including asset classes). It is evident from Table 3.1 that there are differences between SDFs in relation to their legal status. While most are state-​owned companies (e.g. Bahrain, Brazil, and Venezuela), the Malaysian SDF is a public limited company that is entirely self-​financing. Being a public limited company, the Malaysian SDF has an unconventional eleven-​ member board of directors comprised of representatives from public and private sectors as well as the Minister of Finance, and is chaired by the Prime Minister. Oversight is subject to company law rather than to a government department or even the assembly. In many cases, the sponsor (government) appoints board members—​sometimes directly by the Prime Minister (as in Vietnam)—​with a mix of government officials and independent board members. Often, the executive directors of a fund cannot claim a place on their board. Typically, boards have nine members, mimicking best practice in the private sector around the world (see Clark and Urwin 2008 for more details). But there are exceptions outside of Khazanah. For example, the Palestine Investment Fund (PIF), which is sponsored by the Ministry of Finance, has a board with 11 members appointed by the President reporting to the General Assembly. Here, it is reasonable to suppose that the governance structure of the PIF is tilted toward representation as opposed to expertise (Clark 2008). In some cases, the board is accountable to a government audit office (as in Bahrain), or is subject to a government agency (as is the case with South Africa’s Financial Services Board). Among SDFs, management of teams tends to follow global best practice, with some exceptions. Often, the managing director is the fund official charged with overseeing and directing the activities of other senior fund officials, including investment managers and operations employees. A case in point is Malaysia’s Khazanah, where the managing director of the fund has a place on the board and is responsible for 18 executive directors over a wide range of responsibilities. In other cases, the managing director reports directly to the board. It is more common, however, for the managing director to chair a small management executive committee, which is responsible for the day-​to-​day activities of the fund, including the framing and implementation of investment strategy,

Table 3.1 Governance and Management

Legal Status

Objectives

Source of Assets [*>15%; **>25% of investments]

69

Established

Sponsor

BAHRAIN Mumtalakat

Government of State-​owned Bahrain independent holding company

2006 *BoD—​ultimate decision-​making body; *National Audit Office of Bahrain & Tender Board of Bahrain

Nine members (key public & private sector figures). Prime minister chairs the board.

Select nominees for portfolio company directorship; daily activities.

Grow wealth of the country by diversifying the economy, improving CSR and transparency, and promoting young generations and entrepreneurship.

Aluminum production, financial services, telecommunications, real estate, tourism, transportation & food production (38 companies).

BRAZIL Brazilian Development Fund

Government of Independent Brazil; becomes state-​owned state owned in company 1971

1952 *Board—​senior governing body; *Under review of Brazil’s Central Bank & National Monetary Council

Ten board members; all appointed by the President of the Republic.

Seven Managing Directors head the operational departments.

Foster sustainable development, by stimulating export of local goods and services, while reducing domestic inequality by generating higher income.

Infrastructure (incl. energy)**, industry*, services*, telecommunications, agriculture & cattle raising. Ban: banking, weapons, adult establishments.

CHINA China-​ASEAN Investment Cooperation Fund

Export and Import Bank; China Investment Corporation; IFC;

2009 *China State Council; *IFC as General Partner: mitigate risk; influence & review strategy

No evidence of a Board. Under the direction of the China State Council.

CEO oversees investment + admin and finance teams.

Support commercially viable projects in ASEAN through social and environmental investments to improve the living standards of Chinese people.

Infrastructure, energy (conventional + renewables), natural resources, nine partnerships across South-​East Asia

Close-​end private equity fund

Oversight

Status of Board Structure Managers

(Continued)

70

Table 3.1 (Continued)

Legal Status

Objectives

Source of Assets [*>15%; **>25% of investments]

Drive the country’s economic development agenda by overseeing key state-​owned enterprises and focus on new sectors.

Telecommunication**, financial services*, infrastructure*. Since 2008: health care, tourism, renewable energy.

Established

Sponsor

MALAYSIA Khazanah Nasional

Government of Public limited Malaysia company

1993 Board of Directors oversees activities and strategy

Nine members (public and private sectors). Prime Minister chairs the board.

PALESTINE Palestine Investment Fund

Palestinian Ministry of Finance

2003 Board of directors: oversees strategy; *General Assembly: ultimate supervisory & guiding authority

Eleven members Executive appointed by management the President. oversees daily operations.

Revitalize the economy by fueling job creation to reduce poverty and unemployment while delivering long-​term returns.

Capital market**, real estate*, large caps*, infrastructure, treasure, medium & small enterprise. 84% in Palestine region.

UAE Mubadala

Government of Public joint Abu Dhabi stock company

2002 Board of directors: direction and strategy; oversees the management team.

Seven members; Crown Prince of Abu Dhabi chairs the board.

Oversees operational & business development.

Strengthen AD growth potential by diversifying the economy (away from O&G), fostering social development and achieving strong returns.

Semiconductors**, infrastructure & real estate, financial services, aerospace, TCT, oil & gas, renewables.

RUSSIA Russian Direct Investment Fund

Government of Government 2011 Supervisory Russia (owned investment fund Board (SB) by Russian oversees strategic State Bank) governance.

SB of 10 members incl. Chairman of VEB, RDFI’s sponsor, the CEO of RDIF & others.

CEO, COO, 7 directors & 2 advisors overseeing day-​to-​day operations.

Modernize the Russian economy through innovation & investment in primarily domestic private equity. Maximize ROI & boost FDI.

Large amount of foreign capital through partnerships (CIC, Mubadala, Japan Bank, Kuwait Investment Authority, State banks).

Private equity and venture capital firm

Oversight

Status of Board Structure Managers Managing Director oversees 14 executive directors.

SINGAPORE Temasek Holdings

Singapore Ministry of Finance (only stakeholder)

Commercial investment company: independent from 1974

1974 Board of directors manages assets & directs management; Audit Committee (reviews reporting, audit & monitoring to ensure legal compliance

Thirteen members, mostly non-​ executive; appointed by Ministry of Finance.

Drive execution & delivery. Implements strategy & policy direction set by board of directors.

Underwrite economic development by seeding enterprise. Launch an aggressive international investment policy while improving domestic infrastructure. Grow middle income population.

Sectors: 31% majority financial services, telecommunications, real estate, transport, energy and industry; 58% to mature economies; 42% growth regions.

SOUTH AFRICA Public Investment Corporation

South African Government (Ministry of Finance main shareholder)

Government owned investment manager: corporation from 2004

1911 Board manages the fund, directs overall risk policy. Environmental, Social & Governance Working Committee closely monitors the ESG issues in investment.

Ten members, including 7 non-​executive directors oversee permanent committees. Appointed by Ministry of Finance.

75% internal; 25% external. Concentrate on active asset management. Investments are approved by Financial Services Board.

Asset manager that invests only on behalf of public entities. Maximize returns in line with client mandate, and contribute positively to SA development. Good corporate governance.

Focus on economic infrastructure; clean energy & environment; social development (incl. housing, education, and healthcare); agriculture; tourism. [Note: Invests 89% to Government Employee Pension Fund]

SWEDEN AP6

Swedish Government

State owned private equity fund

1996 Board of directors responsible for the business. There are four committees. *Government performs an annual evaluation of operations.

Board (5 directors, chairman & deputy) + Audit & Remuneration Committees → Managing Director

Managing Director & senior management oversee & monitor operation of core business.

Manage risk and invest in Swedish private equity through a focus on mature companies with growth potential in the Nordic region + N. Europe.

Active and passive investment in 40% companies; 28% funds; 32% liquidity.

(Continued)

71

72

Table 3.1 (Continued)

Established

Sponsor

Legal Status

VENEZUELA FONDEN

Presidential, national development fund

State owned company

VIETNAM State Capital Investment Corporation

Government of Largely Vietnam autonomous with oversight from FM

Oversight

Status of Board Structure Managers

2005 Entire FONDEN structure subordinated to the national executive power (minimal accountability for investment strategy)

Board of directors: 4 members (Minster of Finance, Minister of Oil and Mines and 2 others-​ appointed by the President).

Second level, led by Executive & Secretary + 2 “expert” managers appointed by 4 directors. General manager oversees 6 deptartments.

*Promote socialism by investing in major infrastructure & social projects; *finance, social and community projects; *improve external debt profile by the emission of financial guarantees *create a “multipolar” world.

Oil windfall profits & energy (31%); transportation & Communications (18%); defense (12%); energy agreements with Cuba (8%); power generation, housing, agriculture, & mining (30%). [Funding from VCB + Venez. National oil company].

2006 Ministry of Finance & Prime Minister appoint General Director.

Board of directors and Prime Minister. General Director & Oversees Board of Management.

Board of management oversees 14 management sub-​departments.

Improve the operational capacity & competitiveness of state-​invested enterprises; generating maximum returns sustainably.

Manufacturing (40%); 407 portfolio companies in IT, healthcare, consumer goods, financial services.

No asterisk: opaque (no report or very limited info) * fairly transparent (annual reports available but lack key information and metrics) ** Information available and complete.

Objectives

Source of Assets [*>15%; **>25% of investments]

Table 3.2 Investment Strategy Strategy

% In/​ Outsource

Public vs. Private Markets

(Intended) Development Effect

Infrastructure

Venture Capital

Rate of Return

73

BAHRAIN Mumtalakat *

Diversification beyond oil and gas, and across sectors. Establishing Bahrain as a hub for financial services. Prefers investing in domestic business opportunities with global strategies.

Direct equity investments: 96.5%; third party managed funds: 3.5%

Mumtalakat has historically focused on private equity projects with aims to diversify into stocks and bonds. No evidence of investment in public markets.

Mumtalakat aligned with Bahrain’s Economic Vision for 2013—​focus on sustainability, competitiveness & fairness.

*100% ownership of N/​A Gulf Air—​connects Bahrain to key European financial centers *$22B (2014) infrastructure project to increase airport capacity from 9m to 14m passengers.

RoR N/​A In 2014 Group revenue rose 11% from 2013

BRAZIL BNDES *

Focused around innovation, local and environmental development, by following a regional decentralization strategy.

N/​A

About 70% of total assets in credit; 13% corporate shares; 11% bonds (public bonds and debentures); and 6% other assets

* Historical focus on industry and infrastructure; *R$19.5B in social development (2013); R$24.4B Green Economy [out of R$190B]

33% of disbursement ($20BUSD) planned for 2015 to infrastructure. Focus on urban mobility (metro etc.), ports and railways.

BNDES largest investor in VC in Brazil (100 SME); yet 65% of funds go to larger companies.

RoR N/​A 2009–​2012: Net Income CAGR of 6.7%

CHINA CAF

Enhance connectivity, N/​A economic co-​ operation & catalyze investment into the ASEAN region. *Preference for co-​ investment through equity DI with a minority stake.

Private sector has a role to play in filling in gaps in the Government’s public education scheme; this will increase the private sector’s capacity to recruit a capable workforce.

CAF hopes to raise UD$10 billion to invest in ASEAN countries. *The EXIM Bank will anchor the CAF with a seed investment of $300 mil. *Pledged $480 mil. to help fight poverty in SE Asia.

*Part of Chinese strategy to invest in infrastructure (e.g. $40B Silk Road Fund); *China pledged $20B loans to SEA for regional infrastructure development.

*Claims to provide emerging companies with seed capital (but no metrics available).

CAF very opaque on performance metrics.

(Continued)

74

Table 3.2 (Continued) Strategy

% In/​ Outsource

Public vs. Private Markets

(Intended) Development Effect

Infrastructure

Venture Capital

Rate of Return

MALAYSIA KN **

Primarily acquires equity stakes in Malaysian companies. KN directly buys large tranches of shares to control the management. A focus on innovation with commitment to CSR.

Strong national focus on out-​ sourcing, but under growing criticism.

* Fund buys large strategic equity stakes instead of debt instruments. *Focus on GLCs, rarely on private equities (most holdings are publicly listed).

*KN founded to drive the country’s economic development. *Public education to maintain private sector ability to recruit a capable workforce. *Issued world’s first ringgit SRI sukuk.

*High on mandate. Infrastructure: 21.6% *Portfolio companies: PLUS, is the largest highway operator in country + UEM is Malaysia’s leading infrastructure service group.

Compared to other countries in SEA such as Singapore, Malaysia is not a hub for VC in the region.

TSR (under GLC program): growing 12.6% per year.

PALESTINE PIF **

Focus on micro-, small- and mediumsized enterprises. The fund invests in the public equity & fixed income. It takes both direct majority & minority stakes in its portfolio companies.

Managed directly by PIF, by one of its subsidiaries, or by partners or co-​investors.

Public Equity: $278M, about 87.6% of investment in capital markets. Private Equity: $281M; Fixed Income $90M; Bonds & Loans: $26M; Other: $91M

*The largest and most dynamic investor in Palestine. *Has created 1.2M working days in the construction sector, and over 10,500 jobs through its Loan Guarantee Facility.

Infrastructure Portfolio: $178.2M (about 20% of investments). Increased stake in Gaza Marine field to 17.5%; to 39.6% in the Palestine Power Generation Company.

Sharakat Investment Fund managed by PIF to invest in MSMEs. Committed $5.5M in start-​ up funds.

*Ten-​ year return estimated at 10.3% *2014 net income: $36.7M

RUSSIA RDIF

RDIF (value $13B) N/​A co-​invests up to 50% of investment with premier funds that have more than $1bn of assets under management. *Funnel FDI while employing Russian citizens.

$10B private equity fund established by Government. RDIF & partners have invested $4bn into leading Russian companies. *RDIF partnered CIC to create the $4B Russia-​ China I.F.

Grow middle class to increase economic development. *Substitute imports & radically increase efficiency of Russian producers to develop income per capita. Prioritize infrastructure in preparation for W/​C.

*$2B partnership with Mubadala—​set to allocate $5B for infrastructure projects. *13 infrastructure projects in the next few years. *RUB165-400b(rb) invested in high-​tech infrastructure projects.

$200m v/​c fund with Chinese on Skolkovo foundation: Russia’s Silicon valley producing high-​tech. robotics.

The current CEO that RDIF returned 23% on the Moscow Stock Exchange.

75

SINGAPORE Temasek *

Invests primarily in Asia, but an increasing focus on Europe & Americas. Growing interests on mid-​sized cities which are expected to deliver 40% of global growth by 2015.

Less than 10% of portfolio invested in third party managed funds 14.8%

Temasek manages mostly equity investments; about 70% in listed securities, and the rest in private companies. Heavy focus on financial services.

*Strong focus on health and life sciences. $1B investment in Gilead Sciences. The Temasek Emergency Preparedness Fund ($40M) to support communities facing emergencies & trauma.

Supports the amalgamation of City Spring Infrastructure Trust & Keppel Infrastructure Trust to create the largest Singapore infrastructure focused business trust.

Invested since 1988 in 350 start-​ups, primary fund capital to VC and PE funds in US, Europe, Asia; total: US$1.2B.

TSR of 1.5% in 2014; 9% over 10 years; 16% since inception 1974.

SOUTH AFRICA PIF *

Fixed income investments & money markets. *Support black asset managers in Black Economic. Empowerment initiative.

75% equity portfolio is managed in-​ house. 25% is managed by external asset managers.

49% is invested in local equities, 32.4% in local bonds, 7% in cash and money-​market instruments, 4.4% in properties and 5.4% in off-​shore equity & bonds.

2014: Approved R11.4B worth of unlisted companies creating >7805 jobs & sustaining 77,000 jobs. *Est. 2 funds & will invest $1B in projects outside of SA incl. $213M in 2015.

$435M committed to economic infrastructure. *Since 1995 R3.8B was invested in transport & logistics, rail, water, ICT/​broadband and energy resources. *R2.5B retail developments.

Lending to small & micro businesses via private equity.

Fund’s overall return 2014: 14.8% [AR 2014].

SWEDEN AP6 **

Specializes in unlisted companies; directly through private placements or indirectly through GP-​LP fund structure. Clear focus in the *Nordic Region in a shift away from V/​C to mature companies.

46% of SEK managed internally; 27% outsourced

Company investments (46%); Funds (27%); Liquidity (27%) *No investment into public markets.

Gradual recovery since the Global Recession. *Development of the private equity sector.

In 2014: infrastructure SEK 196M; 16% of fund investment. *Limited commitment as AP6 is one of many government pension funds which specialize in infrastructure.

Total venture capital (8.2%) funds. 10%. indirect. 2014: 6% direct companies DI in VC disappeared from Fund strategy ~2011

6.5% (2014); Average return during past 10 years: 5.4% (AR 2014).

(Continued)

76

Table 3.2 (Continued) Strategy

% In/​ Outsource

Public vs. Private Markets

(Intended) Development Effect

Infrastructure

Venture Capital

Rate of Return

UAE Mubadala *

Diversification away from oil. Focus on high tech, green infrastructure investments in emerging markets.

N/​A

Management of a capital to deploy across a range of public & private market opportunities.

Aims to become the world’s largest semi-​conductor manufacturer by 2030.

*7% of portfolio with N/​A projects like UAE Uni, Paris-​Sorbonne Uni * Mubadala Infrastructure private equity fund

Returns negative 2009–​12. 2012: 6.7% & rising.

VENEZUELA FONDEN

Funds are delivered to projects either directly or through a series of bilateral funds that the government has created with China, Libya, Belarus.

Executive power as the sole decision-​maker for spending of the money.

Very limited information available. There was a list of projects on the FONDEN website (with a $30B gap), but the website has been shut in 2011.

Fund initially created to finance productive, social and community projects. A way to leverage the nation’s sustainable economic growth. But no information on how money is spent.

Focus on social and major infrastructure projects. Between 2005 and 2011 $40B allocated to social and infrastructure projects across the nation.

N/​A

N/​A

VIETNAM SCIC

Short-​term focus on ongoing equitization program (transfer from public to private); Long-​ term: increased investing in domestic oversees businesses.

Mostly in-​sourced SCIC portfolio consists by government-​ of mostly state-​owned led management enterprises. teams.

N/​A

N/​A

Portfolio consists of mostly SMEs. 71% of enterprises with capital of less than US$1.1M.

2013 revenue VND 4.9B; After-​tax profit: VND 34.3B

No asterisk: opaque (no report or very limited info) * fairly transparent (annual reports available but lack key information and metrics) ** Information available and complete.

Peter Bruce-Clark and Ashby H.B. Monk    77 management of the investment team and its external partners, and sustaining the operational services of the fund consistent with its objectives. As in other investment institutions, clarity as to the responsibilities of boards in relation to senior managers and the delegated authorities is essential for a well-​managed fund (Clark and Urwin 2008). Another key component of a well-​managed investment fund is clarity about objectives and performance targets (Clark and Urwin 2008). For SDFs, however, a simple performance target, such as a rate of return on investment, is perhaps less important than a set of coherent development objectives that can be translated into clear investment policies and strategies. With respect to our case studies, it was found that SDFs tend to have three types of objectives: those that can be best understood as representing the “mandate” of the fund, those that have a sectorial or regional focus, and those that emphasize certain functional objectives in realizing the fund’s mandate. For instance, the mandate of a fund can be conceived as its overarching charter (top tier), the focus of the fund can be conceived of as its domain of operation (middle tier), and its functional performance can be conceived of in terms of how it goes about realizing its charter in accordance with its domain of operation (lowest tier). To provide an example, the Brazilian development fund’s mandate is to foster sustainable development (top tier), in part by stimulating the export of locally produced goods and services (middle tier), while reducing domestic inequality by generating higher income and employment (lowest tier). In a similar manner, Bahrain’s Mumtalakat has a mandate to sustain economic growth and national wealth, in part by diversifying the economy, and facilitating the socioeconomic development of younger generations. It is arguable that this tiered mode of setting objectives, along with encouraging investments in certain types of activities and/​or sectors, adds considerable complexity.1 One would also naturally expect these tiers to create difficulties in reconciling the types of objectives, even if they were all equally desirable. We return to this issue in the section devoted to best practice SDFs. However, these objectives need not add complexity or confusion if their articulation is deliberately conceived so as to ensure there is a recognized hierarchy or priority attached to each. Moreover, the addition of a secondary or even tertiary mandate affords a well governed and managed investment organization with room to be innovative and dynamic in pursuit of the additional objectives. Given the importance of innovation in long-​term investment outperformance, this seems to be—​with the right governance—​an important competitive advantage for SDFs. As an example, Singapore’s Temasek Holdings combines commitment to wealth creation over wealth preservation with the explicit goal of deepening Singapore’s competitive advantage in the international economy. A by-​product of success, in this respect, would be the realization of the government’s objectives of sustaining the real income growth of the nation-​state’s population. Perhaps the strongest fund mandate is to be found in the RDIF, which emphasizes maximizing the rate of 1  This issue—​efficiency consequences of multiple objectives and the resulting complexity —​is widely discussed in the economics and management literature on the theory of the firm. For instance, see Jensen (2000) and Spulber (2009).

78   Sovereign Development Funds return while modernizing Russia’s economy. There are few SDFs that have objectives as clear and simple as pension funds or endowments but, again, we see this flexibility as a potential source of strength. Less narrowly defined objectives actually serve to empower SDFs to take a path less travelled in the pursuit of returns and development. And it is precisely on that path that is less travelled that innovative and profitable strategies are developed and implemented.

Sovereign Development Funds: Investment Strategy and Management In the previous section, we provided a comparative assessment of the governance and management of certain SDFs, emphasizing both the formal arrangements of these financial institutions and the ways in which responsibilities are distributed within these organizations. There are roughly three groups of SDFs: those that were established in the 1970s and earlier, those that were brought into being through the 1980s and 1990s, and those that were established more recently. We should also acknowledge that SDFs come from countries that vary by their level of development, their reliance on resource wealth, and their objectives for growth. In these ways, SDFs inevitably reflect the development trajectories of their host countries and government sponsors. In this section, we look more closely at SDFs’ investment strategies and management, emphasizing commonalities and differences. To summarize the findings from our case studies, Table 3.2 provides an overview of SDFs’ investment strategies and management. Where possible, we have provided a summary of the strategy, the intended development effect, the reliance on public and/​or private markets, and the nature and scope of the underlying (for instance, infrastructure or venture capital). We have also sought data on investment performance and rate of return targets. In some cases, the former is provided albeit in limited detail. The latter is more difficult to determine, in part because a summary rate of return target could be quite misleading in terms of the various goals and objectives of an SDF as well as the short-​ run volatility of long-​term returns. As we indicated above, some SDFs have a set of goals and objectives not easily reducible to a single number or, indeed, a specific time horizon. This is one way of distinguishing a traditional institutional investor from an SDF. For example, the South African PIC operates in a relatively sophisticated financial environment, combining portfolio investment with direct placements, and a mix of internal and external management of the investment process. Here, though, the PIC has an explicit development mandate with investments in the energy, transportation, and logistics sectors; all investments are aimed at enriching the infrastructure of the South African economy. Furthermore, with a mandate to sustain black economic empowerment, direct placements and infrastructure investments are evaluated at two levels: for their financial returns and for their social returns (particularly job creation).

Peter Bruce-Clark and Ashby H.B. Monk    79 At the other end of the spectrum, both Bahrain’s Mumtalakat and Abu Dhabi’s Mubadala have the structural transformation of their host economies as a key objective. Being resource rich, resource dependent, and vulnerable to resource depletion over the long term, it is not surprising that the sponsors of SDFs, in these circumstances, often frame their investment strategies in terms of industrial diversification. Having the advantage of significant capital inflows in exchange for resource exports, which is unusual by contrast to developing countries, these financial institutions are charged with translating export earnings into sustainable development. This may include catalyzing new industries (for instance, from oil and gas to tourism and intellectual capital) and investment in key assets, whether infrastructure, transport, or related facilities. In doing so, these types of institutions tend to take large stakes in such ventures (public, private or something in-​between). For example, Mumtalakat has a significant stake in Gulf Air and in the transport network that links Bahrain with Europe. It seems clear based on our research that SDFs are much more likely to think about sustainability and, indeed, the connection of their fund to the underlying economy, if it reaps returns from and catalyzes returns within. Most institutional investors fail to link their wellbeing to that of their ecosystem; SDFs, for most part, have this as a core objective. To be sure, sustainability can be conceived in a variety of ways. For illustration, it could refer to economic development that provides a steady flow of jobs for younger citizens. Alternatively, it could also refer to the type of development that bridges resource dependency with the industrial exploitation of resource endowments. Moreover, it could also refer to economic development that sustains the local environment and the lives of indigenous people (e.g. the Brazilian Development Bank). For the Gulf States, sustainable economic development often implies long-​term investment in alternative sources of energy. In the Russian case, RDIF’s investment strategy is framed in terms of facilitating foreign direct investment in Russian resources via co-​investment deals with large global investors. Here, of course, the Russian state is very close to any significant deal with a foreign investor. Not surprisingly, the governance and management of the RDIF is intimately related to its investment strategy and the management of investment projects with foreign partners. In between, there are SDFs like the Malaysian and Singaporean funds, which are the investment and development agencies of government, largely focused on portfolios of investments where they are able to give effect to long-​term strategic goals. Indeed, in the Malaysian case, Khazanah is deeply embedded in the national economy with significant stakes in key sectors, including media and communications, energy, financial services and health services. This fund has a broad range of activities, such as underwriting the competitiveness of Malaysian companies, investing in crucial infrastructure (including public education and transportation), and facilitating the development of the local venture capital industry along with positioning Malaysia as a globally significant Islamic finance hub. In a similar manner, Temasek has sought to underwrite the economic development of Singapore by seeding enterprise, seeding new industries and sectors, investing in infrastructure, and providing platforms for new ventures. That said, Temasek is also an international investor, with a broad portfolio of holdings by sectors

80   Sovereign Development Funds and countries designed to enhance returns, encourage the regional or global extension of their holdings, or a combination of both.

Models of Sovereign Development Fund Operation and Investment The difference between SWFs and SDFs mirrors the distinction between adopting a portfolio or “wealth appreciation” investment strategy as opposed to a “wealth creation” strategy. A wealth appreciation investment strategy is where an investor holds many small stakes in a diversified portfolio of public and private assets characterized by varying degrees of risk and return expectations. This type of strategy is predicated on the belief that holding fairly liquid assets, with a high level of portfolio diversification, will generate financial performance in line with long-​term expectations (Litterman and Goldman Sachs Asset Management 2004). Whether these strategies generate returns above market benchmarks over the long run remains doubtful, as most liquid assets tend to be situated in public markets and are easily accessible to a wide range of investors. Nonetheless, stabilization and savings funds, reserve investment corporations, and most pension reserve funds tend to invest in this way, with modest allocations to private equity and private infrastructure placements. In contrast, SDFs that are managed well and perform well act as wealth creators rather than wealth appreciators. Wealth creation consists of catalyzing new enterprises and industries or driving efficiency and innovation in older industries, or infrastructure or real estate projects that contribute to the dynamism of an economy. This is a strategy employed by some private equity firms and it is the modus operandi of the venture capital industry. These investors usually make large, direct, and strategic investments. Here their internal capabilities and that of the partners they work with are part and parcel of identifying and realizing promising opportunities, and ultimately higher returns. These investors take an active role in their investments, involving themselves in strategic decisions through, for example, board-​level positions and oversight of management. In contrast to a conventional diversified portfolio investment strategy, a wealth creation strategy requires large stakes in a concentrated number of investments, given the necessary time and input required to realize long-​term market-​beating returns. Successful SDFs operate in a fashion comparable to private sector funds and partnerships. Nonetheless, SDFs are fundamentally different from these cognate organizations in the private sector and other LTIs. SDFs have a dual mandate, which underwrites their political legitimacy. They must not generate financial returns from their investments that can be benchmarked against the market and they must contribute to the economic development of the region or country that sponsors them. In effect, SDFs must deliver a double bottom line: risk-​adjusted financial returns consistent with market expectations, and evidence of a contribution to economic growth and development. Otherwise, the

Peter Bruce-Clark and Ashby H.B. Monk    81 sponsor would be better off returning capital to taxpayers or some other agent to invest in private-​sector wealth creators, or allocating capital through a different channel; for example, conventional government spending and investment). These imperatives are expressed in the legal, governance, and management frameworks that shape the mission, mandate, and capabilities of the SDF. Successful SDFs are designed to match their ambitions. As such, SDFs differ significantly in their investment operations when compared to conventional SWFs and institutional investors more generally. It appears the best SDFs essentially seek to harness economic forces to maximize certain impacts beyond financial markets (in this case, development objectives). In this regard, high returns on investment are actually a key input in driving successful developmental outcomes. However, since development objectives change as the economies in which SDFs are situated grow and mature, the role of SDFs may also change over time. The implication of dynamically changing developmental landscapes and objectives means that SDFs must necessarily be built for innovation and evolution. In other words, the way an SDF operates—​organizationally in and through the investment process—​should be dependent on the state of the economy and industrial base within which it participates. Given the imperative of wealth creation, SDFs must rely on more than conventional portfolio management tools. Indeed, it appears that best-​in-​class SDF leverage is what Bachher, Dixon, and Monk (forthcoming) describe as “structural alpha” in their discussion of the venture capital industry. They argue that “while conventional wisdom holds that top performing venture capital (VC) firms benefit from exceptional talent and cutting-​edge knowledge, this alone does not wholly account for their long-​term success. The best VCs benefit from structural advantages that are developed over time: small differences in investment capabilities and resources produce cumulative advantages that are particularly meaningful over time. These advantages come from the identification of, and capitalization on, ‘positive feedback control loops’ that reinforce their advantages in relation to other firms. In other words, private investors cultivate sources of private information that they alone are able to exploit over the longer-​term.”2 In the same way that the best private market investors cultivate and capture structural alpha, so too do top performing SDFs. For example, the best SDFs manage to identify and capitalize on a local knowledge of the opportunities that could exist within their markets and industries. Sovereign funds that operate as wealth creators have to be particularly skilled in this domain. Similarly, the internal capabilities and control of the investment process, which top SDFs require to operate in nascent and capital starved markets, allows for sovereigns to re-​align interests with service providers and co-​investors. Indeed, these new capabilities and controls help SDFs set new terms with their counterparties. SDFs are thus often better able to achieve an alignment of interest with their investment partners. Moreover, investing patiently with internal capabilities 2  For more information on the venture capital industry, structural alpha, and the advantages of firms that take advantage of their capabilities and resources, see Ashby Monk’s Mortal Inspiration from the Gods of Venture Capital (2014) published in Institutional Investor.

82   Sovereign Development Funds

LINK TO NATIONAL ENDOWMENTS & ADVANTAGES

OPERATIVE OBJECTIVES

Reinforcing Professionalizing and reorganizing the existing SOEs and national champions for success

Crowding-In TIGHT

STRATEGIC

COMMERCIAL

Financialization

Catalytic Diversifying old industries by seeding new ones

Through credible commercial focus, attract foreign investors into domestic industries

LOOSE

Through credible commercial focus, bring discipline and commerciality to domestic industries

Figure 3.1  Sovereign development fund types Source: SDF Categories—​Baccher, Dixon, Monk (2016).

in local assets can allow for a variety of ‘synergetic’ returns, which emerge from property developments around other investments, such as infrastructure.3 Given our research, Figure 3.1 provides an analytical framework to better understand the ways in which SDFs may operate. This framework is based upon Chesbrough (2002) who was concerned with venture capital funds in western economies (principally the US). It is arguable that the world of private equity is so different from the world of SDFs that it is irrelevant or worse (a gross distortion of SDFs). While we accept the argument that the legal and institution forms of various types of financial institutions vary by country and by goals and objectives, it is important to go beyond a preoccupation with form. Like Dixon and Monk (2014), we would suggest financial functions and their organizational instantiation are as important as the form of an organization. It is essential, of course, not to collapse form into function: in previous sections we argued that the formal arrangement of SDFs can make a difference to their effectiveness (compare Crane et al. 2008). 3  A single investment in a single asset may not pencil in terms of internal rate of return, but if that investment also serves as a catalyst for a new ecosystem from which many opportunities arise, the SDF can be well positioned for outperformance.

Peter Bruce-Clark and Ashby H.B. Monk    83 The matrix in Figure 3.1 situates SDFs on two axes. The horizontal axis ranges from strategic to commercial in relation to investment objectives. Keep in mind that commercial organizations do not need to perform better than strategic organizations. Rather, it is a function of whether the market or the state is defining the agenda. Within these two axes, we provide four quadrants that describe the different ways in which SDFs operate in order to maximize performance. Although these have been situated in terms of distinct investment operations, this does not signify that an SDF must adopt one strategy. To be sure, many of the most successful SDFs employ several strategies. These four operational strategies are described below (and in more detail in Baccher, Dixon, and Monk 2016): 1. Reinforcing: For states in possession of underperforming assets (e.g. companies, infrastructure, or other real assets), an SDF can take responsibility for reorganizing, professionalizing and innovating the state holdings so as to drive commercialization and higher returns. 2. Crowding-​In:  SDFs participating in emerging domestic industries will enjoy higher financial and developmental returns if other (generally foreign) private and public investors also commit capital to those industries. For this reason it is important for SDFs to be deemed credible commercial investors. 3. Catalytic:  Sponsors can use SDFs to diversify the economy away from those industries that are either no longer profitable or sustainable over the long term. These SDFs can fill “white space” in an economy by providing answers to (and investments around) the question, “What’s missing from this ecosystem that will undoubtedly be here in ten years?” 4. Financialization: By virtue of the strong internal capabilities and deep resources, an SDF can help deepen the financial infrastructure of an economy, thereby underwriting the development process simply through the growth of the capital market and the emergence of new financial intermediaries.

Conclusion Sovereign wealth funds take various forms, have various purposes, and implement diverse investment strategies. Prior to the global financial crisis, the notional “standard” model of an SWF was of a sovereign-​sponsored organization whose assets were deployed through a portfolio of securities traded on global stock markets. This model provided a recipe for investment, based on the principles of modern portfolio theory (Merton and Bodie 2005). It also provided a means of neutralizing possible political tensions at home and abroad as regards the potential power of an SWF, should it take a controlling stake in significant public and private assets—​spreading assets across a wide range of asset classes and asset-​specific securities almost always means that the institution is a minority investor rather than a controlling investor. The standard model also

84   Sovereign Development Funds sought to take advantage of the apparent robustness and depth of liquidity associated with western financial markets. Notwithstanding the claimed virtues associated with the standard model of an SWF, another kind of sovereign investment institution was being developed which sought to mobilize the assets of nation-​state sponsors in favor of national economic development and growth. These investment institutions are strategic investors in that they seek to take advantage of local knowledge, opportunities, and their intimate relationships with public institutions and private organizations. At one level, SDFs are not “new” in the sense of being a break with the past; their contemporary significance represents the re-​ emergence of a type of state-​sponsored organization that can be found through the 19th and 20th centuries. Notice, however, SDFs make claims for legitimacy in ways quite different to that of the standard SWF—​being strategic investors, the best performing SDFs have a level of internal expertise and organizational capacity that few other domestic institutions (public or private) can match. In the aftermath of the global financial crisis, the slowing of the global economy, and recurrent episodes of stock market volatility in the west, it would seem than SDFs have come into their own. Many types of institutional investors have come to recognize that the principles of modern portfolio theory may not be as robust as supposed, given the existence of systemic instability in financial markets (Haldane and May 2011). Furthermore, it has become apparent that being a minority investor while holding many hundreds or even thousands of stocks in companies traded around the world may mean that SWFs have become hostage to the investment process, thereby discounting their capacity to exercise discretion—​local and global. As we suggest, SDFs are able to bypass global financial markets and take significant positions in state-​ sponsored and private organizations that have long-​term investment horizons. These types of organizations also have the capacity to frame and implement economic development strategies. Throughout this chapter, we have emphasized the similarities and differences between SDFs, documenting their profiles characteristics against shared criteria (see Tables 3.1 and 3.2). Whereas SWFs could be assessed against a standard model of best practice (representing some of the largest western asset owners and asset managers), we have shown that the governance and management of SDFs vary considerably including reference to their legal standing, the mechanisms of oversight, and the status of their senior managers. Whereas SWFs are closely monitored as to their investment rate of return targets and their portfolio risk management practices, the goals and objectives of SDFs vary considerably such that quantitative return targets are matched by qualitative development objectives. Indeed, in many cases, SDF investment portfolios are skewed toward particular sectors and development opportunities, thereby carrying significant risks that cannot be discounted by the spread of investments across a diverse investment portfolio. It is arguable that the global financial crisis and its aftermath have rewarded patient investors like SWFs able and willing to carry their portfolios through the ups and downs of global stock markets. However, with the relative slowdown of the Chinese

Peter Bruce-Clark and Ashby H.B. Monk    85 economy and the concomitant slowdown in global trade and economic integration, it is also arguable that large institutional investors, including SWFs, are unlikely to reap a rate of return anything like that of the past 25 years (Clark and Monk 2013). Indeed, in some resource-​rich economies now suffering from the heavy discounting of commodity prices, SWFs may have to surrender large portion of their assets so as to sustain the fiscal integrity of their state sponsors. Paradoxically, we may well see SDFs prosper in this environment precisely because the premium on long-​term economic development is increasing as global stock markets falter in the face of slowing rates of economic growth. Furthermore, we may also see the standard model of an SWF lose favor as state sponsors convert SWFs into SDFs. In that case, state sponsors may, once again, become strategic investors at home and abroad.

Acknowledgments The authors acknowledge the support of Stanford University’s Global Projects Center (GPC) and members of the GPC research consortium on institutional investment. The research program has also benefited from collaboration with the Smith School of Enterprise and the Environment at Oxford University and funding from the Planet Heritage Foundation. We would like to acknowledge the considerable support and insight of Gordon L. Clark of Oxford University and Adam D. Dixon of Bristol University. The authors wish to acknowledge the research assistance of George Boulton, Alice Chautard, and Caroline Nowacki and would like to thank Jagdeep Bachher, Hamid Hamirani, Ray Levitt, Eugene O’Callaghan, Uche Orji, Dane Rook, Sundhiraj Sharma, Shauna Turner, and Allan Wain for useful insights. None of the above should be held responsible for the views and opinions expressed herein.

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Chapter 4

F rom Financia l i z at i on to Vultu re Devel opm e nta l i sm South-​North Strategic Sovereign Wealth Fund Investment and the Politics of the “Quadruple Bottom Line” Daniel Haberly

Introduction Recent years have seen rapid growth in the phenomenon of South-​North investment. In addition to reserve hoarding and so-​called emerging market multinationals, this growth has been driven by the rise of sovereign wealth funds (SWFs), or state-​owned global institutional investors (Clark, Dixon, and Monk 2013). While invariably profit-​seeking in orientation, a large proportion of SWFs pursue a “double bottom line” wherein investments are simultaneously used to pursue so-​called “strategic” national developmental objectives (Haberly 2011). This strategic investment has generated substantial anxiety in much of the developed world, with many fearing that SWF investment will become a vehicle for the logic of “state capitalism” to destabilize the purportedly market-​oriented logic prevailing in the advanced economies. These concerns, however—​as reflected in the creation of an IMF-​sponsored voluntary code of SWF conduct—​have not prevented states in the Global South from undertaking widespread strategic SWF investment in the Global North. Strategic SWF investment constitutes an attempt by states to catalyze national development by inserting themselves into and leveraging the power of global financial networks (Dixon and Monk 2012; Haberly 2011). This can be seen as an adaptive response to the deepening globalization and “financialization” of the world economy,

88    From Financialization to Vulture Developmentalism which have disrupted many traditional development policy tools; however, what is not yet clear is how effective it is as a development strategy. This chapter seeks to dissect the potential and limitations of South-​North strategic SWF investment as a tool for catalyzing technological upgrading in the developing world. The chapter begins with an overview of the problems posed by financialized neoliberal globalization for conventional development policy tools, and how states are seeking to overcome these limitations through the use of strategic SWFs. It then develops a model of the political-​economic factors conditioning the ability of developing countries to utilize South-​ North strategic SWF investment to promote technology transfer in the reverse direction. These investments create globe-​spanning company networks that are hybrids of state and private capital in multiple economies, within which advanced economy host states can play either a facilitative or an obstructive gatekeeper role. Consequently, it is necessary to understand strategic SWF-​led development in terms of not only the “double bottom line” of SWFs and their sponsoring states, but also a second double-​bottom line encompassing the interests of various actors in host economies. In other words, the combined home-​host politics of strategic SWF investment must be described in terms of a “quadruple bottom line.” Crucially, whereas the SWF home state side of this quadruple bottom line can be understood as an adaptive response to the external pressures of financialized neoliberal globalization on developing economies, I argue that the host side has been predominantly shaped by the efforts of public and private actors within developed economies to find a path of least resistance around domestic political and economic deadlocks. As illustrated in the case of Abu Dhabi, the manner in which this has occurred has simultaneously enabled and constrained the attempts of states in the developing world to use South-​North strategic SWF investment to accelerate their domestic economic development.

Financialized Globalization and the Rise of Strategic Sovereign Wealth Funds Late development entails both advantages and disadvantages in comparison to the previous experience of the now advanced economies. While late developers should hypothetically be able to catch up with relative ease by acquiring technological know-​ how and accumulated capital from the advanced economies, in practice they face an uneven economic and political playing field. Not only are advanced economy firms and states highly protective of their most sophisticated technological capabilities, but the price of obtaining technology and capital from them may equal or outweigh its long-​term benefits. Consequently, the success of engagement with more advanced economies has long been contingent on shrewd planning, coordination, and bargaining by developing world states (Amsden 2007; Chang 2002; Evans 1979, 1995; Johnson 1982; Wade 1990).

Daniel Haberly   89 These tensions of late development have been intensified by the progress of neoliberal globalization. On the one hand, globalization promises to promote convergence between rich and poor countries by facilitating the cross-​border flow of knowledge, goods and investment (Bhagwati 2004; Friedman 2005). However, international norms and agreements (e.g. the World Trade Organiation (WTO)) also threaten to deprive states of traditional industrial policy tools, such as infant industry protection and performance requirements for foreign multinationals, and have the potential to impede the diffusion of knowledge through stringent intellectual property protection (Amsden 2007; Chang 2002; Cumings 1999; Wade 2003). Rendering these tensions even sharper is the “financialized” character of contemporary globalization. Financialization is a somewhat contested and broad concept (see Epstein 2002). In practice, however, it is generally used to refer to the shift from managerialism to shareholder-​value maximization at the microeconomic level, and the increasing weight of financial activities in overall corporate profits, coupled with increasing systemic financial instability, at the macroeconomic level. Like globalization, moreover, it is often understood to be closely related to the rise of a broadly “free market” philosophical and policy orientation in areas such as financial regulation and monetary policy (Crotty 2003; Davis, Diekmann, and Tinsley 1994; Dixon and Monk 2014; Epstein 2002; Lazonick and O’Sullivan 2000; Milberg 2008; Palley 2007). As for globalization generally, these tendencies have created a mixture of threats and opportunities for developing countries. The unrelenting pressure for shareholder-​ value maximizing, restructuring on advanced economy firms, has clearly intensified the imperative to offshore and outsource low-​end manufacturing and service activities to developing economies (Milberg 2008). This has, in turn, facilitated export-​oriented industrialization strategies on the part of the latter. However, the combination of deepening global financial interconnectedness and deepening global financial instability has proven to be exceedingly treacherous for developing economies. Beyond the balance of payments risks they create for smaller, non-​reserve currency issuing economies, these tendencies have undermined the efficacy of traditional industrial policy instruments. Banks, in particular, have long functioned as industrial policy nerve centers in many developing countries, mobilizing and directing capital to priority areas (Johnson 1982; Zysman 1983). This requires that the state establish interest rates and levels of credit access for different savers and borrowers that diverge from market clearing rates (Zysman 1983), creating a pressure for outward or inward cross border capital movements, which weaken state control over the national flow of funds.1 In the wake of the East Asian financial crisis, there has been a resurgence of attempts by many developing countries to restrain these “hot money” flows. However, as the recent experience of China has demonstrated, even strict systems of capital controls have proven increasingly porous in practice (Martin and Morrison 2008).

1 

Relatedly, cross-​border “hot money” flows also result from attempts to pursue independent macroeconomic policies.

90    From Financialization to Vulture Developmentalism A key problem with many traditional industrial policy tools is that they rely on forms of exclusive territorial economic sovereignty, which are increasingly difficult to assert with deepening global economic integration (Haberly 2011; Weiss 1997). However, while this mode of sovereignty has often been taken for granted as the defining feature of “stateness,” states are in practice highly adaptable actors, particularly where there is a clear political demand for their services (Evans 1997; Phelps 2007; Rodrik 1998; Weiss 1997). Crucially, state agency is not exercised over territory per se—​rather, territory is an intermediary in relationships between the state and other actors (Agnew 2009). As such, it may be possible for states to reconstitute these relationships in ways that do not pass directly through the medium of territorial sovereignty. More specifically, Weiss (1997), building on Lind (1992), argues that the “integral state” (i.e. defined in terms of exclusive territorial sovereignty) is increasingly being replaced by the “catalytic state,” which “seeks to be indispensable to the success or direction of particular strategic coalitions” (Weiss 1997, p. 24). An increasing number of states have sought to transcend the limits of territorial economic sovereignty by inserting themselves into, and modifying the logic of the very global financial networks that threaten them. A key institutional innovation enabling this is the SWF (Clark, Dixon, and Monk 2013; Haberly 2011). SWFs constitute an attempt by states to locally capture the benefits of financial globalization through the institutional imitation of global financial investors (Monk 2011). From the standpoint of institutional form and political rhetoric, they can be seen as an extension of the “financializing” logic of shareholder value to the state itself. However, they are also fundamentally an effort to tame and bend the logic of financialization to assert a broader state political remit. For developing countries, SWFs are often established as an extension of reserve hoarding strategies aimed at insulating national budgetary and balance of payments autonomy from international financial and trade shocks (e.g. violent commodity price swings).2 Beyond this attempt to grapple with the macroeconomic dimensions of financialization, moreover, SWFs have also in many cases sought to redefine the microeconomic parameters of shareholder value maximization. These “strategic” SWFs pursue a “double bottom line” of shareholder returns and national developmental externalities (Clark, Dixon, and Ashby 2013; Haberly 2011); a balancing act that Dixon and Monk (2014) describe as the “financialization of development.” At the less interventionist end of the spectrum, a number of strategic SWFs (e.g. those of North Dakota and New Zealand) are simply mandated to—​all else being equal—​favor investments that make some contribution to the local economy of their sponsoring state. Meanwhile, at the more interventionist end of the spectrum (e.g. Abu Dhabi’s Mubadala and IPIC, discussed later in this chapter), other SWFs establish long-​term relationships with domestic and foreign firms, as well as other states, with the aim of directly securing their cooperation in the national developmental project. As can be seen in Figure 4.1, these behaviors are the norm rather than the exception among SWFs, with more than 2  The massive stockpiling of reserves by states in the developing world is an attempt to defend macroeconomic stability from increasingly disruptive global financial markets (Monk 2011; Rodrik 2006).

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Figure 4.1  SWFs by investment orientation (2015)

92    From Financialization to Vulture Developmentalism half of all funds managing just under half of total SWF assets, pursuing some form of double bottom line.3 Moreover, while they tend to be smaller than average in comparison to other funds, a large number of SWFs can be classified as “sovereign development funds,” for which national or international strategic objectives are of primary, as opposed to secondary, importance in relation to shareholder returns (Clark and Monk 2015; Dixon and Monk 2014). The motivations for the creation and use of strategic SWFs have been explored in other work (Clark, Dixon, and Monk 2013.; Haberly 2011). However, little research exists that analyzes their effectiveness as a development policy tool. One of the few investigations is that of Phelps (2007), who found that the domestic benefits of Singapore’s extraterritorial industrial park strategy (coordinated by the SWF Temasek Holdings) were elusive, and that its pursuit was primarily an “act of faith.” However, given that Singapore possessed a relatively sophisticated economy when it began this strategy, which has primarily taken the form of “North-​South” investments in lower income economies such as Indonesia, Malaysia, and China, it is not clear how generalizable this finding is to states at lower levels of development. Particularly striking is the apparent potential for South-​North state investment to catalyze rapid technological “leapfrogging” by simply purchasing control of advanced economy firms, in order to absorb their capabilities and/​or restructure their operations. Indeed, it is precisely this prospect of foreign, and often authoritarian, states leveraging their financial wealth to radically overturn the world economic and political order, that has stoked advanced economy fears of SWF investment (Cohen 2009). The basic assumption in this backlash is that SWF-​owning states can simply act unilaterally, within what is essentially an international political vacuum. As Phelps (2007) notes, however, extraterritorial economic policy instruments cannot be understood in isolation from the “internationalization of the state,” wherein its political foundation is extended to overseas constituencies (Glassman 1999). Crucially, advanced economy host states retain a gatekeeping ability to keep out unwanted foreign direct investments—​a fact ironically underscored by the very “national security” concerns that are often raised around SWF investment (Cohen 2009; Monk 2009; Nolan 2012; Hatton and Pistor 2011). This is not to say that South-​North strategic SWF investment has been blocked by advanced economy hosts altogether. However, in order to undertake it, SWFs have had to embed themselves within systems of “state-​led global alliance capitalism” serving the perceived interests of host economy firms and states (Haberly 2011). Consequently, understanding the economic transformational potential of strategic SWF investment requires theorizing how the multiple actors within these systems of state-​led global alliance capitalism—​state and private, developing and advanced economy—​interact with

3  Note that this only requires that some part of the SWF’s assets, and not all of them, is managed with an explicit or implicit eye toward some broader national/​national economic consideration other than SWF financial returns. In some cases, this mandate is limited to a compartmentalized portion of assets under management (e.g. of the four permanent funds managed by the New Mexico State Investment Council, only the Severance Tax Permanent fund has a mandate to make “economically targeted investments”).

Daniel Haberly   93 one another and with territorial political authorities in both developing and advanced economies. In other words, rather than simply being analyzed in terms of a “double bottom line” of home state financial and developmental interests, the logic of strategic SWF investment must be understood in terms of a home-​host “quadruple bottom line.” In addition to the conventional SWF-​owning state “double bottom line”, this encompasses a second, host “double bottom line” that balances a slightly different set of objectives on the part of both public and private actors.

South-​North State Investment and the Politics of the “Quadruple Bottom Line” The central thesis of this chapter is that just as the “double bottom line” can be understood as an attempt by SWF-​owning states to navigate the contradictory opportunities, pressures, and ideological semiotics of financialized neoliberal globalization, the logic of the “quadruple bottom line” has also been shaped by the efforts of host economy actors to navigate these same types of tensions. However, the manner in which these tensions manifest themselves for hosts is predominantly domestic rather than international. Specifically, the advanced economy host “double bottom line” within the “quadruple bottom line” can be described as the conflicting desires of public and private actors to, on the one hand, maintain a commitment to the basic parameters of financialized, neoliberal globalization—​most importantly shareholder value-​driven strategy at the firm-​ level, and “market-​oriented” policies at the state level—​but on the other hand, alleviate various negative economic, political, and social consequences of these paradigms. In this respect, far from SWFs being an externally imposed foreign threat, advanced economy states and firms have increasingly used inward South-​North state investment as a magic bullet to circumvent deadlocks in their own political-​economic regimes. By, in effect, commercializing and exporting the services of the developmental state, South-​ North strategic SWF (and other state) investment in turn gives SWF-​owning states traction to advance their own national developmental agendas. However, the paradox of this responsiveness to target firm and host state needs is that strategic SWF investment tends to follow a somewhat constrained and distorted pattern, which poses a challenge to the autonomy and coherence of this developmental agenda. The phenomenon of the Global South exporting state capacity to the Global North is a striking historical reversal, the origins of which cannot be explored in detail here. However, at its root, it is arguably a result of the divergent macroeconomic experiences of developing and developed countries between the 1980s and early 2000s. Whereas the developing world experienced a series of devastating debt and financial crises—​which ultimately prompted a wave of state-​led economic policy innovation focused on the troublesome area of finance—​most major advanced economies experienced a period of relative macroeconomic stability (i.e. the “Great Moderation” [Bernanke  2004]), which arguably bred complacency among government and business elites. In particular, the dot-​com boom of the late 1990s gave the US model of deregulation-​oriented

94    From Financialization to Vulture Developmentalism public policy, and shareholder-​value-​oriented corporate strategy, an air of invincibility (Greenspan 2000). This illusion of invincibility was shattered by the shocks of the 2007–​08 global financial and subsequent Eurozone crises. In addition to underscoring that advanced economies are susceptible to the types of deeply traumatic financial and sovereign debt crises that have afflicted developing economies since these 1980s, these shocks unmasked an array of long-​term economic and social structural tensions across the developed world. These include an increasingly severe under-​provision of infrastructure and other key public goods, and the collapse of many industries and associated communities under the twin pressures of international competition and shareholder-​ value driven corporate restructuring. As many have noted, however, the paradox of contemporary politics in the developed world is that deteriorating economic performance has mostly prompted a re-​doubling rather than reform of the existing neoliberal policy paradigm, most notably in the pursuit of intensifying austerity (Peck, Theodore, and Brenner 2010). The result has been the emergence of an unstable political vacuum, as reflected in the push toward power of various left-​and right-​wing fringe movements. The key argument here is that the selective promotion and/​or permission of South-​ North state investment has become a stopgap for host political and economic establishments to partially fill this political vacuum. By outsourcing economic policy intervention to foreign states pursuing a “double bottom line” of financial and political objectives, host actors seek to achieve their own “double bottom line” of addressing various critical problems without fundamentally altering their own status quo behavior. Specifically, there are five host political niches, supporting five key home-​ host “quadruple bottom line” configurations, which have had a particularly powerful enabling effect on investment. These can be described as white knight investing, patient project funding, inverted mercantilism, venture developmentalism, and vulture developmentalism.

White Knight Investing The first host political niche for SWFs is the emergency recapitalization of firms and sectors which are in temporary distress, but whose competitive position is (at least believed to be) fundamentally strong. As underscored by the global financial, and subsequent Eurozone crisis, this has been a highly effective door-​opener for SWFs to otherwise inaccessible investment opportunities in leading advanced economy firms. Indeed, whereas western political discourse on the eve of the crisis largely cast SWFs as shadowy “state capitalist” intruders, by the end of the crisis they had been recast as “white knights” riding to the rescue of distressed financial and industrial firms. Provided that it is not seen as conveying undue foreign influence, such support has been particularly welcome for the most nationally important financial and industrial firms (e.g. German automotive manufacturers and a number of western banks), where it directly offsets the financial and political capital that hosts are forced to expend in bailouts (Haberly 2011, 2014; Hatton and Pistor 2011).

Daniel Haberly   95

Patient Project Funding A key component of not only the reality, but also to some extent the mythology4 of the aforementioned rescues is the potential for SWFs to take a long-​term “patient” view, that allows them to both financially and politically arbitrage the “short-​termist” behavior of private investors (Clark and Knight 2011; Stiglitz 2012). Aside from an unwillingness to support strong firms in temporary distress, this private investor “short-​termism” is itself often a cause of distress to the extent that shareholders pressure firms to engage in behaviors (e.g. share buybacks) that are contrary to their own interests (Crotty 2003; Haberly 2014). Relatedly, the second key advanced economy political niche for SWFs and other developing state firms are investments which are potentially lucrative financially, but require the commitment of capital on a scale, and over a time horizon, which private investors are unable to provide, and host states are unwilling to provide. Most important, in this respect, has been the potential for South-​North state investment to address steadily worsening backlogs of host infrastructure underinvestment (Clark, Monk, Orr, and Scott 2012). Often, this involves large-​scale coordination between not only state (SWF and non-​SWF) providers of finance, but also industrial firms from the investing state that are directly involved in the execution of the project (e.g. in the case of recent Chinese investments in UK infrastructure, see Giles and Plimmer 2015).

Inverted Mercantilism In the previous example, SWF investments cultivate export markets for industries in the SWF-​owning state. However, to the extent that investments in foreign firms seek to recruit their participation in the SWF-​owning state’s development, they also have the potential to reciprocally cultivate export and investment opportunities for these firms. This opens the door to the third conjunction of interests facilitating South-​North strategic SWF investment, namely, the potential for it to serve as a vehicle for “inverted mercantilism” by target firms and host states committed to an ostensibly liberal international trade strategy (Haberly 2011). In this respect, just as it is possible for hosts to substantially outsource the funding and operation of basic infrastructure foreign developmental states, it is possible to outsource elements of national trade and industrial policy which might otherwise be politically taboo (particularly in relation to supranational organizations such as the EU). Importantly, given the enormous market capitalizations of leading advanced economy multinationals, even relatively small investments are likely to constitute a substantial fraction of a SWF’s total portfolio. As such, provided that they are not allowed to purchase stakes so large as to gain outright control, SWFs may become at least as beholden to portfolio firms as vice versa. More broadly, investments may act as a political entrée for portfolio firms into the rapidly growing “state

4 

As underscored by the divergent results of statistical analyses in Chapters 13 and 14, there is some disagreement regarding whether SWFs live up to their advertised stabilizing role in practice.

96    From Financialization to Vulture Developmentalism capitalist” markets where SWFs are based—​at best, granting them a quasi-​national status that allows them to benefit from tacit protectionism. As noted by Siemens CEO Peter Loescher: “These investors [SWFs] don’t have to take over the firm, but could acquire a portfolio of stakes in the best companies . . . they have the money and a big market, so it is a double advantage” (Schaefer, England, and Milne 2009). More bluntly, the CEO of Teck Resources welcomed CIC’s 2009 investment as an excellent way to “deepen our relationship with the largest customer of our core products . . . Clearly, CIC knows so much about the Chinese economy and all the people who run those [state-​owned] companies . . . this really helps build a strong Canadian competitor on the world stage” (Johnson 2009).

Venture Developmentalism In the previous scenario, the target firms for SWF investment are assumed to be relatively large or at least well established. However, there is also a clear host political niche for strategic SWF investment in smaller, less well established companies, particularly those seeking to develop and or scale up new technologies. Notably, although some regions such as Silicon Valley possess robust risk-​capital financial ecologies, small-​and medium-​sized enterprises (SMEs) in most of the developed world have been subjected to a protracted external fundraising squeeze since the global financial crisis (Wehringer 2013). In this respect, an attractive mode of SWF engagement for host firms and states are “venture developmentalist” investments that support the expansion of high-​tech startups and other SMEs, while offering the promise of reverse technology transfer to (and potentially enormous financial returns for) the investing state. The Chinese government has recently promoted a particularly aggressive domestic and international high-​tech private equity investment push by a mixture of state, quasi-​state (e.g. university) and private (often joint domestic and foreign) capital, which has met with a notably positive reception in the UK (Greenhalgh 2016; Tozzi 2012).

Vulture Developmentalism In the previous scenario, firms attract SWF investment due to their promising long-​ term prospects. However, there are other cases where SWFs invest in firms and sectors that suffer from a long-​term structural lack of competiveness and profitability, but are nevertheless seen as potentially being able to contribute to the SWF-​owning state’s development. This final conjunction of quadruple bottom-​line interests can be described as “vulture developmentalism,” wherein industrial policy in the SWF-​owning states is constructed from the unwanted assets discharged by advanced economy firms and investors in the course of shareholder value-​maximizing restructuring. In addition to SWF investments in whole companies, this often involves the purchase of underperforming assets sold by firms seeking to refocus on their most profitable core activities (see Nolan 2012). On the one hand, this effectively entails a distressed asset seeking strategy on the part of the SWF, similar to those traditionally followed by private equity or hedge “vulture” funds. However, rather than ruthlessly dismantling the acquired firms at the expense of employees and host economies, SWF investment is seen to (at least in theory)

Daniel Haberly   97 grant firms a new lease of life as participants in the development of the SWF-​owning state. In this respect, even while such “strategic resource-​seeking” South-​North investments have become increasingly widespread among both public and private market multinationals in general (Luo and Tung 2007), those undertaken by SWFs and state-​backed firms specifically appear to offer the promise of particularly strong financial and political support for both target firms and host communities.

The Quadruple Bottom Line and Technology Acquisition The fact that strategic SWF-​owning states are in many respects exporting political as well as financial capital to advanced economies, suggests that the former should have the upper hand in this relationship. However, the argument here is that the configurations of the “quadruple bottom line” that support SWF entry into hosts provide, in conjunction with the prevailing organizational patterns of international business, a counterintuitively limited purchase for SWF-​owning states to use South-​North investments to advance their national development. Figure 4.2 proposes a framework for understanding the role of the “quadruple bottom line” configurations described above in the context of South-​North strategic SWF investment-​driven technology transfer. As the second mode (patient project funding) is most likely to act as a device for expanding the exports of existing industries, or in some cases cultivating new overseas sources of Strong Technology intensive

Competitive position of firm

Weak

Sub-scale High-tech firms

Schumpeterian Monopolies

“Inverted” Mercantilist” investments “White Knight” non-controlling investments

Technological sophistication/ sensitivity of activity

Low-tech, cost, sensitive

“Vulture/Venture” Developmentalist” acquisitions

Low-cost Low-tech firms

High-cost Low-tech firms

Figure 4.2  Rough typology of strategic South-​North SWF investment by target firm and sector

98    From Financialization to Vulture Developmentalism raw materials for these industries (e.g. where major infrastructure and mining projects are coordinated with one another), the focus is on the other four discussed above. The potential contribution that a target firm can make to the technological upgrading of the SWF-​owning state’s economy can be understood as a function of:  (1)  the sophistication of the technological capabilities possessed by the firm, (2) the strength or weakness of the firm’s global market position, and (3) the degree of influence that the SWF-​owning state is able to gain over it. Figure 4.2 attempts to show, in a stylized manner, the relationship between these three parameters. The vertical axis represents the technological sophistication of activities, while the horizontal axis represents the competitive strength of particular firms in these activities. Meanwhile, the darkness of shading represents the maximum politically permissible shareholder influence a foreign state can gain, ranging from outright acquisitions (darkest), to the purchase of substantial non-​controlling stakes via “white knight” capital injections (light grey), to “inverted mercantilist” investments in which the net direction of influence may run from target firm to SWF (white). Importantly, the “lighter” types of investment may also be undertaken within the “darker” zones, but not vice versa. As illustrated in Figure 4.2, the basic conundrum confronting technology-​seeking South-​North strategic SWF investment is that the level of shareholder influence a foreign state can gain over a firm tends to be inversely related to the contribution that this firm can make to national development. For firms falling broadly into the upper left-​ hand quadrant, which possess a fundamentally strong long-​term competitive position in technological intensive activities, the maximum level of SWF shareholder influence will tend to derive from “white knight” capital injections provided at a moment of temporary crisis. However, this influence will typically be circumscribed by explicit or implicit host political constraints, particularly if the recapitalized firm does indeed quickly return to health. Even more problematically, the most technologically sophisticated activities are mostly dominated by “Schumpeterian monopolies/​oligopolies” whose position of leadership in global value chains/​production networks is sustained by positive feedback loops between market-​pricing-​power, economies of scale, intellectual property assets, profitability, R&D/​capital reinvestment capacity, and in many cases direct home state backing (Dedrick, Kraemer, and Linden 2010; Nolan 2012). In theory, the global leadership position of these firms is often so entrenched that they would have substantial leeway to unilaterally reorganize themselves, and the multi-​firm global production networks they lead (Coe et al. 2004), to advance the development of any state purchasing a controlling stake in them (see Dixon and Monk’s 2012 discussion of “productivist” SWFs). In practice, however, their monopolistic position also means that they are relatively unlikely to even experience the type of temporary crisis that would serve as an entrée for significant “white knight” investments, except as a harbinger of decline. Moreover, their status as national champions means that any unsolicited (or in some cases even solicited) foreign state approach, beyond a low of influence, will risk triggering a tripwire of host protectionism (Haberly 2011; Nolan 2012). With this in mind, the most significant strategic SWF investments in the most powerful monopolistic firms (at the extreme upper left corner of Figure 4.2) are likely to fall

Daniel Haberly   99 into the “inverted mercantilist” category, wherein they are seen to produce tangible strategic benefits for firms without the ceding of substantial control. As noted previously, such investments are, in and of themselves, arguably more likely to allow target firms to co-​opt SWFs than vice versa. However, to the extent that the SWF-​owning state is, or has the promise to be, a critical market for portfolio firms, it may possess a much greater degree of market/​buyer leverage which can be used to prod firms into developmentally oriented strategic cooperation. Moreover, to the extent that SWF-​owning states become implicitly beholden to partner firms in which they are deeply invested, this may in and of itself build trust by firms in the shareholding state, potentially making them more amenable to cooperation. This logic of deepening reciprocal influence through interwoven trade and investment relationships poses a dilemma in cases where the establishment of SWF-​owning state market power over leading foreign firms is impractical. Moreover, even where such market power exists, this pattern runs the risk of entrenching a trajectory of national dependent development, beholden to powerful foreign partners who will invariably draw red lines around the transfer of certain sensitive activities and capabilities (Cardoso and Faletto 1979; Evans 1979). In this respect, an alternative strategy to exercising weak influence over strong foreign partner firms is to exert stronger influence over weaker partners that are less subject to host protectionism. In theory, this can involve investing in either healthy or distressed foreign firms. However, in practice there is reason to believe that states will rely disproportionately on a “vulture developmentalist” paradigm focused on distressed firms, for a combination of economic and political reasons. For high-​tech activities, the fundamental obstacle to using South-​North investment to “leapfrog” technologically remains the winner-​take-​all pattern of monopolistic competition prevailing in these sectors. Even if the SWF invests in second-​tier high-​tech firms (at the upper fight of Figure 4.2), to avoid political barriers to controlling investments in leading firms (at the upper left), this will merely displace the confrontation with the latter to the level of product market competition. One way of theoretically outflanking this dilemma is the “venture developmentalist” strategy of investing in foreign startups with new business models or technologies not yet claimed by powerful incumbents. However, it is not clear that SWFs have a great deal to show for this.5 Notably, the dislocation of SWFs from the local social milieus and networks of overseas high-​ tech industrial districts (Saxenian 1996) may make them poorly placed to function as venture capitalists, except in partnerships with local investors that will tend to dilute

5 

The attempts of Abu Dhabi’s Masdar to use overseas venture capital investments to promote the development of Abu Dhabi’s solar PV industry illustrate the difficulties of this approach. Masdar concentrated its bets in apparently promising thin-​film solar cell technology, shortly before a rapid drop in the price of competing crystalline silicon technology drove large numbers of thin-film producers out of business. In addition to investing in the ill-​fated Solyndra, which went bankrupt in 2011, Masdar established its own Germany-​based thin-​film solar PV start-​up, Masdar PV, which went bankrupt in 2014.

100    From Financialization to Vulture Developmentalism their influence (Delaney 2015). As such, the path of lesser resistance for South-​North investment-​mediated technological leapfrogging is arguably to purchase established but struggling high-​firms (or pieces thereof), which can theoretically be returned to competitiveness with sufficient SWF-​backed capital investment in R&D and scale (i.e. firms that can be purchased in the upper right of Figure 4.2, and then pushed toward the upper left). The drawback to this high-​tech vulture developmentalist strategy is that it will have to be undertaken in the face of direct competition with the most powerful high-​tech monopolistic firms. However, it has the benefits of strategic clarity, as well as the attendant host political advantages of investing in struggling firms that have “nothing to lose.” There is an even stronger logic to vulture developmentalist investments in less technologically sophisticated sectors (at the bottom of Figure 4.2), including low-​value segments of high-​tech value chains. In contrast to the challenging monopolistic competition dynamics of high-​tech industries, competiveness in these activities will tend to primarily stem from the ability of firms to reduce costs—​often by exploiting the low-​cost labor and/​or raw material inputs of developing countries (Froebel, Heinrichs, and Kreye 1980)—​and to establish or tap into downstream sales networks. For developing countries, South-​North strategic SWF (and other emerging market multinational) investment in low-​tech advanced economy firms has the potential to contribute to national development by accelerating the North-​South relocation of production, and acquiring established customer relationships, distribution systems, and brands. In other words, strategy can focus on investing in firms in the lower right of Figure 4.2, in order to move them to the lower left. Directly assisting this process are the low margins prevailing in these activities, which will tend to make shareholder-​value-​conscious advanced economy firms and investors eager to divest them to buyers in the global south (who often pay a premium for such assets in comparison to other buyers (see Hope, Thomas, and Vyas 2011). Moreover, to the extent that it helps to partially sustain declining advanced economy industries, this North-​South transfer of control is also likely to be encouraged by host states. Problematically, however, low-​tech/​mature sectors will also have the weakest potential to transform the SWF-​owning state’s economy. The remainder of this chapter applies this framework to an analysis of Abu Dhabi’s ambitious strategy of South-​North strategic SWF-​investment-​led technology acquisition. As will be shown, Abu Dhabi’s South-​North strategic SWF investments have been conditioned by a home-​host “quadruple bottom line” spanning a range of “white knight”, “inverted mercantilist”, and “vulture developmentalist” configurations. However, due to the greater level of shareholder influence that can be gained over struggling, low-​value firms, its SWFs have, in practice, come to rely disproportionately on the last of these as a technology acquisition mechanism. This has proven to be reasonably effective in catalyzing the development of a low-​tech industry, in which Abu Dhabi has a clear existing competitive advantage. However, it has proven to be less powerful as a mechanism for bringing about high-​tech leapfrogging, particularly in comparison to Abu Dhabi’s success at leveraging market power over global value chain lead firms to achieve the same effect.

Daniel Haberly   101

The Case of Abu Dhabi No state has given South-​North strategic SWF investment a more central developmental role than Abu Dhabi—​the lead state of the United Arab Emirates (UAE) federation—​ making it an ideal case study of the effectiveness of this investment. Indeed, as can be seen in Figure 4.1, the UAE as a whole is home to approximately half of the world’s total sovereign development fund assets (based on the SDF definition employed here). Home to close to 10% of the world’s proven conventional oil reserves, Abu Dhabi has saved a large proportion of its oil export earnings within its four SWFs. As of 2015, these manage as much as $1 trillion in assets (SWF Institute 2015). Like many resource-​rich states, Abu Dhabi has traditionally accumulated these savings primarily as a buffer against hydrocarbon earnings fluctuations, and to offset long-​term hydrocarbon depletion (Clark and Monk 2012). However, it has increasingly channeled them into an ambitious long-​term economic diversification effort. This aims to escape from hydrocarbon export dependence by developing a “knowledge economy” centered on high value manufacturing and services (Abdelal 2009; Davidson 2009; Government of Abu Dhabi 2008; Oxford Business Group 2010). Abu Dhabi constitutes a useful natural experiment for gauging the developmental potential of South-​North strategic SWF investment in advanced economy firms. Within living memory, Abu Dhabi was one of the world’s most underdeveloped and impoverished states, with the emirate not possessing a single road or hospital until the early 1960s (Al-​Fahim 1995). Even today, it effectively remains a developing country from the standpoint of economic structure, which is founded primarily on raw material exports and low wage (imported) labor. However, this fairly low level of economic development is coupled incongruously with: (1) enormous financial wealth; (2) a reasonably effective “developmental state”6 apparatus, which typically scores among lower ranks of advanced economies (i.e. far above most developing countries) in international surveys of bureaucratic efficiency, corruption, etc.; and (3) strong political and military relationships with the leading advanced economies, which give Abu Dhabi unusual leeway to purchase and reconfigure the operations of high-​tech companies in the sector of its choice. As such, it can be seen as something of a limiting case of the potential for development to be simply “bought” through South-​North investment. Abu Dhabi’s economic diversification strategy has been led by two sovereign development funds, the International Petroleum Development Company (IPIC), and Mubadala Development Company, a portion of whose key international and domestic activities and alliances are shown in Figure 4.3. IPIC, in the upper left corner of Figure 4.3, is jointly owned by the Abu Dhabi National Oil Company (ADNOC) and Abu Dhabi’s primary 6 

Although Abu Dhabi’s “rentier state” political economy (see Beblawi 1990) is in many respects radically different from the East-​Asian economies traditionally classified as “developmental states”, this term was originally developed in reference to Latin American countries which sought to channel mineral export rents into a state-​led industrialization effort (Cardoso and Faletto 1979). An appropriate classification for Abu Dhabi might be a “developmental rentier state.”

102    From Financialization to Vulture Developmentalism

Figure 4.3  Abu Dhabi’s SWF-​led global developmental network (2012)

Daniel Haberly   103 macroeconomic reserve/​savings SWF, the Abu Dhabi Investment Authority (ADIA). In practice, it has acted as an extension of ADNOC that has focused on the development of downstream petrochemical industries—​in which Abu Dhabi has a clear comparative advantage—​through the coordination and funding of cooperation between foreign partner firms and domestic joint ventures. Meanwhile, the Mubadala Development Company (center of Figure 4.3) was created to oversee the civilian commercial wing of Abu Dhabi’s military procurement-​focused high-​tech industrial development strategy. In contrast to IPIC’s low-​risk approach to strategic industrial development, Mubadala has pursued a much more ambitious leapfrogging strategy focused on the aerospace, semiconductor, and “green tech” industries. This has involved the establishment of elaborate networks of cooperation between foreign partner firms and domestic start-​ups/​ joint ventures, and institutions of higher education within and outside of Abu Dhabi. These networks are mediated through a mixture of capital investment, civilian, and military procurement, and international personnel movements. This chapter will take an in-​depth look at the activities of IPIC and Mubadala respectively, with a focus on their attempts to catalyze the development of the polyolefins plastics, aerospace, and semiconductor industries in Abu Dhabi. As will be shown, the case of polyolefins demonstrates the relative ease with which developing countries with low-​ cost production inputs can move firms purchased in the lower right-​hand quadrant of Figure 4.2 into the lower left-​hand quadrant. Meanwhile, the case of aerospace development demonstrates how the acquisition of buyer, more than shareholder, leverage over firms in the upper left-​hand quadrant of Figure 4.2 can drive a relatively radical process of technological leapfrogging. Finally, the semiconductors case demonstrates the difficulty of attempting to push firms purchased in the upper right-​hand corner of Figure 4.2 into the upper left-​hand corner.

The International Petroleum Development Company and Incremental Petrochemical Industrialization For Abu Dhabi, like the other Gulf Cooperation Council (GCC) states, the easiest way to capture additional value from oil and gas extraction is to vertically integrate into downstream refining and petrochemical activities (Luciani 2007). IPIC was founded in 1984 with a mandate to promote this vertical integration through its domestic and overseas investments. IPIC clearly demonstrates the potential of “vulture developmentalist” South-​North strategic SWF investment to catalyze the North-​South transfer of a low-​entry barrier, resource intensive industry—​namely polyolefin plastics—​in which developing economies with low-​cost raw materials have a clear comparative advantage. Polyolefins (Polyethylene and Polypropylene) are the most widely produced class of commodity plastics. Production technologies are substantially embodied within turnkey capital goods, and competitiveness stems primarily from vertical integration into low-​cost hydrocarbon feedstocks (Johnson 2006; Pappu, Song, and Haire 2010). Consequently, it is a highly commoditized industry in which there is complementarity between the desire

104    From Financialization to Vulture Developmentalism of advanced economy capital to exit from low-​margin advanced economy operations, and the desire of developing states to purchase these operations in order to gain access to basic petrochemical industry technology, and downstream outlets for low-​cost domestic hydrocarbons. Indeed, the industry has increasingly been ceded globally to developing world state capital, with those advanced economy oil and diversified chemical companies (e.g. ExxonMobil) that still have a presence in it under strong shareholder pressure to divest to private equity or developing world ownership (Johnson 2006). Despite being highly commoditized, the polyolefins sector remains an important basic industry with beneficial local employment and supply chain externalities. Consequently, while advanced economy private capital has mostly lost interest in the industry, many advanced economy states have retained an interest in its health. Facing a particularly uncomfortable dilemma have been states in western Europe with uncompetitive state-​owned petrochemical champions, who must balance the local benefits of supporting these firms against their cost to the state as a shareholder. One solution is to sell equity stakes in these firms to oil and gas rich developing states that can restore them to health by providing infusions of capital and access to low-​cost feedstock. It is through investments in struggling state-​owned European petrochemical champions that IPIC has gained entry into the polyolefins sector. Through a series of deals involving the governments of Abu Dhabi, Austria, Norway, and Finland, a network of alliances has emerged wherein: (1) Abu Dhabi gains access to polyolefins technology and global market reach via strategic SWF investments in the commodity plastics divisions of the latter three states’ petrochemicals firms, while leveraging low-​cost domestic feedstock to earn profits in this otherwise low-​value sector; (2) the governments of these three European countries alleviate the strain of low-​return state-​owned polyolefins operations on their respective taxpayers, without sacrificing either domestic employment in these industries, or national control over critical national petrochemical champions; and (3) advanced economy investors gain access to cash flow generated by the high-​value portions of partially privatized national petrochemical champions, while assuming minimal exposure to commodity plastics. In the early 1990s, the Austrian government was seeking a strategic investor for its struggling national oil and petrochemical champion, OMV, as part of its partial privatization (Kordik 2012). The sale of a 20% stake in OMV to IPIC reportedly reflected an understanding that Abu Dhabi would not pressure OMV to divest its money losing petrochemicals operations, and would provide access to oil and gas resources (Hamilton 1994). In 1998, OMV and IPIC jointly acquired a 50% stake in Borealis, a Scandinavian company created as a joint venture/​spinoff of the polyolefins divisions of the Norwegian and Finnish national oil and petrochemical champions, Statoil and Neste (Hamilton 1998). Like OMV, these firms were undergoing partial privatization, and seeking to exit from commodity chemicals to focus on higher value activities. In conjunction with the investment, OMV merged its petrochemicals division into Borealis, thereby allowing OMV to distance itself from this unit. In 2005, IPIC and OMV jointly acquired the remainder of Borealis—​with IPIC assuming majority control—​and relocated its headquarters to Vienna (Rodger 2005).

Daniel Haberly   105 The configuration of alliances established through these SWF investments has proven to be both politically viable and capable of producing a substantial expansion of plastic manufacturing in Abu Dhabi. Its developmental potential is inherently limited, however, insofar as these are relatively low-​tech, low-​value manufacturing activities. IPIC’s underwriting of a benevolent restructuring of the Austrian and Scandinavian petrochemical industries was contingent on Borealis’s participation in the industrialization of Abu Dhabi. In 1998, Borealis and ADNOC established an Abu Dhabi-​based polyolefins joint venture, Borouge,7 whose operations now have a larger production capacity than any of Borealis’s European facilities. Borealis is also helping Abu Dhabi to move beyond bulk commodity plastics production into R&D. The centerpiece of this effort is the Borouge Innovation Center, a facility on the campus of the Abu Dhabi Petroleum Institute, which opened in 2015 (Sparrow 2015). This forms part of a network of cooperation (see Figure 4.4) with Borealis Innovation Headquarters and Johannes Kepler University in Linz, and the Petroleum Institute (Borouge 2010; Henni 2011; Petroleum Institute 2012). Borealis and Borouge are major suppliers of plastic components to the automotive industry in Europe and Asia (Bardsley 2010; Borealis 2012), and IPIC has supported their R&D activities through a strategic investment in a major customer firm, Daimler. Daimler is the second largest German company by sales, and a controlling investment along the lines of IPIC’s investment in Borealis would have been politically infeasible. Rather, IPIC’s entry took the form of a minority “white knight” capital injection during the depths of the financial crisis in 2009—​giving IPIC a substantial 9.1% ownership stake—​which likely averted the need for a costly German government rescue of the firm. The first R&D project involving Daimler, Borealis, and Borouge was announced in 2010 and aims to develop new lightweight plastic compounds for use in electric vehicles, specifically the electrified version of Daimler’s popular Smart Fortwo car, which has a plastic body manufactured by Borealis and Borouge (Borealis 2010). Despite these initiatives, Abu Dhabi continues to occupy a relatively low position within the international division of labor of Borouge and Borealis’s operations. The net impact of Abu Dhabi’s investments in these companies has been to connect European petrochemical technology centers, such as Linz, to the rapidly expanding Asian market for plastic automotive components, cable insulation, and building materials, by enabling these centers to tap into Abu Dhabi’s low-​cost natural gas (Alperowicz 2005; Bardsley 2010; Borealis 2012; Carlisle 2010b).8 Primary R&D activities by the group are delegated to Borealis’s global innovation headquarters in Linz, which maintains a research staff several times larger than Borouge’s R&D center in Abu Dhabi (Borealis 2012).9 Meanwhile, Borouge’s marketing headquarters is located in Singapore, and its 7 

Borouge is 60% owned by ADNOC and 40% owned by Borealis. This was the basic logic underlying the initial transfer of control to IPIC (Alperowicz 2005). 9  Borealis’s innovation headquarters was relocated to Linz, Austria in 2009 under the influence of Borealis’s Austrian ownership, allowing it to collaborate closely with Johannes Kepler University within the regional “plastics valley” initiative (Borealis 2009; Österreichischer Rundfunk 2009). Prior to this, primary R&D activities were conducted at sites in Finland, Sweden, and Norway (the first two of which are still in use). 8 

106    From Financialization to Vulture Developmentalism

Figure 4.4  The Austro-​Abu Dhabi petrochemicals network (2012)

Daniel Haberly   107 facilities for converting bulk plastics into specialized compounds in China, where it also maintains a local applications R&D center. Ultimately, Abu Dhabi’s petrochemical industrialization drive, like those of the other GCC states, is hindered by the fact that the petrochemical value chain exhibits an increasingly market-​pull locational logic as one moves from bulk commodity chemicals production toward more sophisticated activities (Pappu, Song, and Haire 2010). The government of Abu Dhabi has sought to remedy the lack of such a local market by establishing a “polymers park” focusing on downstream polyolefins conversion (Stanton 2009).10 However, it has been reported that Borouge’s unwillingness to provide discounted inputs to local firms has prevented this project from gaining traction (Jagger 2012).

Mubadala and High-​Tech “Leapfrogging” into Aerospace and Semiconductors In contrast to IPIC’s low-​risk push into commodity chemicals, Mubadala has sought to drive more radical technological “leapfrogging” (Abdelal 2009; Davidson 2009). Abu Dhabi’s approach to high-​tech industrial policy can be described as a variant of the US military-​industrial-​led model (Markusen 1991; Mazzucato 2011), wherein procurement acts as a major locus of both funding and strategic planning. The key difference is that procurement has primarily been used as a mechanism for acquiring foreign, as opposed to developing, indigenous technology. In this respect, Abu Dhabi has been able to leverage both its strategic importance as a western ally, and status as one of the largest importers of defense hardware (number three worldwide over 2005–​09, and number four over 2010–​14 according to SIPRI 2015) to catalyze a substantial local transfer of military and dual use technology and production.11 At the center of this military-​based development strategy is the UAE Offset Program (Eident 1997; Industrial Development Program [IDP] 2012; OBG 2010), which requires foreign defense contractors to reciprocally participate in national economic development (Markusen 2004). The Mubadala Development Company (originally the Offset Development Company) was created in 2002 as a non-​military commercial investment adjunct to the Offset Program, with a mandate to produce both strong financial returns and developmental benefits for Abu Dhabi (Carvalo 2003; Mubadala 2015).12 It is now a $66 billion strategic investor

10  Extensive electronic searches by the author could only identify a single tenant, a foreign producer of polyethylene artificial turf, despite claims by the government in 2009 that the park would be home to dozens of tenants by this time. 11  Areas of military manufacturing include domestic production capabilities in naval shipbuilding and systems integration, for up to 900 ton corvettes, armored reconnaissance vehicles, unmanned aerial vehicles, small arms, light and heavy munitions, body armor, cyber operations, and military vehicle and aircraft maintenance, repair, and overhaul (MRO) services (Offset Program Bureau [OPB] 2011). 12  A second investment company, Tawazun Holding, oversees most of the military (as opposed to civilian or dual-​use) industries created through the Offset Program (IDP 2012).

108    From Financialization to Vulture Developmentalism (Mubadala 2014) with numerous foreign and domestic investments in sectors including shipbuilding, aerospace, aluminum production, overseas oil and gas exploration, renewable energy, healthcare, and real estate. Mubadala’s leapfrogging attempts into advanced manufacturing have primarily proceeded through a two-​pronged strategy of: (1) acting as a holding company for local startups and joint ventures, typically established with support from foreign firms in conjunction with procurement relationships, and (2) making strategic investments in advanced economy firms with the aim of transferring part of their production to Abu Dhabi. With respect to the first, the most notable successes have been in the aerospace manufacturing, maintenance repair, and overhaul (MRO) sector (see Haberly 2011 for a detailed discussion). Aerospace is a classic example of a technology intensive industry whose value chain is controlled at key points by deeply entrenched Schumpeterian monopolies/​oligopolies (Nolan 2012). Airbus and Boeing have an almost complete duopoly on the manufacture of large jet aircraft; meanwhile, General Electric, Rolls Royce, and United Technologies have an effective lock on global jet engine manufacturing. Crucially, given the status of Abu Dhabi (and the UAE broadly) as a critical aerospace market, this concentrated industry structure has clearly worked to its benefit, as the relative insulation of key aerospace firms from competition means that they have substantial leeway to reorganize their supply chains to reward key customers. Mubadala’s most striking success story is Strata Composites, a wholly Mubadala-​ owned and Abu Dhabi-​based manufacturer of carbon fiber composite aero-​structures, established in 2010 with technical assistance from EADS/​Airbus and other European aerospace firms. Abu Dhabi’s ability to enter this technologically sensitive and demanding sector appears to reflect the buyer leverage that it has over the European defense and aerospace industry, with the UAE accounting for 14% of Airbus’s order book as of mid-​2010—​including 34% of A380 orders—​and 28% of France’s total defense exports (Haberly 2011). Beyond a one-​off symbolic gesture, Strata has been able to secure a series of multibillion dollar long-​term orders from both Airbus and Boeing, who have incorporated its components into a lengthening list of aircraft including the A330, 340, 350 and 380, and Boeing 777 and 787. It has also served as a key pillar of Abu Dhabi’s efforts to train highly skilled national workers, and has training and R&D partnerships with several local universities (Strata 2015). Notably, Abu Dhabi has also purchased stakes in some of the key foreign partner firms at the heart of these procurement-​focused aerospace industrialization efforts. As part of a broader strategic alliance, Mubadala owns approximately 1% of GE, which is a key supplier of aircraft engines and gas turbines to the emirate, operates a turbine servicing joint venture and various training programs with Mubadala, and has been a key partner in Mubadala’s Masdar “green tech” project. Meanwhile, European governments, in particular France, appear to have encouraged GCC investment in Airbus as an “inverted mercantilist” strategy for building influence in this key market (see Haberly 2011 and Thatcher 2013; also see Carlisle 2010a for a discussion of France’s intertwined promotion of GCC investment and reactor sales in its nuclear industry). Neighboring Dubai—​an even more important Airbus customer, with whom Abu Dhabi has partially

Daniel Haberly   109 coordinated its aerospace development activities (see Haberly 2011)—​is a substantial shareholder in Airbus. Moreover, until Daimler divested its Airbus stake in 2013, Abu Dhabi was a significant indirect investor in the firm. In the final analysis, however, these shareholdings clearly constitute a minor source of influence over firms such as GE or Airbus in comparison to the level of market power Abu Dhabi is able to wield. The same cannot be said of Mubadala’s efforts to catalyze the development of semiconductor manufacturing in Abu Dhabi, an initiative that has in some years consumed more than half of its total capital outlays (Kucera and King 2012; Nair 2012), and currently accounts for nearly half of its annual revenues (Mubadala 2015). The semiconductor sector has significant structural parallels to aerospace, with the military-​strategic sensitivity (and R&D/​market support) of key technologies nearly as high, and the monopolistic organization of most industry segments even more pronounced (Mazzucato 2011; McGrath 2012a; Naeher, Suzuki, and Wiseman 2011) (see Figure 4.5).13 However, unlike in aerospace, Abu Dhabi lacks any market power that would give it leverage over monopolistic semiconductor industry leaders. With the acquisition of significant shareholder influence over monopolistic semiconductor firms (e.g. Intel) being off-​the-​table politically, and Abu Dhabi lacking any obvious resources for either attracting foreign semiconductor branch plants, or establishing new firms from scratch, Mubadala has fallen back on a mixed “white knight” “vulture developmentalist” strategy of assembling a national semiconductor champion from distressed and uncompetitive producers. Like most developing states since the late 1980s, Abu Dhabi’s chosen point of entry to the semiconductor industry has been the merchant foundry sector, which provides contract manufacturing services for chip design firms. At the center of this strategy has been Mubadala’s relationship with Silicon Valley based Advanced Micro Devices (AMD). Although AMD is Intel’s only competition to speak of in the PC CPU market, Intel has long had an essentially monopolistic ca. 80% market share (Wilkins 2011). Consequently, AMD has little hope of mobilizing the resources to compete with Intel in rapidly advancing process technology as an IDM (see Footnote 16). During the onset of the global financial crisis in 2007 and 2008, Mubadala and a debt-​laden, nearly insolvent AMD arranged a series of transactions whereby: (1) Mubadala rescued AMD in two successive capital increases, giving it a nearly 20% ownership stake, and (2) AMD spun

13  The semiconductor industry has been undergoing a process of restructuring over the past two decades, dividing it into a mixture of vertically integrated firms combining design and manufacturing (IDMs), and “fabless” design-​only firms contracting to dedicated “merchant foundries” specializing in manufacturing. The mounting plant and R&D costs associated with successive waves of process node miniaturization and wafer size increases are producing an increasingly stratified and concentrated industry organization, in which only a handful of dominant IDMs and merchant foundries are able to remain competitive at the technological cutting edge. Within this context of industry restructuring, three manufacturers stand out as Schumpeterian monopolistic giants, with Intel and Samsung dominating among IDMs, and Taiwan-​based TSMC controlling half of the merchant foundry market. Meanwhile, other firms are either exiting manufacturing to focus on design, merging in an attempt to achieve competitive scale, or falling back on lower end forms of niche production (Macher, Mowery, and DiMinin 2007; McGrath, 2012a; Naeher Suzuki, and Wiseman 2011; The Economist 2009).

110    From Financialization to Vulture Developmentalism

Figure 4.5  Mubadala-​GlobalFoundries-​AMD-​IBM network (2016)

Daniel Haberly   111 off its manufacturing division as Mubadala-​controlled GlobalFoundries.14 The latter freed AMD to compete with Intel as a “fabless” design only firm, while simultaneously granting Abu Dhabi a toehold in the merchant foundry sector with a guaranteed major customer (Don 2008; Mubadala 2008). Subsequently, GlobalFoundries has continued to expand its market share as a merchant foundry by acquiring the unwanted operations of other manufacturers. In September 2009, GlobalFoundries purchased Chartered Semiconductor—​Singapore’s unprofitable national semiconductor champion—​from the Singaporean SWF Temasek Holdings (Nicholas and Tan 2009)  (see Figure 4.5). More recently, in 2015, it acquired the money-​losing semiconductor manufacturing operations of IBM, as part of the latter’s ongoing policy of shedding underperforming non-​core assets (Barinka and King 2014).15 It is too early to say whether this strategy will achieve its goal of establishing a semiconductor industry in Abu Dhabi itself. The construction of GlobalFoundries has been a heroic and essentially unprecedented effort for a state with no existing semiconductor industry expertise. To its credit, GlobalFoundries is now the world’s third largest merchant foundry, and counts itself among the uppermost ranks of semiconductor firms in terms of the sophistication of its manufacturing technology. This technology is so sensitive that both of its US acquisitions were subjected to US Federal CFIUS scrutiny, with their greenlighting a testimony to the strength of the strategic military relationship between the US and the UAE (AMD 2009; Amprimoz 2008; GlobalFoundries 2015). However, this strategy of high-​tech industrial development also faces severe, possibly insurmountable structural obstacles, and does not appear to have gone entirely to plan. The basic problem is that the merchant foundry sector, like the CPU sector, has a highly polarized winner-​take-​all structure (Clendenin 2010; Economist 2009)  (see Figure 5.4). While the state-​of-​the art process technology GlobalFoundries inherited from AMD is superior to that of all merchant foundries save Taiwanese TSMC and UMC, maintaining this position is a continuous challenge (Jelinek 2011). Market leader TSMC has a 50% market share, and operates at a 30–​50% gross margin. This enables it to make investments in capacity and technology, which not even Abu Dhabi can match—​ $22 billion in new capacity over 2010–​12, compared to $11 billion by GlobalFoundries (Luk 2012; McGrath 2012a). GlobalFoundries lacks the market share to invest at this rate without operating at a loss, yet increasing market share will be difficult given the investment disparity with TSMC (Luk 2012; Nair 2012). Given its uphill battle with TSMC, and the $4–​8 billion cost of constructing a state-​ of-​the-​art semiconductor plant, GlobalFoundries has to date not had the maneuvering room to contribute substantially to Abu Dhabi’s development (Luk 2012; Zyl 2011). Initially, construction on an enormous $6–​8 billion Abu Dhabi fab was scheduled to begin in early 2012 (Flanagan 2011). In November 2011, however, it was announced that 14  The direct parent of GlobalFoundries, Mubadala subsidiary ATIC, gradually purchased 100% control of GlobalFoundries between late 2008 and March 2012 (McGrath 2012b). 15  This has more famously involved IBM’s sale of its PC and low-​end server divisions to Chinese Lenovo.

112    From Financialization to Vulture Developmentalism construction would be delayed due to “poor global economic conditions” (Zyl 2011). As of the end of 2015, there was no evidence of any immediate plans to restart the project. Ironically, even while indefinitely delaying plans to develop the semiconductor industry in Abu Dhabi, GlobalFoundries has been making multibillion-​dollar investments in production at established advanced economy semiconductor manufacturing centers in Singapore, Dresden, Germany, and upstate New York. Unlike Abu Dhabi, these have the concentrations of semiconductor manufacturing skills and R&D activity necessary for GlobalFoundries to survive under intense competitive conditions (Ehrlich 2011; Weber 2003).16 Moreover, Abu Dhabi’s semiconductor investments are considered to be so important to the local economy in these regions that host states have been willing to support them with heavy subsidies (European Commission 2011; State of New York 2008). Ultimately, whether or not Abu Dhabi is successful in translating its creation of GlobalFoundries into a domestic semiconductor industry is likely to hinge on the network of training and R&D partnerships that Mubadala and GlobalFoundries have established with research institutions in and outside of Abu Dhabi (see Figure 4.5),17 as well as advanced economy host states for their investment (e.g. Saxony).18 In theory, a concerted strategy of international personnel training and rotation centered on GlobalFoundries could eventually allow Abu Dhabi to cultivate a substantial local skill base in this sector. In the meantime, however, the key question will be how many tens of billions of dollars Mubadala is able or willing to invest in a firm that has so far only contributed to the shareholder returns and industrial development of foreign firms and regions. This question is particularly salient in the context of low and declining oil and gas prices.

Conclusion: The Limits of the Quadruple Bottom Line What are the implications of these findings for our understanding of the developmental effectiveness of strategic SWF investment, as well as a-​or extra-​territorial development policy tools more generally? Firstly, the case studies demonstrate that Abu Dhabi has in 16  Upstate New York, where GlobalFoundries recently opened a $4.6 billion new fab, is home to: (1) the headquarters of IBM, with which GlobalFoundries cooperates closely; (2) one of the world’s leading semiconductor research and education programs at SUNY Albany; and (3) process technology global R&D consortiums including SEMATECH (Ehrlich 2011; GlobalFoundries 2012; TechValley 2012). 17  These include a “research-​driven” academic program in microsystems engineering established in partnership with MIT and Masdar, and four semi-​conductor R&D centers. Two centers are based in Abu Dhabi; one jointly between ATIC (now Mubadala Technologies) and the Khalifa University of Science and Technology (ATIC 2011; Parmar 2012). Two additional centers are planned in upstate New York, one fully controlled by GlobalFoundries, and one jointly operated with SUNY Polytech (GlobalFoundries 2013, 2016). 18  To promote GlobalFoundries’s expansion, in the Dresden area the government of Saxony has established a microelectronics training and R&D “partnership committee” with Abu Dhabi (ATIC 2010).

Daniel Haberly   113 fact been able to leverage its relationships with advanced economy firms and states—​in a manner partially bypassing territorial economic sovereignty—​to “leapfrog” into certain areas of high-​value manufacturing. However, this feat has been mostly performed by leveraging the state’s power as a customer within buyer–​supplier relationships, notably via purchases of aerospace and defense hardware. Meanwhile, South-​North strategic SWF investment itself has made relatively little contribution to this leapfrogging to date; instead, primarily showing an ability to catalyze more modest and incremental forms of development. What the case studies underscore is that the ability of states in the developing world to translate leverage over advanced economy firms into domestic developmental benefits hinges not only on the degree of leverage that states can exert, but also the type of firms over which they can exert this leverage. Some advanced economy firms—​namely those possessing a dominant monopolistic or oligopolistic position in a high-​tech market segment—​have an inherently greater level of agency to dramatically drive forward a state’s developmental agenda. The problem confronting South-​North strategic SWF investment, is that while acquiring substantial buyer leverage over such a firm simply makes a developing state a good customer—​for example of EADS/​Airbus in the case of Abu Dhabi’s successful aerospace sector development program—​purchasing a controlling equity stake in the same firm is likely to be regarded as an intrusion into the sovereignty of the host state. As such, developmental alliances mediated through South-​ North strategic SWF investment must operate within different political constraints than developmental alliances that do not depend on South-​North state investment. Even Abu Dhabi, which has strong political relationships with the major advanced economy states, has to tread lightly with its investments, ensuring that these serve a “quadruple bottom line” encompassing private and public host interests. In practice, this typically means taking over sectors, firms, and functions that advanced economy capital and states would like to see performed, but no longer want to take responsibility for themselves—​in short, an internalization of the logic of “offshoring” within the territories of the advanced economies, via transfers of assets to developing world SWFs. This can entail rescuing critical advanced economy firms (e.g. Daimler) through non-​ controlling capital injections, with limited associated leverage. It can also mean assuming control of a highly commoditized basic industry (e.g. polyolefins), which would have low entry barriers for states in the developing world even without strategic investments in advanced economy firms. Finally, for states such as Abu Dhabi that are close political allies of advanced economy states, it is possible to buy control of advanced economy firms which possess state-​of-​the art technology, but are uncompetitive in relation to their peers (e.g. GlobalFoundries). The latter high-​tech “vulture developmentalist” investments superficially appear to open the door to rapid developmental leapfrogging into sophisticated areas of economic activity. However, rehabilitating a troubled, second-​tier firm in a sector dominated by Schumpeterian monopolies is both costly and risky. Rather than being free to harness the firm to promote national developmental objectives, the buyer faces the risk of being enslaved to the commitment of attempting to turn around its competitive prospects. To

114    From Financialization to Vulture Developmentalism be fair, these investments do appear to serve as an effective means of enrolling foreign portfolio firms in various training and R&D agreements, which may eventually yield tangible developmental benefits for SWF-​owning states. However, what is clear is that even a successful leveraging of these networks to promote domestic high-​tech industrialization is at best a long and arduous process. This hardly qualifies as overnight leapfrogging, wherein the acquisition of foreign firms allows for high-​tech development to be simply bought “off the shelf.” In all, there are two rather striking paradoxes in the cases examined. Firstly, the basic promise of strategic SWFs is their potential to free industrial policy from the standard confines of territorial sovereignty. However, most of the tangible benefits of Abu Dhabi’s strategic SWF-​led development appear to have directly derived from the leveraging of conventional territorial resources—​most importantly low-​cost production inputs (i.e. in petrochemicals) and market power (i.e. in aerospace). This suggests that territorial sovereignty may indeed, notwithstanding the institutional adaptive potential of states, be a somewhat inescapable pillar of “stateness.” Secondly, Abu Dhabi’s strategic SWF-​led industrial policy has, by and large, been much more coherently conceived and executed than those of the advanced economy hosts in which it invests. Indeed, economic policy in most of these hosts is in a state of disarray. However, the benefits of Abu Dhabi’s industrial policy seem to have disproportionately “trickled-​up” from south to north, primarily as a result of the inherited structural economic and political power position of the latter. This paradox is particularly striking in the semiconductor sector, where Abu Dhabi’s meticulously planned national development strategy has so far only produced a high-​tech renaissance in upstate New York and the former East Germany. Ultimately, this underscores the critical importance of incumbency in national development; by the same measure, however, it raises the question of how long this incumbency can be maintained in the face of ambitious and well-​funded developing world industrial policy intervention.

Acknowledgments I would like to thank Yuko Aoyama, James Murphy, Jody Emel, Henry Wai-​Chung Yeung, Lauren Bonilla, Rory Horner, and Seth Schindler for their comments on earlier drafts of this chapter. Any errors or omissions are solely the responsibility of the author. Fieldwork for this chapter was supported by National Science Foundation grant number 1030638.

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Chapter 5

Sovereign Wea lt h Fu nd s an d the Resou rc e  C u rse Resource Funds and Governance in Resource-​Rich Countries Jędrzej George Frynas

Introduction Historically, a key purpose of sovereign wealth funds (SWFs) has been to help manage and minimize a range of negative economic and political consequences of natural resource wealth, often lumped together as the “resource curse.” This chapter asks the pertinent question: Are SWFs—​specifically “resource funds”—​a good mechanism to tackle the resource curse? SWFs—​even if defined very broadly as “separate pools of government-​owned or controlled assets that include some international assets” (Truman 2010, p. 10)—​are dominated by natural resource wealth. Based on Truman’s (2010) extensive listing of SWFs, 48 of out 83 SWFs received their financing from non-​renewable natural resources, or just under 60%; if one excludes non-​pension SWFs, the share of natural resource financing was around 70%. Indeed, SWFs have originated as “stabilization funds” (to address the challenges related to the volatility and unpredictability of the income from natural resources) or “savings funds” (to address the need and desire to save a portion of the resource income) in resource-​rich countries (Davis, Ossowski, Daniel, and Barnett 2001a; Bacon and Tordo 2006). Over more than sixty years, stabilization and savings funds across many resource-​ rich countries (ranging from Kuwait’s fund created in 1953 to Mexico’s new fund created in 2014) were set up to help mitigate the resource curse. Perhaps most notably, Norway’s fund “was established as a policy designed to avoid the curse of resource wealth” (Clark, Dixon, and Monk 2013, p. 20). “The first modern sovereign fund” was arguably

124    Sovereign Wealth Funds and the Resource Curse established by Kuwait in 1953 to manage excess oil revenues, even though most stabilization and savings funds in resource-​rich countries (focused on macroeconomic stability and local development requirements) later transformed into the modern SWFs (focused on financial returns on capital and global financial markets) (Balding 2012, Chapter 1). In this chapter, we simply refer to “resource funds” as a generic term to encompass all types of savings funds, stabilization funds or SWFs which are funded by revenues from natural resources in resource-​rich countries. However, while recent books on SWFs extensively discuss the governance of SWFs and their impact on financial markets, they normally fail to discuss the resource curse or, at best, mention it in passing. Truman (2010), for example, only mentioned the Dutch Disease phenomenon (one mechanism of the resource curse) in passing in a single exhibit in his book. These books devote almost no attention to the question as to what extent resource funds are actually able to mitigate the curse of resource wealth in resource-​rich countries, and what are the factors that determine the effectiveness of resource funds in terms of minimising resource course effects, even though such discussions have actively taken place in policy circles over many years, most notably within the International Monetary Fund (IMF) (Cashin, Liang, and McDermott 1999a, 1999b; Davis, Ossowski, Daniel, and Barnett 2001a; Gupta, Segura-​Ubiergo, and Flores 2014; Shabsigh and Ilahi 2007). Consequently, this chapter asks to what extent resource funds can help to mitigate the resource curse. We start by briefly explaining the resource curse, followed by a discussion of the role of resource funds in mitigating the resource curse and a discussion of the evidence for the effectiveness of resource funds. The main part of the chapter discusses the relationship between societal governance and the effectiveness of resource funds, which is followed by a conclusion.

The Resource Curse The resource curse thesis suggests that countries with a high dependence on natural resources tend to suffer from a range of negative macroeconomic and macropolitical effects. There are some differences of opinion as to which “resources” contribute to the resource curse, but studies widely agree that oil, gas and mineral resources are behind the resource curse, while most studies agree that agricultural resources do not have significant resource curse impacts. The empirical evidence of resource curse effects is most robust for oil and gas resources (for useful recent reviews, see Frankel 2010; Ross 2014; van der Ploeg 2011). The resource curse thesis has occasionally been challenged. Some studies have found no evidence, or mixed evidence, of certain resource curse effects (for example, on the resource curse effects on economic growth, see Alexeev and Conrad 2009; Brunnschweiler 2008)  and other studies have suggested that resource curse effects are subject to considerable contingencies (for example, on the relationship between

Jędrzej George Frynas   125 democratic rule and resource curse effects, see Bhattacharya and Hodler 2010; Ross 2014). Nonetheless, developing countries in particular suffer from at least some resource curse effects related to three main areas: impact on the economy, impact on governance and impact on conflict, which are briefly outlined below. First, the inflow of natural resource revenues can lead to the so-​called Dutch Disease phenomenon—​the appreciation of a country’s currency exchange rate, which can reduce exports of agricultural and manufacturing goods. While empirical evidence does not necessarily suggest that resource wealth per se leads to lower economic growth, the natural resource sectors can draw capital, labour and entrepreneurial activity away from non-​resource sectors, thereby stifling the development of those sectors (Brahmbhatt, Canuto, and Vostroknutova 2010; Ismail 2010; van der Ploeg 2011). Based on the evidence from 41 resource exporting countries between 1970 and 2006, a recent study by Harding and Venables (2013) suggested that, in response to one dollar of natural resource revenue, non-​resource exports decrease by approximately 75 cents and imports increase by 25 cents, and indeed, the windfall effect was most severe for countries with a large manufacturing sector. Second, the inflow of natural resource revenues can undermine good governance and the quality of institutions in a society. Given their dependence on extractive revenues, governments in resource-​rich countries have greater incentives to focus their efforts on political competition to capture resource rents, and on patronage to pay off political supporters to stay in power, rather than on providing incentives to create wealth by improving the quality of societal institutions (Auty 2007; Robinson, Torvik, and Verdier 2006). Most notably, empirical evidence strongly suggests that resource-​rich countries tend to suffer from higher levels of corruption than non-​resource rich countries (Kolstad and Søreide 2009; Petermann, Guzman, and Tilton 2007) and that natural resource abundance helps autocratic regimes to remain in power (Ahmadov 2014; Wright, Frantz, and Geddes 2015). Third, natural resource revenues provide fewer incentives for human co-​operation and tend to be less affected by violent conflicts than other economic sectors, as extractive firms can build the necessary infrastructure, provide their own security and—​being enclave economies—​rely less on local business linkages. At the same time, the prospects of gaining control over natural resource revenues may fuel the activities of rebel groups, potential coup leaders and other violent forms of political opposition. There is strong empirical evidence that the presence of natural resources significantly increases the threat of armed conflict, albeit this impact is subject to a number of contingencies (Collier and Hoeffler 1998; Humphreys 2005), above all, the location of the natural resources is of critical importance (e.g. if resources are located inside the actual conflict zone, a conflict can be significantly exacerbated, but the impact on conflict is less pronounced (if oil and gas resources are discovered offshore) (Lujala 2010; Ross 2014). Despite the potentially significant detrimental impact of the inflow of natural resource revenues, it has been recognized that a small number of resource-​rich OECD countries (such as Norway and Canada) and non-​OECD countries (such as Botswana and Chile) have been able to largely mitigate the resource curse. The diversification of the economy,

126    Sovereign Wealth Funds and the Resource Curse good governance and special fiscal institutions (SFIs)—​which include resource funds, fiscal rules, fiscal responsibility legislation and budgetary natural resource prices used in the fiscal management in resource-​rich countries—​have been cited as recipes for escaping the resource curse (e.g. Humphreys, Sachs, and Stiglitz 2007; Rosser 2006; Sharma and Strauss 2013; Stevens 2005).

Resource Funds and the Resource Curse The question “Are resource funds a good mechanism to tackle the resource curse?” is pertinent because such funds were originally established in resource-​rich countries to mitigate the resource curse. The main motives for establishing resource funds in the first instance have included: (1) the desire to stabilize natural resource income (to address the volatility and unpredictability of natural resource revenues); (2) to facilitate savings of natural resource revenues in order to meet future spending obligations (to address volatility and unpredictability); (3) to meet the needs of future generations (to address the challenge of the finite nature of natural resources); and (4) to diversify the natural resource income away from natural resources (to address the crowding out of non-​ resource sectors and to lessen dependence on natural resource revenues) (Bacon and Tordo 2006; Clark, Dixon, and Monk 2013, p. 15). In order to address different aspects of the resource curse, van der Ploeg (2014) made a normative argument for the establishment of different types of resource funds. He suggested the creation of an intergenerational sovereign wealth fund to smooth consumption across generations, a liquidity fund to address commodity price volatility, and an investment fund to save a portion of the natural resource income until the country is able to absorb additional spending on domestic investment. More typically, authors have traditionally distinguished between a savings fund and a stabilization fund (Bacon and Tordo 2006; Davis, Ossowski, Daniel, and Barnett 2001a) and their rationale is briefly outlined below. On the one hand, it has been long been argued that the volatility and unpredictability of natural resource revenues presents one of the biggest challenges of resource wealth and that resource funds can directly address that challenge (Arrau and Claessens 1992; Hasson 1956). Resource-​rich countries face, on the one hand, very volatile and unpredictable commodity prices, while on the other hand, they face stable and predictable government spending commitments. Therefore, governments in resource-​rich countries sought to use special stabilization funds to stabilize natural resource income by smoothing out the tremendous swings in government revenues, by depositing a part of the extractive revenues when commodity prices are high to provide the government with a source of income to withdraw during periods when commodity prices are low (Arrau and Claessens 1992; Collier, van der Ploeg, Spence, and Venables 2009; Davis, Ossowski, Daniel, and Barnett 2001a).

Jędrzej George Frynas   127 On the other hand, it has been argued that the finite nature of natural resources raises the challenges of intergenerational equity and long-​term fiscal sustainability. Natural resources are finite and, once depleted, will fail to benefit future generations, hence a depletion of all resources would be viewed as unfair and undesirable in terms of intergenerational equity. At the same time, the depletion of all resources will undermine long-​term fiscal sustainability of government finances. Therefore, governments in resource-​rich countries sought to use savings funds to store wealth for future generations, by saving a part of the resource revenues so that future generations could benefit from the revenues extracted in the current period and so that future governments could meet future spending obligations (Bacon and Tordo 2006; Collier van der Ploeg, Spence, and Venables 2009; Davis, Ossowski, Daniel, and Barnett 2001a). A number of countries have set up separate savings and stabilization funds. For example, Iran set up the National Development Fund of Iran in 2011 to supplement its existing Oil Stabilization Fund. Similarly, Ghana set up two separate funds in 2011. However, resource-​rich countries often set up resource funds that combine elements of a savings fund and a stabilization fund. Indeed, international organizations such as the World Bank, through its Energy Sector Management Assistance Program (e.g. Bacon and Tordo 2006), and the IMF, through its policy prescriptions (e.g. IMF 2012), have advised resource producing countries that a single resource fund would be most appropriate. This is because a single fund may inter alia minimize financing costs, maximize returns on pooled savings, and avoid some of the practical difficulties of operating multiple funds. For example, Norway’s Government Pension Fund was originally established in 1990 to fulfil a dual—​stabilising and savings—​purpose, while Mexico established the Fund for Stabilization and Development in 2014 with a dual purpose.

Evidence on the Effectiveness of Resource Funds As outlined above, savings funds and stabilization funds were established to tackle the resource curse, and this raises the issue of robust empirical evidence being available to answer the question: “Are resource funds a good mechanism to tackle the resource curse?” Based on a literature review conducted for this chapter, the relevant econometric studies have notably measured the impact of resource funds on governance and on exchange rate movements. Some econometric studies have suggested that resource funds are associated with better governance and fiscal outcomes (Tsani 2013, 2015; Sugawara 2014). For example, Etemad (2014a) has found that countries with resource funds have improved their fiscal balances as a share of GDP compared to countries without funds. However, other econometric studies have not found significant effects of resource funds on fiscal outcomes (Crain and Devlin 2003; Davis, Ossowski, Daniel, and Barnett 2001a; Ossowski,

128    Sovereign Wealth Funds and the Resource Curse Villafuerte, Medas, and Thomas 2008). Indeed, Crain and Devlin (2003) found that resource funds can lead to greater volatility of government expenditure. Similarly, econometric studies have provided mixed empirical evidence for the impact of resource funds on exchange rate movements. For example, Shabsigh and Ilahi (2007) have found that, while resource funds are associated with reduced price volatility and lower inflation, they are also associated with greater volatility of the real exchange rate. In contrast, Etemad (2014b) found that, while the real exchange rate slightly increased following the creation of resource funds, there is a statistically weak negative association between the presence of an oil fund and volatility of the real exchange rate. As this brief discussion suggests, econometric studies have provided mixed empirical evidence for the impact of resource funds and there is currently no conclusive evidence that resource funds mitigate resource curse effects such as through improving governance or reducing price volatility. These mixed findings are perhaps unsurprising since, on the one hand, the research on the impact of resource funds has been relatively recent, and, on the other hand, scholarship on the resource curse in general has been mixed over the years. As with the resource curse literature in general, the literature on resource funds appears to suggest that the impact of resource funds is contingent upon a multitude of factors. Resource fund scholarship pointed to factors such as the quality of the fiscal framework (e.g. Dabán 2011; Davis, Ossowski, Daniel, and Barnett 2001a), the type of investments in resource funds (e.g. Landon and Smith 2013, 2015) and the duration of price shocks (e.g. Cashin, Liang, and McDermott 1999a, 1999b). If the impact of resource funds is contingent upon a multitude of factors, the question arises as to whether the governance framework of an SWF is a key factor. In other words, can the quality of the governance frameworks of resource funds explain the effectiveness of resource funds in terms of mitigating the resource curse? Some writers have formulated benchmarks and practical guidelines for the governance of resource funds that could help to minimize resource curse effects (e.g. Ang 2010; van der Ploeg 2014). There have also been attempts to classify resource funds in terms of their governance, transparency and accountability, in order to benchmark them and to encourage better fund governance, with the most notable attempt being the Truman Scoreboard for SWFs designed at the Peterson Institute for International Economics (Bagnall and Truman 2013). The so-​called “Santiago Principles” were the most noteworthy attempt at regulating resource funds and improving their governance. Established by the International Working Group of Sovereign Wealth Funds (IWG) in 2008, one of the main objectives of the Santiago Principles was to “have in place a transparent and sound governance structure that provides for adequate operational controls, risk management, and accountability” (IWG 2008, p. 4). The Santiago Principles encompass 24 voluntary principles for SWFs, which include principles on governance, accountability and transparency (for more details, see Chapters 7 and 24). However, there are no robust econometric studies on the effectiveness of the Santiago Principles and the effectiveness of these principles has been seriously questioned.

Jędrzej George Frynas   129 One problem with the Santiago Principles is the low level of compliance. According to the “Santiago Compliance Index” compiled by the political risk consultancy GeoEconomica, the commitment of SWFs to implement the Santiago Principles is very uneven—​indeed, various SWFs that formally abide by the Santiago Principles have very poor transparency and governance records (Behrendt 2014). As Lavelle points out in this Handbook, the Santiago Principles have more fundamental flaws inter alia in that they concentrate too narrowly on SWFs themselves and not on their relationship with the host countries and that there are no sanctions for non-​compliance (Lavelle 2017). Going beyond the Santiago Principles and the governance of SWFs, it has been suggested that resource funds can only work well when they are underpinned by appropriate institutions at national and local levels, such as robust structural budget-​balance rules (Dabán 2011; Snudden 2013). As a notable example, it has been argued that “the cornerstone of Chile’s impressive fiscal performance has been its structural balance rule” (Dabán 2011.). The rule was introduced in 2001 to help business cycle stabilization, and complemented the already existing resource fund. In general, Davis, Ossowski, Daniel, and Barnett (2001a., p. 26) argue that “in some cases where the underlying fiscal policies were generally sound to begin with (such as Norway), [resource] funds have been better able to address the problems posed by the behavior of non-​renewable resource prices and fungibility issues.” Therefore, the key question arises to what extent the effectiveness of resource funds is associated with wider societal governance. This will now be explored further.

Resource Funds and Societal Governance As already noted, econometric studies have provided mixed empirical evidence for the impact of resource funds on wider societal governance. It is particularly noteworthy that only a minority of studies point to a positive association between resource funds and societal governance (e.g. Tsani 2013, 2015; Etemad 2014a), while the majority of studies point to a negative, mixed or insignificant association (e.g. Crain and Devlin 2003; Davis, Ossowski, Daniel, and Barnett 2001a; Ossowski, Villafuerte, Medas, and Thomas 2008). Indeed, the arguably most serious argument of critics has been that resource funds per se do not matter—​it is the specific fiscal rules and the institutional environment of a country that matter. In other words, we may want to shift attention from the question “Are resource funds a good mechanism to tackle the resource curse?”, to the question “Are good societal institutions a necessary prerequisite to ensure the effectiveness of resource funds in tackling the resource curse?” What is perhaps surprising is that some of the most damning critiques of resource funds comes from within International Monetary Fund circles (Baunsgaard, Villafuerte, Poplawski-​Ribeiro, and Richmond 2012; Davis, Ossowski, Daniel, and Barnett 2001b;

130    Sovereign Wealth Funds and the Resource Curse IMF 2007), given that stabilization and savings funds have long been regarded as a key mechanism to tackle the resource curse. Notably, the IMF’s Fiscal Affairs Department conducted econometric tests to assess the impact of special fiscal institutions (SFIs)—​ including oil funds—​on key fiscal variables such as the average growth of government expenditures in real terms, as well as the correlation between expenditure and oil revenue, using data from 1992–​2005. They found that SFIs do not have a significant effect on fiscal outcomes, which are more dependent on the short-​term volatility of oil receipts. Furthermore, they found that SFIs have no significant effect on expenditure growth or on reducing the correlation between expenditures and oil revenue (IMF 2007). Crucially, in contrast to the ineffectiveness of SFIs (including SWFs), the findings of the IMF’s Fiscal Affairs Department suggested that “broader governance institutions do seem to have an impact on the non-​oil primary balance and expenditure dynamics” (IMF 2007, p. 23). The evidence suggested, among others, that better quality of institutions (as measured by political stability, law and order as well as regulatory quality) was associated with decreased non-​oil deficits, and that countries with less corruption had lower correlations between expenditures and oil revenue. As IMF staff specifically noted, such findings conform with the previous “voracity effect” argument suggesting that countries with the weakest institutions have higher government expenditures during revenue windfalls because there are fewer institutional barriers that would prevent the transfer of wealth from the private sector to powerful political interests in those countries (Lane and Tornell 1996; Tornell and Lane 1999). There are many examples of countries where weak societal institutions have undermined the success of resource funds. In countries with weak institutions and weak fiscal rules—​such as Papua New Guinea and Venezuela—​resource funds are said to have exhibited poor or mixed performance in terms of stabilising government budget expenditure or setting aside revenue for future generations, since the government was able to unilaterally change, bypass or eliminate the operating rules that govern deposits and withdrawals to resource funds, in response to an increase in commodity prices or current budget increases. The rules in some countries such as Bahrain and Libya explicitly allowed discretionary transfers from the resource fund to the budget; hence undermining its function. Furthermore, in the absence of liquidity constraints, governments in countries such as Algeria were able to take on additional debt in order to fund higher government expenditure even if the government simultaneously set up a stabilization fund intended to smooth budget revenue. Indeed, governments in some countries such as Chad and Papua New Guinea found their resource funds politically unworkable and abolished them outright (Davis, Ossowski, Daniel, and Barnett 2001a; IMF 2007; Ossowski, Villafuerte, Medas, and Thomas 2008). While we still require more future scholarship on the relationship between resource funds and wider societal governance (such as on assessing the role of democratic accountability, civil society or free media in this relationship), the available findings suggest that wider societal governance may be of significantly greater importance for tackling the resource curse than the existence of a resource fund. Indeed, Davis, Ossowski, Daniel, and Barnett (2001b) argue that many challenges of the resource curse could be

Jędrzej George Frynas   131 addressed with good governance without the need for establishing a resource fund. For example, the negative effects of the Dutch Disease could be potentially addressed by the government or the country’s central bank investing resource revenues in foreign deposits or exchange reserves, while increases in government expenditure could be curbed by imposing liquidity constraints. In summary, the quality of societal governance may matter more for the management of natural resources than specific technocratic solutions to the resource curse such as resource funds, which is supported by studies on other technocratic solutions to the resource curse. Most notably, studies on revenue transparency initiatives in resource-​ producing countries, above all the Extractive Industries Transparency Initiative (EITI), have suggested that such initiatives are significantly constrained by weak institutional environments and that it may be difficult to ascribe governance improvements to the EITI (e.g. Aaronson 2011; Frynas 2010; Sovacool and Andrews 2015). Conversely, studies show that the quality of wider societal governance (such as the quality of government budget documentation or the presence of a free civil society and independent media) helps toward improvements in government expenditure; for example, by reducing the scope for corruption and waste (e.g. Alt and Lassen 2006a, 2006b; Besley and Prat 2006; Haslam 2016; Mehlum, Moene, and Torvik 2006).

Governance of Resource Funds and Country Governance Indicators As already outlined, previous studies seem to imply that resource funds may require an enabling societal governance as a prerequisite for minimizing resource curse effects. Alternatively, at the very least, resource funds can be more effective policy instruments when they operate in an environment with good governance. In order to explore these arguments further, we have compared the Truman Scoreboard for resource funds with national governance indicators, expecting some overlap between the two (see Table 5.1). Table 5.1 includes information on all resource-​rich countries where there is a resource fund in operation, for which a rating has been provided in the updated Truman Scoreboard in 2013. For example, Malaysia’s National Trust Fund and Bahrain’s Future Generations Reserve Fund are not listed in Table 5.1 because these funds have not been given a Truman Scoreboard rating. For each country, Table 5.1 lists the Truman Scoreboard rating for the country’s largest resource fund. The Truman Scoreboard relies on asking simple yes/​no questions within four categories, including structure of the fund, governance of the fund, accountability and transparency of the fund and behavior of the fund. In total, the Truman Scoreboard has 33 individual elements that are equally weighted and translated into a 100-​point scale. The overall summary rating for each country is reproduced in Table 5.1.

Table 5.1 Resource Funds and Governance in Resource-​Rich Countries (2013 Data)

Country’s Largest Resource Fund

Fund’s Year of Foundation

Fund’s Total Assets (US$ billion)

Fund’s Truman Scoreboard Index

Country’s Political Country’s Stability Rule of Index Law Index

Country’s Regulatory Quality Index

Country’s Resource Governance Index

Country’s Corruption Perceptions Index

Norway

Government Pension Fund-​Global

1990

720

98

95

100

95

98

86

United States

Alaska Permanent Fund

1976

47

91

66

91

87

92

73

Chile

Social and Economic Stabilization Fund

2007

22

91

60

88

92

75

71

Canada

Alberta Heritage Savings Trust Fund

1976

17

86

84

95

95

76

81

UAE

Abu Dhabi Investment Authority

1976

627

58

75

71

75

n.a.

69

Kuwait

Kuwait Investment Authority

1953

342

73

52

63

50

41

43

Russia

National Welfare Fund and Reserve Fund

2004

171

53

22

25

38

56

28

Qatar

Qatar Investment Authority

2005

115

17

91

83

74

26

68

Kazakhstan

National Fund

2000

76

71

35

30

37

57

26

Libya

Libyan Investment Authority

2006

56

6

5

6

2

11

15

Algeria

Revenue Regulation Fund

2000

55

29

12

31

12

38

36

Iran

National Development Fund

2011

54

41

11

17

6

28

25

Country OECD Countries

Non-​OECD Countries

Azerbaijan

State Oil Fund

1999

35

88

33

30

35

48

28

Timor-​Leste

Petroleum Fund

2005

13

85

34

9

17

68

30

Oman

State General Reserve Fund

1980

8

27

62

67

67

n.a.

47

Mexico

Oil Revenues Stabilization Fund

2000

6

44

23

35

67

77

34

Angola

Fundo Soberano de Angola

2012

5

15

34

9

15

42

23

Botswana

Pula Fund

1994

5

56

86

68

73

47

64

Trinidad and Tobago

Heritage and Stabilization Fund

2000

5

83

51

48

59

74

38

Nigeria

Sovereign Investment Authority

2011

1

18

4

12

26

42

25

Ghana

Ghana Petroleum Funds

2011

0.9

47

47

56

55

63

46

Venezuela

National Development Fund

2015

0.8

29

16

1

3

56

20

São Tomé and Príncipe

National Oil Account

2004

0.1

48

51

24

23

n.a.

42

Equatorial Guinea

Fund for Future Generations

2002

0.1

2

50

7

7

13

19

Sources: Scoreboard index adapted from Bagnall and Truman (2013); Political instability index, Rule of law index and Regulatory quality index from the World Bank World Governance Indicators database available from the World Bank at data.worldbank.org; Resource Governance index from the Revenue Watch Institute website at www. resourcegovernance.org/​rgi; Corruption Perceptions index from the Transparency International website at www.transparency.org/​cpi2013.

134    Sovereign Wealth Funds and the Resource Curse For each country, Table 5.1 also lists three indicators of the quality of societal governance—​political stability, regulatory quality and rule of law—​from the World Bank’s Worldwide Governance Indicators research dataset (cf. Kaufmann, Kraay, and Mastruzzi 2010). The IMF’s Fiscal Affairs Department (IMF 2007) found these three indicators to be statistically significant in terms of the association with decreased non-​ oil deficits (see earlier discussion). These three indicators were supplemented with the Resource Governance Index compiled by the US-​based watchdog Revenue Watch Institute, which measures the quality of governance in the oil, gas and mining sectors in 58 countries, as well as the Corruption Perceptions Index compiled by the global anti-​ corruption watchdog Transparency International, which measures the perceived levels of public sector corruption in 175 countries and territories. The latter two indicators have previously been used by Bagnall and Truman (2013) for a comparison with the Truman Scoreboard. Conveniently, all of these five indices and the Truman Scoreboard provide a score of between zero (lowest) and 100 (highest), which permits a simple comparison. All of these indices inevitably have limitations and any assessment of “good governance” may be somewhat imperfect, but a comparison of these indices may allow us to draw a few tentative conclusions. As a starting point, we may use the Revenue Watch Institute labels, which suggest that any Resource Governance index score in the range 71–​100 is “satisfactory”, while they label lower scores as partial (51–​70), weak (41–​50), and failing (0–​40). We will tentatively assume that any score above 70 is a satisfactory score. Table 5.1 demonstrates that all relatively developed OECD member countries (most OECD members are high-​income economies with well-​developed societal institutions) have a satisfactory score, both in terms of resource fund governance and in terms of wider societal governance (except for the political stability score for the US and Chile). This seems to conform with the findings of the resource curse literature that selected OECD countries, including most notably Norway, Canada, and Chile, have largely been able to evade the resource curse due to good governance in their societies (Mehlum, Moene, and Torvik 2006; Holden 2013; Robinson, Torvik, and Verdier 2006; Rosser 2006; Stevens 2005). In contrast, all non-​OECD member countries listed in Table 5.1 have considerably lower governance ratings. In order to further explore the link between resource fund governance and wider societal governance, we reproduce five scatter charts that depict the association between the Truman Scoreboard and each of the five societal governance indices listed in Table 5.1 (see Figure 5.1). These five charts suggest that there is some association between resource fund governance and societal governance, albeit this association is far from perfect. The association between resource fund governance and resource governance seems to be the closest, while the other four associations are less clear-​cut. There are obvious outlier countries where there seems to be little association between resource fund governance and wider societal governance. Two countries—​Qatar and Oman—​appear to have considerably higher scores for societal governance, but very low scores for resource fund governance. However, both countries seem to be rated very low in terms of resource governance by the Revenue Watch Institute, which described Qatar as “opaque” in terms of resource governance in general and has not even rated Oman.

Jędrzej George Frynas   135 Truman Scoreboard Rating (X-axis) and Political Stability (Y-axis)

Truman Scoreboard Rating (X-axis) and Rule of Law (Y-axis)

100

100

Qatar

Qatar

80

80

Oman

Trinidad & Tobago

60

Timor Leste

40 20

Oman Kazakhstan

40

Kazakhstan Azerbaijan

0 0

Trinidad & Tobago

60

50

100

20 Timor Leste

0

0

100

Qatar

80

Trinidad & Tobago

60

80 Timor Leste

Azerbaijan

40 Qatar

20

20

Kazakhstan Timor Leste

0

50

100

Trinidad & Tobago

60

Oman

40

0

50 Truman Scoreboard Rating (X-axis) and Resource Governance (Y-axis)

Truman Scoreboard Rating (X-axis) and Regulatory Quality (Y-axis) 100

Azerbaijan

0 100

0

Kazakhstan Azerbaijan

50

100

Truman Scoreboard Rating (X-axis) and Corruption Perception (Y-axis) 100 Qatar

80 60

Trinidad & Tobago

Oman

40

Timor Leste

20 Kazakhstan

0

0

50

Azerbaijan

100

Figure 5.1  Association between Truman Scoreboard and societal governance indicators

Hence, there seems to be at least an association between a low score for resource fund governance and a low score for wider resource governance for these two countries. There are several other outlier countries—​ including Azerbaijan, Timor-​ Leste, Trinidad and Tobago, and Kazakhstan. All four countries have pledged to abide by the Santiago Principles and they have considerably higher scores for resource fund

136    Sovereign Wealth Funds and the Resource Curse governance but considerably lower scores for societal governance. These countries deserve some attention because they could potentially demonstrate that better resource fund governance could contribute to better management of resource revenues, even in countries that suffer from particularly bad societal governance in other dimensions. One commonality among the above four countries is that they were all active members of the Extractive Industry’s Transparency Initiative (EITI). The EITI was launched at the initiative of the UK government in 2003 to improve the transparency of revenues paid by oil, gas and mining companies to host governments, which in turn were expected to improve the effectiveness of the management of such revenues. All four countries were EITI compliant countries at some point. Azerbaijan, Timor-​Leste, and Kazakhstan were EITI compliant in the year of our dataset 2013, while Trinidad and Tobago was already part of the compliance process and became compliant in 2015. In other words, all countries were eager to demonstrate transparency and accountability in the management of resource revenues and the transparency and accountability of the resource fund was an integral part of that effort. However, the establishment of a resource fund and membership of the EITI did not seem to improve transparency and accountability of resource revenue governance (the main purpose of the EITI), if judged by the Voice and Accountability index of the World Bank’s Worldwide Governance Indicators. Of the above four countries, only Timor-​Leste’s Voice and Accountability score increased from 40.38 in 2005 (resource fund established) to 50.74 in 2014. The Voice and Accountability score of the other three countries fell following the establishment of the resource fund and following EITI membership (see Figure 5.2). For example, Kazakhstan’s score declined from 20.67 in 2000 (resource fund established) to 19.23 in 2005 (EITI membership started) to 15.27 in 2014. 70 60 50 40 30

EITI candidate member

Resource fund established

Azerbaijan* Kazakhstan

20

Timor Leste Trinidad and Tobago

10

14

13

20

12

20

11

20

10

20

09

20

08

20

07

20

06

20

05

20

04

20

03

20

02

20

20

20

00

0

Figure 5.2  Voice and Accountability rating of four selected countries (2000–​14) Source: World Governance Indicators (WGI) database available from the World Bank at data.worldbank.org * Azerbaijan’s resource fund was established in 1999 but no WGI data exists for that year.

Jędrzej George Frynas   137 Out of the above four outlier countries, Azerbaijan deserves particular attention because the State Oil Fund of the Azerbaijan Republic (SOFAZ) is considered the most well-​governed fund. Azerbaijan has a long experience of resource revenue transparency initiatives, as SOFAZ was already established in 1999 and Azerbaijan was one of the first three EITI pilot countries in 2002. In the chapter by Lavelle in this Handbook, SOFAZ is listed among the most transparent SWFs on the Linaburg-​Maduell Transparency Index (Lavelle 2017). SOFAZ also has the highest Truman Scoreboard score for a non-​OECD country. In marked contrast, Azerbaijan receives very low country scores with respect to wider societal governance. Indeed, Azerbaijan displays the highest gap between the resource fund score (Truman Scoreboard score of 88) and the societal governance country scores (e.g. 28 and 30 for Corruption Perceptions and the Rule of Law, respectively). In other words, SOFAZ is a well-​governed SWF that operates in a very badly governed society. Given that SOFAZ has already been in existence for almost two decades and is considered a relatively well-​governed SWF, the question arises: “To what extent has SOFAZ been able to improve the management of resource revenues in Azerbaijan?” A  number of academic studies have specifically addressed the effectiveness of the efforts to improve the management of oil revenues in Azerbaijan. These studies suggested that, while SOFAZ exhibited a few weaknesses in the governance of the fund (including the lack of withdrawal rules and the lack of parliamentary oversight), SOFAZ has become the country’s most transparent public body and, indeed, the EITI board designated Azerbaijan as an “EITI compliant country” in 2009. However, the country’s management of resource revenues reportedly continued to be highly corrupt and opaque, and the lack of independent media and free civil society hampered the functioning of the EITI and prevented improvements in governance, which is supported by the low governance scores for the country (Aslanli 2015; Frynas 2010; Sovacool and Andrews 2015). As a consequence, the resource fund in Azerbaijan operated as an island of relative transparency and accountability, but it has been reported that once any funds were transferred from SOFAZ to the state budget, they were reportedly subject to opaque and corrupt monetary decision-​making (Aslanli 2015; Economist Intelligence Unit 2006). Indeed, it has been argued that “unlimited and unconditional transfers from SOFAZ to the state budget have threatened fiscal sustainability, effective revenue management and the overall macroeconomic equilibrium” (Aslanli 2015, p. 115). In April 2015, notwithstanding the high Truman Scoreboard score for SOFAZ, Azerbaijan became the first-​ever country to be downgraded from an “EITI compliant country” to an “EITI candidate country” due to shortcomings in EITI implementation (EITI 2015). In other words, the country’s resource fund and the EITI framework did not succeed in overcoming the constraints of bad societal governance. The above evidence seems to support the initial expectation based on the literature that bad governance in a country prevents even the most transparent resource funds to become an effective policy instrument; or conversely, resource funds require enabling societal governance in order to be effective in minimizing resource curse effects.

138    Sovereign Wealth Funds and the Resource Curse

Conclusion The resource curse can have debilitating effects on the economy, on governance and on societal conflicts in resource-​rich countries. Resource funds have been said to potentially help minimize resource curse effects, either through the stabilization route or the savings route. This chapter set out to investigate to what extent resource funds can help to mitigate resource curse effects. Econometric studies have provided mixed empirical evidence for the impact of resource funds, and this impact appears to be contingent on a number of factors. Our reading of the literature suggests that societal governance is the key contingent factor. We have investigated the role of governance by comparing the Truman Scoreboard for resource funds with a number of societal governance indicators. Our brief analysis seems to support the initial assumption that bad governance in a country prevents even the most transparent and robust resource funds from becoming an effective policy instrument; or conversely, resource funds require enabling societal governance in order to be effective in minimizing resource curse effects. In other words, effective societal institutions such as sound fiscal rules, the quality of government budget documentation, a free civil society or independent media appear to be a prerequisite for minimizing resource curse effects. In contrast, the establishment of a resource fund may either have no effect on mitigating resource curse effects, or at best may have a moderating effect. If wider societal governance is the crucial factor in determining the effectiveness of policies toward resource curse effects, then resource-​rich countries face a difficult dilemma: following the resource curse thesis, the inflow of resource revenues can undermine a country’s good governance and the quality of institutions; however, corrective measures such as resource funds depend on the country’s good governance to function well. There are no simple solutions to resolve this dilemma. From a policy perspective, a focus on the development of good governance in resource-​ rich countries is hence considerably more important than technocratic solutions, such as SWFs, and other measures, such as EITI membership. Expectations of achieving better management of resource revenues by creating SWFs may be misplaced, unless such policies are accompanied by improvements in governance, including better government budget documentation, effective anti-​corruption measures and nurturing free civil society.

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Pa rt  I I

P OL I T IC A L A N D L E G A L A SP E C T S OF S OV E R E IG N W E A LT H  F U N D S

Chapter 6

Sovereign Wea lt h Fu nd s an d the Gl oba l P ol i t i c a l Ec onom y of T ru st and Legit i mac y Gordon L. Clark and Adam D. Dixon

Introduction For some in the West, the growth of sovereign funds in the first decade of this century, most of which came from Middle East and East Asia, reflected the crisis of western power and dominance in global affairs and, in particular, the rise of China (Truman 2010). Were these new state-​sponsored investment vehicles benign giants simply pursuing risk-​adjusted returns in global financial markets? Or, would they be used to advance the geopolitical and mercantile interests of the sponsoring state (Cohen 2009)? Consequently, would they distort global financial markets and the allocation of capital across time and space? Even though there are clear policy reasons for establishing a sovereign fund, such as managing natural resource revenues through stabilization and savings, or achieving higher returns on foreign exchange reserves from export-​ led development, they are still entities of the state (Balding 2012; Das, Mazarei, van der Hoorn, and IMF 2010; Dixon 2016). As such, were they trustworthy and were they legitimate players in global financial markets? The anxiety in the West vis-​à-​vis sovereign funds reached a turning point with the DP World controversy, which ironically had nothing to do with sovereign funds directly. In 2006, DP World, a state-​owned infrastructure operator from the UAE, purchased UK-​ based ports operator P&O, which had concessions to operate a number of ports in the US. Although the Committee on Foreign Investment in the US endorsed the deal and the UAE was a US ally, members of the US Congress—​Representative Peter T. King and Senator Charles Schumer of New York—​questioned the national security implications

146    Sovereign Wealth Funds and the Global Political Economy of the deal. Arguably, the deal fell victim to the post-​9/​11 “war on terrorism” and anti-​ Arab political rhetoric. Eventually DP World divested from the US operations, rather than face negative publicity and a possible congressional bill to block the transaction completely. What is significant about this event was that it helped spur action on the status of sovereign funds in the global political economy. By 2007 it was clear to the International Monetary Fund (IMF) and the US Treasury that something had to be done in this environment of heightened protectionist sentiment to normalize the status of sovereign funds and underwrite their legitimacy in global financial markets (Norton 2010). In the spring of 2008 the IMF facilitated the establishment of the International Working Group of Sovereign Wealth Funds (IWGSWF), which subsequently in autumn of 2008 introduced a set of 24 voluntary Generally Accepted Principles and Practices of sovereign funds; these are commonly referred to as the “Santiago Principles”. At the heart of the Santiago Principles is the promotion of greater transparency and disclosure, as a means of generating an evidence base on which the trustworthiness of sovereign funds could be judged, for organizations exclusively commercial in focus. Implicitly, the principles seek to define the form and function of sovereign funds through governance principles that reflect the conventional western model practiced by cognate institutional investors; namely, supplementary occupational pension funds (Clark, Dixon, and Monk 2013). In short, sovereign funds and their exclusive commercial orientation would be deemed legitimate if they adopted the institutional form and function of their counterparts in the West. The Santiago Principles were, however, adopted in the midst of the worst financial crisis since the Great Depression. In the years following, subpar growth and austerity in the West has seen sovereign funds welcomed with open arms. Moreover, the conduct of Western investment banks and other financial institutions that created and intensified the financial crisis—​through the massive mispricing and obfuscation of risk through complex financial products made sovereign funds—​look comparably benign in comparison (Engelen et al. 2011). If there was a crisis of trust and legitimacy in the financial system, it was not sovereign funds that were the target. Rather than a threat, the rise of sovereign funds became a potential source of stable long-​term capital that could underwrite recovery. As such, it is not clear if the Santiago Principles and the successor organization to the IWGSWF—​the International Forum of Sovereign Wealth Funds (IFSWF)—​has been significantly consequential in terms of underwriting the trust and legitimacy of sovereigns in global capital markets. The economic conjuncture has been, arguably, of greater consequence. What is more, many sovereign funds remain opaque organizations—​somewhat distant from the open and transparent organizations inherent to the vision of the Santiago Principles. In this chapter we unpack the concepts of trust and legitimacy as they pertain to sovereign funds in the global political economy. Our argument is divided into three parts. First, we consider the importance of trust in finance and geopolitics, and the critical role of transparency, and how this relates to sovereign funds. We then consider the legitimacy of sovereign funds at home and abroad in general. In particular, we explain how the regulatory regime surrounding public institutional investors in developed

Gordon L. Clark and Adam D. Dixon    147 democracies, which derives from principles of modern portfolio theory and trust law, is emulated in the Santiago Principles, and why it is significant for understanding the legitimacy of sovereign funds. The penultimate section evaluates the current state of trust and legitimacy for sovereign funds, where we explain why the continued opacity of some sovereign funds has not reduced trustworthiness. The final section concludes on a speculative note, suggesting that the expected institutional form and function of sovereign funds may be at odds with the long-​term interests of their state-​sponsors.

Trust in Finance and Geopolitics Are sovereign funds worthy of confidence? Or, expressed more concretely, should sovereign funds in general be trusted to act in good faith as institutional investors in pursuit of risk-​adjusted returns on global financial markets? In comparison to private actors in global financial markets, trust is two-​sided in the case of sovereign funds. On the one hand, there is the matter of trust as pertains to any financial institution and any individual involved in investment decision-​making and the execution of financial transactions on behalf of others. On the other hand, there is the matter of trust as pertains to states and state-​controlled entities in the international system. Although these two sides are not mutually exclusive, wherein trustworthiness achieved in one contributes to trustworthiness in the other, they come with different considerations and potential outcomes. This two-​sided trust problem poses a dilemma for sovereign funds that other actors in financial markets do not face. As such, there is a greater potential uncertainty regarding the status of sovereign funds in global financial markets and their place in the international system. Before considering where trust comes from in both of these contexts, we unpack further their conceptual foundations. At its core, the financial system is simply a collection of principal-​agent relationships between savers and borrowers. Savers (providers of capital) purchase a promise from a borrower (users of capital) in the form of a financial asset. A financial asset is simply a contract between these two parties wherein the borrower agrees to pay back the saver over a period of time and under certain conditions (e.g. a fixed rate of return or a share of profits). In entering into this relationship, savers face the risk that the promised returns do not materialize or that the financial asset loses much or all of its value at some point in time. Contracts can be written to provide some security to capital providers, such as giving access to other collateral held by the capital user, which act to motivate the capital user to fulfill the promise and to employ the capital in the manner in which the promise was made. Contracts are, however, insufficient to generate confidence at a systemic level. This is partly a consequence of the multiple intermediated principal–​agent relationships that characterize investment flows from initial capital provider to the end user. Contracts and a strong legal system, in which contracts can be enforced, provide some confidence in these relationships, but the principal requires trust that the agent fulfills the

148    Sovereign Wealth Funds and the Global Political Economy promise (Tomasic and Akinbami 2011). Such trust is needed systematically across multiple principal–​agent relationships, such that there is generalized confidence in the financial system. If trust at an aggregate level is weak, meaning that providers of capital have limited trust in financial agents and/​or end-​users of capital, this increases the likelihood that capital providers may not release their capital. Consequently, there is less capital available to the economy, which could damage growth (Morris and Vines 2014). In this rendition of the place of trust in financial relationships the onus of trustworthiness is on financial intermediaries, or the financial services industry and the end-​users of capital such as corporations and governments (Mayer 2013). Sovereign funds are generally principals in financial relationships. But this does not mean that principals do not figure in the creation of trust, and therefore aggregate confidence in the financial system. Inherent in this conceptualization of trust in financial relationships is a focus on achieving risk-​adjusted returns. If a corporation raises debt or equity on capital markets, the expectation is that managers will use this capital for purposes that make the corporation capable of repayment. The market expects, and trusts, that managers will do so. Misuse of the capital would constitute a breach of this trust. The reverse of this relationship is the expectation that capital providers employ their capital in pursuit of risk-​adjusted returns. Not doing so could distort the efficiency and price signaling of financial markets, leading to the misallocation of capital across time and space and generalized confidence in the financial system. This expected comportment of sovereign funds as principals in financial markets pursuing risk-​adjusted returns reflects the norms and expectations of other states in relation to the state sponsors of sovereign funds. In the international system of sovereign states, trust can be defined as the belief that the other side is willing to reciprocate cooperation. Mistrust is when one side believes the other prefers to exploit one’s cooperation, and is therefore untrustworthy (Kydd 2005). This cooperation is important to the functioning of the global financial system, which is underwritten by a market-​based logic. The multilateral institutions such as the IMF and the various non-​governmental agencies that promote standardization and convergence of policy and regulation (e.g. international accounting standards), at the behest of and in concert with the advanced industrialized economies, work to sustain and drive the integration of a market-​driven global financial system. The global financial system may be a space driven by and consisting of private flows of capital, but the cooperation of states in the international system makes this global space possible (Helleiner 1994). This cooperation requires a certain degree of trust among states. If states are to open their markets to flows of foreign capital and financial services providers, they usually require reciprocity but more importantly reassurance that other states will not exploit this cooperation and act in ways that undermine confidence in the system. In both cases—​the principal–​agent relationship in financial transactions and cooperation among states in the international system—​placing trust relies on judgment of available evidence. This means judging past actions as well as current actions and pronouncements to act in a certain way or another. Together, all available evidence should provide sufficient information to render judgment on the likely willingness of the agent

Gordon L. Clark and Adam D. Dixon    149 concerned to live up to his/​her word in terms of fulfilling preconceived normative expectations (O’Neill 2002). In effect, placing trust requires transparency. Hence, the architecture on which global (western) financial markets are built is underwritten by disclosure regimes. For example, just as issuers of securities are required to regularly disclose information on their financial performance and activities generally, institutional investors must also adhere to strict disclosure requirements. As an example, the Investment Company Act of 1940 in the US, which covers mutual funds and closed-​ end funds, requires the publication of a fund’s investment policy and regular disclosure of the fund’s financial statements. The intent is to instill confidence in the sector and protect the public interest (Markham 2011). Comparable obligations appear likewise in the EU Directive on Undertakings for Collective Investment in Transferable Securities (Lamfalussy 2001). To instill confidence in sovereign funds, transparency is at the core of the Santiago Principles. Indeed, transparency is explicitly framed through some form of disclosure in all three sections of the Santiago Principles, which consist of: (1) legal framework, objectives and coordination with macroeconomic policies, (2) institutional framework and governance structure, and (3) investment and risk management framework. For example, Generally Accepted Principles and Practices (GAPP) 1–​5, 11–​12, and 15–​17 directly appeal for transparency by calling for the periodic publication of statistical and financial data, as well as public disclosure of the broader purpose of the fund in relation to a) its fiscal and macroeconomic policy function and b) its investment policy and financial objectives. Where transparency is not directly suggested, it is evoked indirectly through the fund’s relationship with the sponsoring government authority.

Legitimacy and Institutional Design More significant than trust is the issue of whether sovereign funds are legitimate actors in global financial markets. Held up against the mirror of the neoliberal thought that has underwritten state asset privatization and the deregulation of markets since the 1980s (Peck 2010), state-​sponsored institutional investors pose a conundrum. Sovereign funds are in many ways at odds with the prevailing expectation that direct state involvement in economic affairs should be limited. The state may play some role in providing a legal and regulatory architecture through which contracts can be written and enforced, and an issuer of debt securities, for example, but should the state be able to compete alongside of private actors in the market? Can the state have a dual role as market enabler and market participant? Does this not give an unfair advantage given the political authority the state has over private market actors? Adding the geopolitical element, does this not give some states a source of influence—​positive or negative—​in the international system? And as such, does this influence pose a risk to geopolitical stability? Institutional legitimacy, as thought of in the liberal tradition, rests on two different points of reference (Clark, Dixon, and Monk 2013, pp. 88–​90). In the first instance, the

150    Sovereign Wealth Funds and the Global Political Economy legitimacy of an institution can be judged against the moral and political expectations of the society in relation to its roles and responsibilities. This view is, in effect, normative as it relates to what the ideal form and function of an institution should be. In the second instance, the legitimacy of an institution can be judged against its functional effectiveness, or rather its performance, as benchmarked against other cognate institutions. Unlike the first theory of legitimacy, this second theory is concerned less with what the institution should be but, rather, how well it realizes predetermined goals (Coleman 2001). If the first theory of institutional legitimacy rests on social norms and expectations, this essentially means that the legitimacy of state institutions is deeply conditioned by country-​and culture-​specific conditions (Reus-​Smit 1999). This results in a diverse taxonomy of legitimacy, given the political and cultural diversity of nation-​states. The proper roles and responsibilities of an institution in western democracies may be very different from the social norms and expectations of an institution in authoritarian regimes or single-​party states. A realist critique of this view of legitimacy could counter that institutional legitimacy is less about social norms and expectations of the polity. Rather, legitimacy is claimed by those who control the effective means of power, and how institutions are used to protect and or extend their claims to power internally and externally. Social norms in this context are simply tools of popular control that local elites use to advance their interests and their grip on power. Either way, the legitimacy of an institution is embedded in the local political context and practice of state sovereignty. One possible explanation for why the geography of sovereign funds shows a concentration of funds in emerging markets and countries without democratic governance is because of this normative dilemma over whether the state should be allowed to accumulate and invest fiscal resources. One could look to Norway as a counter-​example, but it is likely an outlier that is explained by Norway’s small and homogeneous population and the outsized significance of the country’s oil and gas resources, as well as greater state ownership in the means of production. Consider, in contrast, that the UK under the Callaghan government—​with a population more than ten times that of Norway and a significantly more socioeconomically diverse–​considered establishing an oil fund in the 1970s when North Sea oil and gas production started to take off. However, resource revenues were used, instead, to fund government spending or tax breaks. The privatizations during the Thatcher government further eroded the government’s involvement in the means of natural resource production, and consequently further reduced opportunities to harness a greater share of natural resource revenues beyond royalties. Although most developed democracies are not sovereign-​fund sponsors, which may in part be explained by the above reasoning, this does not mean that governments do not sponsor institutional investors (Dixon and Monk 2014). Indeed, some of the largest institutional investors in global financial markets are public-​employee pension funds from developed democracies. However, there are important differences between a public pension fund and a sovereign fund. The former is part of the wage relationship between the state as an employer and its employees—​like any other employer. In

Gordon L. Clark and Adam D. Dixon    151 most cases, the latter do not have any pre-​defined liabilities that the assets are meant to cover. Though some sovereign funds have been established to cover implicit liabilities of governments or the social security system, such as Australia’s Future Fund and the New Zealand Superannuation Fund. This absence of liabilities allows sovereign funds a freedom of action that is not afforded to public pension funds. It is this freedom of action that calls into question the legitimacy of sovereign funds as institutional investors (Monk 2009). This freedom of action suggests that sovereign funds could be used in ways that are at odds with a legitimate mission of achieving higher risk-​adjusted returns on accumulated fiscal savings, regardless of the source of the savings (e.g. commodity rents or foreign exchange reserves); an example being unfairly advancing a country’s mercantile interests. But it is not fair to claim that the state is like any other employer. Hence, while the wage relationship and the presence of liabilities is a significant operational constraint for a public pension fund, it is still sponsored by a political authority that possesses political power and resources that a private actor does not. In this way, a public pension fund is much closer to a sovereign fund in comparison to a corporate-​sponsored pension fund or a union pension fund. At issue is whether this relationship with the state or some other political authority (e.g. a municipal government) can lead to a politicization of investment decision-​making and, hence, the asset allocation of the fund; for example, requiring a public pension fund to invest in government/​municipal securities or national/​local business interests (Clark 2000). Such investment could be considered market distorting as well as politically corrupting. This does not mean that local investment is an illegitimate activity. It is legitimate if it is made through a process that acknowledges the risk of such investment and, more importantly, the opportunity cost of not investing elsewhere in relation to achieving the most optimal outcomes for the beneficiaries of the fund. Here, institutional legitimacy rests on the function of the institution, which elides with the above-​mentioned second theory of institutional legitimacy. In this case the function of a public pension fund is to provide benefit to its members. Actions which go against this mandate risk the proper functioning and, therefore, expected outcomes of the fund. What is at stake in order to prevent the politicization of pension fund investment decision-​making is how public pension funds are governed (Clark 2006). The legal/​regulatory regime that shapes the governance architecture of public pension funds in developed democracies sees a strict separation of the political authority that sponsors the fund and the fund’s investment management. However, this does not mean that the sponsoring authority is not involved in pension fund governance. With many public pension funds, the government as the employer is represented by one or more of the pension fund trustees. Employees and other stakeholders (e.g. unions) are also represented on the fund’s trustee board. What this separation does mean, moreover, is that the sponsoring authority is not involved in the regular operation of the fund, and its influence on the asset allocation of the fund is limited. Although the membership of the trustee board is important for defining the separation of the fund from government—​ and therefore its institutional legitimacy—​the underlying principles that have come

152    Sovereign Wealth Funds and the Global Political Economy to shape investment decision-​making and procedure in asset management are more significant. For pension fund trustees, modern portfolio theory (MPT) has become a guiding principle for investment decision-​making (Markowitz 1952). This “language of finance” which offers a theoretical foundation to diversification as a risk-​management tool, effectively depoliticizes the investment decision-​making process. MPT endows trustees with a framework for asset allocation based on the principle that the risk of any single asset is judged against the risk profile of the total portfolio. The aim is to construct a portfolio where the poor performance of one security is balanced with the positive performance of others. This drives diversification of the portfolio, rather than the concentration of the portfolio in a select (and possibly politicized) set of assets. Trustees of public pension funds in developed democracies are also subject to strict fiduciary standards, in particular the “prudent person rule.” The principle of this rule is that a fiduciary must discharge his or her duties with care, skill, prudence and diligence as another prudent person acting in a similar capacity and in a similar enterprise of similar aims (Galer 2002). It is important to stress that the aims of the pension fund are to meet promises made to plan beneficiaries, as in the case of a defined benefit arrangement, or to maximize the long-​term risk-​adjusted return such that wealth is grown and preserved to meet the income needs in retirement of plan beneficiaries, as in the case of a defined contribution arrangement. What the prudent person rule does is drive a particular behavior among the “organizational field” of pension fund trustees, which in turn shapes the institutional form of the pension fund (Clark 2008). For example, a pension fund that makes targeted local investments that appear to be at odds with what other similar funds are doing, would be suspect under the prudent person rule. Consequently, the behavior of pension fund trustees tends to conform around principles of portfolio diversification. Notwithstanding economic arguments for diversification, this behavior is about depoliticizing public pension fund investment, or at least limiting the potential influence from the political sponsor or other interested stakeholders (e.g. unions) (cf. Hebb 2008). Given the normative expectations surrounding the ideal institutional form and function of public institutional investors in the developed democracies as depoliticized actors that have a clear separation from their political sponsors, it is unsurprising that this same logic figures centrally, if implicitly, in the Santiago Principles. The international legitimacy of sovereign funds therefore rests on their ability to mimic a similar institutional form and function as public institutional investors in the advanced economies: institutions that may be sponsored by a political authority, but function to maximize risk-​adjusted returns in order to support a clear policy objective or objectives (e.g. long-​term intergenerational savings). In relation to the separation of decision-​making authority, GAPP 16 in particular states: “The governance framework and objectives, as well as the manner in which the SWF’s management is operationally independent from the owner [our emphasis], should be publicly disclosed.” What is curious about GAPP 16 is that although it is framed around transparency, there is an implicit expectation that the sovereign fund will be (or should be) operationally separate from government.

Gordon L. Clark and Adam D. Dixon    153 In relation to the process of investment decision-​making GAPP 18 states: “The SWF’s investment policy should be clear and consistent with its defined objectives, risk tolerance, and investment strategy, as set by the owner or the governing body(ies), and be based on sound portfolio management principles” [our emphasis]. GAPP 19 furthermore states: “The SWF’s investment decisions should aim to maximize risk-​adjusted financial returns in a manner consistent with its investment policy, and based on economic and financial grounds” [our emphasis]. Clearly, the Santiago Principles represent a western project that seeks to harmonize the form and function of sovereign funds, at least in terms of the global-​facing investment function. Through the lens of the first theory of institutional legitimacy, the Santiago Principles seek to define global norms surrounding the acceptable behavior of state-​sponsored institutional investors. Here, what makes a sovereign fund legitimate at the national level is irrelevant, so long as its outward-​facing actions match global (western) expectations. However, this puts an emphasis on portfolio investing as the functional means to that legitimate end. This would assume that this function matches the purpose of the institution. Portfolio investment matches the needs of a long-​term savings fund or a short-​term stabilization fund. Yet, portfolio investment may not match the functional needs of different policy options and political interests, such as targeted strategic investment in support of national industry and economic interests. But the potential illegitimacy of the latter is only relevant if such activity spills over into international economic relations. Ultimately, there is a tension between the expected form and its resulting function, as institutions are rarely designed in such a way as to coincide with a single coherent and unambiguous purpose. The dynamic nature of nation-​state interests further weakens any expectation that a sovereign fund will continue along an institutional design path over time. Consequently, holding fixed the form and function of sovereign funds is problematic.

Progress Deferred? Overall, the activities of sovereign funds appear to be benign (Epstein and Rose 2009; Rose 2013). Sovereign funds may still be state entities, but the evidence appears to suggest that they are mainly pursuing risk-​adjusted returns. They do not in general appear to be used for mercantilist purposes or for gaining geopolitical leverage, as early skeptics had suggested was a possibility (Kirshner 2009). Yet, this does not mean that sovereign funds are not being used to further economic policy goals that are ultimately in the interest of the state and national economy. For example, many sovereign funds from the Gulf States are actively used to further industrial development of their economies beyond natural resource extraction (Haberly 2011). Furthermore, the activities of China are still a cause for concern in some quarters. Some of the investment activities of the China Investment Corporation—​one of China’s sovereign funds—​are seen to be working in tandem with the foreign investment activities of Chinese state-​owned enterprises

154    Sovereign Wealth Funds and the Global Political Economy to facilitate their global expansion (Backer 2010; Gilligan and Bowman 2014). It could be that the perceived benign behavior of sovereign funds reflects not so much a greater appreciation of their activities but, rather, a continued under-​appreciation of what they are doing and where they are effective. This is particularly apposite given that some sovereign wealth fund (SWFs) are still relatively opaque organizations. Indeed, the available evidence shows that the Santiago Principles have led to some increased levels of transparency in aggregate. For example, the Truman Scoreboard shows that for the period 2007–​12 the Abu Dhabi Investment Authority and the Government of Singapore Investment Corporation increased their scores by 50%. Nonetheless, their scores are still much lower than the most transparent funds; namely, the Norwegian Government Pension Fund Global (GPFG) and the New Zealand Superannuation Fund. As such, there is still room for improvement in terms of sovereign fund transparency (Bagnall and Truman 2013). This continued divergence between more transparent and less transparent institutions underlines the inherent political nature of sovereign funds, as they reflect the norms and conventions of their sponsors in regard to transparency and accountability (Dixon and Monk 2012; Gelpern 2011; Hatton and Pistor 2012). As would be expected, sovereign funds from liberal democracies demonstrate high levels of transparency. Sovereign funds from countries that are not democracies demonstrate lower aggregate levels of transparency. Yet, a puzzle exists in that continued opacity has not constrained less transparent sovereign funds from investing in global capital markets and from taking large direct equity stakes in firms in advanced democracies. For example, the Qatar Investment Authority (QIA) is one of the more opaque sovereign funds according to transparency rankings. The QIA is, however, a major shareholder in several large German industrial concerns such as Volkswagen (Haberly 2014). It is not known why continued opacity, or rather slower progress toward greater transparency, has not resulted in a crisis of confidence. A simple explanation is that because there has been no evidence of impropriety, there is therefore no reason to suggest that (some) sovereign funds should not be trusted. On the other hand, full transparency and proof is not a necessary condition for trust. Where there is complete evidence or proof, trust becomes redundant. Trust must come in advance of proof (O’Neill 2014). As this suggests, a continued lack of transparency need not lead to less trust. One possible explanation for robust confidence in the face of ongoing opacity is that many sovereign funds have become more visible entities in the global political economy, in part through their involvement with the IFSWF, whose members include the largest sovereign funds in the world. Here, visibility does not necessarily refer to more transparency. Rather, they are actively promoting their good conduct without having to reveal greater information about their operations and performance. To be sure, the IFSWF has helped improve transparency (see IFSWF 2014). But there are limits as to what the IFSWF can do in this regard. As a voluntary and consensus-​ based organization, the IFSWF cannot force member institutions to abide by the Santiago Principles and its call for greater transparency. Consequently, the organization is left simply promoting a greater understanding of the Santiago Principles and encouraging its use among member institutions. Yet, the IFSWF also acts to promote

Gordon L. Clark and Adam D. Dixon    155 a greater understanding of sovereign funds in the global political economy. For member institutions, participation in the IFSWF, which does not require full implementation of the Santiago Principles, provides an important signal to global audiences that a sovereign fund is committed to employing its capital in ways that are deemed legitimate and acceptable to global norms and conventions. Skeptics could counter that the IFSWF simply provides a smokescreen, which could obfuscate potentially illegitimate activity or intentions. But confirming this concern would require greater evidence that sovereign fund investment activity is illegitimate. Little to no evidence exists to show that past sovereign fund investments have been motivated by non-​commercial considerations. Although the explicit investment function of a sovereign fund is focused exclusively on commercial considerations, which provides the organization with legitimacy, it is still a policy tool of the state. This unbreakable link leaves sovereign funds in a grey area that no governance architecture can ultimately resist. Again, this does not mean that sovereign funds are at risk of being used in illegitimate ways. Rather, at issue potentially is what the sovereign fund—​particularly in the case of the very largest funds—​means for the state in international relations. Does the existence of a sovereign fund, which itself is used in legitimate ways, defer potential scrutiny of a state’s activities in international economic relations, such that other states may be less likely to challenge the state’s perceived power brought on by the sovereign fund? In other words, the sovereign fund indirectly provides a state with greater influence in global or bilateral affairs. Certainly, the international system has serious power imbalances among states, and powerful states use any number of means to influence global affairs through hard (e.g. military) or soft (e.g. cultural) power. A  sovereign fund could be considered one of these means, even if at the level of the investment function the fund operates no differently than a conventional portfolio investor. Hence, even if the form of a sovereign fund comes to match that of conventional cognate investors like public pension funds, this may not provide as much legitimacy as would be expected. Changes to, for example, the global balance of economic and political power over time may reveal this fundamental characteristic. Consequently, while progress has been made in terms of the trustworthiness and institutional legitimacy of sovereign funds more generally, this means that skepticism could return.

Conclusion SWFs have become important actors in the global political economy in the last two decades. Their growing numbers and assets under management have partially changed the landscape of global financial markets, adding new pools of capital to support the growth, development, and integration of economies across the world. As the sovereign fund phenomenon has reflected the growth of emerging market and resource-​rich economies in East Asia and the Middle East, this new-​found power has resulted in some concern over whether sovereign funds could potentially destabilize global power dynamics and the

156    Sovereign Wealth Funds and the Global Political Economy position of the western developed democracies. Sovereign funds are economic policy tools of governments, but there are few reasons to contend that they are untrustworthy and illegitimate institutions. The investment profile of most sovereign funds fits with conventional portfolio investment practices of other large public institutional investors, as does their institutional form. Sovereign funds in aggregate have become more transparent and clear as to their intentions and activities, even if there continues to be divergence between funds from developed democracies and other types of political regime. This progress can be attributed, in part, to the roll-​out of the Santiago Principles and the continued work of the IFSWF. Trust and legitimacy are stable for now. It is important, however, to recognize the factors that have contributed to the massive growth of sovereign funds: high commodity prices and global imbalances. The global financial crisis saw the collapse of commodity prices generally, but these recovered as global growth (a demand from China) resumed. In 2015, commodity prices collapsed nearly to the lows of the global financial crisis in 2009. Consequently, the source that fueled the growth of commodity-​based sovereign funds has collapsed, and governments are withdrawing capital to stabilize their economies. For the export-​led economies of East Asia, particularly China, the shift toward more consumer-​centered economies may reduce the accumulation of foreign reserves. The implications of a changing global economic environment could result in a changing form and function of sovereign funds. Rather than following the form and function of other large portfolio investors, investing through intermediaries in the major financial centers, sovereign fund sponsors may use their funds in a more strategic fashion that benefits local economic growth and development. This shift in form and function should not be seen as somehow illegitimate because states throughout the world are ultimately concerned with national prosperity and well-​being. What it does mean is that in an environment where the sources driving growth in assets under management are dwindling, and where the focus of investment turns inward, sovereign funds may not be the global force that they have come to represent in the first two decades of this century. Issues of trust and legitimacy at the global level may therefore cease to be of any significant concern.

References Backer, L.C. (2010). Sovereign Investing in Times of Crisis: Global Regulation of Sovereign Wealth Funds, State-​Owned Enterprises, and the Chinese Experience. Transnational Law & Contemporary Problems, 19(3), 3–​144. Bagnall, A.E. and Truman, E.M. (2013). Progress on Sovereign Wealth Fund Transparency and Accountability: An Updated SWF Scoreboard. Policy Brief, 13-​19, 1–​29. Balding, C. (2012). Sovereign Wealth Funds:  The New Intersection of Money and Politics. New York: Oxford University Press. Clark, G.L. (2000). Pension Fund Capitalism. Oxford: Oxford University Press. Clark, G.L. (2006). “Regulation of Pension Fund Governance.” In: G.L. Clark, A.H. Munnell, and J.M. Orszag, eds, Oxford Handbook of Pensions and Retirement Income. Oxford: Oxford University Press, pp. 483–​500.

Gordon L. Clark and Adam D. Dixon    157 Clark, G.L. (2008). Governing Finance: Global Imperatives and the Challenge of Reonciling Community Representation with Expertise. Economic Geography, 84(3), 281–​302. Clark, G.L., Dixon, A.D., and Monk, A.H.B. (2013). Sovereign Wealth Funds:  Legitimacy, Governance, and Global Power. Princeton: Princeton University Press. Cohen, B.J. (2009). Sovereign Wealth Funds and National Security:  The Great Tradeoff. International Affairs, 85(4), 713–​31. Coleman, J.L. (2001). The Practice of Principle: In Defence of a Pragmatist Approach to Legal Theory, Clarendon Law Lectures. New York: Oxford University Press. Das, U.S., Mazarei, A., van der Hoorn, H., and International Monetary Fund. (2010). Economics of Sovereign Wealth Funds:  Issues for Policymakers. Washington, D.C.: International Monetary Fund. Dixon, A.D. (2016). “The State as Institutional Investor: Unpacking the Geographical Political Economy of Sovereign Wealth Funds.” In: R. Martin and J. Pollard, eds, Handbook of the Geographies of Money and Finance. Cheltenham: Edward Elgar. Dixon, A.D. and Monk, A.H.B. (2012). Rethinking the Sovereign in Sovereign Wealth Funds. Transactions of the Institute of British Geographers, 37(1), 104–​17. Dixon, A.D. and Monk, A.H.B. (2014). Frontier Finance. Annals of the Association of American Geographers, 104(4), 852–​68. Engelen, E.I., Ertürk, J., Froud, J., Sukhdev, A., Leaver, M., Moran, A., Nilsson, and Williams, K. (2011). After the Great Complacence:  Financial Crisis and the Politics of Reform. Oxford: Oxford University Press. Epstein, R.E. and Rose, A.M. (2009). The Regulation of Sovereign Wealth Funds: The Virtues of Going Slow. The University of Chicago Law Review, 76(1), 111–​34. Galer, R. (2002). Prudent Person Rule Standard for the Investment of Pension Fund Assets. OECD Financial Market Trends, 83, 41–75. Gelpern, A. (2011). Sovereignty, Accountability, and the Wealth Fund Governance Conundrum. Asian Journal of International Law, 1(02), 289–​320. DOI:10.1017/​S2044251310000391. Gilligan, G. and Bowman, M. (2014). State Capital: Global and Australian Perspectives. Seattle University Law Review, 37(2), 597–​638. Haberly, D. (2011). Strategic Sovereign Wealth Fund Investment and the New Alliance Capitalism: A Network Mapping Investigation. Environment and Planning, A 43 (8), 1833–​52. Haberly, D. (2014). White Knights from the Gulf:  Sovereign Wealth Fund Investment and the Evolution of German Industrial Finance. Economic Geography, 90(3), 293–​320. DOU: 10.1111/​ecge.12047. Hatton, K.J. and Pistor, K. (2012). Maximizing Autonomy in the Shadow of Great Powers: The Political Economy of Sovereign Wealth Funds. Columbia Journal of Transnational Law, 50(1), 1–​81. Hebb, T. (2008). No Small Change:  Pension Funds and Corporate Engagement. Ithaca, London: ILR Press/​Cornell University Press. Helleiner, E. (1994). States and the Reemergence of Global Finance: From Bretton Woods to the 1990s. Ithaca, London: Cornell University Press. IFSWF. (2014). Santiago Principles: 15 Case Studies. International Forum of Sovereign Wealth Funds. Kirshner, J. (2009). Sovereign Wealth Funds and National Security: The Dog that Will Refuse to Bark. Geopolitics, 14(2), 305–​16. DOI: 10.1080/​14650040902827765. Kydd, A.H. (2005). Trust and Mistrust in International Relations. Princeton, N.J.: Princeton University Press.

158    Sovereign Wealth Funds and the Global Political Economy Lamfalussy, A. (2001). Towards an Integrated European Financial Market. World Economy, 24(10), 1287–​94. Markham, J.W. (2011). A Financial History of the United States. 2 vols. Armonk, N.Y.: M.E. Sharpe. Markowitz, H. (1952). Portfolio Selection. Journal of Finance, 7(1), 77–​91. Mayer, C.P. (2013). Firm Commitment: Why the Corporation is Failing Us and How to Restore Trust in It. First edition. Oxford: Oxford University Press. Monk, A.H.B. (2009). Recasting the Sovereign Wealth Fund Debate: Trust, Legitimacy, and Governance. New Political Economy, 14(4), 451–​68. Morris, N. and Vines, D. eds. (2014). Capital failure: Rebuilding Trust in Financial Services. First edition. New York and Oxford: Oxford University Press. Norton, J.J. (2010). The Santiago Principles for Sovereign Wealth Funds:  A  Case Study on International Financial Standard-​Setting Processes. Journal of International Economic Law, 13(3), 645–​62. DOI: 10.1093/​jiel/​jgq034. O’Neill, O. (2002). A Question of Trust. Cambridge: Cambridge University Press. O’Neill, O. (2014). “Trust, Trustworthiness, and Accountability.” In: N. Morris and D. Vines, eds, Capital Failure: Rebuilding Trust in Financial Services. Oxford: Oxford University Press, pp. 172–​89. Peck, J. (2010). Constructions of Neoliberal Reason. Oxford: Oxford University Press. Reus-​Smit, C. (1999). The Moral Purpose of the State: Culture, Social Identity, and Institutional Rationality in International Relations. Princeton, N.J.: Princeton University Press. Rose, P. (2013). Sovereign Investing and Corporate Governance: Evidence and Policy. Fordham Journal of Corporate & Financial Law, 18(4), 913–​62. Tomasic, R. and Akinbami, F. (2011). The Role of Trust in Maintaining the Resilience of Financial Markets. Journal of Corporate Law Studies, 11(2), 369–​94. Truman, E.M. (2010). Sovereign Wealth Funds: Threat or Salvation? Washington, DC: Peterson Institute for International Economics.

Chapter 7

Sovereign W e a lt h F u nds and D ome st i c P olitical  Ri sk Paul Rose

Introduction As sovereign wealth funds (SWFs) mature and as the literature describing and analyzing them continues to develop, some of the primary concerns that initially animated SWF analysis—​namely, SWFs as a sign of shifting financial power, SWFs as potential political actors, and protectionist responses from governments worried about SWF investment activity—​have turned to fundamental concerns about how SWFs are governed. Even within this literature, however, questions of governance are often focused on SWF governance as risk mitigation for foreign entities and governments rather than on the domestic impacts of SWF governance. For some analysts and regulators, SWFs must be quarantined; little thought is given to the health of the SWF itself, so long as it does not adversely affect foreign entities. This chapter fills this analytical gap by discussing SWF governance as a tool to manage domestic political risk, and not merely as a tool for managing international risks. In particular, this chapter adds to the literature on the domestic legitimacy of SWFs,1 and theorizes that legitimacy, broadly conceived, serves as a signal of appropriate entity and political risk management. Sovereign fund legitimacy is a question of increasing importance to sponsor countries as decreasing oil and gas prices force some governments to face the question of whether the role of SWFs should be changed to deal with the loss of revenue resulting from decreased oil and gas exports, or other budget shocks. It is crucial that policymakers and fund officials structure and govern SWFs in such a way as to adequately and legitimately fulfill their mandate. Among the threats to legitimacy are issues 1 

See, for example, Clark, G. and Monk, A. (2009); Clark, G., Dixon, A., and Monk, A. (2013); Monk, A. (2009); Grünenfelder, S. (2013).

160    Sovereign Wealth Funds and Domestic Political Risk involving ultimate ownership of the fund, corruption, unclear or shifting purposes and uses of the fund, and misalignment of the fund with societal mores and interests. The concept of legitimacy, though relatively recent, has inspired a rich literature in political science, law, and management, among other areas. As argued by Weber, legitimacy is a belief on which the authority of the government rests, and “a belief by virtue of which persons exercising authority are lent prestige”2 (Weber 2009, p.  382). Legitimacy may be conceptualized as having two aspects (Coglianese 2007, pp. 159–​67). First, legitimacy is often thought of as having a procedural aspect. Procedural legitimacy is achieved through mechanisms such as domestic accountability, power-​limiting or power-​sharing structures, such as a separation of legislation and judicial functions, transparency of governmental activities and proceedings, and, in general, the rule of law. Legitimacy can also be conceived as having a substantive aspect. Substantive legitimacy typically refers to the basic rights held by citizens, individually and collectively. An initial, unavoidable question is whether a concept such as “legitimacy” can or should be used to analyze SWF governance. SWFs, after all, are often associated with non-​democratic regimes. A  definition of legitimacy premised on democratic rule may seem inappropriate for the many SWFs which are not sponsored by democracies; indeed, the majority of SWFs are sponsored by regimes that are not fully democratic. However, the concept of legitimacy need not be so constrained; it does not necessarily reflect a binary judgement, in which a regime is either legitimate or it is not by reference to a common governance metric. This point is particularly salient when considering autocracies and oligarchies. As Burnell notes, “[M]‌any autocracies can—​do—​enjoy some measure of legitimacy among social groups or strata even while they may possess no legitimacy at all among other subjects, a fact that is conveniently overlooked by much present day talk of democracy as a ‘world value’.” (Burnell 2006, pp. 4–​5). As a second and related point, analysis of legitimacy along a continuum sheds light on governance adequacy and political risk; relative illegitimacy may signal serious domestic political risk for an SWF. (Grunenfelder 2013, p. 135). Political risk associated with public funds may flow in two directions: the consequences of an Arab Spring affect all governmental entities, including SWFs. And, as in Malaysia, political crises may even develop from the governance failures of a public fund. Political legitimacy may differ significantly depending on whether a fund has been created by an autocracy, a democracy, or something in between. Following the methodology of Barbary and Bortolotti (2012), one can track the connection between SWFs and the politics of the sovereign creator. Using data compiled by the Sovereign Wealth Fund Institute (SWFI) and the Polity IV Project, Table 7.1 shows the political orientation of the SWF sponsor countries of the 15 largest funds in the SWFI database (organized by size of assets under management), with the Polity Score ranging from –​10 (strongly autocratic) to 10 (strongly democratic).3 2 

See also Peter, F. (2014). For a description of the Polity IV dataset and coding conventions, see Marshall, M., Gurr, T., and Jaggers, K. (2014). 3 

Paul Rose   161 Table 7.1  P olitical Orientation of SWF sponsor countries of the 15 Largest Funds in the Sovereign Wealth Fund Institute’s 2015 Ranking Country

Fund

AUM

Polity Score

Norway

Government Pension Fund Global

$882

10

UAE–​Abu Dhabi

Abu Dhabi Investment Authority

$773

–​8

Saudi Arabia

SAMA Foreign Holdings

$757.20

–​10

China

China Investment Corporation

$652.70

–​7

Kuwait

Kuwait Investment Authority

$548

–​7

China

SAFE Investment Company

$547

–​7

China–​Hong Kong

Hong Kong Monetary Authority Investment Portfolio

$400.20

–​7

Singapore

Government of Singapore Investment Corporation

$320

–​2

Qatar

Qatar Investment Authority

$256

–​10

China

National Social Security Fund

$236

–​7

Singapore

Temasek Holdings

$177

–​2

UAE–​Dubai

Investment Corporation of Dubai

$175.20

–​8

Australia

Australian Future Fund

$95

10

UAE–​Abu Dhabi

Abu Dhabi Investment Council

$90

–​8

Russia

Reserve Fund

$88.90

4

Primarily because of the low Polity Scores for China and the Gulf States, the largest funds tend to have much lower average Polity Scores, with the world’s largest SWF—​ Norway’s GFGG—​as the obvious outlier. Extending this analysis to all SWF sponsor countries, one sees that smaller funds tend to reside in more democratic regimes. The fact that many of the largest SWFs are sponsored by autocratic regimes is a primary concern for some observers focused on the international impact of SWFs. But what is the connection between an SWF, the political orientation of a given regime, and the regime’s sovereign fund? A public choice analysis might suggest that in democratic regimes elected officials would not lock up large sums of money for a long period of time, but would instead try to spend it in ways that ensure re-​election. In autocratic regimes, the government does not have the same concerns, although the rulers still may face some pressure to reward an elite group of supporters. In broad terms, however, the stated purposes, investment policies, and funding mechanisms of SWFs suggest that SWFs play many of the same domestic political risk mitigation functions for a political regime regardless of the regime’s political orientation. Nevertheless, significant differences in

162    Sovereign Wealth Funds and Domestic Political Risk

−5.4 −0.4 4.1

$100 B and above

$50−99 B

$10−49 B

3.9 Below $10 B

Figure 7.1  Average Polity IV Project Polity Scores by amount of assets under management

political regimes, including the nature of political participation (if any) by citizens of the regime, necessarily create differences in how the SWF should be expected to operate. The salient point is that there is not a one-​size-​fits-​all standard of legitimacy for SWFs; likewise, the purposes for which the fund is created, the manner in which it contributes to intergenerational wealth or current economic prosperity, and the legal structure of the fund create important differences in how the fund should be governed. As discussed below, these differences also suggest that the legitimacy of a fund, as well as its particular domestic political risks, will vary significantly from fund to fund, regime to regime. This chapter proceeds as follows. First, the chapter argues that the concept of legitimacy is useful as a way of characterizing appropriate entity and political risk management for a fund, and that, as with state-​owned enterprises, SWF legitimacy has political and corporate dimensions. The chapter then focuses on the procedural legitimacy of SWFs, and how procedural and governance mechanisms help to mitigate domestic political risks associated with them. Following this, the chapter turns to a discussion of structural legitimacy. Here the analysis moves from the what and how of SWFs to the question of why a fund is created, and how the fund may be used to reflect the values of polity, again showing how these uses are linked to domestic political legitimacy.

Sovereign Wealth Fund Risk:  Political and Entity Dimensions Examining SWFs through the lens of domestic legitimacy helps identify risks facing them as both corporate entities and as governmental entities. Thus, legitimacy can be seen as a risk-​management measurement:  legitimacy is a necessary characteristic of well-​managed SWFs. Because legitimacy is a function of the public’s opinion of the SWF, however, legitimacy is not a sufficient characteristic of a well-​governed fund; a fund may

Paul Rose   163 be a whited sepulcher, deceptively appearing to be well managed from the outside, but in reality proving to be corrupt and poorly governed when it is inspected more closely. Legitimacy for SWFs is complicated by the fact that they present risks not merely as political agencies, but as business entities, and so to analyze SWF risk one must consider it as both a political and business entity. Although legitimacy has been primarily used as a political concept, Coglianese (2007) shows that legitimacy can be usefully applied to analyze corporate entities as well. In his view, the corporate law parallels are clear: “What is called corporate governance is akin to procedural legitimacy . . . What is the substantive legitimacy parallel? It is corporate regulation.” In this regard, “[r]‌egulation imposed by government says that even properly constituted corporations with fully functioning boards of directors (a test of procedural legitimacy) cannot take actions that will pollute the environment, treat their workers badly, or take money from investors” (Coglianese 2007, p. 162). SWFs are entities operating within a political system—​that is, from the perspective of domestic constituencies, successfully-​governed SWFs should be politically legitimate entities—​and yet are also entities typically operating as quasi-​(or more fully) independent business entities, subject to the same standards of entity legitimacy as other business entities. Thus, SWFs should be expected to exhibit corporate legitimacy and political legitimacy. Although in most cases the governance imperatives of either form of legitimacy should correlate—​for example, accountability is a virtue in both political and corporate entities—​there will also be instances in which the imperatives of one form of legitimacy may predominate, the legitimacy of one form conceding to the imperatives of the other form. For instance, transparency may be more important to the political legitimacy of the SWF, particularly when the SWF sponsor nation is a democracy with a strong tradition of transparency in governmental activities. However, transparency can create difficulties for the SWF as a corporate entity, particularly where the tensions between the SWF as a political actor and corporate actor are acute. Tensions are apparent, for example, in the compensation arrangements of a related type of entity, US public pension funds. With these funds, as compensation arrangements for public fund officials are disclosed (as they often must be through public disclosure laws regarding compensation for public servant pay), there is often strong resistance—​ironically, often from those who would most benefit from high quality investment talent—​if the compensation is even a significant fraction of what the official could receive in a similar role for a private entity. This makes hiring talented officials more difficult, and often results in the outsourcing of investment activity to external managers, who often charge significantly more in management fees for results that could be obtained as reliably in-​house. However, this is not to argue that there should be no transparency in compensation arrangements for SWF officials. Indeed, corporate executives in most jurisdictions are required to provide significant disclosures about their compensation. SWFs though, just like pension funds, must often face the difficulty of explaining compensation arrangements for fund officials as public officials, all while competing for and with private entity talent. Trade-​offs are unavoidable when entities have a foot in both the public and private spheres.

164    Sovereign Wealth Funds and Domestic Political Risk SWFs are like state-​owned enterprises in that they have all of the standard governance risks of the corporate entities, including the importance of transparency of operations to the owner, the need for accountability, and the importance of compliance with established procedures and governmental regulations (both of the sponsor country and the countries in which the fund does business). However, they also have risks as political entities, including the need to protect the fund from political interference, the special risks that come from having a state entity engage in private markets (such as the possible use of material, non-​public information acquired through governmental investigations, filings, or other governmental actions), and the risk of corruption, all of which affect the legitimacy of the SWF. In the following section, we turn to the procedural legitimacy of SWFs and how legitimacy is connected to domestic political risk.

The Procedural Legitimacy of a Sovereign Wealth Fund Procedural legitimacy, when applied to an agency of a government or other governmental body, implies, inter alia, “that the agencies are created by democratically enacted statutes, which define the agencies’ legal authority and objectives; that the regulators are appointed by elected officials; that regulatory decision making follows formal rules, which often require public participation; that agency decision must be justified and are open to judicial review” (Majone 1996, p. 291). In basic terms, legitimacy depends on the governmental instrumentality being created and governed according to the rule of law. Legitimacy also depends on general principles—​applicable to both business entities and political entities—​of accountability, transparency of proceedings and agency activities (at least to the sovereign, if not to the public at large), and power-​limiting or power-​ sharing structures. This section will focus particularly on the foundational concepts of accountability and transparency, both of which implicate corporate and political legitimacy. We then turns to two prominent instances of procedural governance failure—​Malaysia’s 1MDB fund and Equatorial Guinea’s Fund for Future Generations—​and how these contributed to both entity and political illegitimacy.

Accountability and Transparency Accountability is a core component of entity governance; corporate codes and governing documents, such as articles of association or incorporation, are replete with mechanisms imposing accountability on managers and directors. Likewise, accountability has been identified as a key issue in SWF governance, both as political and business entities. Gelpern (2010), for example, identifies four types of accountability for SWFs: public

Paul Rose   165 internal accountability, private internal accountability, public external accountability, and private external accountability. The first two are particularly useful to the analysis here, as they relate to the legitimacy of SWFs as domestic political entities and as domestic business entities. Public internal accountability quite simply refers to the necessity of the sovereign fund to be accountable to the sovereign itself: “The state may be democratic, in which case SWFs answer to elected officials, or not, in which case they might answer to the monarch and her five cousins” (Gelpern 2010, p. 25). Clark, Dixon and Monk have noted that public support for Norway’s Government Pension Fund-​Global (GPFG) “depends upon the process whereby the public interest in its decision-​making is governed” (Clark, Dixon, and Monk 2013, p. 83). The GPFG’s legitimacy also flows from its public accountability mechanisms, “represented by the Minister of Finance and the accountability of the Minister to government and ultimately Parliament. This process-​ based claim of institutional legitimacy has been quite successful” (Clark, Dixon, and Monk 2013, p. 83). Private internal accountability refers to SWFs’ duties to a subset of shareholders, creditors, or other stakeholders, which stem predominantly from their charters and contracts. The tension between these two spheres of accountability may develop where, for example, “a fund formed to save for future generations is raided to advance unrelated strategic goals” (Clark, Dixon, and Monk 2013, p. 83). The concern with accountability is also reflected in several places in the Santiago Principles, including in: Principle 1. The legal framework for the SWF should be sound and support its effective operation and the achievement of its stated objective(s). Principle 1.1. Subprinciple. The legal framework for the SWF should ensure legal soundness of the SWF and its transactions. Principle 1.2. Subprinciple. The key features of the SWF’s legal basis and structure, as well as the legal relationship between the SWF and other state bodies, should be publicly disclosed. Principle 6. The governance framework for the SWF should be sound and establish a clear and effective division of roles and responsibilities in order to facilitate accountability and operational independence in the management of the SWF to pursue its objectives. Principle 10. The accountability framework for the SWF’s operations should be clearly defined in the relevant legislation, charter, other constitutive documents, or management agreement. “Accountability” and “operational independence”, as noted in the Santiago Principles, need not conflict in theory, although there are often unavoidable tensions in practice. Accountability in the context of an SWF means that the managers of the fund are accountable to the sovereign for the fund’s performance. Operational independence may be unaffected by this accountability; the fund managers may operate independently,

166    Sovereign Wealth Funds and Domestic Political Risk and it is only after poor performance that the managers face accountability. However, to the extent that the general polity exerts pressure on public officials with respect to fund performance—​and particularly expected where the polity has much at stake with the performance of the fund, as with the payment of a dividend to citizens of Alaska based on the performance of the Alaska Permanent Fund—​public officials may correspondingly pressure fund managers in ways that jeopardize their independence. Accountability with sovereign funds is also complicated when the SWF does not have a “single bottom line,” but is operated for a variety of public purposes, some of which may be difficult to quantify. Indeed, if an SWF’s purposes include difficult-​to-​quantify imperatives, standard business entity accountability mechanisms may be counterproductive. This concern is reflected in the Santiago Principles, Principle 2, which simply states that “the policy purpose of the SWF should be clearly defined and publicly disclosed.” Clear disclosure of fund purpose should also be coupled with financial reporting reflecting fund purposes. As Capalbo and Palumbo (2013) argue with reference to state-​owned enterprises, “the financial reporting model SOEs derive from their legal form need then to be integrated and adapted to reflect the different control and information needs generated by the public nature of purposes pursued and resources used” (Capalbo and Palumbo 2013, p. 46). They offer suggestions that are equally applicable to SWF reporting, including offering a Statement of Intent to the financial statements “to describe the non-​business-​like purposes of the company and the levels at which they have been achieved,” and adapting the financial reporting model “to reflect the enlargement that the use of public funds generate in the accountability chain” (Capalbo and Palumbo 2013, p. 46). Another important difference with SWF reporting is that, as long-​ term investors, SWFs should provide appropriate context for their performance, including appropriate benchmarks that reflect long-​term metrics as opposed to short-​term equity market performance. Providing transparency with respect to fund purposes and appropriate benchmarks helps increase legitimacy and decrease the risk of the public misinterpreting fund performance. Transparency also functions to reduce what in a corporate governance context are referred to as “agency costs,” including tunneling and rent-​seeking. By reducing these costs, transparency thus helps increase legitimacy and reduce governance and political risks. As Gelpern writes, “transparency can expose internal accountability tensions. A transparent SWF set up to maximize financial returns may have to forego opportunities in politically unpopular sectors or countries to maintain public support” (Gelpern 2010, p. 25). Transparency does not simply reduce the risk of intentional harms to the fund, but also reduces the risk of negligence. Transparency of operations, which includes transparency of governance structures and decision-​making processes,4 reduces negligence as fund managers recognize that both the decision-​making process and the ultimate 4 

Public disclosure of decision-​making process and operations more generally will, of course, be somewhat limited compared to the disclosure provided to the sovereign itself.

Paul Rose   167 decision will require justification before the sovereign and, perhaps, the polity. Again, in terms of agency costs, transparency and accountability help to reduce the costs of negligence through shirking and poor decision-​making, as well as reducing the likelihood of intentional actions such as rent-​seeking. To varying degrees, all of these costs pose political risks to the fund and the sovereign.

1MDB and the FFG: Case Studies in Procedural Legitimacy and Political Risk Despite most of the fears about the use of SWFs as neo-​mercantilist tools, they are at least as likely to be used for nefarious domestic purposes as nefarious international purposes. In the simplest form of this type of corruption, SWFs can be used to buy votes or reward supporters. Although it has been argued that SWFs serve as a tool for smaller states to preserve autonomy through outsized influence in the financial markets (Dixon and Monk 2010), SWFs can also be part of a much more common scheme of political patronage, and thereby decrease domestic legitimacy. An important, cautionary example of procedural illegitimacy comes from the recent scandal involving not a true sovereign wealth fund, but the sovereign development fund 1MDB.5 1MDB was created to drive “the sustainable long-​term economic development and growth of Malaysia” (1MDB 2014). The fund engages in a variety of energy and real estate projects, often serving as a catalyst and partner for foreign investment. 1MDB is, for example, the master develop of the Tun Razak Exchange financial district in Kuala Lumpur, and is developing land around the Sungai Besi airport into “a new urban mixed-​use development that we envisage will serve as a benchmark for sustainable communities in the region” (1MDB 2014). The fund has also invested in desalination plants and power plants. 1MDB is not funded directly by the government; the fund managers claim to have received only RM1 million in equity from the government. It primarily obtains funding through local and international debt offerings (although, as discussed below, these too have raised serious questions). The fund has incurred large debts through its business activities, and was forced to reschedule debt payments in 2015, in addition to receiving $1 billion from an Abu Dhabi state fund. The Wall Street Journal reports that 5 

As a general matter, sovereign development funds (SDFs) may present more domestic political risk in that they can be more easily (or at least more directly) used for rent-​seeking activity than a sovereign wealth fund. SDFs typically invest a portion, if not all, of their assets within the country. As the name implies, the goal of an SDF is to spur development of the country, a region, and/​or other countries. SWFs, on the other hand, typically invest abroad for macroeconomic purposes or to provide for intergenerational equity. The risk of political corruption through improper “investments” in domestic companies is thus higher with SDFs.

168    Sovereign Wealth Funds and Domestic Political Risk 1MDB played a role in financing Prime Minister (and Finance Minister) Najib Razak’s re-​election campaign. 1MDB allegedly made overpriced purchases from a subsidiary of Genting Group, which then made a donation to a charity called Yayasan Rakyat 1Malaysia (YR1M). Najib stated during his re-​election campaign that YR1M would donate a large amount of money to certain schools, which many interpreted as simply a form of vote-​buying. The Wall Street Journal also reports allegations that 1MDB funds flowed into personal accounts controlled by Najib or his friends and family. According to the Journal, 1MDB received a loan from PetroSaudi as part of a joint venture arrangement, and set up a loan repayment program for 1MDB to pay back the loan. Payments of $700 million, $160 million and $300 million were made in 2009, 2010, and 2011, respectively, to a company called Good Star Limited, controlled by an infamous associate of Najib—​Jho Low. Low claimed that Najib controlled the disposition of the funds, stating, “Guys, it’s very simple, there’s a board, who’s the shareholder? . . . Are you telling me the prime minister doesn’t make his own decisions? No one seems to ask the question who is the ultimate decision-​maker on 1MDB? No one asks that. No one ever asks about the shareholder’s role” (The Malaysian Insider 2015). Frank (though self-​serving) comments such as this undoubtedly raise concerns with regulators tasked with evaluating investment activity by state-​controlled funds and enterprises. Indeed, the purpose of governance efforts such as the Santiago Principles is to reduce the risk and fear that funds could be used as vehicles for corruption. The comments also highlight a peculiar tension with SWFs, sovereign development funds (SDFs) and other government funds: in an era of shareholder activism, where fiduciary owners, particularly, are expected to be vigilant defenders of the interests of their beneficiaries, how can state-​owned funds at once be active owners yet reassure regulators and portfolio companies that the fund will only pursue appropriate goals and use its power as a shareholder in appropriate ways? The answer lies in fund governance and procedural legitimacy, just as the answer to political corruption generally lies in a procedural system that protects against rent-​seeking, pay-​to-​play, and other forms of corrupt market distortions. As discussed above, procedural legitimacy in the context of a sovereign fund includes, among other things, a clear purpose for the fund and rigorous adherence to the investment policies that enact that purpose. Accountability, transparency, and robust auditing, as with other business entity forms, ensure that investments have been made according to policy. 1MDB does not merely provide lessons about political corruption and political legitimacy. It is also a case study of a failure of business entity legitimacy. As might be expected from a fund that has such a large governance and legitimacy failure, the Frequently Asked Questions section on its website reveals a fund that has been dogged with questions over numerous “smaller” governance failures over the years, including the use of offshore accounts, fees paid to investment bankers (particularly Goldman Sachs), accounting treatment, and acquisition of certain assets and contracts. Regardless of whether the underlying accusations are true, the fact that 1MDB must publicly defend against such accusations signals a failure of legitimacy of the fund, arising from

Paul Rose   169 inadequate transparency and poor accountability mechanisms. Because 1MDB is a sovereign fund, this failure of entity legitimacy is also accompanied by a domestic political crisis. The small but oil-​rich country of Equatorial Guinea also provides important lessons on the importance of governance and procedural legitimacy. Equatorial Guinea started large-​scale production of its hydrocarbon resources in 1996, and a large majority of the government’s revenues are derived from these resources. Equatorial Guinea’s governance structures were not equipped to handle the flow of vast amounts of new wealth into its governmental finance structure, however; the effect seemed like attaching garden hose governance to fire hydrant resource flows: much of the value from the resources appear lost to corruption. With a view to ensuring that some of the resource windfall was received by the citizens rather than collected and distributed only to the ruling elite, Equatorial Guinea was advised to create an SWF. It accomplished this in 2002 with the creation of the Fund for Future Generations (FFG). In what was an important governance decision, the government agreed to send funds for the FFG to an African regional bank, the Bank of Central African States (BEAC); Equatorial Guinea could thus be seen as leveraging regional governance as a means of overcoming its own limited governance capabilities. The World Bank noted problems with the arrangement, however, as the government had difficulty identifying and segregating assets from various sources. (Toto Same 2008). One commentator noted that “government’s statistics on money held at the BEAC appear to present global figures rather than a breakdown, suggesting that the money could be spent without safeguards—​and that the rhetoric behind the initiative is designed to satisfy an external constituency while the substance of policy and practice on the ground effectively remains little changed” (Goldman 2011, p. 9). Equatorial Guinea’s FFG offers a reminder that while SWFs can be used to help mitigate domestic political risks, they do not themselves confer strong procedural legitimacy; indeed, they can create risks of illegitimacy unless they benefit from institutionalized procedural safeguards. As Monk has noted, “[a]‌n SWF is not a mechanism to bypass weak institutions and poor governance at the local level. Rather, it should be the manifestation of these effective institutions and good governance” (Monk 2012).

The Substantive Legitimacy of Sovereign Wealth Funds SWFs, like other government-​owned enterprises and funds, will reflect the legitimacy of the sponsor government. It is less likely (though, if the fund is structurally independent, certainly not impossible) that a sovereign fund will be considered to be procedurally legitimate even if the sponsor government is not. However, one can imagine some level of procedural legitimacy simply as a tool used to decrease host country fears

170    Sovereign Wealth Funds and Domestic Political Risk about an SWF. In this way, reduced domestic political risk may be a positive spillover effect of legitimacy-​enhancing procedures designed to reduce international political risk. Substantive legitimacy also effects how the SWF is perceived internationally, but because the question of substantive legitimacy implicates the purpose and values of an SWF, it is of greater importance domestically. Substantive legitimacy, as described above, refers to the basic rights held by citizens. Broadly speaking, a fund that is substantively legitimate should reflect the basic values of the citizens, to the extent that the SWF is managed for the benefit of the citizen. Fund legitimacy is linked to fund purpose, not merely because the fund is a governmental instrumentality; funds are subject to the same legitimacy constraints that should guide the behavior of all government agencies. However, SWFs sometimes serve as much more than a just a governmental agency: they can be understood as the projection of domestic public policy through private markets (Cata-​Backer 2010), and as a savings vehicle for all of a country’s citizens. Each citizen, then, has a stake in the purpose and legitimacy of the SWF in a way that she or he might not in, for example, a state-​owned company. Countries create SWFs for a variety of reasons, and in many cases funds are created for multiple reasons. Justifications for funds are as different as the economic and political environments of each sponsor country, and the justifications described below should be understood as complementary, rather than competing, explanations for the existence of SWFs.

The Public Purposes of Sovereign Wealth Funds Numerous academics, politicians, regulators and sovereign fund managers have explained SWFs from various perspectives, including financial and economic, foreign policy, and domestic political justifications. Non-​commodity funds, such as the China Investment Corporation, typically start life for financial purposes. As Kimmitt (2008) summarizes, these SWFs are funded through excess foreign exchange reserves: “[l]‌arge balance-​of-​payments surpluses have enabled noncommodity exporters to transfer ‘excess’ foreign exchange reserves to standalone investment funds that can be managed for higher returns” (Kimmitt 2008, p. 121). Other kinds of non-​commodity funds are created as “an exchange-​rate intervention involving a domestic liquidity increase that has to be absorbed by issuing domestic debt to avoid unwanted inflation” (Kimmitt 2008, p. 121). These funds operate as a kind of “SWF carry trade” as they attempt to earn more on their investments than they must pay on their domestic debt. Funds may also shift purposes over time, from purely financial purposes to a broader role within the sponsor country. For example, many SWFs formed by capturing funds generated by commodity exports—​most commonly oil and gas—​have developed additional roles beyond their original financial purpose. As Kimmitt states, “[t]‌hese funds serve different purposes, including fiscal revenue stabilization, intergenerational saving, and balance-​of-​payments sterilization (that is, keeping foreign exchange inflows from

Paul Rose   171 stoking inflation). Given the current extended rise in commodity prices, many funds initially established for the purposes of fiscal stabilization or balance-​of-​payments sterilization have evolved into intergenerational savings funds” (Kimmitt 2008, p.  120). SWFs may also reduce the dependence of the economy on a single export such as oil or liquid natural gas (LNG). As put in a report urging the creation of an SWF in the UK, “[SWFs] help to protect the economy against the high volatility of resource prices and the unpredictability of extraction. Resource-​rich countries can reduce their dependence on a single commodity by investing the returns in a greater range of industries. In doing so, they can create a more complex infrastructure and a greater number of jobs on a national scale” (Wedmore 2013, p. 7). SWFs can also provide for a more stable economy because they can serve as a mechanism for financial infrastructure transfer for an economy. For example, SWFs can be thought to serve as a mechanism to acquire investment expertise that would enable an SWF to make its own investments. A natural progression of this explanation is that SWFs first hire external managers, then perhaps “internalize” external manager expertise through secondment arrangements, then perhaps begin to co-​invest with an external manager as a co-​principal. Finally, the SWF may invest on its own as a sole principal, and, as has happened with the Ontario Teachers’ Pension Plan fund, the fund may even act as a general partner and invest on behalf of other limited partners, including other SWFs. Less discussed, however, is the importance of the larger financial ecosystem that allows such deals to take place, including the importance of highly experienced and skilled attorneys and accountants. These professionals are key players in every significant investment, and as SWFs grow in size and become more active in international financial markets, such service providers compete for SWF business. As service providers open offices in new financial centers (perhaps in part to be near new SWFs), and as SWFs complete deals staffed by the most experienced and sophisticated service firms, the firms also provide important network effects. Indeed, it is likely that many service firms would not maintain offices in far-​flung locations such as Doha were it not for the presence of an SWF with a regular stream of deals to be managed. Another possible positive effect, besides the positive network effect of professional service firms operating in developing economies, is the possibility of other kinds of “professionalism” transfer. Much of this occurs as professionals from, for example, China, who have been educated and trained in large financial centers return to work for SWFs of SWF service providers in their home countries. Foreign professionals may also train native SWF employees, who may in turn leave the SWF to work in other enterprises. And, of course, other kinds of knowledge transfer may occur as SWFs learn about and invest in technology-​driven companies. Some have feared that the government of the SWF could use such information to gain military advantages or to compromise the security of the portfolio company’s home country. However, with national security restrictions in place around the world prohibiting investments of appreciable size by state-​controlled entities such as SWFs, the more likely outcome of such SWF investment activity and knowledge transfer is that it could be used in domestic (SWF home country) industry.

172    Sovereign Wealth Funds and Domestic Political Risk Dixon and Monk ( 2010) add a political dimension to these financial justifications. They argue that SWFs must be understood within a broader context of the evolving nature of sovereignty in an era of increasing globalization and financialization. SWFs “reflect the recognition on the part of nation-​states that their economic and social wellbeing has become dependent on, or at least vulnerable to, the functioning of foreign markets and the behavior of foreign countries and firms” (Dixon and Monk 2010, p. 27). Some sovereigns have recognized that they suffer from what Dixon and Monk term a “sovereignty deficit,” thus necessitating the need to use financial power to preserve and even expand their sovereignty. They conclude that “the rise of SWFs is symptomatic of a new economic and political reality; they demonstrate that 21st-​ century global capitalism favors the holders of financial assets over simply the domestic institutions and macroeconomic circumstances of western countries” (Dixon and Monk 2010, p. 27). Hatton and Pistor seek to amend Dixon and Monk’s explanation by recasting SWFs not as tools of state sovereignty, but as tools of elites within a sovereign state: We argue that the true stakeholders in the SWFs analyzed in this paper are the ruling elites in the sovereign sponsor, and that as such, it is the interests of these elites that SWFs advance. To these elites, SWFs serve as a valuable tool for protecting their interests. Limiting the interests of the ruling elite to state sovereignty, as would be necessary to justify a singular focus on sovereignty-​maximization, appears to miss the complex geopolitical and geoeconomic conditions to which these elites feel compelled to respond. In fact, one can point to instances where the elites have been quite willing to compromise on their monopoly on the legitimate use of force within state borders (the key aspect of Westphalian sovereignty) but not control over SWFs (Hatton and Pistor 2011, p. 13).

These financial and political uses of SWFs reduce political risk by creating a more stable and secure political state and economy. Note, however, that a more stable system does not necessarily mean a more legitimate political system, as seems the case with Equatorial Guinea. Indeed, as elites use an SWF not just to project power but to reward domestic and foreign rent-​seekers, an inevitable issue arises: What happens when the flow of funds dries up? This issue seems particularly salient as low oil prices have dramatically reduced revenues for many countries. In such a case, what may have seemed a stabilizing governance strategy becomes a political risk as rent-​seekers become dissatisfied with decreased rents. SWFs are also used as tools to promote intergenerational justice, and it is this use that presents the greatest risk and reward for the SWF. Many SWFs, and particularly those whose funds are derived from natural resource wealth, are explicitly set up in order to ensure that wealth from present extraction operations is available for future generations. There are other, equally important intergenerational conflict issues, however, that SWFs can help resolve. As Cappelen and Urheim (2012) explain, “There is a direct link between intergenerational justice and the size of these funds because these funds represent private and national savings. Future generations benefit from high savings today because

Paul Rose   173 high savings imply less consumption by the current generation and more investment that will benefit the future generation” (Cappelen and Urheim 2012, p. 3). However, they also identify a second, indirect link between SWFs and intergenerational justice: the growth of SWFs means that “these funds potentially get more influence as owners,” and that the funds can use this influence to affect the development of the world economy. They argue that SWFs and public pension funds can use their influence to reduce what they refer to as “intergenerational externalities,” defined as “the unintended consequences on future generations of decisions made today” (Cappelen and Urheim 2012, p. 4). Corporations may create intergenerational externalities when they take actions that may not have a large present impact—​and are thereby not taken into account by corporations (and, one might add, by regulators)—​but have a significant negative impact on future generations. For example, “[e]‌missions of greenhouse gases due to human activities alter the atmosphere in ways that are expected to affect the climate. The cost of climate change will be primarily carried by future generations” (Cappelen and Urheim 2012, p. 4). Applying a legitimacy analysis to the reduction of intergenerational externalities is complicated by the obvious fact that legitimacy is a concept attached to present sentiment about the government and its instrumentalities, and it is not always clear that present public opinion will support efforts to reduce uncertain future harms. Indeed, the rancorous arguments about how to tackle complex problems such as climate change suggest that it is politically risky for a fund to press too strongly on issues without a clear public consensus. This is not to say that measures designed to tackle negative intergenerational externalities are not justified, but merely to acknowledge the relationship between fund purpose and legitimacy. The difficulties in managing this relationship will now be explored, focusing on Norway’s Government Pension Fund-​Global.

Sovereign Wealth Funds as an Extension of Public Values: Norway’s Government Pension Fund Global and Substantive Legitimacy As would be expected from a governance framework designed to assuage host country regulators as much as to guide sovereign investors, the Santiago Principles contemplate investment focused on financial returns. For example, Principle 19 states that “SWFs’ investment decisions should aim to maximize risk-​adjusted financial returns in a manner consistent with its investment policy, and based on economic and financial grounds,” and deviations from this orientation “should be clearly set out in the investment policy and be publicly disclosed.” Likewise, Principle 21states that if an SWF chooses to exercise its ownership rights, “it should do so in a manner that is consistent with its investment policy and protects the financial value of its investments. The SWF should publicly disclose its general approach to voting securities of listed entities, including the key factors guiding its exercise of ownership rights.”

174    Sovereign Wealth Funds and Domestic Political Risk Norway goes beyond the financial orientation promoted by the Santiago Principles (Cata-​Backer 2013), as least as far as the term “financial” is reflective of easily-​quantified returns on investment (one could argue, of course, that a focus on environmental, social and governance (ESG) issues contribute to better returns, not just in the long term but also in the short term; however, the long-​term effects of ESG efforts are difficult to quantify, and the short-​term effects are typically negative) (Eccles and Serafeim 2013). Given their portfolio size, Norway has a unique opportunity to affect the corporate governance of many companies, particularly across Europe and in North America. Generally, Norway uses its power in two ways. First, and quite notably, Norway may decide to exclude certain companies from the available pool of investments, based either on the products the companies make or on the way that the company is operated.6 Product-​based exclusions include companies that: a) produce weapons that violate fundamental humanitarian principles through their normal use; b) produce tobacco; and/​or c) sell weapons or military materiel to states that are subject to certain investment restrictions (such as trade embargoes). Norway may put companies under observation or may exclude investment if there is an “unacceptable risk that the company contributes to or is responsible for”: a) serious or systematic human rights violations, such as murder, torture, deprivation of liberty, forced labor and the worst forms of child labour; b) serious violations of the rights of individuals in situations of war or conflict; c) severe environmental damage; d) gross corruption; and/​or e) other particularly serious violations of fundamental ethical norms. Currently more than four dozen companies, including Airbus, WalMart, Rio Tinto, and Textron, have been excluded from Norway’s sovereign fund portfolios. 6  Norway recently reformed the Council on Ethics as part of a broad governance reform at the GPFG (and, in part, because of the recommendation of the panel noted above).

At the beginning of 2015, the Ministry of Finance issued revised guidelines for observation and exclusion from the fund and five new members were appointed to the Council on Ethics. This annual report has been prepared by the outgoing Council. The criteria for observation and exclusion from the fund remain the same. The Council on Ethics previously advised the Ministry of Finance. Under the revised guidelines the Council will advise Norway’s central bank, Norges Bank, which will decide whether or not to exclude companies or place them under formal observation1. One of the objectives of changing the guidelines is to achieve better coordination of the work on exclusions and active ownership. (Council on Ethics for the Government Pension Fund Global 2008, p. 8, accessed at http://​etikkradet.no/​files/​2015/​01/​Council-​on-​Ethics-​2014-​ Annual-​Report.pdf)

Paul Rose   175 Second, Norway provides an interesting study not just because of its exclusion list, which deservedly gets a large amount of attention from the press, but also because of its active efforts as a shareholder. In the US, this engagement manifests itself primarily through active proxy voting and, occasionally, behind-​the-​scenes negotiations with company management. Rarely, when companies are not responsive to shareholder concerns, Norges Bank Investment Management (NBIM) may make a formal shareholder proposal. In the last five years, NBIM has made nine such proposals (see Table 7.2). Because shareholder proposals are precatory under US law, a majority vote in approval does not bind a board to act. Furthermore, given the relatively small positions held in any single company (limited by law to less than 10%, (NBIM 2015) and in practice typically much lower), the financial impact will likely be negligible, even assuming that the proposal has an impact. Norway’s activism thus begs the question: Why engage in such activism, when it is both merely episodic and not likely to make a significant impact on the portfolio? For example, suppose that Norges Bank sponsors a shareholder proposal for Charles Schwab, as it did in 2013. As of the end of 2013, the GPFG owned approximately $80 million worth of Charles Schwab stock. And, as of the end of 2013, the GPFG had a market value of approximately $830 billion. The investment in Charles Schwab thus represents less than 0.01% of the GPFG, and so any change in the value of Schwab is immaterial to the overall value of the portfolio. This question is part of a bigger debate that has been the subject of a large amount of research among finance and legal scholars:  Does shareholder activism produce

Table 7.2  N  orges Bank Investment Management Formal Shareholder Proposals (2010–​14) As Percentage of Votes Cast Year

Company

Proposal

For

Against

Abstain

2010

Constellation Energy Group, Inc.

Independent Board Separate Chair-​CEO

18.3%

81.3%

0.4%

2012

Charles Schwab Corporation

Adopt Proxy Access

30.9%

68.9%

0.2%

2012

CME Group Inc.

Adopt Proxy Access

37.8%

61.8%

0.4%

2012

Wells Fargo & Company Adopt

Proxy Access

32.3%

67.3%

0.4%

2012

Western Union Company

Adopt Proxy Access

33.4%

66.2%

0.4%

2013

Charles Schwab Corporation

Adopt Proxy Access

31.5%

68.0%

0.5%

2013

CME Group Inc.

Adopt Proxy Access

32.8%

67.0%

0.2%

2013

Staples, Inc.

Adopt Proxy Access

36.7%

62.8%

0.5%

2014

UMB Financial Corporation

Independent Board Separate Chair-​CEO

14.9%

84.6%

0.5%

176    Sovereign Wealth Funds and Domestic Political Risk shareholder value? In recent years the debate has primarily turned to the value of hedge fund activism, which, as it turns out, tends to result in not only a positive stock price impact, but also improved financial performance over longer time periods. Recently, for example, Bebchuk, Brav, and Jiang (2015) find that shareholder activist interventions are followed by improved operating performance during the five-​year period following the intervention. They also find no evidence that the initial strong positive stock price impact following activist interventions fails to take into account the long-​term effects of such interventions. More specific to the type of defensive activism engaged in by Norges Bank shareholder proposals, several recent papers also identify a positive impact from such activism. Bach and Metzger (2014) find, for example, that majority-​supported shareholder proposals generate positive shareholder returns, which they attribute not necessarily because their content has intrinsic value, but because they increase pressure on the board of directors (Bach and Metzger 2014). Similarly, Cuñat finds that increasing shareholder “voice” in corporations through say-​on-​pay rules leads to a 7% increase in market value, as well as increases in firm profitability and firm performance (Cuñat, Gine, and Guadalupe 2013). Cunat, Gine, and Guadalupe (2010) also find that adoption of shareholder proposals on governance matters leads to significant positive abnormal returns. In the case of Norway (and with other very large investors), such activism is justified for several reasons. As Hawley and Williams (2000) have argued, investors such as NBIM are “universal owners”—​and, given the size of the GPFG there is perhaps no investor more “universal” than NBIM—​who cannot escape bad governance by diversifying. This is particularly true as Norway limits its scope of potential investments through ethical considerations. When a fund has nearly a trillion dollars to invest, it looks for value wherever it can find it. Thus, if the fund can enhance value of its current investments through activism with a positive return on investment (ROI), it should do so. And the larger the amount invested in a particular company, the more incentive the fund has in engaging in corporate governance-​enhancing activism. Further, it is also the case that other investors are more likely to support corporate governance-​enhancing activism by large investors such as NBIM and SWFs because as the percent invested in the portfolio company increases, the more value the fund is likely to obtain through improved performance as opposed to private benefits from firm influence.7 Thus, other 7  There is a tension between economic incentives of ownership and the legal rules designed to limit control and influence, such as the rules imposed through the US Foreign Investment and National Security Act (FINSA), which tend to limit the amount of investment a fund may make to a non-​controlling and even non-​influential percentage. From an economic perspective, a significant minority shareholder can have an important effect in limiting managerial agency costs through more active oversight. It is the very fact that the investment is large enough that makes the minority investor determine it is worth the effort to actively monitor the firm. However, FINSA encourages smaller investments by public investors because it imposes significantly higher transaction costs for deals involving “influential” amounts of ownership, even when the stock ownership amounts to 5% or less of the company. Furthermore, other US laws, such as regulations designed to limit insider trading, (e.g. Section 16 of the 1934 Act) also discourage larger block investments by imposing reporting requirements and effectively restricting some types of trades for investors owning 10% or more of a company’s stock.

Paul Rose   177 investors will tend to support proposals coming from larger investors, or from investors proposing governance arrangements that empower larger investors, as opposed to empowering smaller investors (Rose 2014). There is, then, a plausible (if not strong) financial case for governance activism from large investors such as SWFs. In addition, by engaging instead of remaining passive, large public investors can drive the governance agenda toward a more long-​term, sustainable orientation. Norway offers another reason for engaging in such activism, however: the legitimacy of the GPFG is linked to the way in which the fund’s financial power is exercised. The Norwegian Ministry of Foreign Affairs, in a report to the Norway’s legislature, stated, The Government expects enterprises in which the state has ownership interests to actively follow up social responsibility in their activities . . . [C]‌ompanies in which the state has ownership interests should take the lead in exercising social responsibility. The . . . state’s legitimacy could be weakened, for example as legislator and in matters concerning foreign policy, if, in its role as owner, it failed to comply with high standards in this area. (Norway Ministry of Foreign Affairs 2009)

The difficulty faced by fund owners such as Norway, which acknowledges that legitimacy is tied to more than the financial returns offered by the fund, is to reconcile the sometimes shifting view of what constitutes “legitimate” ownership with fund policies. For example, ten years ago a fund may have had relatively less pressure to consider ESG issues generally, and specific concerns within the sphere of ESG, such as the need for multinational tax reform, were not widely acknowledged as serious issues. Likewise, as a new government takes office (if, as in a democracy, a new party takes control of the legislature, or a new generation of leaders takes control of a sovereign in the case of a monarchal government), there may be shifts in the scope of legitimate activity, and the new government may believe that they have a mandate to change direction entirely; in other words, legitimacy is a fluid concept, particularly in democracies where the government operates under a high standard of accountability. For this reason, even funds such as Norway’s tend to stay on rather safe political ground of financial returns, which operate as a lowest common denominator for fund legitimacy. They may engage in ESG efforts, but even these tend to be couched in either performance-​related explanations, or as exclusions of companies that are viewed as illegitimate investments. With respect to company exclusions, Norway’s legitimacy calculation is somewhat similar to Sharia-​based exclusions used by certain funds. Just as non-​Sharia-​compliant companies would not be legitimate investments to the citizens or powerful elite in predominantly Muslim countries, so are certain arms-​manufacturers (for example) illegitimate investments for the GPFG. Almost no set of investors would accept financial returns at any ethical price. Sovereign fund managers and ethics committees should (and most likely do) make such legitimacy calculations with each investment and each investment mandate. This is not to say, of course, that every Norwegian agrees with all of the suggestions made by the Council of Ethics. Robust and continuous debate is to be expected on investment policies.

178    Sovereign Wealth Funds and Domestic Political Risk Investment limitations such as Sharia-​compliant investment and Norway’s exclusion list teach an important lesson about legitimacy: substantive legitimacy for SWFs tends to be defined negatively. Just as a body is “healthy” if it is free from disease, so a fund may be “legitimate” if it does not hold illegitimate investments. This is perhaps an unwelcome observation for those who would have SWFs positively define themselves as ESG investors that aggressively pursue investments and governance changes that, for example, reduce intergenerational externalities. However, beyond the idea that a fund should maximize returns, it is difficult to achieve popular and political consensus on the types of objectives a fund should pursue. This recognition suggests that although some public funds may devote a small segment of their portfolio to pursuing purely ESG objectives, such as green investments, most funds will not have any such objectives. To the extent that funds have any non-​financial considerations in their mandates at all, the consideration will be whether to exclude certain investments, rather than explicitly include certain investments. This hypothesis is borne out in the publicly-​disclosed policies of the largest SWFs. A review of the policies of the 26 largest SWFs shows that while ESG exclusions and requirements to “consider” ESG factors are relatively uncommon, ESG mandates are unheard of (Rose 2014a). Only four of the SWFs reviewed (16%) report any ESG restrictions or considerations, and no fund reports a specific mandate to invest in certain companies to promote ESG objectives. Legitimacy for SWFs is determined as much, if not more, by what they don’t invest in as what they do invest in.

Conclusion SWFs, as government instrumentalities, face questions of both procedural and substantive legitimacy. Procedural legitimacy requires the creation and maintenance of appropriate governance mechanisms that will ensure transparency and accountability of the fund. The Santiago Principles, and other governance efforts, are designed to increase procedural transparency, although the goal of such efforts has primarily been to increase the legitimacy of SWFs in international markets and with host country regulators. This chapter argues, however, that such efforts can also promote the procedural legitimacy of the fund domestically, and that legitimacy can serve as an indication of appropriate risk management. The substantive legitimacy of the fund depends on the fund’s adherence to general societal values. Most commonly, legitimacy is tied to the exclusion of investments that are inconsistent with societal norms, such as non-​Sharia-​compliant investments by SWFs owned by predominantly Muslim countries, or, as in Norway, investments in companies engaged in the production of certain harmful products or engaged in harmful practices, including human rights abuses. Legitimacy, however, is a fluid concept, so one can expect that substantively “legitimate” investment policies will shift over time as funds’ political environments shift and evolve. As what constitutes legitimate

Paul Rose   179 governance shifts over time, so too does the calculation of domestic political risk associated with a sovereign fund.

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Chapter 8

Sovereign We a lt h Fu nd s a nd Foreig n P ol i c y Kathryn C. Lavelle

Introduction Sovereign wealth funds (SWFs) pose a unique paradox for analysts of foreign policy. Their nature as sovereign means that they could potentially act as an instrument of a state’s foreign policy—​meaning one state could use an SWF in an attempt to influence another to do something it would not otherwise do. Their nature as wealth funds classifies them as pooled investment vehicles—​meaning SWFs seek to maximize economic returns over a period of time. The foreign policy analysis of SWFs thus sits at the intersection of studies of politics and financial management because the priority attached to these potentially conflicting goals is unclear. Moreover, the range of funds, countries, and alliances involved makes it difficult to sort out when the preference could be geostrategic, and when profit maximizing. In order to distinguish between the political and economic dimensions of the relationship of SWFs to foreign policy, we borrow language from earlier literature on foreign direct investment and divide the analysis into “host” and “home” country issues (Dunning 1981; Gilpin 1975; Moran 1985). Then we ask what a home or host country could do, and if they are actually doing it. That is, we will consider how a home country could potentially use its SWF as an instrument of foreign policy—​and what, if any, mechanisms it has for political control in order to pursue foreign policy through its foreign investments in a unified, rational, manner. Then we will consider any evidence that such countries do so. Next, we will examine the concerns the host country might have with respect to incoming financial flows from an SWF, and how they have responded to the potential from SWFs to act this way. While many analysts have pointed to the possibilities for SWFs to be used as instruments of foreign policy (Drezner 2008; Kimmitt 2008), a closer examination of political institutions in each state reveals the competing actors and pressures that contribute to actual policy decision-​making. Thus, we will

Kathryn C. Lavelle   183 offer insight into the strengths and weaknesses of various foreign policy arguments that have been advanced about SWFs, depending on the apparatus of the state in question, and not in the abstract. The first section reviews the relevant literature on foreign policy decision-​making as it intersects with that of SWF management. It illuminates gaps in the literature on SWFs that would be enhanced by findings from other, more general, studies of foreign policy that examine inputs into decision-​making that are both internal and external, democratic and authoritarian. Democratic features of governments compel transparency in regulations and render public institutions—​notably SWFs—​subject to notions of the public good that policymakers must be accountable for, albeit democracy is never realized in its perfect form. The second and third sections of this chapter investigate issues related to the politics of home and host country SWF investment respectively, depending on the democratic features at work. A fourth section will offer some observations on attempts to coordinate the behavior of SWFs at the international level. We conclude with remarks about the relationship between pools of wealth and state power in foreign affairs.

Foreign Policy and Pooled Investment Vehicles In the study of politics, the analysis of foreign policy mirrors the analysis of any policy insofar as it addresses what a government actually does, and what choices it makes. Thus, foreign policy analysis draws heavily on several other social science disciplines for insight into both empirical reality and theory-​building:  chiefly political science, sociology, public administration, and psychology (Stuart 2008). When the economic aspects of SWFs are added to the mix, foreign policy arguably becomes the most ambitious and multifaceted area of international political economy. In sum, the study of foreign policy and SWFs raises questions about who makes the investment decisions, and how those decisions are connected to nationalist goals at home and abroad. Any country’s foreign policy decisions result from both internal and external sources. Therefore, its domestic political processes and politics play a role, as well as the necessity of responding to events beyond its borders. In attempting to amalgamate the wide range of sources that contribute to foreign policy outputs, Rosenau (1971, p. 54) identifies five categories of inputs: individual, role, governmental, societal, and systemic. In a popular textbook on world politics, Kegley and Blanton (2014, p. 56) offer a model of decision-​ making they term the “funnel of causality,” which highlights three similar categories of influence: global conditions, the actor’s internal characteristics, and leaders. These wide-​ranging inputs into the funnel shape the decisions that produce specific outputs. Since decisions occur across time, the foreign policy output becomes its own input at the next stage in a dynamic process where no factor explains a decision exclusively, and where any decision cannot be separated from those that preceded it.

184    Sovereign Wealth Funds and Foreign Policy Moreover, decisions take place at one of three levels:  the individual, the group, or the coalition. Individual decisions are more common when the individual policy maker has an inordinate amount of power within the state. Group decisions can be made within a group where the allegiance is directed within the group, and the actors do not have to consult outsiders, or within agencies or cabinets. With coalition decision-​making, no one actor can decide policy. Individuals must bargain with others and no one single unit can make a decision unilaterally. Mintz and DeRouen (2010, p.  38) point out that one problem any leader can make in foreign policy decision-​making is his or her tendency to be influenced by biases and errors due to cognitive limitations. Crucial decisions take place under constraints of information-​ processing limitations. Foreign policy models debate whether or not states make choices according to the expected utility of their actions, and thus act consistently and rationally (Allison 1971). Others add that humans are selective in the information they use to make decisions and generally select a satisfactory, as opposed to optimal, alternative (Simon 1957). Still others look to the psychological makeup of individuals in order to ascertain how leaders might deviate from rationality. For example, the decision makers’ images of reality may influence his or her decisions (Jervis 1976). Characteristics of the individual may influence how he or she makes decisions (Hermann 1980). Public opinion also plays a role in foreign policy decision-​making. In democratic political systems, long-​term trends in the public’s orientation can influence party positions on issues and positions on the use of force overseas. Moreover, the public can, and does, place items onto the policy agenda. However, influence over the long term rarely results in substantive policy innovation, particularly in arcane issue areas such as financial governance. For example, after the mortgage meltdown commenced in the US in 2006, SWFs invested billions of dollars in the American and European financial systems. In the first six months of 2008, SWFs stabilized segments of the banking industry with over $80 billion of equity stakes in Merrill Lynch, Morgan Stanley, UBS, and Barclays (Hemphill 2009, p. 556). These investments lost a considerable degree of their value, leaving domestic constituencies apprehensive about the direction of future flows. When SWFs were also criticized in the West, much of the discussion in both home and host countries moved toward developing an international code of conduct that would resolve some of the tensions (Behrendt 2008, p. 16). As noted earlier, the decisions made by managers of an SWF could potentially have strong political, as well as profit-​making, implications. Thus, SWFs pose a particular conundrum for foreign policy making among advanced, industrial states. On one hand, economic doctrine teaches that the greatest allocative efficiency and highest prices for assets can be obtained when the greatest number of potential buyers can participate in a market free of government intervention. Yet, on the other hand, many of these funds are not transparent. When the bidders are themselves state-​controlled, as is the case with SWFs, ownership could potentially be passed outside market arrangements as they are currently understood, undermine those arrangements, and ultimately threaten state autonomy.

Kathryn C. Lavelle   185 The problem of SWFs is thus not an economic one because they are one form of collective investment vehicle among many that may or may not disclose holdings or investment strategies, and many are highly profitable. The problem is political because when they are introduced into a liberal financial system, all bidders may no longer seek profit maximization. Moreover, not all states have good or bad relations with each other. As discussed, past experiences with states influences future expectations with respect to their foreign policy behavior. Thus, nationalism in each country of origin does not provoke the same degree of national concern in the states where they invest—​depending on whether they are allies or adversaries (Lavelle 2008). Hence, because individual decision-​making in an SWF occurs in an international context, where some states are allies and others are adversaries, the connection of the individual decision-​maker to the state’s goals and relationships to others is crucial to understanding the connection between foreign policy and SWFs. When an SWF’s decision-​makers are part of the state’s apparatus, their goals could be tied to nationalist goals seeking to advance state power and not just wealth. Hence, many contemporary states that do not necessarily seek to restrict the outflow of private resources, do seek to restrict investment inflow to sectors that could be considered sensitive for national security, or on a scale that could reshape their financial market systems with untoward (foreign) government intervention (Kimmitt 2008). Whereas unease in the US may be oriented toward national security and Chinese investment, the same discomfort in the European Union exists with respect to Russian SWF investment (Bahgat 2008, p. 1202; Chaisse, Chakraborty, and Mukherjee 2011, p. 838). In all cases, foreign policy apprehensions associated with SWFs appear to relate to the combination of their size and lack of transparency. By 2011, SWFs and central banks with a large SWF function were estimated to mange US$3.2 trillion in assets (Chaisse, Chakraborty, and Mukherjee 2011, p. 840). While hedge funds and private equity funds are similar to SWFs in their lack of transparency concerning holdings and investment goals, SWFs are larger than all hedge funds combined. Moreover, their size is expected to grow, depending on the price of oil, the strength of the US dollar, and the current account surpluses in China and other Asian countries. Due to the lack of transparency of many SWFs in home countries, their investment objectives are not always known. Less transparent governments tend to have fewer democratic features reinforcing notions that differing incentives within the same capital market structure of less democratic states could ultimately distort the price mechanism that operates within some (more democratic) national financial market institutions, and the corresponding allocation of resources. In an extreme case, the large-​scale operation of SWFs could curtail a significant volume of capital market intermediation, if leveraged buy-​out firms turned directly to alternative sources of debt financing—​among them SWFs, public pension funds, hedge funds, and mutual funds—​in a credit squeeze (Arnold 2008). Other specific concerns arise from direct ownership or control of strategic sectors of an economy, its critical infrastructure, or major financial institutions. Even outside these sensitive areas, SWF ownership could leave firms vulnerable to sabotage, which would cripple a country’s productive capability. Conversely, once an investment

186    Sovereign Wealth Funds and Foreign Policy is made, the SWF could threaten to withdraw the investment. Finally, ownership by an SWF could co-​opt domestic interests within the recipient state, influencing political outcomes (Drezner 2008). Table 8.1 summarizes the major, specific foreign policy concerns attached to SWF investment and outlines attempts at regulation by national authorities to address them. Later, this chapter will flesh out many of these concerns in cases and regulations devised in response. There is some evidence in the aggregate that political relations do play a role when SWF investment decisions are made, albeit the political objective is not always clear. Knill, Lee, and Mauck (2012) separate decisions regarding where to invest from those

Table 8.1 Major Foreign Policy Concerns Associated with Investment by Foreign Sovereign Wealth Funds Concern

Attempted Regulatory Remedy

Control of strategic sectors

• Special laws to regulate market structure and firm behavior of industries considered to be of strategic or social importance (e.g. energy, media and telecommunications) • Creation of special agencies charged with the review of investments based on national security considerations

Stabilization of financial markets

• Subject SWFs investing in supervised financial institutions (such as banks and insurance companies) to prudential rules. Acquisitions of significant shareholdings above a certain threshold may be subject to prior approval supervisors on the basis of a “suitability test” to safeguard management of the financial institution

Influence over firm management in the marketplace

• Investment activities of SWFs may be subject to scrutiny by regulatory agencies applying anti-​monopoly or take-​over regulations on market structure grounds if the size of the investment would give the SWF enough managerial influence over the firm to constrain it from acting competitively

Securities market manipulation

• Subject SWFs to reporting requirements on their shareholdings • Extend corporate governance rules of publicly-​traded companies to perceived concerns of the noncommercial influence of SWFs in such companies, such as applying legal principles on fiduciary responsibility and avoidance of conflict of interest to directors and the company when an SWF acquires influence over directors of a company in order to moderate risks of noncommercial behavior by those directors and the company • Apply market integrity rules, such as those related to insider trading and other forms of market manipulation, to SWFs as with other investors, recognizing that enforcement against SWFs may be difficult due to the potential application of sovereign immunity rules

Source: IMF (2008) “Sovereign Wealth Funds—​A Work Agenda,” p. 19.

Kathryn C. Lavelle   187 concerning how much to invest. Whereas they find that SWFs prefer to invest in countries where they have weaker political relations, politics plays less of a role in determining how much to invest. They conclude that SWF investment improves political relations when the investment is in states that are relatively closed, and hurts political relations when the target country is open. Nonetheless, these authors also find that SWFs are diverse enough that they should be considered individually, and not be subject to broad policy for all SWFs. The upshot of this literature is that any definitive statements about the connection between SWFs and foreign policy are open to question, given the gaps in verifiable information between the two literatures. Most notably lacking is the absence of any nuanced analysis of the mechanisms through which an SWF could potentially conduct foreign policy on behalf of the state, if it is in fact doing so. To put it another way, the SWF literature takes the potential for foreign policy goals as a given, yet fails to elucidate how decision-​makers might direct the investments with respect to the target state. That is, who makes the decisions concerning which state is the object of the foreign policy objective? Is the mechanism located in a different ministry or the governance of the SWF? How do these decision-​makers determine if selling shares, changing firm management, or any other policy will be the most effective way to achieve the foreign policy goal? How do they follow up in the next round if they have been successful or not? That is, in the absence of any psychological, bureaucratic, or organizational studies of SWFs, theory lacks an understanding of the agency used to accomplish investment decisions with a political goal. Given the lack of transparency of the SWFs in question, there is no way to validate the statements made by political leaders, nor to generalize about the relationship across SWFs. Hence, additional research is needed to disprove the rival thesis that foreign policy does play a role. Future scholarship may close the gap by investigating the relationship among bureaucracies, or other actors, that could carry out the foreign policy goals they are allegedly pursuing. Later in this chapter, we will see that overt political activity confronts these issues in both SWF home and host countries.

Home Country Issues How do countries attempt to use SWFs as instruments of foreign policy? As with any state or issue area, the output of foreign policy in any area results from a mixture of inputs. Since foreign policy operates across time and within the context of other geostrategic relationships, the results of decisions made in the past will affect those that will be made in the future. The internal construction of the state matters as well, even in authoritarian models that may be under the control of a fewer set of political actors. Therefore, the studies that do exist that could shed light on how SWFs could be used as foreign policy instruments reveal the competition among domestic actors with respect to the means and ends of such policy. In short, domestic politics matter in foreign policy

188    Sovereign Wealth Funds and Foreign Policy decision-​making, and SWFs are no exception to this rule. Even non-​democratic political systems are not immune to the same international and other pressures involved in foreign policy decision-​making since fund managers report to some authority for economic performance. Global conditions and investment returns affect democracies and non-​democracies alike. Prior decisions made influence future ones. And leadership varies in terms of qualifications for office and accountability to factions within the state. The definition of a democracy is a particularly thorny topic in the study of comparative politics. While no government has ever lived up to perfect standards, most theorists would argue that a democratic system must have political accountability insofar as there must be formal procedures by which those who hold power are held responsible for their actions. The chief mechanism is regular, free, and fair elections where voters elect candidates for office. Political parties must be able to organize and present candidates for office, and all citizens must possess political insights and civil liberties. Finally, in a democratic system, all citizens must be entitled to participate in politics (Kesselman, Krieger, and Joseph 2000, p. 16). In international relations theory, democracies are thought to be less likely to engage in violent conflict with each other (Doyle 1983). Hence, states that value the freedom of the individual pose less of a threat in their foreign relations than those that do not. The constrained role of the state leaves room for a wider role for the market and private property. Where do domestic politics meet SWF management if the state is not democratic? Or to put it another way: To whom do fund managers answer when they are not elected leaders? Models of governance differ according to the type of political institution at work in the state. While the SWF internal governing structure may recognize that it exists in order to manage the assets as trustees on behalf of the people, this is not always the only goal domestically, and “national” interests are rarely uniform, even in authoritarian states. While the management structure should reflect the citizens’ best interests as ultimate owners of its assets, and reflect a chain of governing bodies from the legislature down to individual asset managers with accountability at every level, this also is not always the case (Al-​Hassan, Papaioannou, Skancke, and Sung 2013, p. 14). Moreover, financial theory does not offer an appropriate level of risk for SWFs in general. For investment professionals to do their jobs, a governing body such as a parliament or Ministry of Finance should establish an appropriate level of risk tolerance. If such a chain of command is established and publicly available, concerns about the investment motives of an individual SWF might be assuaged, even in states with few democratic features. Liberal publications such as The Economist point out that the free operation of sovereign enterprise spreads financial capital, know-​how, and technology. It helps the world economy adjust to imbalance and gives countries, particularly those from emerging markets, a stake in each other’s prosperity and capitalism’s future. Securities and Exchange Commission (SEC) chair Christopher Cox stated:  “I believe these developments (with respect to SWFs) are part of a continuing shift away from statism and toward genuinely free markets. In this, I see only a rising sun, a stabilizing and modernizing influence in global finance” (Cox 2007). Deputy Secretary of the Treasury Robert

Kathryn C. Lavelle   189 Kimmitt (2008) argues that it is in the US’s interest to be open to market-​driven investments, even if reciprocal opportunities are not available. The Economist nonetheless acknowledged the theoretical risk posed by SWFs to abuse companies and markets. Similarly, Cox (2007) emphasizes the importance of ensuring the transparency of sovereign business and investment. Kimmit (2008) states that “SWF investment decisions should be based solely on economic grounds rather than political or foreign policy considerations . . . During times of market stress, SWFs should be committed to communicating effectively with the official sector to address financial-​ market issues (Kimmitt 2008).” Senate Banking Committee member Evan Bayh (2008) summed up many views when he opined in The Wall Street Journal that “investments by foreign governments are inherently different than private investment.” Given the lack of transparency associated with many SWFs, it is difficult to prove or disprove the political suspicions attached to them. A researcher would have to have access to the internal decision-​making structure of the fund under study, which—​for proprietary reasons—​is not likely to be available to external researchers, among others. Moreover, the incentives to attempt to alter another state’s behavior vary dramatically depending on the relationship between any home and host country relationship—​allies would have little reason to use an SWF as an instrument, whereas adversaries may find such investment quite useful. Nonetheless, more general insight can be gained from considering what, if any, democratic features—​such as elections or accountability—​ exist in the political institutions. Moreover, these features can be situated within the country’s global context, internal characteristics, and leadership. These features provide clues to understanding how easy or difficult it would be to mobilize an SWF as a tool of state power.

Asia’s Sovereign Wealth Funds When viewed by region, SWFs in Asia are among the largest, comprising roughly 39.1% of the total for all SWFs, albeit these figures are subject to change depending on the value of the assets held (Sovereign Wealth Fund Institute 2015). Although they have vastly different political systems, histories, territories, and composition of citizenry, two countries in Asia receive the most attention: China and Singapore. In both cases, despite the distinctions in how it is carried out, each is also subject to a certain amount of oversight from domestic pressures on performance, and competition for the resources contained in the funds. The Chinese political system could be categorized as a communist party state, wherein one political party holds a monopoly on power (Kesselman, Krieger, and Joseph 2000, p. 21). Nonetheless, the party contains factions that support different avenues for future growth and how the funds should be used. The political structure of Singapore is woven into the business interests of the state—​which is tied to the ruling family. While some regard the country as a developmental state with a bureaucracy distinct from politics, others point out that the ruling People’s Action Party (PAP) dominates the bureaucracy and helps the SWFs to serve as economic tools for the

190    Sovereign Wealth Funds and Foreign Policy political survival of the ruling family and the PAP (Shih 2009, p. 332). However, even in Singapore, information about the value of SWFs is known and management is criticized if it drops considerably. Therefore, despite their lack of overt democratic features, political struggles exist within each state, particularly with respect to the resources held in the SWFs. Without elaborating on who wins contests for control of investment decisions or other policy matters, authors stress that they are not under the control of any one set of actors. Analysts of the Asian region underscore that the lack of ability to settle on any one policy with respect to investments—​either domestic or foreign—​is true of both democratic and authoritarian regimes there (Pekkanen and Tsai 2011). A range of stakeholders, such as political elites, government agencies, private sector firms, state-​owned enterprises, and societal groups contest the ways that their interests could be served by sovereign wealth. Hence, the investment profile of SWFs results from leadership, bureaucratic competition among financial regulators, public and private interest groups, societal demands for provision of public goods and services, and ideological positions on unimpeded economic globalization. Any and all of these pressures constrain the capacity of Asian SWFs to serve as geostrategic instruments of the state (Pekkanen and Tsai 2011, p. 2). The first of these—​China—​has several SWFS, the largest of which is the China Investment Corporation (CIC), established in 2007. The CIC has assets valued at US$746.7 billion as of November, 2015, making it the world’s third largest, after the Norwegian Government Pension Fund and the Abu Dhabi Investment Authority (Santiso 2014, p.  102; Sovereign Wealth Fund Institute 2015). Although the Chinese Communist Party dominates the state, it nonetheless contains factions that seek to direct the assets of these funds. When situated within the context of domestic Chinese politics, the creation of the CIC could itself be considered a bureaucratic compromise (Chwieroth 2014, p. 754). From the outset, a large share of the CIC’s investment portfolio was directed at the domestic banking sector. This strategy appears to result from competition among the State Council, People’s Bank, and National Development and Reform Commission of China that the CIC could only be established if it would support state-​owned banks, that are not known to be highly profitable (Pekkanen and Tsai 2011, p. 24). Once established, the CIC was drawn into further competition with the state foreign exchange reserve management agency. The two each sought high-​risk, high-​yield investments that China’s leadership has been able to use to discipline fund management (Eaton and Ming 2010). In 2003, Central Huijin Investment, Ltd. was established in order to manage the Chinese government’s ownership in the national banking sector. The CIC later acquired control of Hujin from the exchange reserve management agency and held on average 50% of the bank’s share capital—​ranging from approximately 35% to 67%. Hujin’s management has openly acquired shares of Chinese state banks through the equivalent of open market operations that are designed to provide price support to Chinese bank shares and signal the government’s support for Chinese equity more generally. Hence, during the three years ending December 31, 2013, the Shanghai index declined cumulatively by

Kathryn C. Lavelle   191 nearly 25% but the shares of the four Chinese state-​owned banks remained relatively flat, returning –​0.5% (ICEX-​Invest in Spain 2014, p. 97). Internally, the CIC’s governance is both technocratic and politicized. Because it is a ministerial-​level state-​owned enterprise, authority to make decisions lies in the CIC’s party group and not its board of directors, albeit several executive committee members also serve in its party group (Pekkanen and Tsai 2011, p. 22). China’s SWFs are subject to some public scrutiny. When they suffer losses on international investments, criticism emerges on blogs, advocating for better use of China’s foreign reserve. Bureaucratic interests echo these criticisms, and question why the resources are held in the SWFs and not used to improve domestic welfare (Pekkanen and Tsai 2011, p. 25). Each of these characteristics make it difficult for the CIC to pursue clearly defined foreign policy goals of the Chinese state, since they would have to be weighed against other—​domestic—​policy goals. Some other types of publicly available evidence exists where fund management asserts the independence of the SWF from the state, and conversely where suspicions of diplomatic objectives are voiced. For example, Gao Xiqing, the (then) chief investment officer of the CIC gave several interviews with western media outlets—​notably the American news show 60 Minutes on April 4, 2008—​where he pledged to increase the transparency of the Chinese sovereign wealth fund (Sender 2014). The second country in the region that has received a large amount of attention in the literature on SWFs is Singapore. Singapore has two major SWFs, Temasek Holdings and the Government of Singapore Investment Corporation (GIC). The government seeks to use these SWFs to protect its small, export-​oriented economy against external shocks. While both SWFs report to the Ministry of Finance, they differ in that the GIC does not invest in Singapore. As discussed earlier, Singapore is a developmental state. The business interests of the state, the ruling party, and the ruling family are nearly indistinguishable from each other. Nonetheless, citizens do voice their displeasure when the SWFs do not perform well financially, as occurred when Temasek lost over 30% of its value in early 2009 (Pekkanen and Tsai 2011, p. 19). As with the management of the CIC, Temasek’s management publicly asserts its independence from political interests. The executive director of Temasek Holdings, Simon Israel, testified before the US Congress in March of 2008 and took pains to emphasize the independence of Temasek from the government of Singapore in both its management structure and in the constitution of Singapore (House Hearing, 110 Congress 2008). At the time, 40% of the firm’s senior management’s national origins were outside Singapore. Despite statements to the contrary, it is difficult to separate foreign relations from SWF acquisitions in the popular mind. Notably, Temasek’s purchase of the Thai family conglomerate, Shin Corporation, resulted in a series of diplomatic problems. It was considered to be one of the factors in a 2006 coup against Thai leadership because many in Thailand felt that the sale transferred a national Thai asset to foreigners (Arnold 2006). The foreign minister of Singapore, George Yeo, later commented that Singapore would not object to the sale of Thailand’s Shin Satellite to address worries that Singapore used the satellite operator to spy on Thailand’s communications. The Prime Minister of Thailand similarly phrased his remarks in purely commercial terms, noting that the

192    Sovereign Wealth Funds and Foreign Policy government would not object to a sale to the Thai private sector if it decided to buy Shin satellite (Burton 2007). Efforts to sell its stake in Shin Corp persisted through 2014 (Grant 2014). The political reality of foreign policy and SWFs in Asia could be summed up as SWFs asserting their interest in pursuing financial, and not political, objectives; whereas domestic constituents expect SWFs to serve their particular interests, leaving little or no room for leadership to use them to exert foreign policy pressure on other states. Is this the case in the SWFs associated with Gulf States?

Sovereign Wealth Funds in the Gulf States Politics in the Middle East results from historical processes accompanying colonial rule, the political legacy of Islam, the shifting price of oil, regional labor migration, and previous regional conflict. Therefore, there is not one type of state structure in the region, although the SWFs associated with the Arab Gulf states (Kuwait, Dubai, Abu Dhabi, Saudi Arabia, and Quatar) are closely connected to the surplus oil revenue they have managed for forty or more years. During these years, actors in the region have gone from operating in an international system where their policies were largely reactions to the policies of the US and USSR, to one where their power dispersed toward other industrial states, to one where they can originate international exchange both politically, economically, and militarily as major actors in the international arena (Andersen, Seibert, and Wagner 1990, p. 216). Early theories of political economy stressed that the character of the state’s revenue—​oil—​impedes democracy and limits political liberalization (Brynen, Moore, Salloukh, and Zahar 2012, p. 193). While these theories have largely been challenged in recent times, authoritarianism in the region has been connected to the considerable rents that states are able to amass. Oil has impeded class development, broken the taxation–​ representation linkage, and eased the purchase and security of political loyalty since the state dominates the economy to such a large extent (Brynen, Moore, Salloukh, and Zahar 2012, p. 198). The economic rents that fueled SWFs in a number of Middle Eastern states allowed for the construction of what some theorists have termed “preindustrial welfare states” with significant housing, education, and full employment—​particularly in Kuwait and the United Arab Emirates (UAE) (Brynen, Moore, Salloukh, and Zahar 2012, p. 203). Liberal monarchs in these states sought modernization and did not tolerate ethnic and sectarian cleavages, dealing with them by force. The legitimacy of most of the monarchies in the region does not come from the expression of popular will or sovereignty. In most cases it rests with some notion of the divine right of kings. Moreover, monarchical regimes tend to handle diversity and pluralism by balancing among factions and not allowing any one to become too powerful or wealthy (Richards and Waterbury 1990, p. 317). In Kuwait and Saudi Arabia specifically, the ruling families arbitrate among major factions. Over 40% of the population of Kuwait is not Kuwaiti. The al-​Sabah ruling

Kathryn C. Lavelle   193 family established a National Assembly whose members are chosen by an electorate from which foreigners are excluded. On the one hand, Kuwait’s revenue distribution and welfare provision have come to define all of the Gulf states. Its political opposition is among the best organized in the region and outside formal channels, pluralistic forms of debate and participation are well developed. On the other hand, Kuwaitis did not participate in the kind of mass protests that swept the “Arab Spring” of 2011. The ruling family has a final say in all important decisions. Political parties are illegal, and rulers can and have disbanded parliament (Brynen, Moore, Salloukh, and Zahar 2012, p. 75). The Saudi monarchy manipulates regional divisions and a foreign working population (Richards and Waterbury 1990, p. 321). Given the history of foreign relations among home and host country governments in the region, these SWFs received a great deal of attention prior to the global financial crisis. Moreover, they were viewed with apprehension because they grew so rapidly in size, and new funds were established. At about that time, they were estimated to manage over US$1 trillion (Behrendt 2008, p. 4). During the subprime mortgage meltdown, Arab Gulf SWFs made investments in the ailing US financial services industry of more than US$40 billion. While this influx of capital played a significant role in stabilizing the industry for a period of time, western media outlets criticized the role that SWFs played, and highlighted their lack of transparency and governance practices (Behrendt 2008, p. 15). Table 8.2 shows the top ten most transparent SWFs as measured by the Linaburg-​ Maduell Transparency Index of ten essential principles that depict transparency to the

Table 8.2 Sovereign Wealth Funds Receiving a Ten on the Linaburg-​Maduell Transparency Index Country

SWF Name

Assets (in US$ Billions)

Norway

Government Pension Fund

824.9

Singapore

Temasek Holdings

193.6

Australia

Australian Future Fund

95

UAE–​Abu Dhabi

Mubadala Investment Authority

66.3

US–​Alaska

Alaska Permanent Fund

53.9

Azerbaijan

State Oil Fund

37.3

Ireland

Ireland Strategic Investment Fund

23.5

New Zealand

New Zealand Superannuation Fund

20.2

Chile

Social and Economic Stabilization Fund

15.2

Bahrain

Mumtalakat Holding Company

11.1

Chile

Pension Reserve Fund

Source: Sovereign Wealth Fund Institute, “Sovereign Wealth Fund Rankings 2014.”

7.9

194    Sovereign Wealth Funds and Foreign Policy public, such as government ownership structure, audited annual reports, ownership percentage of company holdings, etc. Table 8.3 shows the ratings for the Middle Eastern Funds. The Sovereign Wealth Fund Institute recommends a minimum rating of eight or above to claim adequate transparency. While two of the Middle East funds received the highest score of ten according to this index, most others fall below the minimum of eight to be considered adequate. As with the Asian region SWFs, leadership of the Arab Gulf state sovereign wealth community attempt to address the situation with public statements about their goals. For example, the leadership of Abu Dhabi sent a letter to western financial officials affirming the goals of the SWF to maximize risk-​adjusted returns, and denying claims that they were using their investments as a tool of foreign policy (Behrendt 2008, p. 17). SWFs also asked for more transparency from the West about the regulatory frameworks to be pursued and for clear definitions of the strategic or critical sectors that needed to be protected. Finally, managers hinted that emerging markets were more welcoming of their investments than Europe and the US. Additional regulations would make these regions less attractive for sovereign investors, and thus risk a decrease in global capital from flowing from SWFs to the West. Since the connection between the control of these SWFs and the state is so much tighter, in theory they could potentially respond to the dictates of monarchs in terms

Table 8.3 Sovereign Wealth Funds in the Middle East Ratings by the Linaburg-​ Maduell Transparency Index Country

Sovereign Wealth Fund Name

Index Number

UAE–​Abu Dhabi

Mubadala Development Company

10

Bahrain

Mumtalakat Holding Company

10

UAE–​Abu Dhabi

International Petroleum Investment Company

9

UAE–​Abu Dhabi

Abu Dhabi Investment Authority

6

Kuwait

Kuwait Investment Authority

6

UAE–​Dubai

Investment Corporation of Dubai

5

Qatar

Qatar Investment Authority

5

Saudi Arabia

SAMA Foreign Holdings

4

Oman

Oman Investment Fund

4

Oman

State General Reserve Fund

4

UAE–​Federal

Emirates Investment Authority

3

UAE–​Ras Al Khaimah

RAK Investment Authority

3

UAE–​Abu Dhabi Iraq

Abu Dhabi Investment Council Development Fund for Iraq

Source: Sovereign Wealth Fund Institute, “Sovereign Wealth Fund Rankings 2014.”

n/​a n/​a

Kathryn C. Lavelle   195 of foreign policy goals more successfully than some others. However, if they were to use them in this way, their profit motive would most likely suffer. Ultimately this would undercut the base of their power and their ability to provide the kind of massive welfare benefits that have secured their rule since independence.

European Sovereign Wealth Funds Two European home countries to SWFs feature prominently in the debate on SWFs and foreign policy: Norway and Russia. Both rely on oil revenues to fund their operations but they diverge dramatically in their governance and transparency records. Although not a member of the EU, the Norwegian SWF sets the standard for transparency globally for SWFs (ICEX-​Invest in Spain 2014, p. 102; Sovereign Wealth Fund Institute 2015). The government of Norway is a constitutional monarchy with vibrant political parties and elections. It established the Petroleum Fund in 1990 as a fiscal policy instrument to improve the long-​term management of the revenues from its abundant oil resources. In 1997, the Norwegian Ministry of Finance redefined the fund’s investment strategy by investing 40% of its assets in equities. The Norges Bank Investment Management was established in 1998 to manage the fund. In 2006, the fund changed its name to the Government Pension Fund Global (GPFG), yet despite the change, the fund has never operated as a pension fund and has no pension obligations (ICEX-​Invest in Spain 2014, p. 50). Publicly available reports detail the value of the Norwegian SWF portfolio, its composition, returns, management, budgetary relations with the government, market trends, risk exposure, and administrative costs (Bahgat 2008, p. 1199). The Norwegian oil fund excludes producers of nuclear weapons and tobacco from its portfolio. The fund publicizes its voting intentions ahead of annual meetings and argues that it is active on boards, not activist, by following widely backed governance standards. For this reason, it does not provoke controversy because the government has embraced transparency in both its portfolio and its ethical investment strategy, even while it is the world’s largest SWF (Financial Times 2015). The Russian state has been in a period of democratic transition since the end of the Cold War. However, the country’s attempt at democratization has been damaged by corruption and limited accountability of its political leaders since that time (DeBardeleben 2000, p. 476). An initial SWF was created to use Russian oil revenues to stabilize the economy. The Russian Reserve Fund has a stabilization function insofar as its role is to contribute to the funding of federal budget expenses and maintain the federal budget balance in case the Russian government’s oil and gas revenues decline. Assets can also be withdrawn for other purposes in the national budget or can be used for early repayment of foreign national debt (Behrendt 2015, p. 4). Nonetheless, a domestic debate emerged over the strategy for how to invest the resources of the Stabilization Fund. Business leaders and regional governors wanted to use the fund to increase pensions, social benefits, and greater investment in infrastructure projects and development loans. Others, including the International Monetary

196    Sovereign Wealth Funds and Foreign Policy Fund (IMF), sought to use the resources of the fund to pay down Russia’s foreign debt. In February 2008, the fund was split in two. The Reserve Fund is now invested in conservative projects in order to cushion the effects of falling oil prices. The National Wealth Fund seeks riskier investments with higher returns (Bahgat 2008, p. 1200). Therefore, the definitive factor for political concerns with host country SWFs across regions appears to be the combination of fund size and lack of transparency, and not whether it is constituted as an oil fund or foreign exchange management vehicle. SWFs use a range of investment operations, including hedge funds and private equity, which further obscures their activities (Politi 2008). More transparent objectives and holdings would allay many concerns with sovereign enterprises as they grow in size. Most countries that operate SWFs (or plan to) such as Dubai, Singapore, Kuwait, and Canada are US allies; nonetheless, they have dramatically different tolerance levels for public, domestic criticism of their own activities. Hence, it is questionable whether or not they would be forthcoming with their own investors if they did not pursue their stated goals (Cox 2007).

Host Country Issues Although the literature on SWFs does not specify the mechanisms through which they would execute decisions about their investments as foreign policy tools, the previous section has shown that the mixture of economic and political goals in the SWF home countries could potentially contradict the host country’s emphasis on profit-​making and free market competition when it is an advanced, industrial, democracy. Nonetheless, it is not so easy to accomplish other goals, even in authoritarian regimes, for domestic political reasons. Transparent, democratic home countries such as Norway are even less likely to be able to do so without the target state knowing it. While advanced, capitalist democracies serve as host to SWF investments from middle-​income, less democratic states, most recipient states are different from home states because they have established securities markets with extensive regulations concerning transparency and disclosure requirements that have evolved over the histories of their industrialization. These features make them attractive places to invest overseas in general. Hence, in order to address the foreign policy concerns accompanying less transparent foreign investment from SWFs, home countries have used the tool that is available to them on their markets—​regulation—​to address foreign policy concerns, mostly subjecting SWFs to the same directives as other forms of foreign direct investment1. Much of the debate over this investment that escalated prior to the 2008 financial crisis collapsed with the value of many SWFs of up to 53% when the crisis obliterated the value of 1  Foreign direct investment can be distinguished from portfolio investment insofar as the former investor seeks a lasting stake in an enterprise and gains a voice in its management and holds more than 10% equity. Portfolio investment includes both debt and equity instruments.

Kathryn C. Lavelle   197 SWFs along with other market investments (Fotak and Megginson 2009). Nonetheless, the debate between free market capitalism and investment vehicles that may serve political motives remains part and parcel of each of these efforts at regulation.

The Debate in the US over Sovereign Wealth Fund Investment Much of the discussion of host country issues and SWFs has converged on American politics because it dominates the foreign policy literature (Stuart 2008, p. 578), and because it has been the recipient of the magnitude of foreign direct investment flows for many, albeit not all, years (UNCTAD 2015, p. 5). While the US does not oppose SWF investment as a policy matter, such investment is nonetheless subject to US laws restricting, or otherwise affecting foreign investment, in the US; these laws date back to 1872 and were enacted in response to national security questions of the day (Yager and Hillman 2009, p. 18). These worries escalated with the US’s entry into World War I  and fears that German-​controlled firms in the US threatened national security. Such anxieties culminated when Congress passed the Trading With the Enemy Act in 1917, which empowered the president to take action against transactions between US subsidiaries of foreign corporations and their parent organizations (Graham and Marchick 2006, p. 5). When SWFs became a growing segment of the foreign investment flows into the US, the initial set of concerns had to do with the disinclination toward government-​ owned business in American political culture, and thus, the lack of any similar vehicles in most of the US economy (with the exception of an Alaskan state oil fund associated with the Alaska pipeline) (Lavelle 2013). Given the US constitutional guarantees of private property, the US government never had the impulse to own exchanges, investment banks, broker deals, or the companies whose securities they traded. Hence, free-​market advocates such as Christopher Cox and Ethiopis Tafara of the Securities and Exchange Commission (SEC) argue that the problem of SWF investment in the US is not one of foreign ownership, but of government ownership (Cox 2007; US Congress 2008). In sum, sovereign enterprise encapsulates multiple contradictions between liberal and nationalist ideologies. Both ideologies have the potential to enhance capitalism and mutual dependency internationally, or to undermine the Anglo-​American capital market structure and global convergence on this type of financial market institution. Despite the theoretical risk, US federal laws do not address SWF investments apart from foreign investment more generally. Hence, SWFs are restricted according to the same statutes that restrict foreign investments in the US in specific sectors, including banking, communications, transportation, natural resources and energy, agriculture, and defense. In some cases, provisions restrict the level of permissible foreign investment; others limit the use of a foreign-​owned assets; and others require approval or disclosure of any foreign investments (Yager and Hillman 2009, p. 11). Following the public outrage over the People’s Republic of China’s attempt to acquire Unocal Corporation through the government-​owned enterprise the China National

198    Sovereign Wealth Funds and Foreign Policy Offshore Oil Corporation (CNOOC), and the UAE’s attempt to acquire certain US marine cargo facilities through the state-​owned Dubai Ports World, the US Congress and Presidential Administration passed the Foreign Investment and National Security Act of 2007 (FINSA), that codified the agency of the government’s Committee on Foreign Investment in the US (CFIUS). Several laws affect foreign investment in the US across sectors, if they are determined to have national security considerations. These laws can limit foreign investment directly, or by discouraging them by investors who find the process to be too cumbersome, and their chances of success slim. Among these laws, the Defense Production Act of 1950, as amended by FINSA (Section 721), authorizes the President to suspend or prohibit a foreign acquisition, merger, or takeover of a US business that is determined to threaten the national security of the US following a review by the interagency CFIUS (Yager and Hillman 2009, pp. 12–​13). Technically, it is voluntary for an SWF to file a notice of a transaction with CFIUS; however, CFIUS can initiate a review and compel the provision of certain information about the terms of any transaction. If not satisfied concerning national security, it can recommend that the president suspend or prohibit such a transaction and the president has the power to order divestment if the transaction was already completed, regardless of whether or not a notice was filed (Yager and Hillman 2009, p. 13). Other informal political restrictions limit the range of SWF investment in the US. For example, some legal experts that represent SWFs take clients to meet with members of Congress prior to initiating a transaction that might be viewed as politically sensitive in order to allay any concerns that could disrupt a transaction (Yager and Hillman 2009, p. 14). Moreover, SWFs must abide by all applicable US laws, particularly disclosures with the SEC under federal securities laws. Mergers and acquisitions still face regulatory review by the Federal Trade Commission or Department of Justice if there are any possible antitrust violations. However, the lack of transparency of many SWFs, combined with their nature, potentially inhibits the SEC from enforcing securities regulations. SEC-​to-​foreign government cross-​border enforcement requests would inherently pose a conflict of interest to sovereign managers who may themselves be the subject of the investigation (Cox 2007; US Congress 2008). Moreover, governments have access to information that may not be available to all market participants, and possess the potential for certain kinds of political corruption that are not possible in the US.

The European Union and Sovereign Wealth Funds The European Union (EU) has likewise responded to the potential national security threat posed by SWF investment, chiefly with regard to their lack of transparency. Also similar to the US, domestic political issues attached to SWF investment in host countries was subsumed by the greater turmoil attached to the 2008 global financial crisis. Nonetheless, the EU policy differs from the US because policy exists at the level of the EU, and also with respect to foreign direct investment in each of its member states. Some of these states are home to SWFs themselves. Moreover, the EU and UK have tended to

Kathryn C. Lavelle   199 understand SWF investment more as a matter of free trade than national security. Many of these states have accepted and welcomed SWF investment, and they have imposed less stringent monitoring and restrictions than the US (Thatcher 2012, p. 1). When the US codified its CFIUS requirements with the 2007 FINSA, many observers in Europe questioned whether or not an EU Committee on Foreign Investments or other screening device would be necessary or desirable (Badian and Harrington 2008; Chaisse, Chakraborty, and Mukherjee 2011, p. 857). Rather than adopting a legislative framework, the EU instead issued a common communication document titled, “A Common European Approach to SWFs.” It has no legal significance, instead recommending a commitment to open investment, support of multilateral work, use of existing instruments, respect of Treaty obligations, and proportionality and transparency. Hence, the European Commission sought to avoid legal action and encourage a common approach (Chaisse, Chakraborty, and Mukherjee 2011, p. 857). When individual EU members adopted investment codes of their own, they were surprisingly friendly to SWF investment, as compared with other types of foreign direct investment by sovereign entities or state-​owned enterprises. Along the lines of US regulations, SWFs are subject to the same requirements of other investments, including state-​controlled companies, private ones, and others. Therefore, SWFs are subject to prohibitions on the movement of capital among member states and third countries or legitimate national security concerns (Chaisse, Chakraborty, and Mukherjee 2011, p. 859). Nonetheless, the relevant provision in the Treaty on the Functioning of the EU has not been invoked with respect to an SWF. The pattern of initial reservation and shift in attitude toward SWFs can be seen in France, Germany, and Italy. Each one restricted foreign equity investment; however, they have also often accepted or tried to attract SWF investments (Thatcher 2013, p. 2). In each case, the state was perceived to restrict equity investment by language, legal restrictions, state intervention and a culture of hostility to outside ownership of national companies. In the 2000s, they placed new legal restrictions on equity investment, but these were limited and not specifically targeted at SWFs. French companies, for example, were traditionally closed to foreign investments. The state-​owned banks and financial bodies owned the larger ones either directly or indirectly. After the mid-​1980s, many of these companies were privatized and the stock market capitalization grew. In 2008, France created its own SWF—​the Fonds Strategique d’Investissement (FSI)—​to invest in French firms. At the time, the French President Nicolas Sarkozy wanted to prevent SWFs from buying French firms that were too cheap. Nonetheless, other French policymakers sought to attract SWF investments with visits by senior officials to selected countries and other contacts, particularly Qatar. Moreover, the FSI began to cooperate with SWFs in joint ventures (Thatcher 2013, p. 3). Similarly, few German companies had shares listed on public exchanges. Much of the German concern with SWFs was focused on those domiciled in certain countries, notably Russia and China (Thatcher 2013, p. 5). In 2009, a new act gave the Federal Economics Ministry the power to verify whether a stake of 25% or above posed a threat to the public order or security. If it is found to do so, the Ministry can impose conditions

200    Sovereign Wealth Funds and Foreign Policy on the purchase or prohibit it. However few SWFs take such a large stake and the Ministry is not obliged to undertake an investigation. Firms can apply for a “certificate of non-​harm” to protect them against action under the law. Finally, the Ministry needs other ministries to consent in order to act. Despite the tighter restrictions, German policies were open to SWFs after that time. With the exception of Russia and China, other countries, such as Kuwait and Dubai have been welcomed (Thatcher 2013, p. 6). Finally, Italy also experienced similar initial reservations and then an open attitude about SWF investment. In 2008, Prime Minister Silvio Berlusconi discussed a 5% cap on SWF ownership in strategic companies, but did not pass a law. When Italy’s debt crisis hit in 2011, Italian officials met in Beijing to meet the CIC and China’s State Administration of Foreign Exchange to seek Chinese investment (Dinmore 2011). In 2012, legislation was passed that concerned equity investments in selected sectors; yet it did not refer to SWFs specifically. In reality, Italy has long had links with Libya and sovereign investment from that country (Thatcher 2013, p. 9).

Australia and Sovereign Wealth Funds Outside of North America and the EU, debate has likewise grown in Australia surrounding investment by entities managed by foreign governments. Australia has responded with regulation that applies to SWFs, particularly in the resources sector. Although Australian infrastructure has benefited from significant inward foreign investment, and the state has encouraged it at times, political polling indicates that Australians do not have a positive view of such investment (Golding 2010, p. 217). In 2008, an Australian think-​tank public opinion survey found that 90% surveyed thought the Australian government has a responsibility to keep Australian companies in majority Australian control. Of the respondents, 85% said that they either “strongly agree” (49%) or “agree” (36%) that investment in Australia by companies controlled by foreign governments should be more strictly regulated than investment by foreign private investors (Hanson 2008, p. 6). More recent polls indicate that a majority of Australians feel the Government allows too much investment from China (Oliver 2015, p. 8). The Organization for Economic Cooperation and Development (OECD) ranks Australia as the sixth most restrictive regime for foreign direct investment among the 43 surveyed (Golding 2010, p. 217; Nicoll, Brennan, and Josifoski 2012, p. 118). The Foreign Acquisitions and Takeovers Act of 1975 regulates Australian foreign investment. The upshot of the law is that the Australian treasurer can make orders in respect of proposals that are considered to be contrary to the national interest, albeit the criteria for assessing the national interest occurs on a case-​by-​case basis. Despite the power of the state to limit transactions, the number of rejections is very small (Golding 2010, p.  222). However, Australian concerns are not limited to questions of national security and the issue of Australian sovereignty over natural resources and food security. Corporate acquisitions are also relevant to Australia’s international competitive positioning with its trading partners (Nicoll, Brennan, and Josifoski 2012, p. 114). After

Kathryn C. Lavelle   201 Australia introduced a new Foreign Investment Policy in 2010, all foreign governments and their related entities should notify the Australian Government and obtain prior approval before making a direct investment, regardless of its size (Nicoll, Brennan, and Josifoski 2012, p. 122).

International Coordination Efforts: The Santiago Principles As we have seen, the size and reach of SWFs grew through the rising prices of natural resources and other commodities prior to the crash in 2008. One important result was that some governments accumulated foreign exchange and financial resources, which accelerated transfers to SWFs. A sizeable amount of this wealth accumulated under the control of governments that are not necessarily allies of the United States and Western European countries. Of six countries that have SWFs with assets of more than $100 billion, only one—​Norway—​is a member of the OECD (Truman 2010, p. 2). Hence, Truman (2010, p. 2) points out that the international growth of SWFs can be seen as symbolic of two trends in the global political economy: a redistribution of wealth and power away from the US and Europe toward countries perceived to share western economic, financial, and political values, and an increasing role for governments in managing wealth and economic power. Any accompanying anxieties about the new reality surfaced in 2006, along with the controversy over the Dubai Powers World purchase in the US and Russia’s Gazprom’s expansion in Europe, despite the fact that these two entities are government-​owned companies and not SWFs. Therefore, SWFs are not only a foreign policy issue for states, but for transnational organizations as well—​as they seek to mitigate the potentially diverging state interests attached to SWFs and embed them in a neoliberal ideology of free market capital flows. As a result, several international organizations likewise responded to the political activity in both home and host countries to resolve some of the tension from real or perceived conflicts of foreign policy interest associated with SWF investment. Specific policy proposals for such transnational action emerged in a variety of domestic and international locales. In October 2007, the International Monetary and Financial Committee of the IMF—​a committee of the IMF’s board of governors—​expressed the need for further analysis of key issues for investors and recipients of SWF flows, including a dialogue on identifying best practices (International Working Group of Sovereign Wealth Funds 2008a, p.  1). In November, the IMF organized a first Roundtable of Sovereign Asset and Reserve Managers (International Monetary Fund 2008, p. 5). The US Senate (2007, p. 24) held hearings on the topic in November 2007, at which time experts presented initial parameters for a set of best practices for these investment vehicles. Early the next year in March, the US House of Representatives also held hearings where the debate deepened over appropriate international action in light of the

202    Sovereign Wealth Funds and Foreign Policy worsening housing crisis in American markets (US Congress 2008). Under the auspices of the IMF, the International Working Group of Sovereign Wealth Funds (IWG) was established at a meeting of countries in Washington, DC from April 30 to May 1, 2008. Other proposals and forums among specific groups of states were held in the EU and the OECD Investment Committee’s project on “Freedom of Investment, National Security and ‘Strategic’ Industries.” The initial response from SWF home countries was lukewarm. Officials argued that hedge funds, private equity firms, and other forms of collective investment were not the object of international inquiry. Since much of the banking industry was under heightened scrutiny at the time, this argument grew increasingly moot (Truman 2010, p. 5). When the IWG released its Generally Accepted Principles and Practices, or “Santiago Principles,” in October of 2008, the announcement was overshadowed by the global financial crisis. Nonetheless, international efforts at coordinating a voluntary set of best practices continued. In April of 2009, the IWG sought to reinforce the positive view it took of the activities of SWFs as important participants in the international monetary and financial system by promoting growth, prosperity, and economic development in both capital exporting and receiving countries. Therefore, the IWG established the International Forum of Sovereign Wealth Funds in order to facilitate the exchange of views and study of SWF activities, to be composed of a voluntary group of SWFs (International Working Group of Sovereign Wealth Funds 2008b). It reached another milestone in March of 2014 when it established its secretariat office in the City of London while continuing to collaborate with the IMF as a sponsoring organization. The full set of Santiago Principles recommends that SWFs disclose sources of funding and the conditions under which owners can withdraw them. Moreover, they will make disclosures, as appropriate under local laws and regulations. Their managers should be independent of owners, but accountable to them by publishing annual reports and undergoing annual audits. The Santiago Principles call for funds to avoid taking advantage of privileged information when investing. Nonetheless, they do not require a pledge not to invest for political reasons, other than a pledge to disclose any investment decisions subject to other than economic and financial considerations (Chaisse, Chakraborty, and Mukherjee 2011; Nicoll, Brennan, and Josifoski 2012, p. 109). Many of the relevant SWFs resist even voluntary compliance with such codes for several reasons. First of all, these codes seem unnecessary when they have attempted to steer clear of political interference all along. Along the same lines, SWFs have argued that they have complied with existing regulations and codes for any relevant investments and additional measures are unnecessary. Finally, many SWF managers charge that such codes are hypocritical when western investment vehicles, such as hedge funds and banks pose similar risks and yet are not similarly regulated (Bahgat 2008, p. 1203). Therefore, while the Santiago Principles are an important step forward in setting a structure for, and governance and management of SWFs, they contain flaws that will prevent them from achieving their desired goals with respect to foreign policy. That is, they are focused on SWFs themselves and not on their relationship with the host countries. As a matter of international relations, there are no standards to measure

Kathryn C. Lavelle   203 compliance with, or achievement of their goals. They do not address the asymmetric information problems that host countries must address. There are no sanctions to ensure compliance. Finally, state-​owned enterprises are not covered in the Principles (Chaisse, Chakraborty, and Mukherjee 2011, p. 867). Efforts at measuring compliance with the Santiago Principles highlight these problems. GeoEconomica, a Geneva-​based political risk advisory group, issued its own rankings of 31 SWFs against the Santiago Principles and found that some of the world’s most active are also among the least transparent, and least likely to comply with corporate governance norms. The CIC, the AbuDhabi Investment Authority, and Kuwait Investment Authority were rated “partly compliant,” which is in the “C” grade category (Behrendt 2014, p. 2; Chassany 2014). In 2013, Revenue Watch Institute, a New York watchdog group released its own study of governance of oil, gas and mining industries in 58 resource-​rich countries that scored only 11 as “satisfactory” overall (Crooks 2013).

Conclusion A major gap exists between the literature on home and host country behavior with respect to SWFs and foreign policy. While SWFs have a clear potential to work to change the behavior of other states, political studies of their operation on the ground reveals competing bureaucratic interests, and political actors seeking to leverage control over their decision-​making. In order to connect these fields of knowledge, further research is needed on the exact mechanisms that could, or are, used to alter state behavior in the international system. Future work also needs to be done on the issues related to SWFs owning a direct stake in a foreign firm, but revealing little about themselves. In addition, the international community needs to work on implementation of the Santiago Principles so that appropriate third parties can verify compliance. Despite the gaps in the literature, however, the political future of SWF investment is far from grim. Of course, the potential exists for foreign policy goals among states to contradict each other because they often do conflict. But in the issue area of SWFs and finance, the potential also exists for these foreign policy goals to align. That is, in order for middle-​income states to become truly globally competitive, they need internal market reforms—​chiefly on transparency—​that tend to reinforce those that mitigate unease over SWF investment in industrial democracies. For advanced, industrial democracies, the external threat from SWF investment is not as great as their own internal threat from stagnant growth, lower levels of technological innovation, education and political stability. That is, a Chinese SWF cannot threaten US technology with its ownership of a thriving, competitive firm if such a firm does not exist in the first place. If the SWF moves to sell those shares in a foreign policy ploy—​the action would open up opportunities for investment from others in a free market economy at lower share prices. Both home and host countries will realize mutual benefits by working to allay domestic political and foreign policy concerns.

204    Sovereign Wealth Funds and Foreign Policy

Acknowledgment The author would like to thank Celia (Zixin) Wan and Mark Eddy for their outstanding research assistance with this chapter, and the editors of the Oxford Handbook of Sovereign Wealth Funds for their helpful comments.

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Chapter 9

Sovereign We a lt h a nd t he Extraterri toria l Manipu l at i on of C orp orate C ondu c t A Multifaceted Paradigm in Transnational Law Salar Ghahramani

Introduction The formation of transnational law is the result of increasingly pluralistic processes, involving not only the state-​based public law and national and international judicial fora but also numerous other sources and norm-​setters that include law firms, corporations, regulators, NGOs, and other enterprises, many of which may lack any apparent public authority (Thornhill 2014). This global law without a state (Teubner 1997) has been viewed both as an independent and self-​governing legal domain as well as one inherently intertwined with national and international law. According to Calliess (2004), for instance, transnational law is an autonomous system of its own—​beyond the traditional national or international law—​and is formed based on general legal principles and customs as advanced by a global civil society. If codified, it is done so through general principles, standardized contract forms and conduct codes established by private norm setting institutions (Calliess 2004). Jessup (1956), however, believes that transnational law is “the law which regulates actions or events that transcend National frontiers . . . including both . . . public and private international law” (p. 2). As such, for Jessup transnational law cannot be conceptually distinct from national and international laws, since both state and non-​state actors—​and thus both publicly and privately created instruments—​could affect it.

Salar Ghahramani   209 In his examination of the transnational legal process, Koh (1997) focuses on “the theory and practice of how public and private actors, including nation-​states, international organizations, multinational enterprises, nongovernmental organizations, and private individuals, interact in a variety of public and private, domestic and international fora to make, interpret and enforce rules of transnational law . . . transnational law is [thus] both dynamic—​mutating from public to private, from domestic to international and back again—​and constitutive, in the sense of operating to reconstitute national interests” (pp. 2626–​7). Transnational law is also associated with lex mercatoria (Dalhuisen 2006; Drahozal 2005; Maniruzzaman 1999), and, under some definitions, has included informal soft law (Levit 2003). Goldman (1983) suggests that the views on law merchant can be summarized as having either a wide or a narrow perspective. Under the wide view, lex mercatoria would include law from both public and private sources, hence encompassing general principles of law, public international law and other conventions, rules advanced by international organizations, customs and usages, and form contracts (Linarelli 2009). On the other hand, the narrow view is origins-​based, and defines law merchant as solely privately derived, albeit enforced by the state when necessitated (Goldman 1983). For Thornhill (2014), the contemporary global society is undergoing processes that involve the birth of a diffused yet multilevel and coordinated political system that defies the state-​centric definitions, and is instead constructed by a set of institutions needed to produce and implement collective societal decisions. This new political system, Thornhill (2014) argues, both transcends and incorporates aspects of national and supranational political spheres, while adding transnational elements to political institutions functioning in national and supranational environments. While this system is partially arranged by state-​driven international law, it now has its own “contingent, internal legal fabric, which is independent of state volition and is generated from multiple sources” (p. 367). In observing the phenomenon, Quack (2007) posits that the numerous actors and activities that are involved in transnational law-​making, and the multilevel nature of the law production make the process inherently rooted in what he calls “a case of distributed agency” (p. 652). To some, transnationalism and the creation of a soft global legal order can be a danger. As Sandel (1996) observes, “If the global character of the economic suggests the need for transnational forms of governance . . . it remains to be seen whether such political units can inspire the identification and allegiance—​the moral and civic culture—​on which democratic authority ultimately depends” (p. 399). Likewise, Benhabib (2009) points to the potential legitimacy problems of transnational law by dissecting the nationalist and the democratic variants of transnational law-​making: The nationalist variant traces the law’s legitimacy to the self-​determination of a discrete, clearly bounded people, considered to be a homogeneous entity—​an ethnos—​whose law expresses and binds its collective will alone. The democratic

210    Sovereign Wealth and the Extraterritorial Manipulation variant says that laws cannot be considered legitimate unless a self-​determining people can see itself both as the author and the subject of its laws. For the democratic sovereigntiste, unlike the nationalist, it is not paramount that the law express the will of a nation, of an ethnos, but that there be clear and recognized public procedures for how laws are formulated, in whose name they are enacted, and how far their authority extends. (p. 693)

With this background, this chapter examines how sovereign wealth funds (SWFs) fit within the universe of transnational law and what roles they play. It will demonstrate that SWFs are indeed major players in effectuating transnational law, as cosmopolitan norm setters of ethics, governance, and lex mercatoria.

Extraterritorial Norm Setting through Shareholder Activism Shareholder activism is “the use of power by an investor either to influence the processes or outcomes of a given portfolio firm or to evoke large-​scale change in processes or outcomes across multiple firms through the symbolic targeting of one or more portfolio firms” (Ryan and Schneider 2002, p.  555). Activists utilize shareholder proposals placed on corporate ballots, direct communication with firm management, and the exercise of their voting rights to pursue their interests (Rose and Sharfman 2014). Activist behaviors range from cooperative to hostile, at times starting with behind-​ the-​scenes interventions and private engagement with management but then escalating into more public fora—​i.e., media campaigns, shareholder proposals, and proxy voting—​if the private tactics fail (Logsdon and Van Buren 2009; Ryan and Schneider 2002). Marler and Faugère (2010) have called the deployment of such approaches “voice activism,” as opposed to what they describe as “exit activism” where disgruntled shareholders sell their shares to punish management. The motivations behind activism vary, but they can generally be categorized into two types: financial activism and social activism. Financial motivations are intended to affect company direction or to modify the firm’s corporate governance mechanisms (Rehbein, Logsdon, and Van Buren 2013). The activist goals may thus include seeking a seat on the board, restructuring, divestiture from certain assets, having a say on potential mergers, influencing corporate expenditure amounts, changing executive compensation, and impacting dividends and stock buyback plans (Filatotchev and Dotsenko 2015; Goranova and Ryan 2014; Rehbein, Waddock, and Graves 2004; Rose and Sharfman 2014). Social motivations, on the other hand, may include the activist’s desire for management to address community and other stakeholder concerns, labor conditions,

Salar Ghahramani   211 environmental issues, product lines with adverse social impact, as well as a host of political and human rights matters (Ghahramani 2011; Guay, Doh, and Sinclair 2004; Marens 2002). Due to their size, long-​term investment horizon, mostly stock-​based asset allocation, and the lack of regular obligations toward pensioners, SWFs should have a tendency toward shareholder activism, which they can use to advance social and ethical objectives (Ghahramani 2013a). This chapter will now examine how such activism has been used in setting transborder ethical norms.

Sovereign Wealth Funds as Ethical Norms Setters and Enforcers Extraterritoriality and Public–​Private Complicity Under most hard law regimes, only the state can be held liable for violating international ethical norms. As such, it is worth considering how (and whether) an SWF, as an arm of the state, may extraterritorially penalize a private actor that the SWF deems to be a norm violator. According to Ghahramani (2015): [T]‌he response to such inquiry requires a two-​pronged analysis of potential SWF complicity in human rights law violations: the SWF’s role as an instrumentality of the state which is obligated directly as a signatory to a particular convention to adhere to and to enforce certain principles, and the SWF as a commercial enterprise itself operating under the presumption that international law requires more than what the traditional view imposes and binds the commercial enterprise regardless of its connection to the state. (pp. 329–​30)

On the latter concern, Ghahramani (2015) argues that certain international law instruments at a minimum require private actors to adhere to specific ethical standards, the violations of which could result in indirect breaches of customary law. Under the preamble of the Universal Declaration of Human Rights (1948), for instance, “every individual and every organ of society  . . .  shall strive  . . .  to promote respect for these rights and freedoms” (p. 72). Similarly, the monitoring for the International Covenant on Civil and Political Rights (ICCPR) has recognized that the Covenant imposes positive obligations on states parties to guarantee that the endowed rights not only protect the citizen from the state but also against “acts committed by private persons or entities” (UN Human Rights Commission 2004, § 8). As such, ICCPR provisions may be violated if the state fails to “take appropriate measures or to exercise due diligence to prevent, punish, investigate or redress the harm caused by such acts by private persons or entities” (UN Human Rights Commission 2004, § 8).

212    Sovereign Wealth and the Extraterritorial Manipulation Moreover, soft law measures such as the UN Global Compact (2000) specifically urge private corporations to follow human rights principles, positing that businesses “should make sure they are not complicit in human rights abuses” by “being implicated in a human rights abuse that another company, government, individual, group etc. is causing” (Principle 2). Specifically, the UN Global Compact (2000) envisages three potential circumstances where complicity could become an issue: through “direct complicity”, by offering products or services that could be used in abuse; through “beneficial complicity,” by somehow benefiting from human rights abuses; and through “silent complicity,” by not taking action when aware of human rights abuses. Another soft law regime, embodied in the three-​pillared Protect, Respect and Remedy Guiding Principles, aims to create global norms that confer upon the state the duty to protect human rights norms. It asks corporations to respect those norms, and encourages the creation of processes whereby the violation of the norms may be voiced by the victims of human rights abuse and hence remedied (Guiding Principles 2011). With this background, SWFs, as instrumentalities of the state, appear to be compelled to adhere to the highest standards, lest they be accused of being complicit in breaking international principles by investing in norm-​violating states or corporations. After all, SWFs are “first and foremost, state actors, fully funded with the state’s resources, the same state that has obligated itself to a series of binding international law principles. As such, distinguishing the political state from its financial vehicles is artificial at best and not a true reflection of the realm in which the 21st century sovereign operates” (Ghahramani 2015, p. 332). It is perhaps due to such considerations that some SWFs have adopted strict policies to set and to transnationally enforce global ethical standards. According to Ghahramani (2014), there are three methods under which state investors, including SWFs, may set and enforce such norms:  through (1)  Ethics-​based Legislative Exclusion, where the fund divests from what it deems to be unethical entities via legally-​mandated processes; (2) Nation-​centric Legislative Exclusion, where the state requires its public funds to cease investing in companies that are engaged in specific nations; and (3) Extra-​legislative Activism, where state funds pursue ethics-​based goals either in complete absence of, or beyond specific public mandates. As an example, Norway’s Government Pension Fund Global (GPFG), utilizing the Ethics-​based Legislative Exclusion method, publicly engages in exit activism—​often centered upon human rights-​based issues—​to ensure that its investments are in line with specific legal requirements. As Backer (2013) notes, through GPFG Norway has practically “developed a toolbox to effectuate its policy-​centered investment strategy, which consists of both the traditional forms of regulatory governance and a policy-​centered invocation of shareholder power . . . [that] operates both within the corporation and, for a large investor, as an advocate for change within those foreign states where those companies are domiciled” (p. 6).

Salar Ghahramani   213 In particular, the government-​imposed Ethical Guidelines (2014) mandate that GPFG exclude or divest from companies based on what the entities produce and/​or how they behave. The product-​based criteria examine corporations that are involved in the productions of weapons that could violate humanitarian norms, produce tobacco, or sell military goods to certain states whose public debt the GPFG is not allowed to acquire. The behavior-​based criteria examine a company’s real or prospective participation in systematic violations of human rights; individual rights violations in conflict or war; grave environmental harm; flagrant corruption; or other violations of basic ethical norms (Ethical Guidelines 2014). GPFG’s ethical divestments and/​or investment exclusions—​which originally had to be approved by the country’s Ministry of Finance but, since January of 2015, must only be accepted by the Norges Bank—​include 65 corporations as of this writing (see Appendix 9.1). For many of the exclusions, GPFG’s Council on Ethics has relied on international and transnational law principles to make divestment recommendations. Under the “Serious or Systematic Human Rights Violations” category, for instance, whereby Wal-​Mart Stores Inc., Wal-​Mart de Mexico SA de CV, and Zuari Agro Chemical Ltd. are excluded, the Council’s reports are heavily influenced by international law norms and principles. As an example, in the case of Wal-​Mart and its subsidiary in Mexico, the Council used the government-​mandated guidelines to render a complicity-​centered assessment, examining acts or omissions that could amount to a serious risk of GPFG becoming involved in “serious or systematic human rights violations, such as murder, torture, deprivation of liberty, forced labor, the worst forms of child labor and other forms of child exploitation” (Council on Ethics 2005, p. 3). To determine whether such risk for complicity existed, the Council analyzed whether there was “a direct link between [Wal-​Mart’s] operations and the relevant violations”, whether the violations were done to enhance Wal-​Mart’s interests, and whether Wal-​ Mart knew of the violations but did nothing to stop or to prevent them (Council on Ethics 2005, p. 1). The Council’s inquiry examined allegations that Wal-​Mart managed its stores “in a manner that contradicts internationally recognized human rights and labor rights standards, both through its suppliers in a number of countries . . . and in its own operations” (Council on Ethics 2005, p. 1). The specific contentions that the Council reviewed appraised the accusations that Wal-​Mart consistently and systematically employed minors in breach of international norms; systematically discriminated against women with regard to pay; obstructed unionization efforts; unreasonably punished and locked up employees; and contracted suppliers at whose facilities working conditions were dangerous and under whom workers were pressured into working overtime without compensation (Council on Ethics 2005, p. 1). As mandated by the guidelines, the Council, through Norges Bank, asked Wal-​Mart and Wal-​Mart de Mexico to respond to the allegations before taking any action. The companies did not respond (Council on Ethics 2005, p. 1).

214    Sovereign Wealth and the Extraterritorial Manipulation When examining Wal-​Mart’s suspected norms violations in its supplier chain, the Council focused specifically on two topics: child labor and forced labor. On the utilization of child labor in Wal-​Mart’s supply chain, it relied upon the UN Convention on the Rights of the Child (UNCRC) and International Labor Organization (ILO) Convention 182 on the Worst Forms of Child Labor (Council on Ethics 2005, p. 18), concluding that because “the standards prohibiting harmful child labor apply to the great majority of states, including the states mentioned in this recommendation, there exists, in the view of the Council, a risk that companies which avail themselves of such labor are contributing to serious human rights violations” (Council on Ethics 2005, p. 18). On the usage of forced labor in the company’s supply chain, the Council examined the International Covenant on Civil and Political Rights (ICCPR) and ILO bans on compulsory labor, concluding that “forcing persons to work beyond working hours without compensation may, depending on the circumstances, fall within the scope of the prohibition of forced labor” (Council on Ethics 2005, p. 19). The Council additionally expressed concern regarding workers being locked inside facilities, calling the practice a clear violation of ICCPR’s personal liberty rights, and noted that harassment and physical punishment unmistakably violated fundamental human rights (Council on Ethics 2005). In studying Wal-​Mart’s alleged infringement of norms in its own operations, the Council reviewed gender discrimination issues, creation of obstacles for worker unionization, usage of minors, and the employment of illegal immigrants. In evaluating gender discrimination concerns, the Council used ICCPR, the International Covenant on Economic, Social and Cultural Rights (ICESCR), the Convention on the Elimination of All Forms of Discrimination Against Women, and ILO Convention No. 100 on Equal Remuneration, and concluded that the US’ status as an ICCPR signatory created a risk for GPFG to be “complicit in possible violations of this Convention’s standards regarding equal treatment of women and men” (Council on Ethics 2005, pp. 19–​20). In assessing the unionization issue, the Council applied a series of international instruments—​ICCPR, ICESCR, ILO Convention no.  87, and the ILO’s Tripartite Declaration of Principles concerning Multinational Enterprises and Social Policy—​and concluded freedom to create and join unions constituted fundamental human rights and that the ability to organize was a fundamental democratic right (Council on Ethics 2005). As such, the Council found that the company’s targeting of unionization efforts and the lack of adequate mechanisms in US law to implement international norms created a risk for GPFG to be complicit in norms violations (Council on Ethics 2005). In examining the employment of children, the Council articulated a particular alarm regarding reports that Wal-​Mart used minors in unsafe types of work and during inappropriate hours, and that the company failed to pay the children overtime (Council on Ethics 2005). On the employment of illegal immigrants, the Council expressed concern on how such workers could be taken advantage of by Wal-​Mart, given that they could not utilize

Salar Ghahramani   215 legal avenues to file reports on hazardous working conditions or other breaches related to overtime pay and minimum wage (Council on Ethics 2005). In the end, the Council called for the exclusion of Wal-​Mart and Wal-​Mart de Mexico from the Fund’s investment universe, a decision with which the Norwegian Ministry of Finance agreed. With regards to Zuari Agro Chemicals, a producer of cottonseed and based in India, the Council focused on the company’s alleged involvement in “the worst form of child labor” after discovering that between 20% and 30% of the workers employed by businesses that Zuari had contracted were children (Council on Ethics 2013). The initiation of the review was based on the Ethical Guidelines’ requirement that companies from the investment universe must be excluded “if there is an unacceptable risk that the company contributes to or is responsible for [ . . . ] the worst forms of child labor and other child exploitation [ . . . ]” (Ethical Guidelines 2014). For its analysis, the Council turned to the UN Convention on the Rights of the Child (1989), which partly requires states to implement measures in recognizing “the right of the child to be protected from economic exploitation and from performing any work that is likely to be hazardous or to interfere with the child’s education, or to be harmful to the child’s health or physical, mental, spiritual, moral or social development” (Article 32). The Council also used the ILO Convention 182 (1999), which defines worst forms of child labor to consist of “slavery or practices similar to slavery, such as the sale and trafficking of children, debt bondage and serfdom and forced or compulsory labor, including forced or compulsory recruitment of children for use in armed conflict” and “work which, by its nature or the circumstances in which it is carried out, is likely to harm the health, safety or morals of children” (Article 3). While the Council admitted that the instruments noted above only compelled states parties, it still justified the usage of the treaties, noting: Even if it is states, as opposed to companies, that are obligated by international human rights conventions, companies can nevertheless be said to contribute to human rights violations. The Council does not take a position on the extent to which the state is responsible for any human rights violations; it is sufficient to establish that the company in question is acting in a manner that links it to serious or systematic violations of internationally recognized human rights. This applies regardless of whether the state where the violations are taking place has ratified the conventions against which the circumstances are assessed. (Council on Ethics 2013, p. 2)

As such, Zuari was found to be complicit in the worst forms of child labor because its contracted farmers employed 3,000 to 4,000 minors, of which about 20% were under the age of ten, 90% under the age of 14, and the majority with no familial connections to the farm. Additionally, the Council expressed concern that the employed minors were in danger of developing serious long-​term health issues because of their regular exposure to various chemicals, especially in the absence of adequate training and protection;

216    Sovereign Wealth and the Extraterritorial Manipulation that the children had to perform arduous physical labor of up to 14 hours a day in excessively hot temperatures; and that the lengthy hybrid seed cultivation season of at least eight months prevented the children from attending school (Council on Ethics 2013). Consequently, the Council decided that while Zuari did not use child labor directly, its wide-​ranging web of relations with businesses that did so created “an unequivocal link between the company’s operations and the use of child labor in production for the company” and a situation where the company purchased seed from farmers “in full knowledge that extensive use of child labor [was] common in seed cultivation” (Council on Ethics 2013, p. 9). As such, the Council advised the Ministry of Finance to exclude Zuari from the Fund’s investment universe, a recommendation that the Ministry adopted. In some ways, GPFG may be considered the state’s agent for international law, adopting and interpreting elements of international law as national mandates and then transforming them into transnational law through its cross-​border enforcement of global ethical norms.

Intergenerational Equity An SWF’s interest in ethics-​based investing may also lie in the basic principles of intergenerational equity (IE), an evolving concept in modern international law that addresses environmental issues, human rights, and economic security of future generations (Castagno 2014; Natarajan and Khoday 2014; Yamin and Norheim 2014) and a potential basis for customary international law (Barton 2001). Brown Weiss (1989) proposes that intergenerational equity begins with the proposition that “each generation is both a custodian and a user of our common natural and cultural patrimony. As custodians of this planet, we have certain moral obligations to future generations which we can transform into legally enforceable norms” (p. 21). Brown Weiss (1990) also elaborates that the three principles of intergenerational equity are as follows: First, each generation should be required to conserve the diversity of the natural and cultural resource base so that it does not unduly restrict the options available to future generations in solving their problems and satisfying their own values. This principle is called “conservation of options.” Second, each generation should be required to maintain the quality of the planet so that it is passed on in no worse condition than that in which it was received, and should also be entitled to planetary quality comparable to that enjoyed by previous generations. This principle is called “conservation of quality.” Third, each generation should provide its members with equitable rights of access to the legacy of past generations and should conserve this access for future generations. This principle is called “conservation of access.” (pp. 201–​2)

In case law, Judge Weeramantry (1993) of the International Court of Justice, writing in the Maritime Delimitation in the Area between Greenland and Jan Mayen (Denmark vs. Norway), has alluded to intergenerational equity principles by recognizing “the

Salar Ghahramani   217 sacrosanct nature of earth resources, harmony of human activity with the environment, respect for the rights of future generations, and the custody of earth resources with the standard of due diligence expected of a trustee are equitable principles stressed by [certain legal] traditions” and the emphasis on horizontal and vertical equitable sharing of natural resources, the former for the sake of the present generation and the latter being done for the “benefit of generations yet to come” (p. 242–​3). Similarly, in his dissenting opinion in the Nuclear Tests Case (New Zealand vs. France), Judge Weeramantry (1995) noted that the rights of a people “include the rights of unborn posterity”, which “a nation is entitled, and indeed obliged, to protect.” The nuclear test case, the Judge wrote, presented the ICJ with the opportunity to address “the possibility of damage to generations yet unborn” (pp. 341–​2). With this context, it is worth noting that there have been SWFs that have either been created by the state based on IE principles or have adopted IE or similar concepts on their own. The Australian Future Fund (AFF), for instance, was established by the government of Australia in 2006, which imposed a two-​pronged mandate on AFF: (1) a commitment to long-​term intergenerational equity and (2) a commitment to exercise international best practices in institutional governance (Clark and Knight 2011). As noted by the Australian Future Fund (2015), the AFF was established “to help Australia prepare for the ageing of the population and promote intergenerational equity for future Australians” (p. 6). As an example of this effort, the Future Fund Management Agency, which operates AFF, has stipulated an investment scheme that would “accumulate assets for the purpose of offsetting the unfunded superannuation liabilities of the Commonwealth which will fall due on future generations” (Australian Future Fund 2015, p. 140). Furthermore, the AFF has adopted environmental, social and governance (ESG) factors that include the examination of “environment, climate change, human and labour rights, supply chain, corruption, and corporate governance” (p. 39).

Sovereign Wealth Funds as Governance Norm Setters and Enforcers In addition to being ethical norm setters, SWFs are also governance norm setters: (1) they are voluntary subjects of an international norm setting body, and (2) they are transnational enforcers of corporate governance norms for target corporations. On the former, no supranational entities regulate SWFs, despite calls for SWFs be regulated by a single international entity or a joint regulation conducted by multiple international organizations. The only quasi-​regulatory body currently available is the International Forum of Sovereign Wealth Funds (IFSWF)—​ which succeeded the International Working Group of Sovereign Wealth Funds (IWG)—​created in 2008 under the auspices of the International Monetary Fund (IMF). IFSWF operates

218    Sovereign Wealth and the Extraterritorial Manipulation based on the Generally Accepted Principles and Practices (GAPP)—​or the “Santiago Principles”—​consisting of 24 best practice norms that may be viewed as an international soft law instrument. According to Ghahramani (2013b), international soft law is “a type of international policy synchronization that is not legally binding on its own. Often, if not always, the law escapes the generally-​prolonged treaty ratification procedures. As such, agreements on soft law are typically attained more swiftly than treaties or other officially binding international requirements” (p. 61). As such an instrument, the Santiago Principles (2008) do not provide specific directives but, rather, overarching should (rather than must) categories of best practices that offer a quasi-​regulatory framework external to the formal accession processes of the state. There are no enforcement mechanisms in the Principles, no reporting requirements, and no tribunals for evaluating non-​compliance. Nonetheless, through the Santiago Principles, SWFs have set global standards on (1) internal governance procedures and management, (2) home government relations, (3) public relations, and (4) host country relations. On international governance, for instance, the Santiago Principles (2008) denote the importance of sound legal and governance frameworks for SWFs, a clear and operational division of roles to ensure accountability, fiduciary aspects of the SWFs’ governing bodies, proper reporting systems in “accordance with recognized international or national accounting standards in a consistent manner”, annual audits “in accordance with recognized international or national auditing standards in a consistent manner”, professional and ethical standards, clear, consistent, and principle-​based investment policies, and asset management strategies “consistent with what is generally accepted as sound asset management principles” (Principles 1, 6, 8, 11–​13, 18, 19). The attempted standardization of these principles is particularly remarkable given the vastly differentiated approaches to legal status, governance, and management issues historically taken by SWFs (De Bellis 2011). On legal status, for instance, some SWFs are distinct legal persons, whereas others operate under the umbrella of a specific state organ, such as a central bank (De Bellis 2011). On home government relations, SWFs, through the Santiago Principles (2008), have set norms that encourage the adoption of proper data-​reporting to the owner states, and investment performance measurement reporting to the owner states delivered based on recognized standards (Principles 5 and 23). On public relations, SWFs have adopted standards regarding the public disclosure of the SWFs’ policy purposes, the disclosure of policies, rules, and procedures as related to funding, withdrawal and spending, transparency in the governance and management frameworks, and in investment policy (Principles 2, 4, 16, 18). On host country relations, the standards include the SWF’s coordination of activities with fiscal and monetary authorities of the host governments whenever macroeconomic impact is a concern, compliance with host country’s regulatory requirements, and the disclosure of financial information to gain the trust of host countries (Principles 3, 15, 17).

Salar Ghahramani   219 Whether the IFSWF, through the Santiago Principles, achieves the success of other transnational financial norm setters has yet to be seen. Throughout the years, the Basel Committee for Banking Supervision (BCBS), the Financial Stability Forum (FSF), the International Organization of Securities Commissioners (IOSCO), the International Association of Insurance Supervisors (IAIS), the International Accounting Standards Board (IASB), the International Auditing and Assurance Standards Board (IAASB), and the Financial Stability Board (FSB) have proven the potential powers of transnational soft law. However, as noted by De Bellis (2011), while the model of administration under the Santiago Principles shares some similarities with some of the above-​noted standard setters and may thus enjoy comparable feats in the future, there are important differences worthy of discussion. For example, some of the financial standard setters—​ while differentiated from each other due to their structures as intergovernmental, transnational, hybrid, or private entities—​still harmonize with each other within the Financial Stability Board, the strengthened successor of the FSF. The IFSWF, on the other hand, does not participate in the FSB framework, and, as such, may not show as much power. In addition to their involvement in global norm setting through the IFSWF, SWFs are transnational enforcers of corporate governance standards through shareholder activism. The leading SWF in this sphere is Singapore’s Temasek Holdings. As Heaney, Li, and Valencia (2011) discovered, Temasek firms have far fewer directors holding more than five percent of the corporation’s shares, a larger proportion of independent directors on their board, and a greater board size as compared to other firms. Heaney, Li, and Valencia (2011) have thus posited that the “result that Temasek firms have bigger boards and more independent directors is reflective of the Singapore government’s commitment to promote best practice guidelines in corporate governance, with the implementation of the Code of Corporate Governance . . . ” (p. 114). The Code, they note, “prescribes guidelines pertaining to reasonable company policies and managerial affairs, such as board composition, delineation of corporate responsibilities, disclosure of information to shareholders, remuneration, and audit and accountability, among others” (Heaney, Li, and Valencia 2011, p. 114).

Sovereign Wealth Funds and Lex Mercatoria As noted earlier, lex mercatoria is a tenet of transnational law. For Berman and Kaufman (1978) the rebirth of the “new law merchant” in the twentieth century

220    Sovereign Wealth and the Extraterritorial Manipulation has seen the revitalization of the international community of merchants engaged in trade across national boundaries, including not only importers and exporters of goods and technology but also shipowners, marine insurance underwriters, commercial bankers and others involved in such trade. Through their contracts and more visibly through their trade associations these various groups have created autonomous legal orders on a transnational scale. (p. 228)

The SWFs of the 21st century are indeed members of this international community of merchants, increasingly involved in the markets through numerous activities. They partake in contested international merger and acquisition deals (Hovland 2016; M&A Navigator 2013), have acted as limited partners in private equity firms (Corporate Financing Week 2013)  and can enter into contracts for international credit derivatives, cross-​border insolvency agreements, and cross-​border privatization efforts. They invest in currencies, public and private bonds, equities, real estate, natural resources, commodities, and precious metals, as well as options, collateralized debt instruments, futures, and various financially engineered synthetic products (Bernstein, Lerner, and Schoar 2009; Scherer 2011; Urban 2011; Xiang, Wang, Kong, and Li 2009). Some have even invested in airports and hospitals (Ersoy 2012). SWFs have also participated in deals involving multiple private, governmental, and quasi-​governmental actors. In 2007, for instance, Singapore’s Temasek, with the help of the China Development Bank, a quasi-​state lender, announced an investment of up to $18.5 billion in Barclays, a British bank, in order to help Barclays bid on the Dutch bank ABN Amro, which had other suitors including a group of investors, led by the Royal Bank of Scotland and consisting of the Belgian-​Dutch bank Fortis and the Spanish company Grupo Santander (Dean, Singer, Sender, and Walker 2007). During the 2007–​9 financial crisis, the Abu Dhabi Investment Authority (ADIA)—​at the time the largest SWF in the world—​invested $7.5 billion in Citigroup, which needed capital due to its sub-​prime mortgage exposure (Citigroup 2007). Likewise, other SWFs from China, Kuwait, Qatar, Saudi Arabia, Singapore and South Korea infused cash into Bank of America, Barclays, Blackstone, Carlyle, Citigroup, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Merrill Lynch, Morgan Stanley, UBS, and others (Pistor 2009). Other law merchant related activities include SWF involvements in goods-​centered, contract-​based investments. Dealings at commodity exchanges, for instance, may fall under the United Nations Convention on Contracts for the International Sale of Goods (CISG), which Linarelli (2009) calls an example of “legislated law merchant” (p. 177), a category of lex mercatoria “that private legislatures or rule-​making bodies create, for either domestic or transnational transactions” (p. 140). As Kantor (1988) notes, “so long as a commodities trading contract is between companies with places of business in different Contracting States and the transaction is not otherwise excluded from coverage under the Convention, the Convention is applicable to international sale of goods consummated on such . . . exchanges . . .” (p. 10). SWFs have also been involved in transnational disputes, through the courts and at arbitration tribunals. The Libyan Investment Authority, for instance, has brought a

Salar Ghahramani   221 $1billion lawsuit against Goldman Sachs over complex derivatives trades (Bollen 2014); Norway has sued Citigroup in a New York court claiming a $835 million loss to the GPFG due to misstatements by the company (Rappeport and Ward 2010); and the Abu Dhabi Investment Authority has filed an arbitration claim against Citi, alleging “fraudulent misrepresentations” (Guerrera and Sender 2009).

Conclusion Global legal harmonization is an aspect of transnational law whereby a family of norms is formed by a non-​state legal order. SWFs, a diverse group in terms of their countries of origin, size, investment strategies, asset allocation tactics, and their underlying purposes, are contributing to the harmonization by setting and enforcing cross-​border ethical norms and governance standards, and by quickly becoming major participants in the community of merchants through their investment activities. This chapter has examined the various aspects of—​and the implications for—​SWFs as transnational lawmakers, a significant phenomenon for the global family of standards and a potential challenge for the more formalistic, state-​based legal orders. As demonstrated, some SWFs have adopted general legal principles and customs as advanced by a global civil society as well as through standardized contract forms and conduct codes. They have also enacted informal soft law and created norm-​setting institutions of their own. As such, they are indeed a part of a diffused yet multilevel and coordinated political system that defies the state-​centric paradigms, contributing to the dynamism that defines transnational law but also creating concerns related to legitimacy, democratic authority, and democratic deficit.

Appendix 9.1 Companies Excluded from Government Pension Fund Global’s Investment Universe The following information was sourced from Norges Bank Investment Management’s “Exclusion of Companies” (2015) available at http://​w ww.nbim.no/​en/​responsibility/​ exclusion-​of-​companies/​

Production of Weapons that through their Normal Use May Violate Fundamental Humanitarian Principles Anti-​Personnel Land Mines • Singapore Technologies Engineering (April 26, 2002)

222    Sovereign Wealth and the Extraterritorial Manipulation Production of Cluster Munitions • • • • •

Textron Inc. (December 31, 2008) Hanwha Corporation (December 31, 2007) Poongsan Corporation (November 30, 2006) Raytheon Co. (August 31, 2005) General Dynamics corporation (August 31, 2005)

Production of Nuclear Arms • • • • • • • • • • • •

Orbital ATK Inc (August 21, 2013) Lockheed Martin Corp (August 21, 2013) BWX Technologies Inc. (January 11, 2013) Jacobs Engineering Group Inc. (January 11, 2013) Serco Group Plc. (December 31, 2007) Aerojet Rocketdyne Holdings, Inc. (December 31, 2007) Safran SA. (December 31, 2005) Northrop Grumman Corp. (December 31, 2005) Honeywell International Inc. (December 31, 2005) Airbus Group Finance B.V. (December 31, 2005) Airbus Group N.V. (December 31, 2005) Boeing Co. (December 31, 2005)

Production of Tobacco • • • • • • • • • • • • • • • • • •

Schweitzer-​Mauduit International Inc. (May 8, 2013) Huabao International Holdings Ltd. (May 8, 2013) Grupo Carso SAB de CV (August 24, 2011) Shanghai Industrial Holdings Ltd. (March 15, 2011) Alliance One International Inc. (December 31, 2009) Altria Group Inc. (December 31, 2009) British American Tobacco BHD (December 31, 2009) British American Tobacco Plc. (December 31, 2009) Gudang Garam tbk pt. (December 31, 2009) Imperial Tobacco Group Plc. (December 31, 2009) ITC Ltd. (December 31, 2009) Japan Tobacco Inc. (December 31, 2009) KT&G Corp (December 31, 2009) Lorillard Inc. (December 31, 2009) Philip Morris International Inc. (December 31, 2009) Philip Morris Cr AS. (December 31, 2009) Reynolds American Inc. (December 31, 2009) Souza Cruz SA (December 31, 2009)

Salar Ghahramani   223 • Swedish Match AB (December 31, 2009) • Universal Corp VA (December 31, 2009) • Vector Group Ltd. (December 31, 2009)

Actions or Omissions that Constitute an Unacceptable Risk of the Fund Contributing to: Serious or Systematic Human Rights Violations • Zuari Agro Chemicals Ltd. (October 14, 2013) • Wal-​Mart Stores Inc. (May 31, 2006) • Wal-​Mart de Mexico SA de CV (May 31, 2006)

Severe Environmental Damages • • • • • • • • • • • • • • • • •

IJM Corp Bhd (August 17, 2015) Genting Bhd (August 17, 2015) POSCO (August 17, 2015) Daewoo International Corp. (August 17, 2015) Sesa Sterlite (January 30, 2014) and (Madras Aluminium Company and Sterlite Industries Ltd. (both excluded October 31, 2007) are merged into Sesa Sterlite) WTK Holdings Berhad (October 14, 2013) Ta Ann Holdings Berhad (October 14, 2013) Zijin Mining Group (October 14, 2013) Volcan Compaña Minera (October 14, 2013) Lingui Development Berhad Ltd. (February 16, 2011) Samling Global Ltd. (August 23, 2010) Norilsk Nickel (October 31, 2009) Barrick Gold Corp (November 30, 2008) Rio Tinto Plc. (June 30, 2008) Rio Tinto Ltd. (June 30, 2008) Vedanta Resources Plc. (October 31, 2007) Freeport McMoRan Copper & Gold Inc. (May 31, 2006)

Gross Corruption • ZTE Corporation (January 7, 2016)

Other Particularly Serious Violations of Fundamental Ethical Norms • Potash Corporation of Saskatchewan (December 6, 2011) • Elbit Systems Ltd. (August 31, 2009)

224    Sovereign Wealth and the Extraterritorial Manipulation Serious Violations of the Rights of Individuals in Situations of War or Conflict • Africa Israel Investments (January 30, 2014) • Danya Cebus (January 30, 2014) • Shikun & Binui Ltd. (May 31, 2012)

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Pa rt  I I I

I N V E ST M E N T C HOIC E S A N D ST RU C T U R E S OF S OV E R E IG N W E A LT H  F U N D S

Chapter 10

Sovereign Wea lt h Fu nd s and Private E qu i t y Mike Wright and Kevin Amess

Introduction Sovereign wealth funds (SWFs) have grown rapidly in recent years as part of a resurgence in state capitalism (Wood and Wright 2015) and now have a significant presence in international capital markets, holding about $6.31 trillion in total assets (Preqin 2015). Governments that establish SWFs do so in order to pursue a variety of objectives: political and social (Kotter and Lel 2011; Knill, Lee, and Mauck 2012), access to strategic resources (Sun, Wang, and Clark 2014), maximizing returns (Bahgat 2008), hedge commodity price volatility to generate stable returns (Gintschel and Scherer 2008; Megginson and Fotak 2015), the creation of wealth for the benefit of future generations (Bernstein, Lerner, and Schoar 2013), and domestic economic development (Bernstein, Lerner, and Schoar 2013). In pursuit of their objectives, SWFs invest in a variety of markets and asset classes. While the vast majority of SWFs invest in public equity and fixed income vehicles, about half invest in private equity (Preqin 2015). Figure 10.1 shows that some 88% of SWFs with assets under management of $250 billion or more invest in private equity (PE) while this is the case for only 13% of SWFs with assets under management of below $1 billion (Preqin 2015). SWFs invest in PE in two ways: direct investment in firms and investment in PE funds. Direct investment allows a government to use its SWF to pursue political and social objectives because the SWF can have direct influence on firms’ business operations. The vast majority of the SWFs investing in PE do so indirectly through a fund; of the 51% of SWFs investing in PE in 2013, 44% did so through a PE fund, and only 7% invested in portfolio companies directly (Preqin 2014). Under the PE heading are included several different types of funds investing in companies at different stages of

232    Sovereign Wealth Funds and Private Equity 100 2013

90

2014

80 70 60 50 40 30 20 10 0 Public Equity

Fixed Income

Private Equity

Real Estate

Infrastructure

Hedge Funds

Private debt

Figure 10.1  Percentage of SWFs investing in different asset classes Source: Preqin.

development (Preqin 2014). Some 78% of SWFs investing in PE have a strategy to invest in buyouts stage funds, 72% have a strategy to invest in venture capital stage funds, 66% invest in growth stage funds, while 56% invest in funds investing in companies at the expansion stage. Only 41% have a strategy to invest in distressed company funds while 38% invest in the secondaries funds market. Some 14% of institutional capital raised by PE funds in 2015 came from sovereign wealth (Preqin 2015). We argue that SWF investment in PE funds is more likely to be part of an investment strategy that seeks to maximize returns because investment in PE funds does not afford the SWF direct control over firms bought using PE funds. Despite the growing importance of SWFs in the PE market, research attention has hitherto been limited. This chapter begins with a discussion of issues pertaining to the investment in PE funds. This is the mechanism through which SWFs can invest indirectly in PE. This is followed by a discussion issues relating to SWFs’ direct investment in PE. In a section about issues in SWF investment in PE, particular attention is given to SWF mandates and political interference, oil prices, and regulation. The chapter concludes with an outline of some issue for future research and draws conclusions.

Investment in Private Equity Funds SWFs invest indirectly in PE via investment in PE funds managed by firms that operate independently from SWFs. In this section we discuss: the structure of PE funds, returns to fund investors, persistence in performance, investment horizon and their implications for SWFs.

Mike Wright and Kevin Amess    233

The Structure of Private Equity Funds Private equity is risk capital provided outside the public (listed) markets. PE firms typically establish limited life funds in order to raise capital that is then put towards the acquisition of a portfolio of mature firms (Kaplan and Stromberg 2009). The ‘portfolio firms’ are acquired via a Leveraged Buyout (LBO) because the PE firms will combine debt finance secured against portfolio firms’ assets and/​or future cash flows, with finance from the PE fund to conduct the acquisition (Gilligan and Wright 2014). The PE funds themselves have a life-​span of ten years before funds need to be liquidated, although there is often an option for an extension of up to about two further years with penalties. Individuals within PE firms that are actively involved in managing a fund are referred to as General Partners (GPs). The GPs also invest in their own funds, normally around 1–​5% of the total capital raised in a fund (Leleux, van Swaay, and Megally 2015). Organizations (such as SWFs) and individuals that invest in PE funds do so via a limited partnership and the fund investors are referred to as Limited Partners (LPs). While LPs have no direct involvement in specific investments made by a fund (that is a matter for GPs), when LPs invest in a fund they can use covenants to broadly determine a PE fund’s investment strategy; for example, in relation to the size, geography, and industry of investments. Thus, while GPs are actively involved with their portfolio firms—​for example, with board of director representation and often taking on the role of Chair of the board—​LPs have no direct involvement with portfolio firms. SWFs investing in PE as LPs are likely to be doing so as part of a financial strategy rather than a political strategy. Indeed, this was the motivation for the Norwegian Government Pension Fund Global (GPFG) considering investing in PE funds (Phalippou 2011). SWF investment in PE funds is challenging for the pursuit of political objectives because it cannot directly target specific firms for acquisition and cannot influence portfolio firms’ business operations via a PE fund. PE funds are regarded as a risky asset class (Phalippou and Gottschalg 2009); therefore, SWF investment in PE funds is likely to be part of a portfolio of assets. Another consideration for SWFs investing in PE funds is the longevity of their investments to PE funds. LPs that commit capital to a fund that has a life-​span of ten years will be committing capital to the fund for up to a ten-​year period and cannot withdraw commitment of cash until the fund realizes returns and closes. This is a consequence of how PE firms generate returns to LPs. LPs do not receive a regular income from dividend or interest payments; rather, they receive a return from capital profit that is generated from the sale of portfolio firms, known as investment exit (Gilligan and Wright 2014). GPs undertake a variety of roles in the management of PE funds. They research and identify firms suitable for an LBO, negotiate and implement deals, play an active role in the corporate governance of portfolio firms, and make the decision of when to exit from investments in order to realize returns. There are two main sources of remuneration for these services: management fees and carried interest. Typically, management fees are set at 2% and carried interest at 20%, although there is some variation around these levels

234    Sovereign Wealth Funds and Private Equity (Metrick and Yasuda 2010). Carried interest is paid on the capital gain generated in the PE fund and is only paid once a hurdle rate of return to LPs has been achieved, this hurdle rate is normally about 8%. More recently, PE funds have been experiencing pressure from institutional investors to reduce management fees and to focus on generating returns from their investments (Gilligan and Wright 2014). With the amount of cash SWFs have available to invest, they are in a strong position to negotiate more favorable management fees and hurdle rates. For instance, Phalippou (2011) argues that GPFG can negotiate favorable fee terms for itself but also has the potential to impact on wider industry fees. Negotiating favorable terms in carried interest is a more complex matter, however. While the 20% rate of carried interest is largely a matter of convention, Gompers and Lerner (1996) point out that financial incentives linking GP remuneration to fund performance reduces agency costs, creating incentives for GPs to maximize LP returns.

Limited Partners’ Returns The structures and mechanisms put in place by PE firms in their portfolio company investments are expected to lead to performance improvements both in terms of efficiency improvements (Harris, Siegel, and Wright 2005) and the exploitation of entrepreneurial opportunities (Wright, Hoskisson, Busenitz, and Dial 2000). The introduction of significant equity stakes for managers alongside concentrated equity ownership by PE investors is expected to reduce agency costs by aligning the interests of owners and managers. The need to service significant leverage is aimed at reducing wasteful discretionary expenditure. Through their board representation, PE firms engage in both active monitoring of performance and specialist added value involvement to support entrepreneurial activities of portfolio firm managers (Amess, Stiebale, and Wright 2016). Studies suggest that more experienced and specialist PE firms have a greater impact on the financial and entrepreneurial performance of portfolio firms (Cressy, Malipiero, and Munari 2007; Cumming, Siegel, and Wright 2007; Meuleman, Amess, Wright, and Scholes 2009). The key source of LP returns is realized capital gains arising from the acquisition of underperforming firms and their subsequent sale (referred to as an investor exit) after improved performance of portfolio firms is established. SWFs concerned with maximizing returns will be concerned with whether PE funds are able to generate superior risk-​adjusted returns compared to alternative investment opportunities. While there is much consensus that PE firms are able to extract higher post-​buyout performance from their portfolio firms (Cumming, Siegel, and Wright 2007), there is considerable debate about whether this translates into high returns for LPs. PE industry trade association studies (e.g. BVCA 2015)  indicate that PE funds out-​perform alternative forms of investment such as quoted shares, although the variation between the best and worst performing funds and the others is considerable. In addition, they rely on self-​reporting from PE firms so the stated returns are likely to be subject to selection bias, although this is the case to a greater or lesser extent of all PE databases.

Mike Wright and Kevin Amess    235 Academic work has used data from firms that provide information to investors, asset managers, and fund raisers e.g. Burgiss and Thomson Venture Economics. They provide access to performance data that is not publicly available, but they may potentially be biased depending on the scope of the funds that are covered. Kaplan and Schoar (2005) report US evidence showing that LBO fund returns (gross of fees) exceed those of the S&P 500 but that returns net of fees are 93% of what could have been earned investing in S&P 500. They also report wide variation in returns across funds: the top 25% performing funds report returns (net of management fees) indicating that investors earn 103% of what they could have earned investing in the S&P 500 while the bottom 25% performing funds provide 72% of what could have been earned by investing in the S&P 500. PE is generally regarded as a riskier asset class than public equity listed in the S&P 500 because the latter will contain large well-​established firms and PE investment creates financial risk by using high levels of debt to facilitate a buyout deal. Phalippou and Gottschalg (2009) find risk-​adjusted performance is 3% lower than the S&P 500 and net of fees performance is a further 3% lower, making it a total of 6% lower than the S&P 500. Both Kaplan and Schoar (2005) and Phalippou and Gottschalg (2009) show that GPs earn more from fees than carried interest. The PE fee structure should therefore be of concern to SWF fund managers, while SWFs might want to maintain financial incentives via carried interest, they might also want to negotiate management fees downwards to ensure that GPs earn more from carried interest in order to ensure GPs incentives are aligned with LP incentives. Subsequent studies cast doubt on underperformance by PE funds. Several studies found over-​performance using various stock market comparator benchmarks using more robust data sources (Stucke 2011) and one study found a zero alpha gross of fees (Franzoni, Nowak, and Phalippou 2012). However, it is important to adopt the appropriate benchmark given that buyout funds typically invest in smaller firms than those listed in the S&P 500. Adjusting for the size premium, there is some evidence that the over-​ performance disappears (Phalippou 2012). Harris, Jenkinson, and Kaplan (2014) report that PE funds outperform a variety of different benchmarks; however, a key finding is that the magnitude of their findings is dependent on the data set used.

Persistence in Performance A key issue for potential investors in PE funds, including SWFs, seeking to maximize returns is in identifying funds where the best returns can be achieved. To this end, an obvious starting point for investors is to see if there is any persistence in GPs’ performance across funds. If past fund performance is a predictor of future fund performance, SWFs should invest in those funds managed by GPs that exhibited high performance on funds theory previously managed. Kaplan and Schoar (2005) find persistence in performance across GPs. This result holds for both current and consecutive funds. More recent evidence, however, suggests that persistence in fund GPs performance has declined over time. Harris, Jenkinson,

236    Sovereign Wealth Funds and Private Equity Kaplan, and Stucke (2014) find persistence in fund performance using pre-​2000 data, consistent with the findings of studies outlined above that also use pre-​2000 data; however, they find little evidence of persistence in fund performance using post-​2000 data, except for the worst performing funds. Braun, Jenkinson, and Stoff (2015) similarly find no evidence of performance persistence across funds and attribute it to the maturity of the PE asset class behaving similar to other mature assets classes and increased competition in the PE sector. Some academic work suggests that, historically, most successful funds have become too large, too fast (Lopez de Silanes, Phalippou, and Gottschalg 2015). There are indications, however, of diseconomies of scale among PE firm investors as investments held at times of a high number of simultaneous investments underperform substantially, with diseconomies being highest for independent firms, less hierarchical firms, and those with managers of similar professional backgrounds. Historically, a challenge for new and inexperienced institutional investors, like SWFs seeking to invest in PE funds, concerns their ability to access the best performing funds, and as a consequence their returns may be lower (Lerner, Schoar, and Wongsunwai 2007). More recent research finds that differences in institutional investors access to the best performing funds has declined and differences in institutional investors’ returns from investing in PE have disappeared (Sensoy, Wang, and Weisbach 2014). At the same time, however, the presence of unsophisticated performance insensitive institutional investors can allow poorly performing PE fund managers to raise new funds. In contrast, more established and successful PE firms can easily find their new funds to be over-​subscribed by their investors from the previous fund. Such firms may be reluctant to scale back commitments from previous investors to enable new entrants to obtain a place in the fund.

Investment Horizons As already mentioned, LPs commit their cash (known as committed capital) to a PE fund for the duration of a fund, which is typically ten years. While the find manager has certain knowledge that funds are available for investment into the LBO of firms, the cash remains with LPs but fund managers can draw on it when required (Gilligan and Wright 2014). A LP’s committed capital is effectively tied up because the PE fund manager can draw down committed capital when it is required. It is therefore necessary for LPs to have long investment horizons. A large fund such as GPFG has a long investment horizon, making it suitable for investment in PE funds (Phalippou 2011). If, however, short-​term liquidity becomes a problem for an SWF it is not easy to sell invested capital and be released from a capital commitment because the secondary market is not well established. Nevertheless, there are an increasing number of buyers specializing in the secondary market and agents that specialize in finding buyers. There are potential reputational consequences for the LP selling their investment in a fund; for instance, the PE firm managing the fund might be wary of allowing the LP invest in future funds.

Mike Wright and Kevin Amess    237

Sovereign Wealth Funds’ Direct Investment in Private Equity When SWFs invest directly in PE, they own and control a portfolio of firms. In this section we discuss issues concerning direct investment in PE: the determinants of direct investment, investment strategies, and portfolio firm performance.

Determinants of Direct Private Equity Investment SWFs are increasingly making direct investment in PE rather than conducting their investments via a PE fund in the light of pressure to recoup losses. Direct investment is sometimes alongside a PE fund partner but SWFs also make direct investments without a PE fund partner (Chassany 2013). The potential benefits to SWFs of direct investment are twofold. First, they avoid the PE firm’s fees and, as already mentioned, fees have been a major source of PE firms’ income. Second, SWFs have greater control over investment decisions and management of portfolio firms. This is particularly important for SWFs that focus on domestic economic development and those governments that use SWFs to buy strategic resources. Analyses of the impact of PE investors often distinguish between selection and treatment effects. This means that SWFs seeking to invest directly in PE would need to be able to access good (proprietary) deal flow as well as having the expertise to add value to portfolio companies. Both these aspects have been noted to provide challenges to PE firms entering the market (Wright, Jackson, and Frobisher 2010). Clearly there would be costs to SWFs of this strategy in terms of building teams with the expertise and know-​ how to identify targets, negotiate deals, structure deals, manage and add value to portfolio firms, and execute successful exit; although, with long investment horizons, there is less pressure to realize capital gains. In 2009, less than 4% of SWF assets were allocated to PE (Jory, Perry, and Hemphill 2010). Although strictly comparative information is difficult to obtain, more recent data indicate that there has been a substantial increase in allocations to PE (Invesco 2014). SWFs likely invest in PE as part of their allocation of funds to a diversified portfolio of assets. As can be seen from Figure 10.1, there was a slight decline in the percentage of SWFs investing in PE between 2013 and 2014 while there was an increase in the percentage investing in real estate, infrastructure and hedge funds. It is notable, however, that there are major regional differences in the percentages of SWFs investing in PE. Some 82% of Middle Eastern SWFs invest in PE, while this is the case for 76% of Asian SWFs and 60% of North American SWFs, but only 29% of European SWFs (Preqin 2015). An SWF is likely to invest in more than one PE fund. For example, Alaska Permanent Fund Corporation (APFC) invested in more than 30 PE funds with a vintage year of 2014.

238    Sovereign Wealth Funds and Private Equity Johan, Knill, and Mauck (2013) show that the investment pattern of SWFs is quite distinctive compared to other traditional institutional investors when investing in PE, suggesting different decision-​making behavior of SWFs with regard to investing in PE. They examine the investments of 19 SWFs in 424 public and PE firms. Using worldwide data covering the period 1991–​2010, they find that SWFs, similar to other institutional investors, are less likely to invest in PE versus public equity internationally; however, the economic significance of this impact is low. Unlike other institutional investors, SWFs are more likely to invest in PE versus public equity in target nations where investor protection is low and where the bilateral political relations between the SWF and target nation are weak. Surprisingly, cultural differences play a marginally positive role in the choice to invest in PE investment outside of an SWF’s own sovereign nation. SWFs’ investment behavior is distinct from that of other institutional investors, which has implications for policy because it means it needs to be tailored.

Investment Strategies Some SWFs are opening offices in several countries to help them access deal flow. For example, Canada’s Pension Plan Investment Board opened its fourth international office, in São Paulo. Middle Eastern SWFs are increasingly investing directly in companies, rather than through PE funds (Chassany 2013). The extent of this behavior varies between SWFs that can be classed as development funds with an obligation to support country’s economy in the short term and so-​called investment funds. The former tend to be less risk averse, while the latter are primarily focused on preserving wealth for future generations. It tends to be the development funds that are building their own teams to invest directly in PE while investment funds are more likely to co-​invest alongside a PE fund in which they already invest. Bernstein, Lerner, and Schoar (2013) examine 2,662 direct PE investments across 29 SWFs during the period 1984–​2007 and their relationship to the funds’ organizational structures. They find that SWFs appear to engage in a form of trend chasing, as they are more likely to invest at home when domestic equity prices are higher, and invest abroad when foreign prices are higher. Where politicians are involved in SWFs there is a greater likelihood of investing at home compared to those SWFs involving external managers. Moreover, SWFs with external managers tend to invest in lower PE industries, with there being an increase in the PE ratios in the year following investment. In contrast, funds with politicians involved invest in higher PE industries that have a negative valuation change in the year after the investment. When distinction is made between funds with strategic objectives (e.g. acquisition of strategic assets and/​or economic development) and non-​strategic objectives (e.g. pension funding) and politicians are involved, there is a significantly higher probability of funds investing at home (Bernstein, Lerner, and Schoar 2013). Nevertheless, when SWFs do invest abroad, they invest in nations with which they have weaker political relations, although the amount invested is not determined by political relations (Knill, Lee, and Mauck 2012).

Mike Wright and Kevin Amess    239 Reflecting the pressure on PE funds noted earlier regarding their fees, some SWFs co-​invest with PE firms in order to reduce fees and to gain experience in initiating deals. Some SWFs are also investing in PE companies directly to obtain greater operational control of portfolio companies. Greater involvement in portfolio companies may hold attractions if the SWF has broader social and economic goals in a particular area. However, questions arise regarding the sourcing of attractive deal flow and the level of expertise of SWF executives to be able to add value effectively to portfolio companies. While SWFs have initially been seen as being passive investors, there is some evidence that this stance is evolving as they strive to become more active as investors (Butt, Shivdasani, Stendevad, and Wyman 2008). The ability to recruit significant in-​house PE teams may be challenging for smaller SWFs. Similarly, some SWFs face challenges in being able to remunerate executives as they would be able to in the PE industry because they are bound by remuneration rules for state employees (The Economist 2014). However, the failure of some PE firms to raise further funds after poor performance of funds raised around the time of the financial crash may mean that there is an experienced pool of PE executives from which to recruit. There is some evidence from institutional investors that sole investment by them outperforms co-​investments with PE funds, especially for later stage deals where informational asymmetry challenges are lower (Fang, Ivashina, and Lerner 2013).The limited examples available that compare direct (internal) and indirect (external) investments in PE by SWFs indicate that experience has been varied, with direct investments significantly outperforming indirect investments in some cases but significantly under-​ performing in others (The Economist 2014).

Portfolio Firm Performance Several studies examine the effect of SWF investment on listed firms; however, there is scant research concerning the impact of SWFs’ outright acquisition of firms. Bernstein, Lerner, and Schoar (2013) is a notable exception. They find that SWFs’ experience falls in the industry price-​earnings’ ratios of their home investments in the year following investment, and a positive change in the year after their investments abroad. They show that SWFs with greater involvement of political leaders in fund management are associated with investment strategies that appear to favor short-​term domestic economic policy goals at the expense of longer-​term return maximization. They suggest their findings regarding trend chasing and worse performance by some SWFs, associated with more home investments and involvement by politicians, could be because of less sophisticated decision structures within these funds, or outright distortions in the investment process due to political or agency problems. The decline in performance after cross-​border SWF investment is reminiscent of the performance of state-​owned enterprises. A large literature on state ownership shows that political interference has a negative effect on firm performance (Megginson and Netter 2001). While this is a well-​recognized problem in domestic markets, the cross-​border

240    Sovereign Wealth Funds and Private Equity investments of SWFs might mean that the under-​performance of state ownership is transmitted across international borders. Foreign state ownership might therefore be damaging to the performance of the recipient economy. Clearly, for those SWFs seeking to maximize returns on their investments in order to create wealth for future generations, this is problematic. When we compare the active involvement of SWFs with PE firms, SWFs compare unfavorably. This might reflect a lack of experience among SWFs in directly managing portfolio firms. This performance gap with PE firms might close when SWFs develop stronger teams to manage their portfolio firms and gain more experience. To determine whether SWFs would be better off indirectly investing in PE via established PE firms, it would be important to compare returns net of fees and costs. Care needs to be taken in interpreting the decline in portfolio firm performance. While some academics and practitioners are concerned about the efficiency of asset allocation and maximizing returns, some SWFs are simply serving political objectives with no regard to their wider impact on the efficiency of capital markets to allocate assets to their best use.

Issues in Sovereign Wealth Fund Investment in Private Equity Sovereign Wealth Fund Mandates and Political Interference Mandates for SWF investing are typically established by their sovereign governments but many funds do not disclose their objectives, despite the “Santiago Principles” on disclosure of SWF’s policy objectives. Different legal structures of SWFs, influencing whether they are subject to direct state control or general corporate law, may determine the nature of the constraints placed on their investment behavior. Many of these mandates may be politically driven but lack of disclosure makes this difficult to determine, although there are indications that this is indeed the case (Knill, Lee, and Mauck 2012). SWFs vary in their investment mandates, with some being expressly prohibited from investing in PE, although shifts are occurring. It has been suggested that SWF investment in PE may be undertaken more for financial reasons in order to compensate for under-​ performance of investments in public equity by diversifying into riskier but potentially higher return investments (Johan, Knill, and Mauck 2013). For example, the Norwegian SWF, GPFG, has only recently taken a more positive stance with regard to extending its mandate to invest in PE in order to pursue higher investment returns (Phalippou 2011). However, as of early 2016, a group of experts are reviewing the equity quota with the government’s decision on the new equity quota not expected until 2017 (Williams 2016). SWF mandates can allow a national government to have both a direct and indirect cross-​border influence. For instance, the Norwegian government has a direct effect via an ethical council, which publicly censors and certifies GPFG’s investments in order to

Mike Wright and Kevin Amess    241 promote the government’s social, ethical, environmental, and corporate governance agenda. Such public behavior also is a mechanism through which the government can have an indirect effect on GPFG’s portfolio firms by projecting investment norms. There is normative pressure for portfolio firms to make responsible investments (Vasudeva 2013). The mandate of the South African Public Investment Corporation, a quasi-​SWF based on public sector pensions savings and thus a generational, rather than intergenerational savings device, means that it fulfils political and stabilization functions. The Corporation has increased its allocation to PE in recent years (South African Public Investment Corporation 2016). The aim of investing in PE is to generate income and capital appreciation by making investments across all company sizes from early stage venture capital, through small-​, medium-​, and large-​sized unlisted companies located in South Africa and the rest of Africa. Traditionally, PE transactions were focused principally on Black Economic Empowerment (BEE) where black partners enter into equity deals without active participation in the company’s operations. The introduction of Broad-​Based Black Economic Empowerment (BBBEE) led to a shift to a preference for investment in companies that link with black partners in productive operational tie-​ups, where the transactions consider board and executive representation, employment equity, skills development, preferential procurement, enterprise development and socially responsible investments. In 2015, R2.5 billion was disbursed to PE with direct investments representing 47% of the total with the remainder through third-​party-​ managed funds owned and controlled by BBBEE fund managers. In addition, the Public Investment Corporation approved investments to the value of R1.8 billion, a decrease of 59% when compared to prior years’ approvals. As an illustration of how the investments meet political objectives, one investment involved a pharmaceutical courier group. This deal directly linked to government policies to improve healthcare as an estimated 63% of its deliveries are to patients in rural areas who are not serviced by community pharmacies. As mentioned previously, care needs to be taken when examining the impact of SWFs on portfolio firms’ performance. While it is interesting to know the impact of SWFs on portfolio firm performance, there is a need for academics, practitioners and policy-​ makers to be clear about why they are interested in portfolio firm performance. There might be concern about the efficiency of resource utilization in firms, which is relevant to those SWFs that are mandated to generate wealth for future generations. For those SWFs that have mandates with broader political objectives, however, there is a concern that the under-​performance of portfolio firms could distort host-​country markets, creating negative externalities for host-​country firms. For instance, under-​performing firms might avoid liquidation because of the financial support of an SWF. Such concerns pose a policy dilemma: Should international organizations continue to support the free movement of capital if there is evidence that it permits distortions to host country markets when some SWFs are pursuing non-​economic objectives? Where individual SWFs have an explicit mandate to maximize returns on investment and evidence indicates that they are pursuing such a mandate, they should be treated like any other institutional investor. In contrast, it is not clear why SWFs that openly pursue political objectives

242    Sovereign Wealth Funds and Private Equity should not be subject to distinctive regulation by organizations that promote the free movement of capital and/​or by host countries.

Oil Prices The sharp drop in oil prices in 2015–​16 had a severe budgetary impact for those states whose economies were heavily dependent on the commodity. The resultant budgetary deficits placed pressure on their SWFs to divest assets to help plug these gaps (Bershidsky 2015). Given the extensive fundraising by PE firms during this period, and the general recognition of the difficulties in finding good deals, it has been suggested that these funds may provide ready buyers of these assets (Bouyamourn 2015). At the same time, these changes seem likely to depress the amounts available to invest in PE and may pose challenges for those PE fund managers raising new funds in the near future. Research is needed to explore the extent to which this issue in relation to those SWFs dependent on oil revenues poses a general problem for the PE market.

Regulation SWFs’ activities in host countries are subject to the regulations of that country. Nevertheless, host countries might be concerned that SWFs may seek to circumvent host countries’ regulatory frameworks, which is why regulatory measures have been proposed, including: limits on ownership and/​or voting rights, prohibiting investment in areas of national interest to the host country, establishing specific regulatory procedures for SWFs, and using external fund managers located in the host country (de Palma, Leruth, and Mazarei 2010). Investment in PE funds is of less concern because it does not offer direct control over a portfolio firm. Indeed, PE funds create a layer between portfolio firms and SWFs meaning that SWFs do not have direct control over the operation and governance of portfolio firms. If, however, SWFs have ownership stakes in PE firms, this could allow them to influence PE firms’ investment strategies (Sethi 2008). In addition, it might permit SWFs to become involved in the governance, strategy, and operational decision-​making of portfolio firms, which is problematic if it impacts on host countries’ national interests or leads to distortions in product markets. The bigger concern for a host country is likely to be direct ownership and control of a firm because there is the potential for a foreign government to control the behavior of that firm. Such concern could relate to national interests (e.g. in relation to energy or defense policies) but there might be broader economic concerns if the behavior of portfolio firms distorts product markets. Nevertheless, the Organization for Economic Cooperation and Development (OECD) has reaffirmed its free capital movement principles and for SWFsto be treated fairly, like other international investors (Gordon 2010). While cross-​country ownership of firms by SWFs might raise legitimate national interest concerns, there is broad agreement from international agencies such as the OECD

Mike Wright and Kevin Amess    243 and International Monetary Fund (IMF) that such concerns should not be used as a motivation for protectionist measures. Considerable criticism of the PE industry for shortcomings in its disclosure regarding investments has led to some country industry associations such as the British Venture Capital Association (BVCA) in the UK to implement detailed reporting guidelines. In contrast, public disclosure requirements for SWFs are quite limited and have given rise to concerns about the lack of transparency regarding their cross-​country investments, especially in PE since there tends to be less disclosure here than for public equity. This concern may be especially accentuated where SWF investment is perceived to have political objectives.

Conclusion In this chapter we have discussed the rationale, nature, and extent of SWF investment in PE. We have distinguished between indirect investment in firms via PE funds and direct investment in firms. Research SWF investment in PE is presently quite limited and there appears to be scope for extensive further research. Recent developments in natural resource markets, especially oil, from which many SWFs generate their funds, have important implications for the future of SWF’s direct and indirect investment in PE. With respect to indirect investments by SWFs, the following areas would appear to warrant particular attention. Further research at the PE fund level might usefully explore the impact on those funds that had been relatively more reliant on SWFs as a result of a reduction in funds’ flow from this source when they came to raise follow-​on funds. Also, the extent of this problem warrants investigation. Research could look into the extent that PE funds are able to substitute SWF funds from other sources. Another area that warrants research at the funds level concerns the need to analyze the impact of SWF investing in the different types of PE fund that invest in different stages of company development. Concerning direct investment by SWFs we would suggest that additional research is needed in the following areas. First, the increase in direct investment by SWFs and their recruitment of experienced executives suggests a need to compare the impact of SWFs with the impact of traditional PE firms on portfolio company performance and behavior. Second, PE research is increasingly recognizing the importance of exploring the behavior of different types of PE firms both in terms of their experience in doing deals and also with respect to their objectives and time horizons; for example, while much attention has traditionally focused on independent PE firms, many firms outside the US are either captive funds or public sector funds. Similarly, as we have seen, there is heterogeneity in SWFs’ relationship between their governments, sources of funds cash, size and experience, so there is a need to analyze the relationships between these differences and portfolio company performance and behavior. Third, when examining portfolio firm behavior, we need to understand whether direct SWF control leads to distortions in the product markets of host countries; for example, pricing practices that drive host country firms out of their markets.

244    Sovereign Wealth Funds and Private Equity Fourth, more fine-​grained research, using qualitative and longitudinal research approaches, might explore the nature and differences in the processes of involvement by SWFs in their PE portfolio companies. Finally, some SWFs are co-​investing with experienced PE firms and we need to understand how this impacts on investment strategies and whether SWFs are using this as a vehicle to enhance their own organizational knowledge. In conclusion, PE represents an important but under-​studied area for researchers interested in SWFs. It is hoped that the findings and potential research agenda discussed in this chapter will open the way for further research in this domain.

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Chapter 11

C o-​I nvestm e nts of Sovereign Wea lt h Fu nd s i n Private  E qu i t y Joseph A. MCCahery and F. Alexander de Roode

Introduction Sovereign wealth funds (SWFs) represent a growing strategic and financial concern for regulators and market participants around the world. This coincides with major changes in the pattern of investment and substantial growth of assets controlled by SWFs since the end of the financial crisis. A significant amount of growth in assets can be attributed to the dramatic increase in the number of countries that have established SWFs to manage their reserves and assets. In terms of total assets under management, the amount has been estimated at $4 to $6 trillion1. The impact of the large stakes of SWF investments may affect valuations in particular sectors of markets, contributing to inaccurate pricing and volatility. Despite the slowdown of capital inflows, SWFs are expected to continue to grow their assets under management and also to allocate their wealth in different types of investments. Why do regulators and policymakers concern themselves about the investment activities of SWFs? Traditionally, SWFs have invested in a wide range of debt instruments and equity instruments in order to pursue their investment objectives. As a result of their rapid accumulation of assets, SWFs have become major investors in the global financial markets, and this is also extended to the less traditional asset classes (Aguilera, Capape, 1  Various estimates of the total number of assets controlled by SWFs exists due to transparency and definitions. Preqin (2015) reports an estimate of US$6.31 trillion for the asset under management for all SWFs, whereas (Bortolotti, Fotak, and Megginson 2015) estimates a size of US$4.98 trillion for the major SWFs.

248    Co-Investments of Sovereign Wealth Funds in Private Equity and Santiso 2016; Al Hassan, Papaioannou, Skancke, and Sung 2013; Bortolotti, Fotak, and Megginson 2015). Several factors may lead to discomfort: the absence of transparency of SWFs regarding their choice of governance structure, investment activities, and influences on the strategies shaping their asset allocation policies. A further discomfort for policymakers is that some SWF investments may be politically motivated, which could lead to excessive risk-​taking (Chhaochharia and Laeven 2009; Karolyi and Liao 2016). While prior literature tends to be undecided on whether SWFs resemble institutional investors in primarily seeking financial return on their investments, it is essential to recognize that the capital flows triggered by SWFs could affect financial assets (Bortolotti, Fotak, and Megginson 2015). In particular, markets with less liquidity may be affected by these price pressures. Empirical studies have started to assess the market impact of SWFs. Much of this literature has focused on the short-​and long-​term influence of SWF investments on the shares of publicly listed companies (Bortolotti, Fotak, and Megginson 2015; Dewenter, Han, and Malatesta 2010; Kotter and Lel 2011). Observers point out that SWFs may have a potential distorting effect on equity markets. Empirically, researchers find no substantive negative impact, suggesting that the depth and liquidity of public equity markets are quite large. However, examples of price influences do exist. Consider the January 2016 drop in global equity prices due to the price pressure from SWFs that receive their income from natural resources. More specifically, SWFs withdrew their assets from public markets to finance state expenditures as a consequence of the prolonged low price of oil. Thus, while SWFs are typically assumed to be long-​term investors that can sustain periods of crisis, they were unable to maintain their portfolio holdings due to their liabilities. This example suggests that SWFs may be less able to pursue long-​term investments than previously thought, but also that state enterprises can have a direct market impact. The alternative view challenges the price pressure account of SWFs. Proponents argue that SWFs tend to have a beneficial impact on financial stability (Beck and Fidora 2008). As long-​term investors, SWFs invest principally in public equity and debt and mainly have unleveraged positions. Since SWFs tend to pursue portfolio reallocations as gradually as possible, this usually limits the adverse price effects on their transactions. Additionally, and perhaps the most important factor, is the ability of SWFs to provide liquidity to the markets when private market participants require withdrawals. Since SWFs have a longer investment horizon, they are less constrained in their ability to overcome the liquidity issues that trap private investors. For example, SWFs provided support for the financial intermediaries and banks during the financial crisis in 2008. Another more recent example is the liquidation of British real estate funds after the turmoil of Brexit, where it was possible for SWFs to provide liquidity in the market. In this light, large exposures to their own market in the form of debt and equity financing can contribute to the growth of local financial intermediaries and various markets. In this chapter, we empirically examine the evidence for SWFs to finance the long-​ term investment needs of private enterprises. Note that in the current economic environment with low yielding government bonds, a search for yield has also reached many

Joseph A. McCahery and F. Alexander de Roode    249 SWFs. Further, many institutional investors and SWFs focus on private equity as an additional source of return. However, such strategies raise many questions about the depth of the market for private equity. By contrast, prior work on SWF investments has typically focused on the security holdings of publicly-​held companies. One of the particular concerns highlighted in this chapter and earlier studies is the high concentration of investments in specific publicly listed firms by SWFs. They study the specific attributes of SWFs as institutional investors—​such as their lack of explicit liabilities, long-​term investment horizon and ability to acquire large stakes—​in establishing the differential investment impact on publicly listed firms (Bortolotti, Fotak, and Megginson 2015). More recent studies, however, examine the motivations that influence SWF investment strategies, suggesting the involvement of political motives to explain their investment strategy (Dyck and Morse 2011; Knil, Lee, and Mauck 2012). Similarly, Johan, Knill, and Mauck (2013) examine the factors that appear to influence SWF investment in private equity compared with public equity. To date, however, very little work has been done on SWF investments in privately-​held firms and other direct investments with illiquid prices such as infrastructure and real estate. In this chapter we believe that our research bridges that gap in the literature. This chapter is related to a number of works that explore the determinants of direct institutional investment in private equity (Fang, Ivashina, and Lerner 2015). In the traditional model of investing in private equity, investors as Limited Partners (LP) hold interest in a private equity fund that is managed by a General Partner (GP) which is typically a reputable private equity firm. The pressure on management fees and transparency in the financial industry has also affected this private equity investment model (McCahery and Vermeulen 2016). Instead of regarding private equity as a passive investment through the GP, institutional investors are turning to large direct investments in listed and unlisted firms. Prior research indicates that the upside of direct investment is the potential for greater control and reduced savings on fees and carry charged by GPs (DaRin and Phalippou 2014; Phalippou 2016). To understand why direct investment strategies are becoming increasingly popular, we need to consider the two models of direct investment. The two distinct modes provide different entry options. First, there is the model of solo direct investment in which the investor or LP sources and makes the investment, directly bypassing the financial intermediary without paying a fee and carry. There may be substantial benefits for investors to source and monitor their investments. Not only can this type of investment structure limit agency problems, but it may also reduce suboptimal performance by refraining from investing in peak periods. Thus, a solo direct investment that allows investors to execute and manage their own strategy and risk exposures may lead to optimal performance. At the same time, the downside risks of direct investing are the costs of developing an aligned management team with the investment experience and skills for selecting and monitoring target companies as well as generating performance. In the second model, co-​investments are made by the LP alongside with a GP. The management fee and carry are paid by co-​investors on a case by case basis. There may be substantial benefits to investors to turn to direct investments through co-​investment.

250    Co-Investments of Sovereign Wealth Funds in Private Equity Co-​investing can help SWFs to deliver more return to the portfolio through better informed agents in selecting higher quality portfolio companies. It is likely that the LP will benefit by co-​investing alongside the GP. Moreover, higher bargaining power is associated with GPs souring their better deals to their more active co-​investors, along with a reduced fee for better-​performing deals. Due to capital restrictions and risk control, private equity funds have limitations on deal size for their target companies. To overcome these hurdles, private equity firms may offer to co-​investment with LPs in the target companies. In fact, GPs may prefer to co-​invest with SWFs rather than other LPs, not only because of their large wealth, but they may also infer that there is the potential to raise more capital from public entities. On the one hand, GPs are free to grant LPs a discount on the management fee and carry structure. On the other hand, if GPs choose the larger riskier deals that involve co-​investment, then they may have additional risks and lower returns. In fact, private equity firms typically focus on a specific part of the market and may not have the expertise for larger deals. Moreover, to the extent funds engage in large co-​invested deals, they have greater potential for agency problems. Last, this may lead to higher risk as SWFs will have more concentrated portfolios than the LPs. In this chapter, we use a dataset of governmental owned entities’ deals in direct investments. The most popular transactions in our dataset involve the creation of governmental funds by large pools of capital (66%). The dataset also includes the direct investments and co-​investments of SWFs in alternative assets. In this context, while some of the co-​investments include established funds that are managed by a GP, most of the larger deals will be under the sole control of the SWF. Looking at the remainder of the deals in our sample, they involve a substantially lower level of governmental capital commitment (29.6%). To finance the remaining capital and expertise, additional LPs are required. We find an average number of 2.36 LPs in our sample. Finally, deals that are solely funded by governmental capital have a lower number of LPs (1.49) and include only SWFs. We explore the role co-​investments can play in making risk capital available to small to medium-​sized enterprise (SMEs) and young firms in emerging and developing countries. Prior work on SWF investment in private equity has highlighted the role played by political motivation in identifying the choice of firm or the location of those investments in privately-​held firms (Bernstein, Lerner, and Schoar 2013; Johan, Knill, and Mauck 2013). Our data reveals the preferences of SWFs to invest in local and similar markets. We find evidence that most direct investments of SWFs are subject to geographical influence. We further consider the influence of management practices, due diligence and the corporate governance of the target firms on the investment decisions of SWFs. Similarly, our results also imply that co-​investment can only prevail under regulatory stability. Due to the associated risks of co-​investment, SWFs may counter risks and asymmetric information by investing in local or similar markets. We find that the majority of the deals involving global projects with a co-​investment structure includes an average of 2.89 LPs. We add to this literature by showing that some of these investors are also development funds that finance investments in emerging markets, and are

Joseph A. McCahery and F. Alexander de Roode    251 motivated not only by expectations for strong markets returns perspective, but also of enhancing public equity markets in the region. This chapter makes several contribution to the literature on SWFs. First, it extends on earlier work showing the growing number of SWFs undertaking direct investments in private equity after the alleged slowdown after the financial crisis. Our results complement recent studies that find the effect of SWF funds involvement in the financing of firms and other direct investments, which can create hidden risks and overvaluation of illiquid assets classes. We also provide theoretical and empirical insights about the government-​funded private equity. Second, our analysis sheds light on current practices in direct investments through co-​investment arrangements by SWFs, including average deal size, number of co-​investors and industry segment of the investment. Finally, our results are consistent with the view that direct private equity investments continue to gather state funds in the developed rather than underdeveloped markets. This chapter begins with a description of recent trends in the investment activities of SWFs and relates them to the pattern of co-​investment made between SWFs, private equity funds and other institutional investors. It continues with an introduction to a sample of private deals. Analyses are also presented on deal structure and target firm investment.

Governance of Sovereign Wealth Funds on Alternative Asset Allocation In this section, we begin with a review of the characteristics of different types of SWFs. Next, we focus on the asset allocation approach used by SWFs in determining their alternative investment allocation. We then discuss the literature on the market impact of SWFs. Governments have many reasons to invest in financial assets. In general, there are two streams in the literature. First, there is a view that state entities are created to manage financial assets with specific long-​term investment goals. Examples include savings to meet future liabilities and budget stabilization through managing reserves. For the most part, these funds are established as an SWF to finance government ambition through the investment of surpluses on commodity resources, foreign currency reserves, budget surpluses or by specific saving premiums. Second, SWFs are involved in national development finance projects in their own countries and sometimes in developing economies (Nurbeck 2007; OECD 2008). Thus, the major economic motivation is to invest in real assets to contribute to the economic and financial development of emerging economies and stabilization of local markets. While there are numerous theoretical and empirical accounts of the development SWFs, their primary focus is to finance and stimulate public investments. The commonly accepted reason to invest in macroeconomic projects is to limit or mitigate

252    Co-Investments of Sovereign Wealth Funds in Private Equity potential market failures. Direct market failure may lead to government intervention to boost long-​term strength of an economy (Stiglitz 1994). The idea is that governments can smooth market cycles by generating a stimulus, and hence limit the impact of market recessions. For instance, tight credit markets may cause enterprises to halt viable projects, leading to stagnation in the short term. It is very likely that improving the credit facility to firms helps to boost the economy and shorten the duration of the impact of market events. Second, public investments in the economy may be necessary due to the lack of private finance (Myrdal 1968). A classic example is infrastructure projects. At the other extreme, however, the development of specific business ventures such as the European Silicon Valley may fit this example as well. While private institutions may face higher hurdles to locate private funding, due to the large risks associated with these projects, governments can limit potential externalities by offering funding to specific sectors (Bruck 1998; Stiglitz 1994). For example, an important group of state-​owned investment vehicles include Caisse des Depots, European Fund for Strategic Investments, European Investment Bank, and the US Small Business Administration. The experience of state-​owned investment institutions is not uniformly positive. For instance, state-​owned development banks have regularly been criticized for misallocating credit and other inefficiencies associated with political factors in developing countries (Ades and Di Tella 1997; La Porta, Lopez-​de-​Silanes, and Shleifer 2002). Another type of criticism, more predominant in developed markets, focuses on inefficient project selection leading to investment in unprofitable projects. Other factors likely to influence the level of such concerns regarding state institutions include taking on excessive risk, interfering with healthy competition and crowding out the private sector, resulting in the growth of vast uncontrollable national empires. We mentioned earlier that SWFs entered into the picture as the vehicle for governmental investments. While it is true that there are many different types of SWFs, there is little consensus on any formal definition of SWFs. They are a heterogeneous group of state entities with financial assets and various investment objectives. There are five specific categories of SWFs, as illustrated in Table 11.1. We will use the International Monerary Fund (IMF) categories of fund objectives to help define the term SWF. The importance of the definition is crucial for the purposes of determining the specific government entities that fall under the notion of SWFs. Several researchers have attempted to describe the notion of an SWF. Truman (2008) argued that the SWF is best viewed “as a descriptive term for a separate pool of government-​owned or government-​ controlled financial assets.”2 As this definition suggests, there are a broad variety of governmental financial institutions that fit within this category. For example, many central banks may fall under the scope of this definition. In contrast, Balding (2008) puts forward a narrow definition that proposes only to identify a state fund as an SWF if their investment objective is to aim for a return above the risk-​free rate. Another constraint

2 

See Truman 2008.

Joseph A. McCahery and F. Alexander de Roode    253 Table 11.1 Categories of Sovereign Wealth Funds Category

Objective of Fund

Stabilization fund

To minimize the effect of a State’s budget and economy against commodity price fluctuation

Saving funds

Accumulating capital for future generations, which aim to convert nonrenewable assets into a more diversified portfolio of assets

Reserve investment corporations

Seeking the increase the return of reserve assets

Development funds

Improve socioeconomic projects and/​or promote macroeconomic growth

Contingent pension reserve funds

Provide returns for governmental pension liabilities

to the general definition as put forward by the IMF is whether SWFs invest in foreign assets. Development funds may, for instance, not qualify as an SWF under this narrower definition; however, they would be classified an SWF under the Truman definition. Overall, SWFs are state entities that have diverse investment objectives and sources capital, leading to various investment guidelines and investment destinations across these funds. To further explore the consequences for their allocations, we examine the investment strategies and portfolio holdings of SWFs in order to evaluate the magnitude of their alternative investment exposure.

Alternative Investments by Sovereign Wealth Funds Strategic asset allocation depends on the investment objectives of the investor, risk tolerance and time horizon. For private institutional investors, these investment objectives may be carefully established. For instance, occupational pension funds have the clearly defined investment object of meeting the pension liabilities of their participants during their retirement. SWFs, however, may have a less clearly defined investment objective and may even have contrarian ambitions. Nonetheless, there is much common ground between portfolios of private institutional investors and SWFs. Following the arguments above, scholars have been interested in SWF optimal asset allocation. One stream of the literature deals with stabilization funds that derive their wealth from commodity resources. To stabilize oil and gas revenues, these funds may apply diversification to their portfolio to mitigate risk. The literature on asset allocation suggests that the portfolios of SWFs are less sophisticated than one would expect based on finance theory. A preference for local markets has been reported. (Bernstein, Lerner, and Schoar 2013; Dyck and Morse 2011). With regard to stabilization funds, diversification may be an important component for their asset allocation. In line with earlier findings on asset liability management of institutional investors such as pension

254    Co-Investments of Sovereign Wealth Funds in Private Equity funds, Bodie and Briere (2014) examine the optimal asset allocation for SWFs. Taking into account a broad definition of the sovereign, they include all entities subordinated to the state and all balance sheet items. The main concern of this approach is that these liabilities may be less well defined and difficult to measure precisely. Table 11.2 shows that the strategic asset allocation of SWFs is tilted toward alternative investments. Of the 15 SWF funds that we include in our sample, the average allocation to alternatives is 22%. This is comparable to the bond investments of the portfolios, although the average holdings are slightly higher for the bond allocation. Moreover, the data shows that the main exposure of the portfolio is public equity with 40% of their portfolio allocated to either global, local or emerging equities. Overall, the average portfolio cannot be associated with a risk averse tolerance, indicating that some funds may seek attractive returns. Table 11.2 also reveals that the variability of strategic asset allocation can vary substantially from fund to fund. It indicates that there are large variations in investment strategies among SWFs, rendering general conclusions for SWFs rather difficult. Focusing on alternatives, however, Table 11.2 indicates that for typical SWF allocations, ranges can be quite high. Although some funds may even have 70% of their assets allocated to alternative investments, there are some development funds that solely consist of only alternative investments. Since many of the SWFs do not publicly disclose their strategic asset allocation, we chose funds of the the International Forum of Sovereign Wealth Funds (IFSWF) member group that report their strategic asset allocation on their website. The estimates in Table 11.2 may be under-​reported due to some funds not reporting their strategic asset weights. These funds do disclose their strategic investments which consists mostly of alternative investments. Given the large exposure of SWFs to alternative investments, this suggests that some asset classes may be affected by SWFs. Typically, alternative assets have a smaller market capitalization than public equity and debt markets. One the one hand, this may lead, Table 11.2 Alternative Tilt of Sovereign Wealth Funds in their Strategic Asset Allocation Portfolio Characteristics Asset classes

Average

Median

Min

Max

Equity

39.55%

43.50%

7.80%

80.00%

Bonds

29.90%

20.70%

0.00%

70.00%

Alternative

22.33%

20.90%

0.00%

70.00%

8.21%

2.00%

0.00%

34.70%

Cash

The data is determined by all SWFs that are members of IFSWF and that reported their strategic asset allocations for 2015. While some funds denote more detailed information on their allocations, we focus on the four main asset categories: equity, bonds, alternatives and cash. For equities and bonds, we use publicly traded security.

Joseph A. McCahery and F. Alexander de Roode    255 in combination with a government’s focus on stimulating economic development, to severe market frictions. On the other hand, investments in this class may create a conflict between the investment objectives of the SWFs and their investment policies. Again, there is much empirical research that confirms SWFs move toward alternatives. Moreover, Chhaochharia and Laeven (2009) analyze investment allocations of SWFs in detail, finding that funds are more likely to invest in local markets or in countries with similar social and cultural norms. Indeed, SWFs are also more prone to fulfill various investment goals that come at a cost of diversification compared to an optimal investment portfolio. Since the financial crisis of 2008, SWFs have reduced their asset allocations to equities and increased their allocations to direct investments in illiquid assets (Prequin 2015). Prior work indicates that SWFs have major allocations to real assets, including property and infrastructure that meet the preferences of long-​term institutional investors (Clark and Monk 2009). With regard to infrastructure, recently formed SWFs have expressed an increased interest in investing in developing market and domestic infrastructure projects (Gelb et al. 2014). In addition, it is possible that other SWFs will increasingly turn to infrastructure in order to improve the quality of public spending and fuel the growth of private investor interest. Along with the long-​term investment horizon, infrastructure investment is likely to offer additional diversification and stable inflation adjusted cash flows that can reduce portfolio volatility (Croce, Stewart, and Yermo 2011). However, we must acknowledge that long-​term infrastructure investments are typically associated with a long lock-​up period and may have hidden risks. Political risk in terms of profitability and risk of technology advancements can render these investments less attractive. One possible explanation for this preference is that some measure of political pressure may induce SWFs to invest in local projects that are politically desirable but less profitable. The expectation is that, given that the government would seek to increase local investments to an even greater degree, SWFs run the risk of inducing a higher weighting of less-​profitable investments for the participating private sector funds. This argument overlooks two essential points. First, the claim overlooks the possibility that such an investment could boost regional financial cooperation among developing economies and improve the local business environment (Gelb et al. 2014). Second, another possibility is that infrastructure investments may provide long-​term cash streams that offer a protection against inflation as they are linked to macroeconomic development. In much the same spirit, real estate is the other key asset class that is likely to attract SWF investment. For example, a BlackRock survey of 100 investors with over US$6 trillion assets under management found that 49% expect to increase asset allocations to real estate (Treacy, Cornet, and Warner 2015). One of the key drivers of this increased interest in real estate is the current environment of low interest rates. Given the low rates found elsewhere, the possible yields from real estate have become more compelling (Allen 2014). As rents tend to rise with real earnings, investments in real estate are attractive, although direct investments may entail more risk (Cotter and Roll 2015). Real

256    Co-Investments of Sovereign Wealth Funds in Private Equity estate is the type of investment that may offer portfolio diversification as an asset class (Goetzmann and Ibbotson 1990). However, over longer horizons real estate investments are less attractive from a return perspective (Eichholtz 1997). While the financial attractiveness of real estate investments are much debated, investments in real estate, such as residential housing, are nevertheless often viewed as socially responsible, increasing the likelihood for SWFs to invest.

Sovereign Wealth Funds and their Market Impact The market impact of SWFs is an important area of research due to the impact of these funds on capital markets in recent years. There are two views on the impact of SWFs on global markets. First, Gilson and Milhaupt (2008) identify market externalities that can arise due to the governance structure of these funds. State-​owned funds, for instance, can have adverse effects on the global markets because their investment behavior is politically, rather than profit maximization, oriented. Second, the development perspective highlights that SWFs have a strategic long-​term investment horizon with a broader scope than short-​term profit maximization (Atkinson and Stiglitz 1980; Stiglitz 1994). Together, these studies reveal why some SWFs deviate from investment decisions motivated by profit maximization and will almost certainly invest in long-​term oriented macroeconomic projects. Similarly, the political theory approach of Shleifer and Vishny (1994) shows that funds may invest in inefficient investments to facilitate political favors. As a consequence, investments influenced by a political mechanism are more likely to have adverse effects on the economy and, therefore, on growth. The impact of agency costs, for example, plays an important role in motivating agents to deviate from the objectives of state-​ backed vehicle ambitions (see, for example, Banerjee 1997; Hart, Shleifer, and Vishny 1997; Tirole 1994). Thus, each of these theories predicts that the inefficiencies are projected on the market. However, recent research on SWFs has provided some evidence of the widespread trend that they are strongly motivated by economic profits and behave similar to private institutional investors in monitoring their investments. Moreover, they have few, if any, financial incentives to accept lower returns on their investments. From this perspective, market externalities or political motivations will be of a much lesser concern for SWFs (see, for example, Bernstein, Lerner, and Schoar 2013). While SWFs are typically seen as long-​term investors, this characteristic is also attributable to many private institutional investors. Many institutional investors are engaged with their investments in order to improve efficiency and governance in public firms. Activists, to a certain extent, exist among traditional investment institutions, but not institutions acting on pure financial incentives. For instance, public sector pension funds and labor unions take lead roles, acting through agents incentivized by prospects of reputational advancement. These actors target companies and challenge their managers with shareholder proposals and “just vote no” campaigns. In contrast,

Joseph A. McCahery and F. Alexander de Roode    257 the hostile activist shareholder role has been taken up by event-​driven activist hedge funds. A typical activist investor takes a large position in a target firms’ stock, criticizes their business plans and governance practices, and confronts their managers, demanding action that enhances shareholder value. The demands, in turn, are likely to include one or more actions assuring a quick return on investment—​sale of the company at a premium, unbundling of the company through the sale or spin-​off of a large division, or a large cash payment to the shareholders in the form of a special dividend or share repurchase. There is evidence that activist strategies are being picked up by SWFs to improve target firm’s performance. To get a sense of the type of strategies favored by SWFs, consider Alberta’s AIMCo’s failed joint attempt with activist hedge fund JANA Partners to take over Dutch based TNT in 2012. By connecting with other SWFs, funds create a unique advantage—​because of the size of their investment—​in influencing the portfolio firm’s governance and influencing management to take decisions that are in the best interests of investors (Gilson and Milhaupt 2008; Smith 1996). In effect, SWFs that exercise their ownership rights in activist campaigns are located in jurisdictions that are most likely to have strong traditions of transparency. Despite the recent increase in transparency, there remains a cloak of mystery surrounding many of the largest funds which are located in non-​transparent and developing countries. Concerns about the need for more transparency are particularly salient in the case of SWFs and this triggered the introduction of the Generally Accepted Principles and Practices for SWFs adopted in Santiago, Chile (“Santiago Principles”). Considerable effort has also been made to create measures of transparency (Truman 2007; Truman 2008). Other measures exist, such as the Linaburg-​ Maduell Transparency index, which is vulnerable to criticism for being too superficial in some of its elements (Bagnall and Truman 2013). Nonetheless, Bagnall and Truman (2013) indicate that the Linaburg-​Maduell Transparency index produces similar results to the SWF scoreboard. In Table 11.3, we summarize the differences in transparency of individual SWFs. Table 11.3 shows that the average score is only 54 out of 100. However, for IFSWF members the score is much higher. The IFSWF members in the sample have about 81% of the total financial wealth of the SWFs. Unsurprisingly, transparency can have important implications for SWFs. Table 11.3 also shows the conditional statistics for funds that have higher transparency levels of 80, 70, 60 and the levels lower than 50 and 40. In terms of financial wealth, 67% of total financial wealth is managed by SWFs with a transparency score that is more than 60. The results of the analysis indicate that only a small proportion of financial wealth is managed by funds with low transparency (scores lower than 40). As was expected, the 17 funds with low transparency are mostly located in developing countries. It is worth noting that since the 2009 scorecard there has been an increase in the number of funds scoring above 80 (from 7 to 12) and 30 or below (from 13 to 14). The increase in lower scoring funds is attributed to the scoring of six new funds in the 2012 scorecard (Bagnall and Truman 2013).

258    Co-Investments of Sovereign Wealth Funds in Private Equity Table 11.3 Sovereign Wealth Funds and Transparency Scores Sample

Transparency Scores Wealth

Foreign Wealth

Percentage of Percentage of Total Wealth Foreign Wealth

No of Funds

SWF average

54

4149

3561

49

IFSWF members

65

3384

2869

81.5%

80.6%

26

Non-​IFSWF members

42

837

740

20.2%

20.8%

23

>80

997

909

24.0%

25.5%

12

Conditional on transparency score

>70

1593

1437

38.4%

40.4%

16

>60

2796

2286

67.4%

64.2%

22

30*

Yes

Malaysia

Khazanah Nasional

1993

25*

No

Korea

Korea Investment Corporation 2005

20

No

New Zealand

Superannuation Fund

2001

13.2

No

United Arab Emirates

Istithmarc

2003

12*

Iran

Iran Foreign Investment Company

2000

12*

Yes

United Arab Emirates

Mubadala Development Company

2002

10*

Yes

a Most recently reported size (in US$billion) b Includes Central Huijin Investment Company c Denotes fund not in manual article search

* Denotes estimate

Finally, we collect events by searching SDC Platinum for transactions with a positive value for the data point Sovereign Wealth Fund Flag. Data on both SWF acquisitions and sales are collected. There are approximately 900 (600) SWF acquisitions (sales/​ divestments). After restricting the events to those involving actual purchases and sales that involve public targets so that we can get returns, the sample is reduced to 170 acquisitions (140 sales).

April Knill and Nathan Mauck    305 After restricting the hand-​collected sample in the same manner as the SDC sample and combining the two datasets (and deleting replicated observations), we are left with 232 acquisitions and 140 sales.7 We only include firms for which we find a suitable benchmark and for which we have a full set of return data for the given period.

Supplemental Data We collect firm-​and market-​specific information on the following variables from Data­ stream: price, return index, local market index, and market value for all target companies. Following Dewenter, Han, and Malatesta (2010), we collect data for a five-​year term surrounding the event. This poses a problem for recent events as not enough time has elapsed for the data to be available. These events are therefore dropped from relevant analyses. The variables included in our regressions are intended to control for relations found in the literature. We include target size in all regressions in keeping with the literature (Ang, Hodrick, Xing, and Zhang 2006), which controls for possible size effects by including market capitalization as a measure of firm size. To control for the potential difference between cross-​border investment and investment within the same country, we include a dummy for investments that involve a target and SWF domiciled in the same nation. Because larger investments can have bigger impacts, we control for the size of the investment as a percent of the target firm’s total assets. We further control for the influence of outliers in the sample by winsorizing the cumulative abnormal returns and volatility ratios at the 5% level to ensure that outliers do not bias results.8

Benchmark Procedure We compare the performance of target firms to that of similar firms using a matched pair benchmarking procedure.9 We match on three criteria: country, industry, and size. Once we have matched on country, we use an industry and size matching procedure to find the matched firms (e.g. Lee and Loughran 1998). Industry classification is from 7   All SWF empirical papers face concerns over limited sample size. This sample size is comparable to other SWF working papers. For instance, Fotak, Bortolloti, and Megginson (2009) have a sample of 182 investments in their analysis of one-​year return performance. Chhaochharia and Laeven (2009) use a large sample of holdings for determinants analysis, but for events with announcement day and relevant return data, their sample is 89 investments. Kotter and Lel (2009) use a sample of 124 purchases in their cross-​sectional analysis, and Dewenter, Han, and Malatesta (2010) use a sample of 178 for their analysis of one-​year return performance. Differences among the samples are likely due to the inclusion or exclusion of certain funds in the search criteria. 8  Winsorizing does not materially affect results involving only the target firm, although benchmark volatility is higher when not controlling for outliers. 9  We match by firm rather than by fund type (i.e. pension funds, mutual funds, etc.). SWFs in our sample generally purchase large stakes all at once, which is different from the purchasing methods of other funds. Further, since we are looking at target performance, this mode of matching is arguably more appropriate.

306    Sovereign Wealth Fund Investment and Firm Volatility Datastream’s Global Industry Classification (e.g. Venkataraman 2001). First, we find all firms with the same industry classification as the target firm. Second, we rank these firms by market capitalization. Last, we select the firm with the closest market capitalization at the end of the month prior to the event.

Summary Statistics Summary statistics and a related correlation matrix for the one-​year prior and one-​year after SWF acquisition are included in Table 13.2. The number of observations in Panel Table 13.2 Data Characteristics Panel A: Summary Statistics Variables

N

Target Return

2,837

Firm Volatility

Mean

Median

Std. Dev.

Min

Max

0.01

–​0.02

0.072

–​16.03

101.92

2,837

0.03

0.02

0.001

0.00

1.57

Target Size (US$million)

2,837

373.94

3.34

0.879

0.011

Target Sharpe

2,837

0.00

0.00

0.004

-​0.82

1.32

Target Treynor

2,650

0.00

0.00

0.000

–​0.78

0.34

Target Return to Idiosyncratic Risk

2,655

0.00

0.00

0.005

–​1.07

1.14

Target Beta

2,650

0.63

0.64

0.006

–​6.27

7.38

Target Idiosyncratic Risk

2,655

0.03

0.02

0.003

0.00

3.79

Benchmark Return

2,837

–​0.06

–​0.01

0.013

–​7.48

3.78

Benchmark Volatility

2,837

0.03

0.02

0.000

0.00

0.45

Benchmark Size (US$million)

2,837

5.72

0.64

0.430

0.03

23,893.96

Benchmark Beta

2,650

0.77

0.75

0.011

–​11.49

13.30

Benchmark Idiosyncratic Risk

2,655

0.02

0.02

0.000

0.00

0.57

Investment (%)

120

21.69

10.38

2.677

0.00

100

Investment (US$million)

120

68.67

0.18

0.683

2.00

7,789.64

Same Country

2,837

0.30

0

0.009

0

1

Oil Producing

2,837

0.70

1

0.009

0

1

G10

2,837

0.27

0

0.002

0

1

Media

2,837

0.32

0

0.002

0

1

SWF Event Dummy

2,837

0.49

0

0.003

0

1

144,000.00

April Knill and Nathan Mauck    307 Table 13.2 (Continued) Panel B: Correlation (1) Target Sharpe (1) SWF Investment (2)

(2)

(3)

(4)

(5)

(7)

1 –​0.07

1

0.36

–​0.06

Target Volatility (4)

–​0.01

0.09

–​0.02

Target Size (5)

–​0.01

0.06

0.02

–​0.04

1

Investment % (6)

0.04

0.13

0.01

–​0.01

0.30

Same Country (7)

0.00

0.03

0.03

–​0.01

-​0.03

Benchmark Sharpe (3)

(6)

1 1

1 –​0.04

1

*Bold numbers indicate significance at 5%. This table provides summary statistics for acquisition target firms on the event date and the correlation table for the one-​year firm volatility ratio panel regressions, respectively. Target (Benchmark) Return is the return of the target of SWF investment (benchmark). Target (Benchmark) Volatility is the standard deviation of monthly returns over month t for the target of SWF investment (benchmark). Target Size is the average market value for the SWF Target over month t. The Sharpe (Treynor) Ratios use the standard deviation of returns (Beta) as the denominator of the dependent m variable and returns as the numerator. Beta is the coefficient of the Rt component of the following m regression: Ri ,t = βi * Rt + ei ,t . Market Return is the average daily log difference of the index related to given target over month t. Investment (%) is the percent stake that was reported for the event. Investment ($) is the amount of the stake involved in US$millions. Same Country is a dummy variable that takes on a value of one if the SWF and target are domiciled in the same nation and zero otherwise. Oil Producing (G10) is a dummy variable which takes on a value of one if the SWF is from an (a) oil-​producing (G10) nation and zero otherwise. Media is a dummy variable which takes on a value of one if the investment was covered by the media and zero otherwise. SWF Investment is a dummy variable equal to zero before SWF purchase and equal to one after. N is the number of observations used in our analysis.

A reflects the number of firm-​months in the sample with the exception of investment amount and investment percent, which are only tabulated once per event. In general, we find that the summary statistics for the target and benchmark are similar indicating a reasonably good match. For example, median return and volatility are roughly the same for the target and benchmark. The mean stake taken by SWFs in our sample is about 22% with a maximum stake of 100%. Stakes in US firms tend to be smaller relative to the rest of world and are typically under 10%. Consequently, we see that the mean stake is positively skewed and the median stake is 10%. Approximately 30% of our sample observations have the same domicile countries. The correlation matrix in Panel B provides information about the SWF investment dummy variable. There is significantly positive correlation between the SWF investment dummy and target volatility, target size, and investment amount.

308    Sovereign Wealth Fund Investment and Firm Volatility

Results Difference in Means Tests In Panel A of Table 13.3 the results show that raw returns for both target and benchmark-​ adjusted returns are lower (significant at the 1% and 5% level, respectively) in the year Table 13.3 Difference in Means Tests Target 1 year

Benchmark Adjusted 3 year

5 year

1 year

3 year

5 year

Panel A: Acquisitions Sample Return (Raw)

–​.00095***

–​.00026**

.00022*

–​.04589**

Standard Deviation

–​.00010

–​.00392***

–​.00736***

–​.00153***

Beta

–​.00089

.00425***

.00740***

Idiosyncratic Risk

.00005

–​.00375***

–​.00844***

Sharpe Ratio

–​.03131***

–​.00754

Treynor Ratio

–​.00158***

Return to Idio. Risk Ratio

–​.03743***

.01074

–​.04279**

–​.00213***

–​.00320***

.00504***

.00878***

–​.13213***

–​.26814***

–​.41415***

.01358**

–​.00687

–​.00680

–​.01225*

–​.00044**

.00037*

–​.00065**

–​.00009

–​.00009

–​.01162**

.01128**

–​.00874

–​.00476

–​.00799

.00008

.00048***

–​.00369

.00096

.05183***

–​.26747

Panel B: Sales Sample Return (Raw)

–​.00028

Standard Deviation

–​.00317***

–​.00536***

–​.00655***

–​.00312***

–​.00142**

–​.00233***

Beta

–​.00469*

.00213

.00557**

–​.44749*

.20352

.53125**

Idiosyncratic Risk

–​.00249***

–​.00522***

–​.00829***

–​.27289***

–​.06471

–​.17662**

Sharpe Ratio

–​.01314

.01223**

.03228***

–​.01059

–​.00322

.01179

Treynor Ratio

–​.00018

.00020

.00117***

–​.00014

–​.00026

.00077**

Return to Idio. Risk Ratio

–​.00500

.00935

.03238***

–​.00500

.00056

.01352*

The variables of interest are defined as in Table 13.2. The reported results test the difference in means for the variable of interest in the noted period of time before and after SWF investment (i.e. After-​ Before). There are 135, 95, and 57 (95, 66, and 50) acquisitions (sales) for the one-​, three-​, and five-​year windows, respectively. The benchmark (BM) adjusted results use the difference between target and benchmark firms. ***, **, and * indicate statistical significance at 1%, 5%, and 10% levels, respectively.

April Knill and Nathan Mauck    309 following SWF acquisitions. This is consistent with the event study results, which find poor return performance in the year following SWF investment. When the window is extended to three years, only the raw returns remain negative and significant and at five years the change in raw (benchmark-​adjusted) return is positive (negative) and significant at the 10% (5%) level. In looking at these target firms alone, the results suggest that the firms do poorly in the short term and marginally well in the long term. Once we look at their performance relative to their peers, however, the firms are associated with negative return performance in the short and long term as benchmark-​adjusted returns are negative at both the one-​year and five-​year windows. Panel A also indicates a change in risk following SWF acquisitions. The benchmark-​ adjusted standard deviation of returns decreases for one, three, and five years after SWF investment. This result holds for the three-​and five-​year windows when compared to the target firms’ own past performance. Total volatility decreases by anywhere from 15 to 74 basis points, depending on whether the standard deviation is benchmark-​adjusted and on the time frame. The decreased standard deviation of returns indicates that firms become less volatile following SWF investment and that this reduction seems persistent. Decomposition of total risk into its systematic and idiosyncratic components indicates that the decrease in benchmark-​adjusted volatility for the one-​, three-​, and five-​ year windows is related to a decrease in idiosyncratic risk. Idiosyncratic risk is reduced in both the unadjusted and adjusted measures across time. In fact, this decrease increases as the time period grows longer. For example, in the unadjusted measure, idiosyncratic risk is reduced by 37 basis points in the three-​year window and 84 basis points in the five-​year window. Looking at the benchmark-​adjusted measure, the risk is reduced by 13% in the one-​year window, 27% in the three-​year window, and 41% in the five-​year window. This decrease in idiosyncratic risk is consistent with the cross-​listing literature but inconsistent with the blockholder literature, which finds increased idiosyncratic volatility following blockholder investment. Recall that this predicted relation is at least partially related to better firm information in quantity and quality (Brockman and Yan 2009). Combining the intuition of both the results and the predictions from the literature suggests that unlike regular blockholders, SWFs are associated with a weaker information environment. We might attribute this difference to: (1) the informational disadvantage of foreign investors highlighted in Choe, Kho, and Stulz (2005); (2) the reduction in information when a large blockholder does not have monitoring capabilities since they often do not take board seats; or (3) a lack of experience. Since we find a decrease in return with a corresponding decrease in volatility, it is necessary to examine risk and return together to determine the level of compensated risk associated with SWF investments. Looking to the Sharpe, Treynor, and return-​to-​ idiosyncratic risk ratios, we find that relative to its own past performance, targets see a deterioration in the return-​to-​risk relation for all three volatility ratios at the one-​year window (significant at the 1% level). For all three ratios, the reduction in the ratio corresponds to a reduction in the level of compensated risk. There is also deterioration in the Treynor and return-​to-​idiosyncratic risk ratios at the three-​year window (significant at the 5% level). Benchmark-​adjusted return-​to-​risk ratios show either a statistically significant decrease in performance using the Treynor Ratio or an insignificant decrease

310    Sovereign Wealth Fund Investment and Firm Volatility in performance using the Sharpe and return-​to-​idiosyncratic risk ratios in the one-​and three-​year windows. The five-​year window shows a statistically significant decrease (at the 10% level) in the Sharpe Ratio. Looking at these results collectively, we see evidence of destabilization. These impacts are short-​term (i.e. one-​and three-​year terms) when looking at the return/​risk ratios. Based on the observed decrease in idiosyncratic risk following SWF investment, poor performance may be due to a weaker information environment for the firm. Unadjusted figures indicate some reversal at the five-​year window. These results are consistent with underperformance, which reverses at longer horizons, but the reversal is not sufficient to match benchmark performance over the same period. It is also necessary to note here that this analysis does not match sales to acquisitions (due to difficulty based on the information given in SDC Platinum).10 Inasmuch as sales are associated with a reversal of this negative effect (see below), this reversal may well be some of the SWFs divesting at least part of their investment. To be sure, our measures are therefore conservative; the real values for the five-​year window could be less positive, insignificant, or even negative.11 Figure 13.1 supplements this analysis nicely by demonstrating the evolution of the volatility ratios. The Sharpe Ratio and return-​to-​idiosyncratic risk ratio are both increasing leading up to SWF investment, then fall in the year after and begin a climb up again at three and five years. Following Dewenter, Han, and Malatesta (2010), we also examine SWF sales. The results are shown in Panel B of Table 13.4. We do not find a statistically significant difference in either raw or benchmark-​adjusted returns for the one-​and three-​year windows. At the five-​year window we find that both raw and benchmark-​adjusted returns increase (significant at the 1% level). From a return perspective, SWF sales indicate positive news for firms in the five-​year window. SWF sales are associated with a reduction (significant at the 1% level) in firm risk as measured by standard deviation of returns and idiosyncratic risk in the one-​, three-​and five-​year windows. This generally holds true using benchmark-​adjusted risk as well. Thus, the risk results indicate that SWF sales are positive news in all time horizons. Further, from an information perspective, the evidence suggests that the information environment of the firm does not improve following SWF sales. This may suggest that the SWFs sell their stakes to other foreign investors, who are equally disadvantaged at producing information about the target. However, we also note that SWFs do not necessarily sell their whole stake in this sample, and thus may still negatively influence the information environment. The return-​to-​risk ratios allow us to evaluate the overall relation between SWF sales and subsequent firm performance. We generally find an insignificant relationship for the one-​and three-​year windows. The five-​year window results suggest that SWF sales are associated with an increase in the compensation of risk as all three ratios increase in this period (significant at the 1% level). Benchmark-​adjusted ratios lead to the same 10  SDC reports percent owned after the transaction, but it applies to the buying firm not the selling firm. 11  When we exclude firms that are at least partially divested during the holding period, the five-​year window Treynor Ratio result becomes statistically insignificant.

April Knill and Nathan Mauck    311 Acquisitions

0.03 0.025 0.02 0.015 0.01

Sharpe Ratio

0.005

Treynor Ratio

0 −0.005

−5

−3

−1

1

3

5

Return to Idiosyncratic Risk Ratio

−0.01 −0.015 −0.02 Sales

0.035 0.03 0.025 0.02 0.015 0.01

Sharpe Ratio

0.005

Treynor Ratio

0 −0.005

−5

−3

−1

1

3

5

−0.01

Return to Idiosyncratic Risk Ratio

−0.015 −0.02

Figure 13.1  Graphs for benchmark-​adjusted volatility ratios

general conclusion. Overall, firms sold by SWFs see an improvement in long-​term performance as return is increased and total risk is decreased. Thus, as SWFs become more removed from the target, the performance improves. This may be due to an improved information environment after the SWF divests or indicates that SWFs are exiting formerly distressed firms after the target has stabilized. The second graph in Figure 13.1 shows the average volatility ratios for SWF sales from the five years prior to the sale to five years after. The Sharpe Ratio and return-​to-​ idiosyncratic risk ratio are increasing in the five years leading up to the sale, decrease in the year after the sale and then continue the increase over three and five years. This trend is consistent with SWFs selling recently improved performers.

Panel Regressions Panel A of Table 13.4 displays results examining comprehensive return-​to-​risk ratios for target firms in the one-​, three-​, and five-​year windows following SWF investment. Using

Table 13.4 Volatility Ratios Sharpe Ratio 1 Year

3 Years

1

Return-​to-​idiosyncratic risk ratio

Treynor Ratio

2

5 Years

1 Year

3 Years

5 Years

3

4

5

6

-​0.001

–​0.001***

–​0.000

0.000

[0.006]

[0.000]

[0.000]

[0.000]

1 Year 7

3 Years 8

5 Years 9

Panel A: Acquisitions Sample SWF Investment

–​0.027*** –​0.014** [0.009]

Volatility Ratiot-​1

[0.006]

–​0.034*** –​0.010* [0.009]

[0.006]

–​0.152*** -​0.120*** –​0.116*** –​0.141*** –​0.086*** 0.023* –​0.139*** –​0.056*** [0.013]

0.344***

0.346***

[0.018]

[0.013]

0.354*** 0.448***

0.395*** 0.398*** 0.339***

0.326***

0.334***

[0.013]

[0.014]

[0.021]

[0.014]

[0.015]

[0.017]

[0.012]

[0.013]

Target Volatility –​0.041

0.496***

0.343*

–​0.018*

0.011*

0.001

–​0.125

0.283*

0.228

[0.275]

[0.181]

[0.188]

[0.010]

[0.006]

[0.007]

[0.264]

[0.163]

[0.168]

47.176*** 33.376**

–​0.126

0.586

0.299

12.416

24.898**

19.281*

[0.718]

[0.428]

[0.424]

[18.094]

[11.644]

[11.458]

0.316

[19.167] [14.850] Same Country

[14.640]

[0.017]

[0.012]

[0.013]

–​0.017

[0.012]

Target Size

[0.013]

[0.006]

[0.017]

BM Volatility Ratio

[0.018]

0.007

–​0.007

–​0.000

0.005

-​0.000

0.000

0.001*

–​0.002

0.002

0.008

[0.010]

[0.008]

[0.009]

[0.000]

[0.000]

[0.000]

[0.011]

[0.007]

[0.008]

Investment (%) 0.002***

0.001*

0.000

0.000***

0.000*

0.000

0.002***

0.001

–​0.000

[0.001]

[0.001]

[0.001]

[0.000]

[0.000]

[0.000]

[0.000]

[0.001]

[0.001]

–​0.037*** -​0.032**

0.001*

–​0.000

–​0.001

0.009

–​0.015

–​0.029**

Constant

0.021 [0.018]

[0.014]

[0.013]

[0.001]

[0.000]

[0.000]

[0.019]

[0.012]

[0.012]

2837

5285

4954

2974

5758

5347

2990

5807

5416

# of SWFs

19

17

11

19

17

11

19

17

11

# of Targets

Observations

132

93

57

129

91

55

129

91

55

Model χ2

470***

812***

737***

557***

818***

739***

506***

758***

683***

Pseudo R2

0.10

0.11

0.11

0.13

0.11

0.12

0.12

0.11

0.11

0.011

0.030***

–​0.000

0.000

0.001***

–​0.014

0.007

0.031***

[0.008]

[0.008]

[0.000]

[0.000]

[0.000]

[0.011]

[0.007]

[0.008]

Panel B: Sales Sample SWF Investment –​0.021* [0.011]

Volatility Ratiot-​1 –​0.175*** –​0.146*** –0​ .156*** –0​ .234*** –0​ .141*** –​0.136*** –0​ .176*** –0​ .115*** –0​ .128*** BM Volatility Ratio

[0.023]

[0.016]

[0.015]

0.301***

0.318***

[0.021]

[0.016]

[0.022]

[0.022]

[0.016]

[0.016]

0.274*** 0.308***

0.316*** 0.279*** 0.271***

0.320***

0.280***

[0.015]

[0.020]

[0.016]

[0.016]

[0.026]

[0.016]

[0.016]

[0.018]

[0.020]

Table 13.4 (Continued) Sharpe Ratio 1 Year 1

Return-​to-​idiosyncratic risk ratio

Treynor Ratio

3 Years

5 Years

1 Year

3 Years

4

5

0.730***

0.015

0.034***

[0.264]

[0.013]

[0.010]

5 Years

2

3

6

Target Volatility 0.354

1.130***

[0.361]

[0.285]

0.851***

0.642***

0.602***

0.020

0.006

0.008

[0.305]

[0.245]

[0.211]

[0.014]

[0.010]

[0.008]

–​0.005

–​0.012

–​0.010

0.000

–​0.000

–​0.000

[0.012]

[0.010]

[0.009]

[0.001]

[0.000]

0.001

-​0.001

-0​ .002*** 0.000**

[0.001]

[0.001]

1 Year

3 Years

5 Years

7

8

9

–​0.010

0.256

0.582***

0.162

[0.009]

[0.296]

[0.223]

[0.217]

0.536*

0.349

0.426**

[0.302]

[0.229]

[0.195]

0.005

–​0.008

–​0.009

[0.000]

[0.012]

[0.009]

[0.008]

0.000

–​0.000

0.002***

0.000

–​0.002

[0.000]

[0.000]

[0.000]

[0.001]

[0.001]

[0.001]

–​0.004

0.000

–​0.002

–​0.020

–​0.027

–0​ .043***

Panel B: Sales Sample

Target Size Same Country Investment (%) Constant

–​0.016

Observations # of SWFs # of Targets

[0.001]

–​0.045** –0​ .057***

[0.021]

[0.020]

[0.018]

[0.007]

[0.003]

[0.002]

[0.024]

[0.018]

[0.016]

1735

3274

3800

1800

3490

3747

1802

3493

3748

17

14

13

17

14

13

17

14

13

84

58

46

79

58

46

79

58

46

Model χ2

281***

495***

499***

280***

361***

334***

269***

474***

421***

Pseudo R2

0.09

0.09

0.07

0.05

0.06

0.05

0.09

0.09

0.07

The following volatility ratio regressions are specified:



SharpeiT,t = θ1,0 + θ1,1SharpeiT,t −1 + θ1,2ViT,t + θ1,3SWFI i ,t + θ1,4 SIZEiT,t + θ1,5 FiT,t + θ1,6Sharpe Bj ,t + µ1,t

TreynoriT,t = θ2 ,0 + θ2 ,1TreynoriT,t −1 + θ2 ,2ViT,t + θ2 ,3SWFI i ,t + θ2 ,4 SIZEiT,t + θ2 ,5 FiT,t + θ2 ,6TreynorjB,t + µ 2 ,t Return / IdioiT,t = θ3,0 + θ3,1Return / IdioiT,t + θ3,2ViT,t + θ3,3SWFI i ,t + θ3,4 SIZEiT,t + θ3,5 FiT,t



+ θReturn / Idio Bj ,t + µ 3,t ,



(1)



(2) (3)

We use raw return for the numerator of these volatility ratios. The Sharpe (Treynor) Ratios use the standard deviation of returns (Beta) as the denominator of the dependent variable and returns as the numerator. Beta is m the coefficient of the Rt component of the following regression: Ri ,t = βi * Rtm + ei ,t . SWFI is a dummy variable equal to zero in the months before SWF investment and equal to one in the months after. Fi,t is a vector of investment specific information including same country and % investment. Same Country is a dummy variable equal to one if the target is domiciled in the same nation as the SWF. Specifically, Investment (%) is the stake taken in the target by an SWF measured as a percent. ViT,t , is the average daily standard deviation of target returns over month t. Standard errors are in brackets. ***, **, and * indicate statistical significance at 1%, 5%, and 10% levels, respectively.

314    Sovereign Wealth Fund Investment and Firm Volatility ratios that evaluate the return-​to-​risk relation enables us to gain further insight into firm performance following SWF investment. Respective volatility ratios (i.e. Sharpe Ratio, Treynor Ratio, and return-​to-​idiosyncratic risk ratio) are the dependent variables in our regressions where these ratios are defined in equations (1) to (3).12 The marginal effect of SWF investment on the Sharpe Ratio is –​0.027 and –​0.014 for the one-​(significant at the 1% level) and three-​year (significant at the 5% level) windows, respectively (specifications 1 and 2). The negative and significant coefficient meshes nicely with the findings in Table 13.3 and indicates that after SWF investment, we see uncompensated total risk relative to before the event. In other words, although the firm’s return has decreased, we don’t see a sufficient corresponding decrease in total risk to preserve the return-​to-​risk relation. The marginal effect of SWF investment on the Treynor Ratio is –​0.001 in the one-​year window (specification 4) and is significant at the 1% level. This result indicates that there is uncompensated systematic risk following SWF investment. The deterioration in this relation is evidence of destabilization at the firm level. This result may also be of interest to short-​term investors in firms receiving SWF investment as it indicates that non-​ diversifiable risk is no longer compensated at the same level. The marginal effect of SWF investment on the return-​to-​idiosyncratic risk ratio is –​0.034 (significant at the 1% level) and –​0.010 (significant at the 10% level) for the one-​and three-​year windows, respectively. Here we see that there is uncompensated idiosyncratic risk following SWF investment. Although the benchmark-​adjusted return and idiosyncratic risk move in the same direction as predicted by Jiang and Lee (2006) and Fu (2009), it seems that the idiosyncratic risk level has not adjusted enough to preserve the pricing relation prior to the event with SWF investments. Taking the results collectively, the volatility ratios provide the most convincing evidence thus far regarding the potential destabilization effect of SWF investment. The statistically significant negative coefficient in the Sharpe, Treynor, and idiosyncratic risk ratios indicates that the decreased return experienced by target firms is not compensated by a sufficient corresponding decrease in risk for these same firms in the one-​and three-​year windows. Panel B shows results following SWF sales. The marginal effect of SWF investment on the Sharpe Ratio is approximately –​0.021 (significant at the 10% level) and 0.030 (significant at the 1% level) for the one-​and five-​year windows, respectively. The results suggest uncompensated risk in the one-​year following SWF sales, but an improvement in the compensation of risk in the five-​year window. The marginal effect of SWF sales on the Treynor Ratio is a positive 0.001, significant at the 1% level for the five-​year window. There is improvement in the compensation of systematic risk following SWF sales. The marginal effect of SWF sales on the return-​to-​idiosyncratic risk ratio is 0.031 (significant at the 1% level) for the five-​year window. Again, there is improvement in

12 

Note that we make no comment as to a “correct” return-​to-​risk relation but, rather, just document the changes in the relation following SWF investment.

April Knill and Nathan Mauck    315 the compensation of risk following SWF sales. Combined with the acquisition results, the volatility ratios suggest that SWFs involvement is not positive news for firms. Performance deteriorates following investment and improves following sales. If risk is not compensated as well during investment in these targets, management and existing shareholders of the target firm, who are often concerned with short-​term investment horizons, should be cautious about investment by these blockholders. In fact, the SWFs themselves should be concerned too. Although some of these SWFs assert that they are long-​term investors (in which case short-​term impacts may be inconsequential), managers in these funds often need to substantiate interim performance to high-​ranking government officials. If SWF investment is in fact destabilizing, as the results in Table 13.4 imply, does the media play a role in the destabilization, or will especially destabilizing events be more likely to receive media attention? If either of these is the case, we would expect to see a lack of statistical significance for the non-​media sub-​sample, or at least a considerable difference between the volatility ratios for the media and non-​media sub-​samples. Tetlock (2007) shows that media pessimism predicts negative market returns. In a recent working paper, Liu, Sherman, and Zhang (2008) find evidence in the IPO market that suggests media attention is related to permanent changes in investor demand for a given firm. Consequently, we believe it is reasonable to expect that the sample involving media mention may behave differently to the non-​media mention sample. Our sample of media events consists of transactions that appear in any of the major publications covered in the LexisNexis database. Panel A of Table 13.5 shows these results for acquisitions. We see that the decrease in the Sharpe Ratio following SWF investment of the target firms is driven mainly by the media sample. The magnitude and significance of the negative relation between SWF investment and the Sharpe Ratio is greater for the media sample (–​0.045 significant at 1% versus and insignificant –​0.018) in the one-​year window. The difference for the two samples is also statistically significant (at the 1% level). That said, the marginal effect of SWF investment in those events not mentioned in the media is negative and significant at the three-​year window. Although the media tends to cover larger, more visible firms and investments, control variables in the specifications control for these differences. These results imply that the media may be somewhat culpable for the immediate reduction in compensated risk but that the bulk of the reduction would happen anyway, albeit delayed. The decrease in the Treynor Ratio is driven mainly by the media sample in the one-​ year window. The effect is negative and significant for both samples, but is larger for the media sample and the difference is significant (at the 1% level). Results for the return-​to-​ idiosyncratic risk ratio show a similar pattern for the one-​year window. The media sub-​ sample shows a negative and significant (at the 1% level) effect of SWF investment on return per unit of idiosyncratic risk that is more than twice the effect of the non-​media sample and the difference is statistically significant (at the 1% level). This disparate effect suggests that the media mention leads to a larger reduction in return per unit of idiosyncratic risk. This, in turn, suggests that the fears of the media are potentially well founded, albeit somewhat self-​inflicted.

316    Sovereign Wealth Fund Investment and Firm Volatility Table 13.5 Volatility Ratios for Sub-​Samples Sharpe Ratio 1 Year

Treynor Ratio

3 Years

5 Years 1 Year

Return-​to-​Idio Ratio

3 Years

5 Years 1 Year

3 Years

5 Years

Panel A: Acquisitions Media

–​.045***

–​.008

–​.014

–​.176***

.000

–​.092*

–​.053***

–​.007

–​.015

Non-​Media

–​.018

–​.015**

.000

–​.123***

–​.042

.026

–​.025**

–​.010

.011*

p(difference)

.00***

.09*

.42

.00***

.38

.24

.00***

.14

.78

G10 Non-​G10 p(difference)

–​.001

.013

.042*

–​.049

.004

.107

–​.012

–​.010

.022

–​.034***

–​.014**

–​.005

–​.158***

–​.035

.002

–​.039***

–​.008

.005

.09*

.95

.16

.01**

.64

.20

.01**

.21

.21

-​–​040***

–​.018

–​.005

–​.176***

–​.070*

–​.053

–​.046***

–​.019**

–​.006

–​.018 .00***

–​.012 .03**

–​.002 .63

–​.108** .00***

–​.022 .06*

.011 .52

–​.025** .00***

-​–​006 .03**

.008 .89

G10

–​.039

.032

.026

.000

.145

.119

–​.027

.026

.024

Non-​G10

–​.016

.008

.032***

–​.029

.021

.112***

–​.011

.005

.033***

.05*

.12

.09*

.84

.11

.10

.17

.20

.11

Oil

–​.036*

–​.012

–​.003

–​.150**

.046

.013

–​.033*

–​.014

–​.003

Non-​Oil

–​.015

.015*

.033***

.017

.040

.110***

–​.007

.012*

.036***

p(difference)

.04**

.88

.34

.24

.41

.30

.08*

.96

.24

Oil Non-​Oil p(difference) Panel B: Sales

p(difference)

The following volatility ratio regressions are specified: SharpeiT,t = θ1,0 + θ1,1SharpeiT,t −1 + θ1,2ViT,t + θ1,3SWFI i ,t + θ1,4 SIZEiT,t + θ1,5 FiT,t + θ1,6Sharpe Bj ,t + µ1,t TreynoriT,t = θ2 ,0 + θ2 ,1TreynoriT,t −1 + θ2 ,2ViT,t + θ2 ,3SWFI i ,t + θ2 ,4 SIZEiT,t + θ2 ,5 FiT,t + θ2 ,6TreynorjB,t + µ 2 ,t

(1) (2)

 

Return / IdioiT,t = θ3,0 + θ3,1Return / IdioiT,t + θ3,2ViT,t + θ3,3SWFI i ,t + θ3,4 SIZEiT,t + θ3,5 FiT,t + θReturn / Idio Bj ,t + µ 3,t ,

 

 

(3)

For the numerator of these volatility ratios, we use raw return. The Sharpe (Treynor) Ratios use the standard deviation of returns (Beta) as the denominator of the dependent variable and returns as the numerator. Beta is the coefficient of the Rtm component of the following regression: Ri ,t = βi * Rtm + ei ,t . SWFI is a dummy variable equal to zero in the months before SWF investment and equal to one in the months after. Fi,t is a vector of investment specific information including same country and % investment. Same Country is a dummy variable equal to one if the target is domiciled in the same nation as the SWF. Specifically, Investment (%) is the amount of the stake taken in the target by an SWF measured as the percent of the target acquired in the transaction. ViT,t , is the average daily standard deviation of target returns over month t. The media sample is SWF acquisitions that received media attention. The G10 sample is SWF events involving targets in G10 nations. We report only the coefficient for SWFI although all regressions include the above controls. The coefficient for the Treynor Ratio has been scaled (x100). p(difference) is the p-​value for a test of the difference in coefficients between the two samples examined. Standard errors are in brackets. ***, **, and * indicate statistical significance at 1%, 5%, and 10% levels, respectively.

April Knill and Nathan Mauck    317 We also examine the role of market development. Specifically, we categorize nations as developed (G10 nations) or less developed (non-​G10 nations). We find a negative and significant relationship between SWF investment and the target Sharpe Ratio only in the case of the less developed target nations (–​0.034 and –​0.014 both significant at 1%) in the one-​and three-​year windows. We also see a statistically significant difference between the two samples for the one-​year window (at the 10% level). This result is consistent with the notion that less developed nations may be more susceptible to the possible destabilizing effects of SWFs. The negative relationship between SWF investment and the target Treynor Ratio is also driven by less-​developed target nations. Again, the relation is only significant in the non-​G10 sample and the difference between the two samples is statistically significant (at the 5% level). This evidence is also consistent with targets from less-​ developed nations being more likely to experience destabilization related to SWF investment. Results for the return-​to-​idiosyncratic risk ratio reveal that results are driven by the non-​G10 sample for the one-​year window in terms of magnitude and significance, and the difference between the two samples is statistically significant (at the 5% level). We find that the firm-​level risk ratios are driven by less-​developed target nations, suggesting that firms in more developed nations may not be susceptible to destabilization related to SWF investment. Finally, we examine whether there are differences in performance between oil-​ producing and non-​oil-​producing nations. We find the Sharpe Ratio reduction is confined to the oil-​producing SWFs. This suggests that it is only SWFs from oil-​producing nations that are related to the observed negative performance following SWF acquisitions. Results for the Treynor Ratio indicate similar results in the one-​year window in that we see a significantly larger impact in the oil-​producing SWF nations (0.00 at the 1% level). We find that a reduction in the Treynor Ratio is only present in the three-​year window for oil-​producing SWFs. Similarly, the reduction in the return to idiosyncratic ratio is stronger in the one-​year window and is only present in the three-​year window for oil-​producing SWFs. For all three ratios, the difference between the two samples is statistically significant. Overall, the results suggest that oil-​producing SWFs are related to worse performance than non-​ oil-​producing SWFs. It is possible that oil-​producing SWFs are poorly informed or are at a disadvantage in information production, which leads to the observed poor performance. However, the poor performance may also be related to oil-​producing SWFs’ desire to diversify oil revenues by investing in non-​oil related targets13 or that there are nonfinancial motives for their investment and that the performance of the target is not of primary importance to this investor. 13  Another explanation for SWF performance may be that the lack of disclosure by SWFs is related to the poor performance. We previously presented results comparing SWF performance based on the disclosure level of the fund and did not find a significant difference. This is suggestive evidence that motives other than profit maximization may explain observed performance.

318    Sovereign Wealth Fund Investment and Firm Volatility Panel B of Table 13.5 shows the results of the volatility ratio sub-​sample regressions using the SWF sales as the event of interest. The sales data are based on events solely from SDC; as a result, no media sub-​sample is available. In Panel B there is little difference between G10 and non-​G10 target nations for any of the three volatility ratios in the one-​and three-​year windows. In the five-​year window, the increase in all three ratios is present only in the non-​G10 sample although the difference between samples is only significant for the Sharpe Ratio. This is the same group that saw a reduction in compensated risk following SWF acquisitions, which suggests that targets in less-​developed nations are recouping the negative effects of the SWF investments. The results in Panel B show that sales by oil-​producing SWFs are associated with a reduction for all three volatility ratios in the one-​year window. An increase in all three ratios is present for sales by non-​oil-​producing nations in the five-​year window although the differences between samples are statistically insignificant. Combining these facts with the acquisition sample, the results suggest that oil-​producing SWFs select targets that perform poorly following their investment, and this poor performance continues after the oil-​producing SWFs sell the firm.

Conclusion SWF investment has received increasing attention in the literature. The drastic increase in the size and visibility of SWFs has recently stirred up controversy about their potential to threaten the stability of firms (among other things). This chapter examines the effect of SWF events on the level of compensated risk of target firms and the information possessed by SWFs. We find that SWF investments are associated with a statistically significant decrease in firm return performance, and a statistically significant short-​and long-​term decrease in total firm risk and idiosyncratic risk. After the first year, SWF sales are associated with a reduction in risk and an improvement in return. Collectively, we find that there is in fact evidence to support the contention that SWF investment is destabilizing. The panel regression results regarding the media coverage sub-​sample suggest that in their coverage of SWF news, the media may be partly culpable for the very negative characteristics that they report to instill fear (i.e. destabilization). The observed poor performance of SWF acquisitions may be related to the funds propensity to invest in distressed assets which they are unable to turn around. The poor SWF performance may also be related to our finding that the funds are not well informed. Specifically, our results suggest that oil-​producing funds are poorly informed, especially in the case of cross-​border investments. These results may be of interest to policymakers of both developed and less-​developed nations, both of which are debating the merits of leaving their borders open to foreign investment by sovereign investors. This is particularly important now that the IMF has reversed its position on capital controls suggesting that nations with some capital controls are faring better in the global financial crisis than those without. They may also be

April Knill and Nathan Mauck    319 of interest to management and the existing shareholders of potential target firms since they are both directly impacted by these results in the short term. We intend to research additional topics in SWF investment such as whether political relations between the target domicile and SWF nations factor into target choice.

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Chapter 14

Sovereign Wea lt h  Fu nd s Investment Choices and Implications Around the World Nuno Fernandes

Introduction In this chapter, we study the changing pattern of world capital markets and analyze the role of sovereign wealth funds (SWFs). We examine what drives SWFs to invest in firms and what role these investors play. We are interested in the impact that SWFs have on a firm’s value and performance. To achieve this, we construct an extensive set of observations of SWF investments, consisting of investments of SWFs in more than 8,000 publicly traded firms in 58 countries. SWFs are unique institutions. Besides being large investors with an increasing amount of assets under management, SWFs are very different from traditional large investors, which justifies studying them separately.1 Furthermore, it is not clear a priori what their impact on companies is, since there are arguments for both positive and negative impacts. Thus, one of the objectives of this chapter is to determine what overall impact SWFs have on firms, and what channels SWFs use to affect firm value and performance. Contemporary research offers conflicting evidence about whether SWFs create value for the firms in which they invest. Using event-​study techniques, Bortolotti, Fotak, Megginson, and Miracky (2010), Chhaochharia and Laeven (2009), Dewenter, Han, and Malatesta (2010), and Kotter and Lel (2011) find positive abnormal returns upon announcement of SWF investments.2 However, the evidence using long-​run 1 

Motivated by the different features of SWFs, several asset managers have set up dedicated SWF teams and departments, in order to specifically address the interests of SWF managers. 2  Bernstein, Lerner, and Shoar (2009) examine the direct private equity investment strategies of SWFs and how these are related to their organizational structures. Karolyi and Liao (2009) analyze motives and consequences of cross-​border acquisitions of government-​controlled acquirers.

Nuno Fernandes   323 stock returns is mixed. In multi-​year long-​horizon tests, small differences in risk adjustment and control groups can yield vastly different results. In the case of studies that analyze stock returns of firms following SWF investments, it is even more difficult because of differences in samples, confounding events (such as earnings releases on the same date as the SWF announcement), pre-​event run-​up, selection effects (SWFs do not select random stocks from the population), etc. Thus, moving beyond stock returns may help to resolve this debate. This is another of the objectives of this chapter. Given the large sample of investments used, we can offer a comprehensive view of long-​run impacts, which mitigates several of the methodological problems with long-​run stock returns evidence. To do this, we focus on valuation and firm performance metrics, rather than on stock returns. Besides focusing on a much larger sample of deals, we can also benchmark valuation and performance metrics against control group firms, as well as performing several endogeneity/​identification tests to achieve robust results. In addition to the value creation role of SWFs, we study the selection process of SWFs by investigating the determinants of their holdings. SWFs invest in virtually all countries in the developed world and in a few emerging market economies. As market players, they are certainly a driving force, holding positions in virtually one out of every five firms worldwide. In terms of determinants of their holdings, first, we find that all SWF investors prefer the stock of large and profitable firms. Second, they have a strong bias for firms that enjoy external visibility—​they tend to choose stocks with high analyst coverage. Third, SWFs tend to hold stocks in countries that have strong governance standards and efficient institutions. Finally, their holdings are not related to the amount of research and development (R&D) activity at the firm level, which runs counter to the political argument that one of their motives might be to import innovation to their home countries “through the backdoor.” Additional evidence suggests that SWFs are also not particularly concerned with stock liquidity, which is a characteristic typically valued by short-​ term investors. We also investigate the relationship between SWF ownership and firm value. Controlling for a variety of firm and country characteristics, across different samples and specifications, we find a positive relation between SWF investments and firm value. This evidence is not consistent with the idea that SWFs extract private benefits of control or that they may be investing with a hidden political agenda or to expropriate minority shareholders. SWF purchases of large stakes in foreign equities have generated considerable political controversy. We find that the results are not driven by any specific SWF in our sample. In addition, we analyze a potentially different role of SWF domestic holdings and SWF foreign holdings. Interestingly, the results suggest that it is mostly the foreign holdings that affect firm value, and there is very limited evidence of a domestic impact. The first part of the chapter provides an introduction to SWFs and the controversies that surround them. The second part describes the sample and looks at how SWFs

324   Sovereign Wealth Funds invest. This is followed by an analysis of firm valuation implications of SWF investments. The chapter concludes with some implications of our work.

The Sovereign Wealth Fund Controversy SWFs have existed since at least the 1950s, but their total size worldwide has increased substantially over the past 10 to 15 years. Oil-​producing nations set up the first wave of SWFs after the oil price increases in the 1970s and 1980s. The crisis in East Asia in the late 1990s resulted in a second wave of SWFs being set up. After the crisis, most emerging markets in the region shifted from being debtors to being creditors. Over time, these countries began using some of their foreign reserves to create several new SWFs. The expansion of SWFs’ activities over the past several years has led to concerns that SWFs could destabilize financial markets and the global economy if their investments are motivated by political rather than economic considerations. The recent emergence and size of SWFs such as the China Investment Corporation (CIC) has provoked intense political debate in western countries. The controversy is not new, however. The first SWF, the Kuwait Investment Office established in 1953, ran into trouble in the UK in 1987 when it acquired a stake of more than 20% in British Petroleum (which had been recently privatized). The UK government, headed by Margaret Thatcher at the time, did not like the idea of an important national asset being owned by a foreign government. In the end, the Kuwaitis had to sell more than half of their stake. SWFs are state owned or controlled by the state. Since they are politically connected, they may have objectives other than obtaining optimum financial returns.3 A large body of literature has shown how public enterprises are relatively inefficient, since they cater not only to their shareholders and customers but also to the interests of politicians. Thus, a possible outcome is that firms with SWF ownership become less efficient, and are thus valued less in the market. The fact that SWFs may be interested in political objectives could also lead them to behave differently from other institutional investors. For instance, SWFs may use overseas investments to contribute to economic development in their home country. In order to achieve these political objectives, SWFs could influence firm strategy in a way that is not consistent with creating shareholder value. By taking sizeable stakes in corporations, SWFs could expropriate minority shareholders and pursue interests other than those that maximize portfolio performance. The possibility that SWFs use their 3 

Because of this possibility, legislators and policymakers around the world have often pushed for regulatory action in response to SWFs. In October 2008, the Santiago Principles were voluntarily adopted by SWFs. These principles include a number of agreed procedures to be followed by SWFs in terms of governance, transparency on investments and strategies, risk management and leverage utilization, and have the objective of alleviating concerns over the dangers of their politically motivated investments.

Nuno Fernandes   325 portfolios to achieve social and political objectives suggests we should observe a negative relationship between firm value and SWF ownership. Conversely, SWFs may have advantages over other types of investors. Indeed, SWFs may be able to increase the value of firms by influencing government decisions in favour of the companies in which they are invested. These decisions could be linked to government-​related contracts, or they could open doors for the firms in which they have invested to enter new markets and help these companies market their products in SWF home markets. If these advantages are indeed important, then we should observe a positive relationship between SWF ownership and firm value and performance. Another important difference compared with other institutional investors is that SWFs do not have liabilities (unlike, say, pension funds or insurance companies). This means that they can make long-​term investments without having to worry about short-​term demands for liquidity. Indeed, many SWFs are clearly set up with an intergenerational time horizon, which means they have a longer time horizon than traditional investors. This, in turn, may bring significant advantages for their invested firms in relaxing capital constraints.

Data Description A New Database on Sovereign Wealth Funds Table 14.1 describes the main SWFs around the world and their size (in absolute terms and relative to the country population). The biggest SWF is the Abu Dhabi Investment Authority (ADIA), with assets under management of more than US$875 billion at the end of 2007. ADIA is the largest fund in the world in terms of wealth per capita. The assets under management are close to US$200,000 per capita. We construct a novel data set of SWF international holdings since 2002. Our data collection follows a three-​step procedure. As a first step, we use the Sovereign Wealth Fund Institute (SWFI) list of SWFs (Table 14.1) and concentrate on the top 20 funds. These funds represent 97% of the SWF universe. In our second step, we gather all ownership information for these funds from many different sources. We start with the SWFI website, which contains information about some funds. We then use each individual fund’s web pages. Although average fund transparency is low (and we discuss the different transparency levels of SWFs later in the chapter), some funds provide detailed information on their holdings in their annual reports. We then obtain stock holdings data from the FactSet/​LionShares database, together with Thomson Financial. These are the two leading information sources for global institutional ownership. They gather holdings information from mandatory filings with national regulatory agencies (e.g. Form 13F filings with the Securities and Exchange Commission or the Share Register in the UK) as well as stock exchange announcements, company proxies, and annual reports. We also merge additional holdings using purchase transactions from the Security Data Corporation (SDC) database.

Table 14.1 The World of Sovereign Wealth Funds

Inception Origin

GDP per capita

Wealth in the Fund per capita

875

1976

Oil

$42,501

$194,964

Norges Bank Investment Management

397

1990

Oil

$83,485

$84,995

Government of Singapore Investment Corporation

330

1981

Non-​Commodity

$35,163

$71,911

SAFE Investment Company

312

N/​A

Non-​Commodity

$2,483

$236

Saudi Arabian Monetary Agency

300

N/​A

Oil

$15,724

$12,351

Kuwait Investment Authority 250

1953

Oil

$33,687

$75,529

China Investment Corporation

200

2007

Non-​Commodity

$2,483

$151

Hong Kong Monetary Authority

163

1998

Non-​Commodity

$29,753

$23,409

National Welfare Fund

163

2008

Oil

$9,075

$1,144

Temasek Holdings

159

1974

Non-​Commodity

$35,163

$34,648

Australian Future Fund

61

2004

Non-​Commodity

$43,163

$2,897

Qatar Investment Authority

60

2000

Oil

$78,754

$64,516

Libyan Arab Foreign Investment Company

50

1981

Oil

$11,484

$8,212

Revenue Regulation Fund

47

2000

Oil

$3,903

$1,366

Alaska Permanent Fund

40

1976

Oil

$37,271

$59,403

National Pensions Reserve Fund

31

2001

Non-​Commodity

$60,209

$7,098

Korea Investment Corporation

30

2005

Non-​Commodity

$20,015

$619

Brunei Investment Agency

30

1983

Oil

$31,879

$77,922

Khazanah Nasional

26

1993

Non-​Commodity

$6,956

$957

Kazakhstan National Fund

22

2000

Oil

$6,748

$1,384

Alberta's Heritage Fund

17

1976

Oil

$43,674

$505

New Mexico State Investment Office Trust

16

1958

Non-​Commodity

$29,673

$8,185

Social and Economic Stabilization Fund

16

1985

Copper

$9,884

$935

Assets (Billions)

Abu Dhabi Investment Authority

Fund Name

Table 14.1 (Continued)

Inception Origin

GDP per capita

Wealth in the Fund per capita

15

2000

Non-​Commodity

$16,698

$653

New Zealand Superannuation Fund

14

2003

Non-​commodity

$30,390

$3,259

Oil Stabilization Fund

13

1999

Oil

$3,981

$180

Excess Crude Account

11

2004

Oil

$1,161

$76

Pula Fund

7

1966

Diamonds & Minerals

$7,933

$4,420

Public Investment Fund

5

2008

Oil

$15,724

$218

China-​Africa Development Fund

5

2007

Non-​Commodity

$2,483

$4

Permanent Wyoming Mineral Trust Fund

4

1974

Minerals

$40,676

$12

State Oil Fund

3

1999

Oil

$3,632

$384

Alabama Trust Fund

3

1986

Natural Gas

$31,295

$10

Timor-​Leste Petroleum Fund

3

2005

Oil & Gas

$440

$2,882

Mumtalakat Holding Company

3

2006

Oil

$22,771

$3,403

State Capital Investment Corporation

2

2006

Non-​Commodity

$829

$25

State General Reserve Fund

2

1980

Oil & Gas

$15,714

$778

RAK Investment Authority

1

2005

Oil

$42,501

$267

FIEM

1

1998

Oil

$8,282

$29

Heritage and Stabilization Fund

0.5

2000

Oil

$16,042

$354

Revenue Stabilization Fund

0.4

1956

Phosphates

$686

$4,082

Poverty Action Fund

0.4

1998

Foreign Aid

$381

$11

National Fund for Hydrocarbon Reserves

0.3

2006

Oil, gas

$952

$101

Reserve Fund for Oil

0.2

2007

Oil

$3,756

$12

Fund Name

Assets (Billions)

National Stabilization Fund

This table records the main SWFs around the world and their size at the end of 2007 (in absolute terms and relative to the country population, all in USD). The assets of each fund in US$billion are from the Sovereign Wealth Fund Institute, and GDP per capita in USD is from the World Bank and the US Bureau of Labor and Statistics. The last column divides the total assets of the fund by the country (state) population. Population data are from the World Bank and the US Bureau of Labor and Statistics.

328   Sovereign Wealth Funds In the final step, we conduct extensive news searches in Factiva using different combinations of the funds’ names as key words. We thus clean duplicate observations, incorrect dates, and other misleading observations in SDC.4 Over the full sample period from 2002 to 2007, we use a total of 42,110 individual fund holdings, of which 4,104 are domestic investments. These 42,110 holdings are invested in more than 8,000 distinct firms in 58 countries. At the end of 2007, our database includes a total of 14,087 individual SWF holdings, representing a total of US$640 billion of SWF holdings in publicly traded firms. Following Gompers and Metrick (2001) and Ferreira and Matos (2008), in our empirical analysis we define total SWF Ownership for each firm/​year as the sum of all SWF holdings of a firm’s stock divided by market capitalization at the end of each calendar year. We add the SWF positions in local and American depository receipt (ADR) shares (if the firm held is cross-​listed in the US).5 In many of our tests, we concentrate on large ownership positions of SWFs in firms. In order to do this, we define a dummy variable for large equity investments by SWFs (SWF Dummy) that equals one if the ownership stake held by SWFs in the company is greater than 1%, and zero otherwise. Table 14.2 presents summary statistics on the variables that capture SWF Ownership in firms:  SWF Ownership (continuous variable without any threshold) and SWF Dummy (for large investments). In summary, during the whole sample period, we have a total of 27,431 yearly observations of firms in which SWFs have invested.6 By the end of 2007, a total of 7,683 firms had investments from SWFs. Table 14.2 Descriptive Statistics of the Sovereign Wealth Fund Ownership Variables SWF Ownership—​Any Size

Large Ownership Positions

All years

2007

All years

2007

Observations

27,431

7,683

2,749

871

Mean Ownership

0.80%

0.83%

5.91%

5.33%

St. Dev. Ownership

4.42%

4.27%

12.87%

11.73%

P5% Ownership

0.02%

0.02%

1.05%

1.05%

P95 Ownership

1.74%

1.96%

32.71%

23.85%

This table reports the descriptive statistics of the SWF Ownership variables. The first two columns present statistics—​for all years and for 2007—​of SWF Ownership in the firm, without any threshold restriction. The last two columns present statistics on all the observations where SWF Dummy is equal to one. These represent the subset of observations for which SWF Ownership is greater than 1% of the firm’s shares.

4  This procedure allows us to confirm the results reported by Dewenter, Han, and Malatesta. (2010) that about 15% of announcement dates reported on SDC are wrong. 5  Our results are unchanged if we redefine SWF ownership as the single largest position any SWF has in the company. 6  Since often more than one SWF invests in the same firm, we have more individual holdings than we do unique firms in which SWFs invest.

Nuno Fernandes   329 The average ownership by SWFs in firms in our sample is 0.80%. When we consider large investments (SWF Dummy equals one), we are focusing on a smaller set of observations (2,749 in all years, and 871 in 2007), but with a significantly higher stake in companies. Indeed, most of our tests focus only on this subset of large holdings, where the average stake is close to 6%. Table 14.3 reports the number of firms in different countries in which SWFs invest during the whole sample period. SWFs invest in virtually all countries in the developed world as well as in several emerging market economies. Overall, SWFs invest in close to 23% of firms around the world.

Table 14.3 Sovereign Wealth Fund Holdings by Country Number of Firms in 2007 Country Argentina

Total Number of Firms

SWF Ownership Large Positions % of Stocks

79

7

0

8.86

1,882

235

15

12.49

Austria

97

34

2

35.05

Belgium

134

55

5

41.04

Australia

Bermuda Brazil Canada

78

24

6

30.77

347

88

13

25.36

1,540

247

14

16.04

Chile

192

6

0

3.13

China

1,918

167

91

8.71

16

4

1

25.00

166

45

2

27.11

33

3

0

9.09

Czech Republic Denmark Egypt, Arab Rep. Finland

132

49

7

37.12

France

685

185

18

27.01

Germany

833

149

17

17.89

Greece

288

58

9

20.14

1,013

245

32

24.19

31

4

1

12.90

India

953

75

12

7.87

Indonesia

361

16

5

4.43

74

26

2

35.14

175

14

1

8.00

Hong Kong, China Hungary

Ireland Israel Italy Japan

292

134

8

45.89

4,049

1,421

142

35.10

(Continued)

330   Sovereign Wealth Funds Table 14.3 (Continued) Number of Firms in 2007 Country Korea, Rep.

Total Number of Firms 1,041

276

28

26.51

39

8

2

20.51

1,026

68

42

6.63

123

43

1

34.96

Luxembourg Malaysia Mexico

SWF Ownership Large Positions % of Stocks

Morocco

15

1

1

6.67

Netherlands

181

74

12

40.88

New Zealand

154

52

28

33.77

Norway

196

15

1

7.65

Pakistan

117

4

4

3.42

90

1

0

1.11

Philippines

228

7

0

3.07

Poland

239

1

0

0.42

Peru

Portugal

50

21

2

42.00

Russian Federation

112

20

0

17.86

Singapore

636

110

27

17.30

South Africa

368

94

1

25.54

Spain

147

81

5

55.10

Sweden

352

96

15

27.27

Switzerland

265

123

16

46.42

1,245

372

3

29.88

Thailand

526

36

17

6.84

Turkey

233

18

4

7.73

Taiwan, China

United Arab Emirates United Kingdom United States Total

52

3

3

5.77

2,260

421

119

18.63

7,847

2,446

136

31.17

33,073

7,683

871

23.23

This table reports the total number of listed firms, as well as the number of firms in which SWFs invest (or hold large positions) in each country, at the end of 2007. “% of Stocks” is the percentage of firms in the country with any SWF investment. The number of firms in each market is from Datastream.

Control Variables The initial sample includes all firms in the Datastream/​Worldscope (DS/​WS) database for the years 2002 through 2007. The valuation measure we use is Tobin’s Q, which we compute as follows. For the numerator, we start with the book value of total assets, subtract the book value of equity, and add the market value of equity.

Nuno Fernandes   331 Table 14.4 Descriptive Statistics of Control Variables Source

Mean

Median

St. Dev.

Observations

Q

Worldscope

1.70

1.25

1.15

162,147

INDUSTRY Q

Worldscope

1.35

1.25

0.35

162,147

SIZE

Worldscope

12.39

12.21

2.11

162,147

LEVERAGE

Worldscope

0.23

0.18

0.25

161,604

INVOP

Worldscope

0.15

0.08

0.44

136,647

DY

Worldscope

1.75

0.78

2.66

161,773

R&D

Worldscope

0.02

0.00

0.06

161,982

CAPEX

Worldscope

0.05

0.03

0.07

158,550

CASH

Worldscope

0.18

0.11

0.20

149,543

ADR

Hand-​collected

0.03

0.00

0.45

162,147

FX Sales

Worldscope

13.94

0.00

26.69

162,147

Analysts

Worldscope

2.25

0.00

4.71

162,147

MSCI

MSCI

0.08

0.00

0.28

162,147

Return

Datastream

0.33

0.16

0.80

151,818

TURNOVER

Datastream

1.04

0.46

1.65

160,284

IO Percentage

LionShares

0.14

0.01

0.26

162,147

IO Dummy

LionShares

0.41

0.00

0.49

162,147

This table presents descriptive statistics of different firm-​level variables. Q is Tobin’s Q computed as book value of total assets plus the market value of equity minus the book value of equity divided by total assets; INDUSTRY Q is the median of the individual firm’s Tobin’s Q in a certain industry-​year (based on 2-​digit SIC); SIZE is the log of total assets in USD; LEVERAGE is the ratio of total debt to total assets; INVOP is investment opportunities, computed as the 2-​year geometric sales growth; ROE is the return on equity; DY is the dividend yield; R&D is the ratio of R&D spending to total assets; CAPEX is the ratio of capital expenditures to total assets; CASH is the ratio of cash holdings to total assets; ADR is a dummy equal to one if the stock is cross-​listed on US exchanges, and zero otherwise; FX Sales is the percentage of foreign sales; Analysts is the number of financial analysts following the firm; MSCI is a dummy variable equal to one if the firm is included in the MSCI index, and zero otherwise; Return is the return in the past year; TURNOVER is the trading volume divided by shares outstanding; IO Percentage is the percentage of ownership by institutional investors, IO Dummy is equal to one if institutional investors hold more than 1% of a firm’s shares. The sample period is from 2002 to 2007. All ratios are winsorized at the 1% and 99% levels.

As control variables, we use a number of variables that have been shown to be related to international investment choices.7 Table 14.4 provides details of the control variables used. Using Worldscope and Datastream, we construct measures of firm size (logarithm of firm total assets), financial leverage (total debt divided by total assets), return on equity

7  Other studies have analyzed the preferences of institutional investors in the US (Gompers and Metrick 2001) and internationally (Ferreira and Matos 2008).

332   Sovereign Wealth Funds (ROE), return on assets (ROA), dividend yield, the ratio of cash to total assets, the ratio of capital expenditures to total assets, and firm growth opportunities (sales growth). We use the percentage of foreign sales (FX sales) as a proxy for the product’s market recognition abroad. We also include information on cross-​listings. ADR (American depository receipt) is a dummy that equals one if a company is cross-​listed in a US exchange in that year.8 In addition, we construct a global industry Q, which equals, for each year, the median Q in the industry to which the firm belongs (based on 2-​digit SIC codes). We winsorize financial ratios such as Tobin’s Q, return on equity, and leverage at the bottom and top 1% levels.

Which Companies Do Sovereign Wealth Funds Choose? What kind of characteristics do SWFs look for when choosing their investments? We explore the determinants of SWFs’ choices of different stocks worldwide. First, we examine the role of different firm characteristics related to the business model. We then examine the roles of visibility, capital market conditions, country-​level development, and quality of institutions. We also investigate whether stock selection is determined mainly by the firm’s characteristics, business model, and operating environment or, alternatively, by country characteristics, such as its level of development and the quality of its legal institutions. We explore the effects of country and firm characteristics on the probability of being chosen by an SWF, using probit regressions. Table 14.5 reports results from probit multivariate regressions of SWF Dummy to assess the marginal effect of each covariate. SWF Dummy equals one if the ownership stake held by SWFs in the company is greater than 1%, and zero otherwise. The probit is estimated using data from 2007. In all specifications, we cluster standard errors at the country level. SIZE is the log of total assets in USD; LEVERAGE is the ratio of total debt to total assets; INVOP is a proxy for investment opportunities, computed as the two-​year geometric sales growth; ROE is the return on equity; DY is the dividend yield; R&D is the ratio of R&D spending to total assets; CAPEX is the ratio of capital expenditures to total assets; CASH is the ratio of cash holdings to total assets; ADR is a dummy equal to one if the stock is cross-​listed on US exchanges, and zero otherwise; FX Sales is the percentage of foreign sales; Analysts is the number of financial analysts following the firm; MSCI is a dummy variable that equals one if the firm is included in the MSCI 8  We used several data sources to determine which non-​US firms are cross-​listed in the US and when they entered and exited the listing. For more details see Fernandes and Ferreira (2008), Fernandes, Lel, and Miller (2010), and Fernandes and Giannetti (2014).

Nuno Fernandes   333 index, and zero otherwise; Return is the return in the past year; TURNOVER is the trading volume divided by shares outstanding; and ANTISELF is the anti-​self-​dealing index constructed by Djankov, La Porta, Lopez-​de-​Silanes, and Shleifer (2008). This index measures the ex-​ante and ex-​post effectiveness of regulation and enforcement against violators. GDP is the gross domestic product per capita from the World Bank, used as a proxy for economic development; MCAP/​GDP is the ratio of country market capitalization to GDP, a proxy for financial development computed using World Bank and Datastream data; and TURNOVER_​ct is the ratio of country value traded to GDP, a proxy for liquidity of financial markets computed using World Bank and Datastream data. The results in (1) of Table 14.5 point to the existence of strong demand by SWFs for large stocks (SIZE). This is consistent with findings in Gompers and Metrick (2001) and Ferreira and Matos (2008). The regression also shows that SWFs have a tendency to invest in companies with proven profitability (ROE). This is consistent with the “prudent man” rules that money managers are likely to follow (Del Guercio 1996). They also reveal a preference for firms with lower leverage ratios. One political argument traditionally raised is that SWFs invest in western corporations as a means of gathering corporate intelligence. Our results do not support this interpretation. As indicated in Column (1) of Table 14.5, SWFs do not have any particular preference for high-​tech firms (as proxied by the ratio of R&D to assets) among the universe of public firms. Firm visibility can play a role in the choices made by SWFs, as suggested by market segmentation theories (Merton 1987). We investigate the role of company visibility characteristics in Column (2) of Table 14.5. We study the role of US cross-​listings, MSCI index membership, analyst coverage, and foreign sales as determinants of SWF investments. Overall, we find that SWFs show strong demand for stocks with high analyst coverage. They do not, however, reveal strong demand for firms that belong to MSCI indices. The index membership result is interesting, since SWFs, unlike regular mutual funds, have no pressing business concerns in terms of performance and flows. The money that flows into the fund is far less dependent on performance or any benchmarking, as sovereign funds do not seek new client investment, relying as they do on their respective domestic economies.9 In Column (3) of Table 14.5, we add variables related to capital markets. We do not find that SWFs have a strong preference for liquid stocks, as the coefficient on turnover is not significant. This is consistent with the evidence that SWFs tend to be long-​term investors, so liquidity is not a major concern. We also do not find that SWFs are momentum investors. The coefficient on past yearly return of the stock is negative, but not significant. The results also suggest that SWFs have a preference for shares held by other institutional investors.

9 

We thank Thomas Karol of the Sovereign Investment Council for this comment.

334   Sovereign Wealth Funds Table 14.5 Determinants of Sovereign Wealth Fund Holdings (1)

(2)

(3)

(4)

(5)

(6)

(7)

SIZE

0.1856** 4.39

0.1639** 7.74

0.1675** 7.6

0.1968** 11.15

0.2598** 6.34

0.1939** 10.14

0.1995** 10.46

LEVERAGE

–​0.3483** 3.39

–​0.2486 1.87

–​0.3034* 2.05

–​0.3028* –​0.3782** 1.97 3.16

–​0.2859* 2.24

–​0.3416* 2.37

–​0.03 0.51

–​0.0462 0.85

–​0.0435 0.77

–​0.067 1.15

–​0.0395 0.57

–​0.0198 0.32

–​0.0149 0.24

ROE

0.0041** 2.62

0.0026 1.82

0.003 1.86

0.0029 1.88

0.0045* 2.29

0.0031 1.65

0.0036 1.79

DY

0.0024 0.26

–​0.011 1.15

–​0.0078 0.77

–​0.0186* 2.02

–​0.0096 0.82

–​0.0158 1.35

–​0.0163 1.28

R&D

–​1.3364 0.9

–​1.2714 1.33

–​1.3387 1.34

–​0.7279 0.79

0.2759 0.22

–​0.7672 0.61

–​0.7981 0.62

CAPEX

0.1568 0.57

0.1206 0.41

0.1606 0.55

0.2425 0.94

1.1281** 4.48

0.7203** 2.6

0.7411** 2.65

CASH

0.2027 1.16

0.2486 1.53

0.2182 1.27

0.2408 1.46

0.2731 1.65

0.1418 0.77

0.1335 0.73

–​0.0792 0.48

–​0.0865 0.52

INVOP

ADR

–​0.8278** –​0.8814** –​0.9103** 3.82 3.92 3.92

FX Sales

0.0008 1.05

0.001 1.26

0.0004 0.66

0.0005 0.71

0.0005 0.67

Analysts

0.0280** 4.24

0.0268** 4.25

0.0245** 4.35

0.0304** 4.34

0.0288** 4.5

MSCI

–​0.0066 0.04

–​0.0181 0.12

–​0.052 0.35

–​0.1456 0.9

–​0.154 0.93

10 DUMMY

0.3966** 4.67

0.4003** 4.27

0.4601** 4.24

Return

–​0.0318 0.71

–​0.055 1.4

–​0.0547 1.28

TURNOVER

0.0428 1.23

0.0432 1.63

0.0376 1.12

ANTISELF GDP

0.7655** 3.69 0.0189 0.34

Nuno Fernandes   335 Table 14.5 (Continued) (1)

(2)

(3)

(4)

MCAP/​GDP

–​0.0003 0.98

TURNOVER_​ct

–​0.0009 0.83

Constant Observations

4.5279** 8.87

4.4904** 19.15

4.5851** 18.47

(5)

–​5.4746** –​10.5562** 11.79 18.15

(6)

(7)

–​9.4260** 35.15

–​9.4868** 38.5

20284

20284

20284

20284

19280

19280

19280

Pseudo-​R2

0.14

0.15

0.15

0.15

0.15

0.15

0.18

Country Fixed Effects

No

No

No

No

Yes

Yes

Yes

The dependent variable is a dummy variable that equals one if the ownership stake of SWFs in the company is greater than 1%, and zero otherwise. All the other variables are defined in Table 14.4. The data are from 2007. We present coefficient estimates from a probit regression. Robust standard errors corrected for heteroskedasticity and clustered at the country level are presented in parentheses. ** and * denote that a coefficient is significant at the 1% and 5% levels, respectively. Columns (5) to (7) include country fixed effects.

In Column (4) of Table 14.5, we combine firm-​and country-​level determinants of SWF holdings. Firms in countries with weak anti-​self-​dealing regulations have, on average, lower SWF holdings. In other words, SWFs are more prone to invest in countries where the legal regime guarantees a minimum of protection to their investment. The coefficients on GDP, market development, and country liquidity are not significant. We interpret this to indicate that economic and financial development is not the main driver of selections made by SWFs, and that the quality of institutions is a much better determinant. To maximize the potential explanatory power of country characteristics, in Columns (5) to (7) of Table 14.5, we include country fixed effects. This estimation accounts for all unobserved sources of SWF selection procedures that can be attributed to the country’s environment. All previous results remain unchanged: SWFs prefer large firms with high analyst coverage. They do not chase momentum stocks, nor do they prefer highly liquid or high-​tech firms. SWFs also do not have a preference for cross-​listed stocks. In addition, they tend to invest more in companies with higher capital expenditure ratios and lower leverage. Interestingly, R2 increases from 15%, in Column (3), to 18%, in Column (7), when we add country fixed effects. The low increase in R2 suggests that firm-​specific factors are a very important driver of the global variation of SWF holdings and are much stronger than country-​level factors.

336   Sovereign Wealth Funds

The Impact of Sovereign Wealth Fund Ownership on Firm Value To investigate the relationship between SWF Ownership and firm value, we use Tobin’s Q as a measure of firm value.

Aggregate Results: Panel Data We estimate regressions of a firm’s Tobin’s Q on variables associated with firm value such as size (SIZE), investment opportunities (INVOP), leverage (LEVERAGE), cash holdings (CASH), cross-​listing dummy (ADR), and median Tobin’s Q for the firm’s global industry (INDUSTRY_​Q). We then add to these variables each of our proxies for SWF investments in the firm: the continuous variable SWF Ownership and the SWF Dummy for large investments. Our unit of observation is the firm/​year. Table 14.6 presents the estimates of the annual time-​series cross-​sectional regressions for Tobin’s Q for our worldwide sample of firms over the 2002–​07 sample period. We restrict the sample to firms with a market capitalization above US$10 million.10 Cross-​sectional dependence across firms in a given year is a concern associated with Tobin’s Q regressions. Another concern is that errors are correlated across time for a given firm (time-​series dependence). We address these issues by using standard errors adjusted for clustering at the firm level, and year dummies in our panel regressions. Panel A  of Table 14.6 presents the results using a dummy variable for large equity investment by SWFs (SWF Dummy) that equals one if the ownership stake held by SWFs in the company is greater than 1%, and zero otherwise. As previously described, in this subset of large SWF positions, the average ownership stake is close to 6%. In Panel B, we present results using the percentage of ownership by SWFs for all firms in the database, without any threshold restriction. In Column (1) of Panel A, we only control for firm size and global industry Q. We find a positive and significant relationship between SWF holdings and firm value. The coefficient on SWF Dummy is +0.3336. In Column (2), we include additional firm-​level control variables, namely, the cash holdings, ADR dummy, investment opportunities, and leverage. In this estimation, the coefficient on the SWF variable is +0.2863. Other control variable coefficients are, in general, consistent with previous findings: smaller firms, firms with investment opportunities, cash-​rich firms, and firms with a US cross-​listing have higher valuations. The magnitude of the coefficients is also comparable to previous results on international determinants of Q. Institutional ownership, in general, is associated with higher firm valuations (Ferreira and Matos 2008; Gompers and Metrick 2001; McConnell and Servaes 1990). In Column (3) of Table 14.6, we control for institutional 10 

In a robustness test, we confirm that the results are not affected by this procedure.

Table 14.6 Sovereign Wealth Fund Ownership and Firm Value (1)

(2)

(3)

(4)

(5)

(6)

SWF DUMMY

0.3336** 9.92

0.2863** 7.45

0.2579** 6.61

0.4227** 12.13

0.3527** 8.8

0.3308** 8.15

SIZE

−0.1704** 62.97

−0.1139** 33.96

−0.1257** 36.58

−0.1847** 68.99

−0.1288** 39.01

−0.1349** 40.25

INDUSTRY Q

0.9314** 54.28

0.7761** 38.35

0.7392** 36.5

0.7914** 46.74

0.6007** 30.97

0.5873** 30.27

INVOP

0.2240** 21.92

0.2276** 22.3

0.1761** 17.86

0.1781** 18.07

LEVERAGE

0.4881** 17.77

0.5084** 18.67

0.4039** 15.41

0.4146** 15.86

CASH

1.3647** 37.39

1.3211** 36.62

1.2548** 35.43

1.2344** 34.94

ADR

0.1526** 4.36

0.1344** 3.82

0.2446** 7

0.2304** 6.57

Panel A: SWF Dummy

IO Dummy

0.1658** 17.48

0.1045** 11.05

Constant

2.4884** 55.88

1.5547** 31.14

1.6780** 33.19

2.4833** 32.48

1.6103** 22.28

1.6847** 23.1

Observations

162147

125359

125359

162147

125359

125359

Adjusted R-​squared 0.2273

0.2087

0.2141

0.2925

0.2867

0.2886

Country-​fixed effects

No

No

No

Yes

Yes

Yes

Year-​fixed effects

Yes

Yes

Yes

Yes

Yes

Yes

0.9932**

0.6751*

0.7576**

1.5467**

1.1263**

1.1121**

Panel B: Ownership Percentage SWF OWNERSHIP

3.37

2.22

2.64

4.73

3.6

3.64

SIZE

−0.1688** 62.62

−0.1123** 33.61

−0.1381** 40.36

−0.1827** 68.35

−0.1268** 38.51

−0.1342** 40.46

INDUSTRY Q

0.9333** 54.34

0.7771** 38.35

0.7125** 35.42

0.7949** 46.83

0.6035** 31

0.5959** 30.65

INVOP

0.2234** 21.85

0.2293** 22.65

0.1758** 17.81

0.1792** 18.15

LEVERAGE

0.4874** 17.72

0.4996** 18.55

0.4039** 15.39

0.4146** 15.82

CASH

1.3684** 37.47

1.2867** 36.11

1.2607** 35.56

1.2514** 35.43

(Continued)

338   Sovereign Wealth Funds Table 14.6 (Continued) (1) ADR

(2)

(3)

0.1568** 4.47

0.1540** 4.34

IO Percentage

(4)

(5)

(6)

0.2499** 7.15

0.2357** 6.71

0.5435** 26.71

0.2071** 9.24

Constant

2.4674** 55.53

1.5328** 30.8

1.8720** 36.83

2.4510** 32.16

1.5777** 21.88

1.6783** 23.09

Observations

162147

125359

125359

162147

125359

125359

Adjusted R-​squared 0.2262

0.2076

0.2236

0.291

0.2852

0.2869

Country-​fixed effects

No

No

No

Yes

Yes

Yes

Year-​fixed effects

Yes

Yes

Yes

Yes

Yes

Yes

This table reports estimates of coefficients of the annual time-​series cross-​sectional firm-​level regression of Tobin’s Q. Panel A presents the results using a dummy variable for large equity investment by SWFs (SWF Dummy) that equals one if the ownership stake held by SWFs in the company is greater than 1%, and zero otherwise. Panel B presents results using the percentage of ownership by SWFs (SWF Ownership) without any threshold restriction. The sample period is from 2002 to 2007. All variables are defined in Table 14.4. Columns (1) to (3) include year fixed effects. Columns (4) to (6) include country and year fixed effects. We restrict the sample to firms with a market capitalization above US$10 million. All specifications use standard errors corrected for heteroskedasticity and clustered at the firm level. Absolute values of t-​statistics are presented below the coefficients. ** and * denote that a coefficient is significant at the 1% and 5% levels, respectively.

ownership. Consistent with previous results, we find that there is still a significant premium associated with SWF ownership. Columns (4)  to (6)  present estimates for the specifications in Columns (1)  to (3), but including country-​fixed effects in addition to year-​fixed effects, to account for all potential unobserved heterogeneity across countries. Our estimates are qualitatively invariant. The economic and statistical significance of the SWF valuation effect is barely affected. In Column (6), the coefficient on SWF Dummy is +0.3308 with a statistically significant t-​statistic. In Panel B of Table 14.6, we use the continuous variable of percentage of SWF Ownership (and not SWF Dummy). We use the same control variables as in Panel A.  Columns (1)  to (3)  include year-​fixed effects and firm-​level clustered standard errors. Columns (4) to (6) include year-​and country-​fixed effects together with firm-​ level clustered standard errors; there is no significant difference here from the primary findings. As found in Panel A, the results using the continuous variable SWF Ownership suggest that firms with a larger percentage of ownership by SWFs have higher Tobin’s Q.

Nuno Fernandes   339 We perform a number of robustness checks (unreported) of the relationship between firm value and SWF ownership. In all cases, we use the most complete specification from Table 14.6, which includes country-​and year-​fixed effects, and standard errors clustered at the firm level. First, we use as dependent variable the log of Tobin’s Q. Overall, the results using log(Q) corroborate the findings of a positive impact on firm value of SWF holdings. We also include all firms in our sample, without any restriction on firm size. As before, there is a positive and significant SWF premium. A possible additional concern with our results is within-​country correlation. To account for possible country-​level correlation of the residuals, we estimate the model with country-​clustered standard errors, in addition to country-​and year-​fixed effects. The results remain unchanged. To obtain a more homogenous sample of firms across countries, we restrict the sample to firms with assets or market capitalization above the threshold of US$10 million or US$100 million, respectively. Finally, we redefine our ownership variables such that they only include the single largest holding any SWF has in the company (as opposed to aggregating all the holdings from different SWFs into the continuous variable SWF holdings). Across all the different models and variable definitions we find similar results, which confirms the positive and significant relationship between Tobin’s Q and SWF Ownership.

Does Any Fund Dominate the Results? We investigate whether the positive valuation effect of SWFs is dependent on any particular fund’s holdings. In particular, one of the largest SWFs in our sample, the Norwegian SWF, represents close to 50% of the individual funds’ holdings data, although most of its investments are small and diversified. Also very dominant in terms of number of observations is the New Zealand SWF. The fund has a total of 2,967 individual holdings at the end of 2007, most of them very small—​mean size = 0.07%. Table 14.7 presents a robustness check of the relationship between firm value and SWF ownership, whereby we exclude all holdings of the Norwegian and New Zealand SWFs from the sample. The variable SWF Ownership now equals the sum of ownership positions of all SWFs after excluding these two funds. Similarly, the variable SWF Dummy is equal to one if other SWFs (other than the New Zealand and Norway funds) have more than 1% of ownership in a firm. We report in Table 14.7 the results of estimations that include country-​and year-​fixed effects, and all the control variables used in the more complete specification of Table 14.7, together with standard errors clustered at the firm level. Columns (1) and (2) report the results obtained by excluding the Norwegian SWF holdings. Even after excluding this large fund from our sample, the positive relationship between SWF holdings and firm value remains robust. We note, however,

340   Sovereign Wealth Funds that the estimated coefficients are smaller than the ones reported in Table 14.6. Columns (3)  and (4)  report results that exclude the New Zealand SWF holdings when computing the ownership variables. The results are unchanged. Finally, in Columns (5) and (6), we exclude both the Norwegian and New Zealand SWFs. We continue to document a positive and significant relationship between SWF ownership and firm value, even after excluding the holdings of the SWFs that dominate our sample. We perform a similar analysis excluding, one by one, all SWFs in our sample. The results suggest that the overall results are not dominated by any particular SWF.

Transparency of Sovereign Wealth Funds Some SWFs are reluctant to disclose much information about their investment policies and objectives. The lack of openness has prompted a political discussion on whether

Table 14.7 Sovereign Wealth Fund Ownership and Firm Value (Excluding Norway and New Zealand)

SWF DUMMY

Exclude Norway

Exclude Norway and Exclude New Zealand New Zealand

(1)

(3)

(2)

0.2119** 3.26

SWF OWNERSHIP

(4)

0.3625** 7.84 0.6600** 3.18

(5)

(6)

0.2044** 3.08 1.2309** 3.74

0.6508** 3.24

SIZE

−0.1591** 40.81

−0.1593** 41.39

−0.1611** −0.1600** −0.1591** −0.1593** 41.17 41.48 40.81 41.39

INDUSTRY Q

0.6208** 28.52

0.6277** 28.85

0.6183** 28.48

0.6272** 28.83

0.6209** 28.52

0.6277** 28.85

INVOP

0.1876** 16.32

0.1887** 16.41

0.1880** 16.38

0.1889** 16.43

0.1875** 16.32

0.1887** 16.41

LEVERAGE

0.5335** 17.13

0.5324** 17.07

0.5333** 17.15

0.5327** 17.09

0.5335** 17.13

0.5324** 17.07

CASH

1.3921** 34.44

1.4063** 34.82

1.3869** 34.35

1.4045** 34.78

1.3922** 34.44

1.4063** 34.82

ADR

0.2770** 7.07

0.2788** 7.1

0.2712** 6.92

0.2775** 7.06

0.2770** 7.07

0.2789** 7.1

IO Dummy

0.1072** 10.25

0.1026** 9.79

0.1073** 10.26

Nuno Fernandes   341 Table 14.7 (Continued) Exclude Norway

Exclude Norway and Exclude New Zealand New Zealand

(1)

(3)

IO Percentage

(2) 0.1951** 7.91

(4)

(5)

0.1941** 7.87

(6) 0.1951** 7.91

Constant

1.8754** 23.87

1.8858** 24.1

1.9082** 24.22

1.8958** 24.19

1.8750** 23.87

1.8857** 24.09

Observations

125359

125359

125359

125359

125359

125359

Adjusted R-​squared

0.2823

0.2818

0.2837

0.2821

0.2823

0.2818

Country Fixed Effects Yes

Yes

Yes

Yes

Yes

Yes

Year Fixed Effects

Yes

Yes

Yes

Yes

Yes

Yes

This table reports estimates of coefficients of the annual time-​series cross-​sectional firm-​level regression of Tobin’s Q after excluding the Norwegian and/​or New Zealand SWFs from the sample. SWF Dummy equals one if the ownership stake held by other SWFs in the company is greater than 1%, and zero otherwise. SWF Ownership is the percentage of ownership by other SWFs without any threshold restriction. The sample period is from 2002 to 2007. All the other variables are defined in Table IV. All specifications use standard errors corrected for heteroskedasticity and clustered at the firm level. Absolute values of t-​statistics are presented below the coefficients. ** and * denote that a coefficient is significant at the 1% and 5% levels, respectively.

and how to regulate SWFs’ transparency. Several countries have called for greater openness on the part of the “opaque” or non-​transparent funds. Recently, an agreement was reached on general practices that should govern SWF investments, called the Santiago Principles (IWGSWF 2008). Thus, one might question whether the degree of transparency of different funds is impacting the results. In Table 14.8, we estimate the impact of SWFs on valuations, for different levels of fund transparency. We use the Linaburg–​Maduell Transparency index (from the SWFI), as well as the Truman (2009) indexes of SWF governance and transparency. The Linaburg–​Maduell index rates SWFs on different disclosure policies, including providing up-​to-​date, independently audited annual reports and providing ownership data and geographic locations of holdings. The Truman (2009) indices are based on individual fund scores on some characteristics: transparency and accountability, structure, governance, and behavior. We divide SWFs into two groups based on the median transparency score. Then we compute the percentages of holdings by high-​transparency funds and by low-​ transparency funds. Using these ownership percentages, we compute new dummy variables for large holdings for each transparency group. We repeat the procedure for each index. Table 14.8 presents the results. Column (1) shows the results for the high-​transparency funds according to the overall Truman index (HIGH), and Column (2) for the lowest levels of this transparency index

342   Sovereign Wealth Funds Table 14.8 Sovereign Wealth Fund Ownership and Firm Value: The Role of Transparency Truman

LM Index

(1) HIGH

(2)

0.346** 6.915

LOW

(3) 0.343** 6.845

0.169* 2.468

0.154* 2.193

(4)

(5)

0.323** 7.420

(6) 0.322** 7.378

0.225** 2.781

0.206** 3.138

SIZE

−0.134** −39.95

−0.133** −39.81

−0.134** −40.02

−0.134** −40.11

−0.132** −39.70

−0.134** −40.10

INDUSTRY Q

0.588** 30.27

0.590** 30.32

0.588** 30.28

0.588** 30.28

0.590** 30.31

0.588** 30.28

INVOP

0.178** 18.03

0.178** 18.01

0.178** 18.03

0.178** 18.04

0.178** 18.01

0.178** 18.04

LEVERAGE

0.415** 15.88

0.415** 15.84

0.415** 15.89

0.415** 15.88

0.415** 15.84

0.415** 15.88

CASH

1.238** 35.06

1.240** 35.04

1.237** 35.01

1.236** 34.97

1.241** 35.08

1.235** 34.96

ADR

0.235** 6.687

0.237** 6.749

0.235** 6.686

0.235** 6.684

0.236** 6.742

0.235** 6.677

IO Dummy

0.106** 11.24

0.109** 11.58

0.105** 11.13

0.105** 11.09

0.110** 11.67

0.105** 11.07

Constant

1.666** 22.86

1.651** 22.70

1.672** 22.94

1.675** 22.99

1.646** 22.64

1.677** 23.00

Observations

125359

125359

125359

125359

125359

125359

Adjusted R-​squared

0.289

0.287

0.289

0.289

0.287

0.289

Country-​fixed effects

Yes

Yes

Yes

Yes

Yes

Yes

Year-​fixed effects

Yes

Yes

Yes

Yes

Yes

Yes

This table reports estimates of coefficients of the annual time-​series cross-​sectional firm-​level regression of Tobin’s Q. The estimations use the Linaburg–​Maduell and Truman Transparency indexes to sort SWF holdings into two groups based on the median transparency score: ownership by funds with high transparency scores (HIGH), and ownership by funds with low transparency scores (LOW). The sample period is from 2002 to 2007. All the other variables are defined in Table 14.4. All specifications use standard errors corrected for heteroskedasticity and clustered at the firm level. t-​statistics are presented below the coefficients. ** and * denote that a coefficient is significant at the 1% and 5% levels, respectively.

(LOW). In both cases, there is a positive effect of SWF ownership on company values. Column (3) combines both high-​and low-​transparency fund ownership. The results are unchanged. We repeat the procedure for the different metrics of SWF transparency and governance described earlier (including the different subscores of the Truman Index—​unreported). Across all the specifications, we find a positive relationship between SWF Dummy and

Nuno Fernandes   343 firm value. We note, however, that the effect appears to be stronger for the holdings of SWFs classified as “high” on the different categories. These results are consistent with evidence in Kotter and Lel (2011) and Dewenter, Han, and Malatesta (2010), who report that announcement returns are higher for more transparent funds. The results are also consistent with the previously documented evidence excluding Norway (one of the most transparent funds in our sample). Importantly, these results also confirm that the positive impact of SWFs on firms’ value is not dependent on any specific type of funds.

Table 14.9 Sovereign Wealth Fund Ownership and Firm Value: Foreign and Domestic Holdings (1) SWF DUMMY Domestic

(2)

(3)

0.2445*

0.1861

2.43

1.65

SWF DUMMY Foreign

0.3036**

0.3011**

6.92

6.82

SWF OWNERSHIP Domestic

(4)

INDUSTRY Q

INVOP

LEVERAGE

CASH

ADR

(6)

0.7872*

0.7724

2.12

1.57

SWF OWNERSHIP Foreign

SIZE

(5)

1.8855**

1.8552**

3.21

3.06

−0.1301**

−0.1462**

−0.1463** −0.1299** −0.1345**

−0.1368**

39.38

42.91

42.85

39.56

40.09

40.94

0.5935**

0.5770**

0.5760**

0.6008**

0.5921**

0.5904**

30.47

29.98

29.89

30.87

30.5

30.42

0.1779**

0.1792**

0.1796**

0.1777**

0.1767**

0.1781**

18.02

18.28

18.31

17.99

17.96

18.09

0.4131**

0.4217**

0.4227**

0.4098**

0.4108**

0.4145**

15.75

16.29

16.33

15.61

15.75

15.89

1.2524**

1.2134**

1.2129**

1.2594**

1.2427**

1.2406**

35.41

34.48

34.46

35.59

35.19

35.16

0.2543**

0.2042**

0.2070**

0.2602**

0.1556**

0.1658**

7.3

5.79

5.88

7.45

4.35

4.64

(Continued)

344   Sovereign Wealth Funds Table 14.9 (Continued) (1) IO Dummy Domestic

(2)

(3)

0.1140**

0.022

10.88

1.93

IO Dummy Foreign

0.1981**

0.1881**

20.21

17.77

IO Percentage Domestic

(4)

(6)

0.1415**

0.0884**

5.6

3.4

IO Percentage Foreign

Constant

(5)

0.7398**

0.7006**

12.74

11.85

1.6326**

1.8250**

1.8295**

1.6170**

1.6891**

1.7192**

22.52

24.68

24.72

22.39

23.12

23.52

Observations

125359

125359

125359

125359

125359

125359

Adjusted R-​squared

0.2868

0.2925

0.2926

0.2856

0.2882

0.2886

Country-​fixed effects

Yes

Yes

Yes

Yes

Yes

Yes

Year-​fixed effects

Yes

Yes

Yes

Yes

Yes

Yes

This table reports estimates of coefficients of the annual time-​series cross-​sectional firm-​level regression of Tobin’s Q on SWF domestic and foreign holdings. SWF Dummy Domestic (Foreign) is a dummy variable for large equity investment by Domestic (Foreign) SWFs that equals one if the ownership stake held by Domestic (Foreign) SWFs in the company is greater than 1%, and zero otherwise. SWF Ownership Domestic (Foreign) is the percentage of ownership by Domestic (Foreign) SWFs without any threshold restriction. The sample period is from 2002 to 2007. All the other variables are defined in Table 14.4. All specifications use standard errors corrected for heteroskedasticity and clustered at the firm level. Absolute values of t-​statistics are presented below the coefficients. ** and * denote that a coefficient is significant at the 1% and 5% levels, respectively.

Overall, the results here suggest that high transparency SWFs have stronger impact on firm value. Nevertheless, even for the lower transparency funds, the evidence suggests that these investors also have a positive impact on firm’s value.

Local and Foreign Holdings In Table 14.9, we estimate the impact of SWFs on valuations, separating local holdings and foreign holdings. We use the individual SWF holdings in each firm to compute two separate variables:  SWF domestic holdings and SWF foreign holdings. Once again,

Nuno Fernandes   345 we use these continuous variables to compute two separate dummy variables for large investments. SWF Dummy Domestic (SWF Dummy Foreign) equals one if domestic (foreign) SWFs hold more than 1% of the firm’s shares. We then test whether there is a different role of SWF domestic holdings and SWF foreign holdings. Whether using the continuous variable or the dummy for large holdings, the results suggest that it is mostly the foreign holdings that affect firm value, and there is very limited evidence of a domestic impact. These results suggest that SWFs’ role in value creation is mainly concentrated in their foreign investments. One possibility behind these results is that, on domestic investments, other considerations (including political) play a role.

Conclusion Although SWFs have recently been widely discussed, much of this discussion is based on anecdotal evidence. Regulators question whether SWF investments benefit shareholders, and numerous critics claim that SWF investment decisions are politically motivated. This chapter studies the impact of SWFs on firm value and performance using a large-​ scale sample of public equity holdings from 2002 through 2007. Our novel data set covers SWF investments across 58 countries during this period and involves more than 8,000 unique companies. The controversy around SWFs is more political than financial because SWF ownership is typically positively valued by the market. We document an increase in firm value following SWF investments, as well as significant improvements in operating performance. Also, the relationship is stronger for foreign holdings. This suggests that, contrary to arguments that SWFs expropriate investors and pursue detrimental political agendas in their foreign investments, they in fact contribute to creating long-​ term shareholder value. The results documents a positive relationship between SWF ownership and firm value that is robust to: (1) exclusion of Norway and New Zealand (or any other fund) from the sample; (2) controlling for a firm’s growth opportunities, cross-​listing, and institutional ownership; and (3) different SWF transparency indicators. These results hint at the value-​enhancing role of SWFs for corporations worldwide. There is a real danger that some governments may play up the fear of SWFs to a level akin to protectionism. Often, this investment protectionism is disguised by claims of national security concerns. The evidence from this cbapter suggests that the majority of SWF investments do not involve partial or complete control of firms. Even for investments that are large, there is no evidence that SWFs harm companies. The overall evidence is that firms perform better and are valued higher when SWFs invest in them.

346   Sovereign Wealth Funds Additionally, the results in Fernandes (2014) show that the impact of SWF ownership, using other operating performance metrics, changes for firms in which SWFs have invested (relative to a control group). Those results, based on a diff-​in-​diff propensity-​ score-​matched sample of firms, show how there is a change in Tobin’s Q of firms in which SWFs invested, before and after the deal occurred, relative to a control group. Similar results are obtained when looking at ROA, ROE, and operating returns (defined as EBITDA/​assets) as measures of operating profitability. Across the different metrics, the results show that the operating performance of firms in which SWFs have invested goes up relative to the control group. Fernandes (2014) also analyzes the potential channels of impact of SWFs on companies and shows that firms with large SWF investments have higher levels of CEO turnover, are able to raise more capital, and can boost their international profile.

References Bernstein, S., Lerner, J., and Schoar, A. (2009). The Investment Strategies of Sovereign Wealth Funds. Working Paper. Boston: Harvard Business School. Bortolotti, B., Fotak, V., Megginson, W., and Miracky, W. (2010). Quiet Leviathans: Sovereign Wealth Fund Investment, Passivity, and the Value of the Firm. Unpublished Working Paper. Norman: University of Oklahoma. Chhaochharia, V. and Laeven, L. (2009). Sovereign Wealth Funds: Their Investment Strategies and Performance. Working Paper. Washington, DC: International Monetary Fund. Del Guercio, D. (1996). The Distorting Effect of the Prudent Man Law on Institutional Equity Investments. Journal of Financial Economics, 40, 31–​62. Dewenter, K. L., Han, X., and Malatesta, P.H. (2010). Firm Value and Sovereign Wealth Fund Investments. Journal of Financial Economics, 98, 256–​78. Djankov, S., La Porta, R., Lopez-​de-​Silanes, F., and Shleifer, A. (2008). The Law and Economics of Self-​dealing. Journal of Financial Economics, 88, 430–​65. Fernandes, N. (2014). The Impact of Sovereign Wealth Funds on Corporate Value and Performance. Journal of Applied Corporate Finance, 26, 76–​85. Fernandes, N. and Ferreira, M.A. (2008). Does International Cross-​Listing Improve the Information Environment? Journal of Financial Economics, 88, 216–​44. Fernandes, N., and Giannetti, M. (2014). On the Fortunes of Stock Exchanges and Their Reversals:  Evidence from Foreign Listing Waves. Journal of Financial Intermediation, 23, 157–​76. [Award for Best Paper of the Year.] Fernandes, N., Lel, U., and Miller, D.P. (2010). Escape from New York: The Market Impact of Loosening Disclosure Requirements. Journal of Financial Economics, 95, 129–​274. Ferreira, M. and Matos, P. (2008). The Colors of Investors’ Money: The Role of Institutional Investors around the World. Journal of Financial Economics, 88, 499–​533. Gompers, P. and Metrick, A. (2001). Institutional Investors and Equity Prices. Quarterly Journal of Economics, 116, 229–​59. International Working Group of Sovereign Wealth Funds (IWGSWF). (2008). Sovereign Wealth Funds: Generally Accepted Principles and Practices. Available at http://​www.ifswf. org/​sites/​default/​files/​santiagoprinciples_​0_​0.pdf [accessed May 23, 2017].

Nuno Fernandes   347 Karolyi, A. and Liao, R. (2009). What Is Different about Government-​controlled Acquirers in Cross-​border Acquisitions? Unpublished Working Paper. Ithaca: Cornell University. Kotter, J. and Lel, U. (2011). Friends or Foes? Target Selection Decisions of Sovereign Wealth Funds and Their Consequences. Journal of Financial Economics 101(2), 360–​81. McConnell, J. and Servaes, H. (1990). Additional Evidence on Equity Ownership and Corporate Value. Journal of Financial Economics, 27, 595–​612. Merton, R. (1987). A Simple Model of Capital Market Equilibrium with Incomplete Information. Journal of Finance, 43, 483–​510. Truman, E. (2009). A Blueprint for Sovereign Wealth Fund Best Practices. Revue d’Economie Financière (special issue) 429–​51.

Chapter 15

T he China Inv e stme nt C orp orati on From Inception to Sideline Christopher Balding and Kevin Chastagner

Introduction China’s sovereign wealth fund (SWF)—​the China Investment Corporation (CIC)—​is large. Established in 2007, it has grown to become the fourth largest SWF in the world with assets and offices spanning the globe.1 However, like all things about China, a range of unique factors need to be properly understood in order to place the CIC in context. When China decided to form its own SWF, it did so by borrowing from the central bank in a complicated swap transaction in order to highlight the CIC’s independence from existing entities such as the People’s Bank of China (PBOC) and the State Administration of Foreign Exchange (SAFE). While most SWFs grow from an excess of natural resource wealth, the Chinese SWF is unique in that it grew out of years of current account surpluses accumulated from ensuring a fixed exchange rate. This helped to ensure that the CIC was an SWF distanced from the long arm of government banks and other political inference. While related to the source of capital for the CIC, the macroeconomic environment leading to the creation of an SWF in China resulted in a different process than is commonly seen in commodithy-​based SWF creation, which transferred natural resource wealth into financial wealth (Hu 2014). The maintenance of an undervalued renminbi (RMB) in order to boost Chinese exports created a need to sterilize large trade surpluses, which could only be satisfied with trillions of dollars of US public debt and

1 

The CIC is the fourth largest SWF in the world according to the Sovereign Wealth Fund Institute’s assets under management ranking.

Christopher Balding and Kevin Chastagner    349 currency.2 The original intent of establishing an undervalued RMB was not to lay the foundation for an SWF, but as a cornerstone of economic policy. Throughout the 2000s, China’s economic growth was driven by rapid export growth from undervalued currency resulting in large trade surpluses. Drawing upon what China saw as the success of export-​led growth models from Japan, Singapore, and South Korea, the Communist Party tasked the PBOC with managing the financial framework to meet their development goals. This system was maintained via debt and currency purchases resulting in an expansion of the domestic money supply, of which about 70% ended up as US dollar assets. The rapid expansion in the money supply acted as an import in capital driving a rapid growth in investment from the build-​up of public savings. The export-​ driven economy, undervalued currency, and low-​wage labor brought about large current account surpluses, but the maintenance of a fixed exchange rate regime resulted in significant opportunity costs. As the RMB continued to appreciate against the US dollar, foreign exchange reserve accumulation started slowing dramatically. The slowly depreciating dollar combined with remarkably low US interest rates resulted in China incurring significant real financial losses. China was forced to continue investment in US debt and currency for fear of a rapidly appreciating RMB derailling their double-​digit growth. The PBOC had fulfilled its mandate of keeping the RMB pegged or semi-​pegged to the US dollar, but this resulted in reserve accumulation that contributed to real losses. To reduce the real losses it was earning, due to low yielding US government debt, China decided to reallocate a portion of its reserves from the PBOC to an institutional investor that would seek out higher risk investments in the hope that this would receive a higher rate of return. China needed an institution that was better equipped to handle the responsibilities of an asset manager and investor rather than the PBOC. To inhibit the negative impact of the mounting economic challenges, the CIC was established as a first step to combat the increased incurrence of real losses due to holding ever-​increasing amounts of low-​ yielding long-​term US public debt. The CIC was founded in 2007 and encountered a variety of difficulties in its first year, ranging from an adverse economic climate to political opposition both domestically and internationally. As a result of this difficult environment, the CIC has undergone a profound evolution in the past decade. Since its beginning, prior to the global financial crisis, the CIC has grown into one of the largest institutional investors in the world (Sekine 2011). The CIC has gone through distinct investment periods and mandates, which are represented in their portfolio construction. Starting in 2007 and 2008, the CIC made significant investments in the US financial sector—​such as Morgan Stanley and Blackstone—​incurring large losses (Wu and Seah 2008). In the next few years, the CIC held a large percentage of assets as cash or fixed income with 2  US$1.208 trillion in Treasury bills as of December 2012 (online at www.treasury.gov/​resource-​ center/​data-​chart-​center/​tic/​Documents/​mfh.txt). The rest is held in currency, agency debt, corporate debt, and equities. Congressional Research Service estimates a total of US$3.3 trillion in total as of September 2012.

350    The China Investment Corporation: From Inception to Sideline smaller strategic investments, and deployed its assets carefully. Since 2012–​13 the CIC has existed with most of its assets deployed, while making regular adjustments to its portfolio, based upon its estimates of global risk and growth but focusing more on equity (Sekine 2015). The CIC has also gained influence in the investment world as well as in political institutions and China in general. What began as a political compromise between the Ministry of Finance (MOF), the SAFE, and the PBOC has arguably grown into an institution more powerful than its founders. Only the PBOC would rival the CIC for influence and even then, it does not carry the political influence of the CIC. The size of the CIC makes it a dominant political actor in China and, as some have argued, due to China’s fragmented political authoritarianism it lends itself to bureaucratic infighting that fails to prioritize long-​term profits (Shih 2009). Owning essentially a controlling stake in every major financial institution in China, as well as purchasing key stakes in companies around the world, the CIC plays a more influential role and has greater political clout than its predecessors. The pioneering head of the CIC, Lou Jiwei, has gone on to become the Minister of Finance, indicating the paramount importance of the CIC. While he originally came to head the CIC as a relative outsider in Chinese policy circles, he left to assume arguably the most important financial position in China. However, the CIC has moved beyond its initial US$200 billion allocation of capital to become an increasingly influence institution (Cai and Clacher 2009). As with most other public institutions in China that had run out of investment funds, the CIC also needed to politically maneuver to be given more funds to manage. After its initial mis-​ steps with early financial services investments, it has largely avoided any notable failures, choosing lower profile and less risky investments even though it has made some questionable investments (Hughes, Hume, and Sheppard 2015). It has successfully avoided the impropriety of political influence by China in the companies it invests in, although it is increasingly willing to vote against management where it feels its interests have been harmed (Dettoni 2016). To maintain its influence and ability to secure additional capital from the PBOC, as well as build credibility and avoid domestic political opposition, it needed to avoid financial losses and political entanglements (Wu and Froystadvag 2015). Overcoming this initial concern, the CIC has earned a reputation for trying to push down costs when working with asset managers while overseeing a diversified portfolio. It is now seen in a new light—​as the epitome of a stable, profitable, and respected institution. By contrast, when the PBOC was founded, its mandate was to seek to sterilize large capital inflows because China was building itself up amidst an array of socioeconomic and political transformations. As a result, in the nascent period following its establishment, the PBOC followed a narrow approach toward external investment without placing much importance on diversifying China’s foreign exchange holdings. Currently, this is not the case because recent developments in finance have redefined the purpose of its functions. Capital is rapidly leaving China, Chinese firms are being encouraged to invest abroad, and the PBOC is trying to steer a gentle path to a floating currency. In this context, it is essential to focus on current trends and determine the significance of the

Christopher Balding and Kevin Chastagner    351 CIC against the backdrop of China’s stellar economic transformation. What path will the CIC now take to tackle the challenges presented by China’s comprehensive scheme to optimize its foreign exchange holdings? In this chapter, we seek to identify the CIC’s direction and strategy in the the years ahead in this new environment. The chapter begins with a brief history of the development and evolution of the CIC, followed by a discussion of the macroeconomic interplay between China and the CIC, and the CIC’s operational framework. It concludes with a reflection on the future scope of the impact of the CIC.

Development and Evolution of the China Investment Corporation The capital that would eventually form the foundation for the CIC grew out of years of current account surpluses accumulated from sterilizing inflows from managing a fixed exchange rate. However, the economic elements that led to the global financial crisis of 2009 presented tremendous challenges to the growth of China’s reserves. Throughout the 2000s, the Chinese government’s predominant concern was to achieve economic growth through an export promotion strategy, aided by an undervalued currency. As the government tried to maintain this via currency and debt purchases, financed by an expansion of the domestic money supply, the undervalued RMB drove an enormous accumulation of US dollar holdings as shown in Figure 15.1. Due to its relative complexity, this financial arrangement with the MOF, SAFE, PBOC, and the new CIC—​albeit all under the same umbrella—​presents some interesting factors in an analysis of SWFs in general and specifically of the CIC. Although the Chinese MOF and the PBOC stipulate the financial relationship of the CIC, its balance sheet lists no liabilities because the debt passes through to the MOF as the guarantor, which must make payments to the central bank and not to the CIC. Given this relationship CIC Global Investment Portfolio Distribution: Divrsified Equities 60.00

Percentage

50.00 40.00 30.00 20.00 10.00 0.00

2008

2009

2010

2011

2012

2013

2014

Years

Figure 15.1  CIC Global Investment Portfolio Distribution: Diversified Equities

352    The China Investment Corporation: From Inception to Sideline between the debtor and creditor, it is exceedingly unlikely that a default would occur if principal payments could not be made. As a result, the CIC has noted the large annual interest payments required by its borrowing obligations. However, the structure of the CIC increases the risk profile of the aggregate financial holdings. The CIC was created with no actual equity; instead it was created with all debt financing from the PBOC. This financial framework of being capitalized with no equity essentially makes the CIC a capital arbitrage fund. By borrowing long at a state-​sponsored interest rate and investing the proceeds in equities, the CIC is collecting the spread between the domestic cost and a globally diversified return on capital. Should the Chinese financial sector or global equities turn negative, this could present a serious problem for the CIC. Although the long-​term average return on equities exceeds the long-​term average return on debt, equity returns are more volatile and could cause problems, especially given their reliance on domestic bank profits. In fact, according to the CIC, its annualized rate is only 4.58% which is nearly equal to the interest rate it is paying on bonds used to finance its creation and the global rate of return on a globally diversified portfolio over the same period of time. The CIC’s inability to exceed its cost of capital by any appreciable margin is less a criticism of its lack of market-​beating ability as a recognition of the state of the world and the constraints within which it operates. It has a relatively high cost of capital in an environment where financial asset returns are simply not returning an excess rate above what it pays. Even though the CIC was created with a clear mandate to operate China’s surplus currency reserves, China did not, however, wish to just transfer capital from the PBOC to the CIC. The MOF, PBOC, SAFE, and the CIC engaged in a complicated transaction designed to create leverage in order to capitalize the CIC. Instead of directly injecting capital from foreign exchange reserves (a pattern that is followed in all other states with SWFs with some basic variations) the Chinese government arranged a bond offering purchase of 1.6 trillion RMB issued by the CIC that was used to purchase US$200 billion at the then exchange rate from the PBOC (Balding 2012). These 1.6 trillion RMB denominated bonds with durations of 7 to 15 years were guaranteed by the MOF with a yield of about 4.5%. The interest rate was about the approximate market rate and all the bonds were bought by the PBOC. The 1.6 trillion of RMB proceeds from the bond sale were then used to purchase US$200 billion of foreign exchange reserves from the PBOC. Put more simply, the CIC issued bonds which were purchased by the PBOC in RMB; the CIC used the RMB to buy US dollars from the PBOC, with everything guaranteed by the Chinese MOF. Due to the CIC’s declared preference to invest 65% to 70% of its capital in China, much of the US$200 billion was held in RMB to enable domestic investments. To boost their total returns, the CIC has been incorporating the profits of four of the major state banks of China onto their returns. Approximately one-​third of the capital is used to buy Huajin Investment from the MOF which holds controlling stakes in banking sector assets Agricultural Bank of China, Bank of China, China Construction Bank, and Industrial & Commercial Bank of China. The remaining two-​thirds is allocated to

Christopher Balding and Kevin Chastagner    353 international investments. In fact, over the past few years, the share price of Chinese banks has stagnated or declined due to concern over rising non-​performing loan ratios. Consequently, the CIC appears to be booking the value of its domestic holdings at an elevated price. While it is not unusual for investment firms to book a different value for firms in which they hold a controlling stake, it does raise concerns about the management influence of the CIC on Chinese banks and how they are accounting for their holdings within this sector. While the CIC has remained a good corporate citizen for its holdings outside of China, there are valid questions about its role in its domestic holdings and the potential impact of political influence. More recently, it was a major shareholder in car hailing app Didi which drove Uber out of China with not insignificant regulatory barriers (Lex 2015). The pace of CIC investment deployment into equities accelerated in 2009 after the global financial crisis and the buildout of necessary infrastructure. At the end of 2008, the CIC had retained a large percentage of its assets in cash and cash-​like instruments, but in 2009 the CIC invested across a range of asset classes and geographic regions, aiming to complete its portfolio allocation plan by the middle of 2010 (Shabbir 2014). The CIC equity holdings also reveal an additional important facet of its investment strategy. The holdings’ sectoral diversity is relatively minimal with a concentration in financial services, natural resources, basic materials, consumer staples, and energy (Tan 2013). This matters because Beijing has emphasized the need to move into specific areas where it lacks technology, expertise, or cutting-​edge firms. The sectors designated as strategic ones by Beijing are the list of industries that the CIC has targeted in its investment allocation. While there is no evidence that the CIC has used its influence to prompt corporate behavior that would be considered questionable, it does raise valid concerns about the intent of the CIC given that their investment strategy so closely aligns with Beijing’s strategic emphasis (Blanchard 2014). Beijing diplomacy is almost always (correctly or incorrectly) seen as intimately linked with the CIC (Giles and Plimmer 2015). For a firm and government so intent at its conception to emphasize their purely financial motivations, the potential conflicts about the CIC political motivations (given the clear alignment of investment and strategic industrial focus of Beijing) deserve consideration. An interesting thing to note here is that the CIC is technically a branch or subsidiary of the MOF. Even though the CIC was set up as an independent entity from the other financial institutes of the Chinese government, the close relationship with the central banking institute cannot be overlooked. Lou Jiwei, who was the head of the CIC when it was founded, is now the Minister of Finance for China. The motive behind establishing the CIC and its functioning involves indirect transfer of funds from one public account to another by the creative use of leverage; this is in the form of a bond offering to purchase assets. Thus, the MOF is the official debtor and the PBOC is the official lender. The borrowing is essentially from one pocket to another as the PBOC is lending to the government. In other words, by borrowing from one of its own subsidiaries, the government is guaranteeing a loan to itself. This creates a

354    The China Investment Corporation: From Inception to Sideline conflict of interest as the CIC essentially owns the banking industry, an industry in which MOC and PBOC—​its parent company and lender—​should play a role in regulating. The CIC can almost be billed as a government-​linked hedge fund rather than as a vehicle for mandating cash reserves. While this may seem like an insignificant detail, it actually gets to the heart of Chinese financial market structure and the CIC’s investment strategy. A second point worthy of note is the CIC’s oversight with regard to the vast majority of the Chinese financial services sector via its subsidiary, Central Huijin Investment. The CIC owns a majority stake in the four major state-​owned banks—​Bank of China, Industrial and Commercial Bank of China, Agricultural Bank of China, and China Construction Bank. Additionally, it owns majority stakes throughout other financial services firms, such as insurance and securities. There are several reasons why this matters. First, the CIC holds enormous influence in Chinese financial services for foreign banks seeking to do business in China. As the CIC may be negotiating with a foreign bank for an ownership stake, they also have the ability to provide market access to China through a partner or the ability to influence other considerations for what is essentially a closed market. Second, the CIC has used its ownership stake to slightly change its initial investment strategy. The range of nuances unique to China and SWFs makes formulating and investment strategy challenging (Bernstein, Lerner, and Schoar 2013). From its inception through about 2013–​14, the CIC was responsible for a major share of outward foreign direct and portfolio investment. However, between 2012 and 2014 other Chinese firms began rapidly increasing their share of outward investment. This began to slowly remove the CIC as the primary investor, turning it primarily into a minority equity holder into firms; thus reducing international focus on it and raising concerns about its involvement with firms (Megginson and Fotak 2015). This shift altered its primary investment strategy, making it—​based upon size alone—​primarily a variation of an index fundholder. As SWFs discover, due to sheer size, it becomes impossible to earn market-​beating returns upon a diversified portfolio so that focus shifts to minimizing risk or geographic allocation. However, given the CIC’s dominant position in Chinese financial services and its political influence in both the MOF and SAFE, it has been able to channel funding to Chinese firms looking to invest abroad. In other words, rather than acting as the primary source of outward investment, the CIC is channelling financing for acquisitions to Chinese firms to act as the primary investor rather than the CIC. This fundamentally alters its role even though its influence is undeniable in the overall process of pushing higher levels of Chinese-​sourced international investment. Through this, the CIC came up with a prudent strategy that helped it to perform well during a time when the world economy was struggling. By remaining heavily invested in cash and other low-​yielding investments (due as much to lack of infrastructure as strategy) the CIC outperformed other asset managers. It is interesting to note that the CIC’s Global Investment Portfolio Distribution in Diversified Equities grew form 3.50% in 2008 to 44.10% in 2014.

Christopher Balding and Kevin Chastagner    355 Due to the concerns regarding Chinese political influence over strategic assets around the world, the CIC, being a Government-​backed corporation, avoided large headline-​ grabbing purchases. From 2010 to 2014, the CIC diversified its portfolio by focusing on key sectors as defined by Beijing. Its returns have been in line with broader market returns during this time—​as would be expected. While the CIC is seen as having a conservative approach when it comes to constructing its portfolio, some sectors have gained a questionable amount of portfolio weighting due to Beijing focus on strategic sectors. It went from a 32% cash holding in 2009 to a 4% weighting of cash, and cash-​like instruments, in its portfolio. Given the risk concerns around the 2008 global financial crisis, the CIC sought to avoid significant losses and its liquidity-​focused emphasis at the time seemed prudent. While holdings of equities have edged up slightly, they have not moved beyond this general asset allocation, though they have pulled back their fixed-​ income holdings in favor of various alternative assets. Since 2015, fixed-​income holdings have been pared back to 14.4% of the total portfolio with public equity at 47.5%. The remainder consists of what they classify as “long-​term holdings” and “absolute return”. The long-​term holdings consist of real estate and infrastructure assets, while the absolute return allocation is an actively managed holding of major assets such as equities and bonds. After meetings its general allocation targets in 2010, the CIC has adjusted them minimally, seeking to avoid large movements but targeting the return stability needed to meet its cost of capital requirements. There is one final point worth noting about how the CIC has managed its portfolio. As of 2015, the CIC had roughly one-​third of its assets under management with the remaining two-​thirds placed under external management. Although the CIC does not delineate the fees it pays to external managers, it is reported that they have pushed for some of the lowest fees among major institutional investors. As there is little to lead us to believe that higher fees will result in improved performance, it is likely this is a solid strategy to drive down costs. Given the thin margin they are currently earning on the spread between the annualized return and their cost of capital, this cost compression is likely not an insignificant factor in helping them achieve return targets. No details have been provided on the asset managers to whom they allocate assets but it is generally understood that they push down costs while guaranteeing a longer-​term mandate that would provide the asset manager greater ability to earn the required fees. While other SWFs do provide external mandates, it is believed that the CIC provides larger external manager mandates compared to the Norwegian Global Pension Fund, which also utilizes external managers. The CIC has created a classic portfolio where it strikes a balance between equities, fixed income, and alternative assets. It has also pushed on fees to ensure that it is lowering its costs. The CIC has invested more in US–​China Exchange-​Traded Funds (ETFs) and other liquid instruments that provide evidence of its overall strategy and focus. After learning some difficult lessons on high profile and risky investments, the CIC has gone through difficult phases but generally produced a relatively classical portfolio split between equities, fixed income, infrastructure, and alternative assets.

356    The China Investment Corporation: From Inception to Sideline

The Macroeconomic Interplay between China and the China Investment Corporation The macroeconomic environment of China, with a huge population and manufacturing-​driven economy, prompted the creation of the CIC. In 1999, the country’s aggregate exports reached US$195 billion and the net trade surplus reached US$30 billion. With the beginning of a new millennium and the joining of the World Trade Organization, the country’s large and sustained trade surpluses started to threaten to push the RMB higher, choking off their initial growth. Due to the structure and organization of the Chinese economy, this rise in RMB simultaneously posed significant threats to the economy. To counteract this pressure, the PBOC began sterilizing the surplus inflows. An increase in the value of the RMB would have substantial consequences for the Chinese economy, which was largely based around export industries relying on low-​ skilled labor. A highly valued RMB risked killing industries based on low-​cost labor. Due to large trade surpluses, the Chinese economy depended heavily on importing large amounts of foreign capital without which China could not have derived a high return. To sterilize the large inflows of US dollars and prevent the RMB from appreciating, the PBOC essentially expanded the domestic money supply to buy surplus US dollars in the FX market. This had the effect of rapidly expanding the state-​owned bank deposits base as RMB replaced the inflows of US dollars. This, in turn, reduced pressure to appreciate the RMB but also helped Beijing meet its development objectives, which relied on an export and investment driven economy. With an increase in the value of the RMB, China would not have been able to import foreign capital. Because it had a large export industry and foreign investment, the country was able to upgrade its infrastructure while generating employment for its large population. While the focus of this policy has been on its impact on pushing exports, much of the work seems to have overlooked its impact on pushing up the domestic money supply and its pass-​through impact on driving investment. Banks who were receiving large inflows of RMB via the USD sterilization policy needed to push them back into the economy via increasing lending rates. Engaging in such mass financial engineering was not without costs. The primary losses were the opportunity costs China and the PBOC incurred in holding US dollars and government debt. The enormity of the US dollar surpluses China was incurring implied that there should have been significantly stronger appreciation of the RMB against the US dollar. However, this would have hampered the export-​led promotion growth model which also drove capital accumulation, allowing for significantly higher levels of investment. If the RMB had appreciated against the US dollar, this would probably have had a negative impact on Chinese exports to the US. To push down the value

Christopher Balding and Kevin Chastagner    357 of the RMB, the PBOC printed large amounts of money using the RMB to buy surplus US dollars. This RMB entered the money supply via commercial banks while the US dollar became FX reserves. However, this created increasingly large opportunity costs. While the Chinese economy was enjoying near double-​digit GDP growth rates, US government debt was yielding in the low single digits. Beijing was trading off holding a bond yielding 2% to 4% for capital that could be deployed in China where it would earn double-​digit returns. When foreign exchange reserves were less than US$1 trillion in 2006, this was not a major problem. However, when it had ballooned to nearly US$2 trillion at the end of 2008, there was a major opportunity cost that China had to address. The CIC became the solution to addressing these low yields being received on US government debt. Fears of increased incurrence of real losses due to holding ever-​ increasing amounts of low-​yielding long-​term US public debt led Chinese policymakers to realize the need for establishing an active investment fund holding riskier assets. It would be necessary to increase the yield on reserves in order to reduce the real losses by actively investing in riskier financial assets. To achieve this, it was essential to create an SWF that was independent from the SAFE and distinct from an entity of an existing public institution like the PBOC. As a result, the CIC was established as the first step to diversifying China’s foreign exchange holdings while seeking to increase returns for its shareholders within acceptable risk tolerances. By diversifying into a larger basket of assets that raised acceptable risks, the CIC hoped to increase its rate of return. Thus, the CIC was set up as a vehicle to utilize the foreign exchange reserves for the benefit of the state, thereby guaranteeing a regulated administration of managing China’s reserves. A key framework issue here is the question of why China accumulated such large US dollar holdings. As a result of the accumulation, China had more holdings than is generally needed for a country to self-​insure during the course of a financial crisis. Furthermore, besides the benefits of an undervalued currency, China was eager to avoid a financial crisis similar to the ones in Thailand, Indonesia, and South Korea. Concerns stemming from the 1997 Asian financial crisis provide the frame through which China sees the world and drive a large amount of their economic policies. From promoting foreign direct investment, which can less easily be liquidated to rigid foreign exchange controls, the Asian financial crisis was a watershed moment for China in establishing a policymaking world view. Fundamentally, Beijing believed that accumulating sufficiently large reserves would help it avoid the type of financial crisis that hit Asia in 1997. This would act as a type of self-​insurance against downward pressures in the currency or financial firepower. After witnessing the abrupt reversal of capital inflows into Asian countries, China created a policy framework that would avoid hot money inflows and be able to effectively combat such pressures should they arise. Building up a more than US$3 trillion foreign exchange reserve was meant to act as a form of self-​insurance that could protect against speculators seeking to push down the currency. Furthermore, capital controls have effectively prevented portfolio inflows and outflows by both domestic and international investors.

358    The China Investment Corporation: From Inception to Sideline However, this policy seems to have moved beyond its intention sometime between 2005 and 2010. If self-​insurance was a primary factor, the holdings provide a relatively stable and predictable level that institutions such as the International Monetary Fund have pegged, even with conservative estimates. While self-​insurance was not an unreasonable objective, it implied that the country seeking to self-​insure against speculative attacks should hold the minimum amount possible and allocate the capital effectively. As a simple example, assume that some amount of foreign exchange reserves is required to self-​insure against a speculative attack for which the country is willing to absorb the cost but all capital above the specified amount is lost opportunity cost. By increasing foreign exchange reserves well past recommended relative levels, Beijing would be incurring enormous opportunity costs. Foreign exchange reserves relative to the Chinese money supply, M2, converted into US dollars, at current exchange rates, peaked in 2008 at 29% and have since fallen steadily to their current level of 14%. This meant that Beijing was losing money in real terms by holding US dollars as assets that were yielding nothing or very little in the low-​interest rate environment of US treasuries. The low yield led the Chinese government to create a plan for the CIC to diversify reserves into higher yielding assets other than US treasuries and cash. However, given the financial structure of the debt incurred and the repayment necessary, this implicitly forced the CIC into US dollar denominated assets. To this day, the large majority of CIC assets are denominated in US dollars as a result. While engaging in asset and liability matching, seeking to avoid currency risk is perfectly understandable; it severely constrains the CIC’s ability to globally diversify their asset base given the US dollar funding basis. The CIC’s dollar funding and asset constraints require them to invest with very specific additional purposes beyond their fundamental constraints. If there were additional considerations given to the CIC capital base by the MOF, PBOC, and SAFE, it would be reasonable to consider diversifying their capital base away from US dollar and include other major currencies in order to provide it with greater global flexibility. However, the focus of the CIC investment targeting remains US dollar assets given their attempts to match their liabilities. As part of the macro-​level framework, the CIC is technically prohibited from owning Chinese assets except via its subsidiary Central Huijin Holdings and the existing portfolio of firms in which they own direct stakes. This owes more to political considerations than macroeconomic planning but remains valid. Beijing is aware of the dangers of permitting political influence into the investment process and is so concerned about this that they forbid the CIC from investing its capital, excluding existing holdings, within China. The CIC however has sought to circumvent these restrictions in unique ways, either because they believe China is a good investment or as a result of underlying political considerations. They do this with purchases of China-​focused assets on US markets, such as China ETFs and similar types of assets. In fairness to the CIC, this appears to be less politically motivated than financially motivated, though it would be a questionable allocation given their already high concentration in Chinese assets. The CIC is purchasing assets that would provide only indirect access

Christopher Balding and Kevin Chastagner    359 to influence Chinese firms or assets such as ETFs, limiting their political influence. This however, has the perverse incentive of further concentrating the risks the CIC is seeking to alleviate. After the CIC’s creation as a new SWF, it controlled all of the PBOC’s shares in China’s state-​owned banks and other investment companies organized under Central Jianyin Investment Corporation, a securities company subsidiary of Huijin.3 As a result, the CIC can be viewed as an arm of the MOF. Because its interests are more aligned with the central government, private investment is slowed and likely results in lower rates than the ones private Chinese investors could achieve. Thus, as the CIC’s relationship within the State Council grows stronger than those of the central bank, there is a high probability of it becoming mired in the bureaucratic conflict between the PBOC and the MOF. The potential size and breadth of the CIC is complex given its scope and complexity. However, it has met its macroeconomic objectives well by managing to earn a return exceeding its cost of capital. Confidence in the CIC follows its success on raising the rate of return on US dollar-​held assets by public institutions. However, it also perpetuates the dominant role of the state in the Chinese economy. Despite the talk of liberalization of the economy and the expected IPO of China Postal Savings Bank, the CIC remains a golden shareholder in almost every major financial services firm in China. It is worth noting the potential role of SAFE within the foreign asset management space in China. There is some evidence that SAFE has attempted to encroach upon the CIC’s domain of international investment of Chinese foreign exchange reserves. Historically, the PBOC has been responsible for monetary policy while SAFE, as its name implies, acts as the primary administrator of all foreign exchange reserves in China though the foreign exchange reserves are officially controlled by the PBOC. SAFE would typically grant licenses for either current or capital account transactions that either took RMB abroad or required the use of foreign currency such as US dollars or Japanese yen. SAFE has confirmed some small investments outside of their typical domain of sovereign bonds and similar highly liquid cash or money market holdings, but they appear limited in scope. It is unclear whether this comes from internal political considerations, financial policy, or a SAFE focus on the fixed income and liquidity management of Chinese foreign exchange reserves. Part of this may be definitional as SAFE focuses heavily on fixed income and highly liquid near cash-​like instruments, leading some to account for higher levels of investment. However, there remains scant evidence that SAFE has fundamentally altered its asset management direction away from more standard-​type, central-​banking-​type asset management. Even comparing Chinese FX reserves statistics to estimated changes in valuation from currency and bond holding, there is little evidence to support the assertion that SAFE has expanded into non-​ traditional FX reserve management. 3  The CIC owns a major stake in China’s largest investment bank which went public in 2015 giving them a controlling, or near-​controlling, stake in every commercial and investment bank in China (Hughes 2015).

360    The China Investment Corporation: From Inception to Sideline

The China Investment Corporation’s Operational Framework As previously discussed, the CIC was established within a specific macroeconomic framework. Given China’s diverse economic and financial strategies, the investment framework of the CIC is a result of certain explicit risk parameters that are essentially exogenous to the local system. Although there are conflicting opinions on these strategies due to seemingly unreasonable targets, these frameworks have been chosen and built upon for very understandable reasons. In order to understand the strategies and the motivation of the CIC it is important to provide more detail about each of the aforementioned considerations. Though the CIC has largely avoided the Xi Jingping-​led corruption crackdown in China, concerns have been raised about internal controls and excessive internal spending (Waldemeir and Wildau 2015). Prior to the establishment of the CIC, China was incurring significant real losses on its cash-​holdings and low-​yielding government debts. To overcome these limitations, which the SAFE failed to account for, the CIC was created with the main purpose of debt financing. As a result, even though it is billed as an SWF, the CIC is in fact a leveraged investment fund. Due to its need to meet regular debt obligations, the CIC has to make annual interest payments for virtually its entire asset base. Therefore, with debt repayment as the main goal of the CIC, its profitability is based not on its total annual return net of fees but on its total annual return less interest costs and less management fees. In relation to the annual return, the CIC’s strategies are focused toward protecting macroeconomic interests while seeking out higher-​risk investments. In line with this desire, a dominant consideration in macro-​portfolio construction is liquidity and low volatility as required to meet annual debt payments. Prior to the establishment of the CIC, between inflation and real exchange-​rate costs, China was suffering significant losses which even the SAFE was unable to account for. There was an increasing concern that active investment management purchasing of riskier assets was needed to prevent ongoing large real losses (Ming Zhang 2009). This was the driving factor behind revamping the financial and operational goals of the newly established CIC and a core component of the strategy that the CIC was to employ going forward. Burned early in their existence by a couple of notable failures, the CIC has been keen to avoid any significant losses. Initially, a large percentage of the CIC’s investments were held in cash and cash-​like instruments; however, post the global financial crisis, the CIC diversified its investments across a wide range of asset classes and geographical regions to limit their downside risk (Wu, Goh, and Hajela 2011). In order to prevent market portfolio losses, the CIC has crafted a balanced portfolio split between low volatility domestic stocks, fixed income, and international equity, thereby growing to become the primary source of higher-​risk asset management for

Christopher Balding and Kevin Chastagner    361 China. While focusing on higher-​risk investments after the crisis, the CIC has taken a cautious approach of slow and gradual expansion into diversifying its investment channels (Liew and He 2012). Taking a prudent and conservative approach to other assets and risks helped the CIC recover a huge proportion of the losses incurred by the other SWFs. Their fixed income portfolio has demonstrated amazing consistency in line with global returns for safe assets. Given this framework, China has demonstrated that they are willing to forego higher returns for the trade-​off of avoiding large headline-​making losses. Another key component of the CIC’s ability to meet its debt obligations is the costs associated with management fees. Financial research has consistently found that a primary determinant of long-​run returns is controlling costs. While the CIC has shown they are willing to forego higher returns, they have also worked to keep costs low as a way to increase the long-​term outlook. In order to achieve this, the CIC hired accomplished and competent individuals qualified in a wide arena of specializations to self-​manage large amounts of its assets. It managed to do this by providing sound incentives to these individuals; for example, offering salaries in line with other Chinese civil servant institutions. Additionally, outside asset managers are given large mandates, but forced to accept low fees as a trade-​off for the size and prestige of managing the operations. They have generally avoided hedge funds and private equity for many reasons, but in no small part due to the associated fees. Furthermore, the CIC also functions as a buy-​and-​hold investor, lowering trading and investing costs—​another novel undertaking for an SWF. Whether it is bonds, company-​specific stakes or fund holdings, the CIC reduces fees by holding for sustained periods of time. This has enabled it to reap monetary benefits without having to incur large expenses. Despite assertions to the contrary, the CIC remains a dominant financial institution in China and is a strong political player by virtue of the investment responsibility it is in charge of on behalf of China’s central bank. CIC investments have been concentrated into a relatively small number of sectors, such as natural resources, materials, energy, and financial services (Wu 2014). These sectors are not, coincidentally, on the list of ones that the Central Government wishes to target as strategic sectors. Finance, natural resources and commodities, and technology lead the list of CIC investments as opposed to the traditional industrial sectors and manufacturing that the Central Government’s investment initiatives focus on. As a result, the CIC’s status as the formal sovereign Chinese investor raises questions about its vested interests, if any. There is no evidence that the CIC has exercised undue influence; even in many cases turning down board appointments. There is, however, some evidence that the CIC is able to open doors for firms in which it holds a stake, but this should be considered very much in line with what many stakeholders would engage in (Ram 2015). The Chinese government created the CIC as an SWF that was independent in every way from the SAFE and other public institutions in order to avoid the pitfalls arising out of homogeneous investment plans. The CIC was successfully able to channel

362    The China Investment Corporation: From Inception to Sideline its investments to propitiously enable domestic investments without compromising its existing foreign exchange reserves. It did this through the use of a unique recapitalization and restructuring scheme. As previously described, the CIC allocated its domestic holdings into Central Huijin Holdings (CHC). CHC holds the golden share in virtually every financial firm in China—​from nationalized and investment banks to securities houses and insurance companies—​but has almost no holdings outside of the finance industry. However, this changed after the 2015 stock market collapse when it was one of the enlisted parties to stabilize prices by purchasing stakes in domestic companies. The CIC’s primary strategy—​by design—​was to concentrate on international investment outside of China with Huijin managing the domestic assets like ownership shares in the major banks. Huijin’s role, as legislated by the State Council, was to administer key state-​owned financial institutions, to exercise its rights and fulfill its obligations as an investor on behalf of the state as limited by its stake in each institution, and to maintain and increase the value of state-​owned financial assets. On the other hand, the CIC solely operated China’s international investments. After the CIC’s initial international investment in Blackstone and Morgan Stanley, they branched out to invest in an array of other international instruments. According to CIC’s annual report for fiscal year 2008, its Public Market Investment Department is responsible for passive investments in public market equities, bonds, commodities, and currencies. The Tactical Investment Department is responsible for achieving absolute returns on in-​house and externally managed investments. The Private Market Investment Department is responsible for investing via third-​party managers, in limited partnerships, and in pooled investments as well as in real estate and infrastructure. The Special Investments Department is responsible for major long-​term investments. These four departments allow the CIC to focus on each of the core areas needed to achieve its mandated goals. The CIC claims that there is a wall between the domestic and foreign divisions of the company, though it would surprise no one if this was, at best, a thin wall. Its foreign assets are mostly limited to liquid financial assets, except for some negligible real estate. These liquid assets range from ETFs, stock bonds and private funds across all major financial markets with small amounts allocated to smaller financials, primarily in emerging markets. The CIC has sought to avoid this domestic and international split by purchasing China-​focused assets like China ETFs in New York that are not technically against this dividing line. In practice the extent of the wall remains an important consideration that may highlight the financial or political motivations of the CIC. When considering the structure of the CIC it is important to understand the impact that the 2008 global financial crisis had on China’s economy. Even though the CIC was designed to showcase a new, confident China, in the aftermath of the crisis, concerns were raised about the political influence over the SWF.4 As a result, the CIC sought very

4 

Even in the summer of 2016, concerns were being raised over potential CIC involvement in a UK nuclear plant as it might give China undue influence over British electricity supply (Guthrie 2016).

Christopher Balding and Kevin Chastagner    363 purposefully to lower its profile. To this end, it has turned down management control, board seats, and other common opportunities as a major investor to emphasize its non-​ influential role as an investor. It also chose to avoid headline-​grabbing investments that would bring it into the spotlight. By investing in funds, ETFs, and less recorded assets such as bonds, it has managed to dodge unwarranted attention. It is interesting to note that the CIC has continued to maintain a low profile. An explanation for this could be that the CIC may be working to channel capital through its commercial bank subsidiaries to send out other companies which make the controlling stake purchases. Many industrial firms have used capital provided by the commercial and investment banks, with the CIC occasionally as an investor, to fund overseas purchases. This allows the CIC to fund other Chinese SOEs with what amounts to helping a sister company and the same controlling stakeholder while avoiding the publicity itself. The CIC is the primary investment vehicle of surplus Chinese reserves and has increased its cooperation with other Chinese SOEs in recent years in order to facilitate more direct control and avoid charges of political manipulation. Understanding the macroeconomic environment that led to the creation of the CIC provides key context, which is important in the effort to understand its current strategy and motivation. Furthermore, understanding the way in which the CIC opperates provides an important view into China’s ongoing economic policy.

The Future Scope of the Impact of the Cina Investment Corporation The CIC faces a challenging future. Currently, capital outflows from China are averaging about US$50 billion per month and foreign exchange reserves have dropped from a peak of US$3.8 trillion to under US$3.2 trillion. The PBOC has been forced to defend whether the CIC counts toward its accounting of foreign exchange reserves and whether CIC will be used to defend the RMB should reserves continue to decline. So far, the PBOC insists that the CIC is not counted toward the foreign exchange reserve holding; however, it is difficult to see how a major portion of their capital does not count toward foreign exchange reserve holdings. Given the unique structure and capital that came from the PBOC foreign exchange reserves, which were turned into CIC capital, it is extremely difficult to see how the bond structure and how PBOC reserve numbers add up if excluding CIC capital. This matters as the future of China and the RMB is inextricably linked with the future of the CIC. If the RMB is depreciating and the PBOC defends the RMB, it is not outlandish to believe that the CIC will be drafted in to defend the RMB due to its centrality within the overall system. Just as the CIC grew rapidly with the explosion of Chinese foreign exchange reserves, the decline in reserves and a declining RMB will place pressure on the CIC to assist other agencies to support the broader macroeconomic framework.

364    The China Investment Corporation: From Inception to Sideline Moving beyond more immediate concerns, the CIC finds itself in a larger conundrum. For instance, what is its purpose if it is failing to exceed its cost of capital by any appreciable amount? Based upon its annual interest payments to the PBOC, after fees for its own services, the CIC is likely losing money for its shareholders. What is the purpose of the CIC if it is not earning a risk-​adjusted return above its cost of capital for its shareholders? While it is obvious to state the political influence, in an era when RMB is flooding out of China and the PBOC is propping up the RMB, it does bear asking what the role of the CIC is within the larger context, especially in the absence of any natural resource wealth. Furthermore, as the CIC was used to diversify PBOC holdings when reserves were appreciating too rapidly, it is reasonable to ask whether CIC assets should be depleted as part of the larger framework when Chinese foreign exchange reserves are declining in value. Going even further, given the outward investment strategy which focuses on direct investment or merger and acquisitions, what is the purpose of the CIC if it is not facilitating direct holdings and transfer of key assets beyond financial returns that Chinese industrial firms are able to facilitate? There is now a greater level of Chinese outward investment than inward investment, with the outward investment being driven by Chinese industrial and financial firms (e.g. insurance) snapping up assets around the world. When the CIC was the only investor of any size, it seemed like a reasonable strategy. However, now that they appear displaced by the shift in investment, it is worth asking—​especially in light of the decline in foreign exchange reserves—​what the purpose and long-​term strategic relevance of the CIC is. Some have argued that the CIC has the ability to remake the relationship between China and the US given CIC’s ability to bind the two countries together. However, given the previous reliance on US sovereign debt, this is a debatable assertion (Clark and Monk 2011). In most ways, the CIC has performed well given the parameters provided them. While their annualized financial returns have not been superlative, they have operated within a strict framework of acceptable risks and industrial targets. They have also avoided large losses and political entanglements that may have resulted in greater loss of confidence, either internally or internationally. It seems like the biggest challenges for the CIC remain.

References Balding, C. (2012). Sovereign Wealth Funds: The New Intersection of Money and Politics. Oxford: Oxford University Press. Bernstein, S., Lerner, J., and Schoar, A. (2013). The Investment Strategies of Sovereign Wealth Funds. The Journal of Economic Perspectives, 27(2), 219–​38. Blanchard, J. (2014). The China Investment Corporation: Power, Wealth, or Something Else?’ China and International Journal, 12(3), 155–​75.

Christopher Balding and Kevin Chastagner    365 Cai, C. and Clacher, I. (2009). Chinese Investment Goes Global:  The China Investment Corporation. Journal of Financial Regulation and Compliance, 17(1), 9–​15. Clark, G. and Monk, A. (2011). The Political Economy of US–​China Trade and Investment: The Role of the China Investment Corporation. Competition and Change, 15(2), 97–​115. Dettoni, J. (2016, August 8). “Silk Road Revival Drives Chinese Investment Push.” Financial Times. Available at www.ft.com [accessed August 18, 2016]. Giles, C. and Plimmer, G. (2015, October 18). “Chinese Investment: Is It Good For Britain?” Financial Times. Available at www.ft.com [accessed April 14, 2016]. Guthrie, J. (2016, September 22). “Li Ka-​Shing Means More Ka-​Ching for Grid.” Financial Times. Available at www.ft.com [accessed September 22, 2016]. Hu, Y. (2014). “China Investment Corporation: China’s Sovereign Wealth Fund.” In D. Chuen G. and Gregoriou, eds, Handbook of Asian Finance: Financial Markets and Sovereign Wealth Funds. Academic Press, pp. 315–​28. Hughes, J. (2015, July 22). “China’s Top Investment Bank Seeks Hong Kong IPO.” Financial Times. Available at www.ft.com [accessed April 16, 2016]. Hughes, J., Hume, N., and Sheppard, D. (2015, June 17). “Noble Group Chief Hits Back at Critics.” Financial Times. Available at www.ft.com [accessed April 12, 2016]. Lex. (2015, August 26). “Uber: Chinese Traffic Jam.” Financial Times. Available at www.ft.com [accessed April 16, 2016]. Liew, L. and He, L. (2012). Operating in an Inharmonious World:  China Investment Corporation. Journal of the Asia Pacific Economy, 17(2), 253–​67. Megginson, W. and Fotak, V. (2015). Rise of the Fiduciary State: A Survey of Sovereign Wealth Fund Research. Journal of Economic Surveys, 29(4), 733–​78. Ming Zhang, F.E. (2009). China’s Sovereign Wealth Fund: Weakness and Challenges. China and the World Economy, 17(1), 101–​16. Ram, A. (2015, December 18). “Carnival Buoyed by Fuel and Ticket Prices.” Financial Times. Available at www.ft.com [accessed April 14, 2016]. Sekine, E. (2011). The Governance of China Investment Corporation on its Way to Becoming a Sophisticated Institutional Investor. Nomura Journal of Capital Markets, 2(3), 1–​16. Sekine, E. (2015). China Investment Corporation:  Investment Performance in 2013 and Outlook. Nomura Journal of Capital Markets, 6(3), 1–​12. Shabbir, T. (2014). “Portfolio Allocation Dynamics of China Investment Corporation in the Aftermath of the Global Financial Crisis of 2007–​09.” In: D. Chuen and G. Gregoriou, eds, Handbook of Asian Finance: Financial Markets and Sovereign Wealth Funds. Academic Press, 329–​47. Shih, V. (2009). Tools of Survival: Sovereign Wealth Funds in Singapore and China. Geopolitics, 14(2), 328–​44. Sovereign Wealth Fund Institute (2008). Tracking the Activity of Sovereign Wealth Funds, Pensions and other Public Funds. Available at http://​www.swfinstitute.org/​fund-​rankings/​ [accessed July 14, 2016]. Tan, X. (2013). China’s Overseas Investment in the Energy/​Resource Sector: Its Scale, Drivers, Challenges, and Implications. Energy Economics, 36, 750–​8. Waldmeir, P. and Wildau, G. (2015, June 29). “China Graft Probe Uncovers Falsified Revenue at Large SOEs.” Financial Times. Available at www.ft.com [accessed April 12, 2016].

366    The China Investment Corporation: From Inception to Sideline Wu, F. and Froystadvag, A. (2015). China Investment Corporation’s Foray into Europe and the United States: Explain the Different Reception. Journal of Contemporary China, 25, 91–​111. Wu, F., Goh, C., and Hajela, R. (2011). China Investment Corporation: Post-​Crisis Investment Strategy. World Economics, 12(3), 123–​52. Wu, F. and Seah, A. (2008). The Rise of the China Investment Corporation. World Economics, 9(2), 45–​68. Wu, K. (2014). China’s Energy Security: Oil and Gas. Energy Policy, 73, 4–​11.

Chapter 16

Investm en t T e rms an d Level of C ont rol of China’s S ov e re i g n Wealth Fund i n i ts P ortfolio  Fi rms Jing Li

Introduction Although they have existed for more than a half century (since the 1950s), it is only in recent years that sovereign wealth funds (SWFs) have attracted worldwide interest. This follows their involvement in some large-​scale cross-​border M&A activities and their major capital investments into certain troubled financial institutions in developed countries (United Nations Conference on Trade and Development [UNCTAD] 2008). While one must admit that SWFs are becoming increasingly important players in the current international monetary and financial system (International Monetary Fund 2008), the rise of significant inflows of government-​owned capital has still aroused heated discussions among both the public and the politicians in recipient countries, which have indicated mixed reactions toward the investments by SWFs (UNCTAD 2008). To begin with, the sheer volume of these government-​controlled funds, which is already so big that the world views them in awe, has also been growing at an extremely rapid speed since 2010—​in fact faster than the assets of any other institutional investor group, including private equity and hedge funds (UNCTAD 2014). As of 2012, SWFs were estimated to manage over US$5.3 trillion worth of assets, 80% of which were in the hands of developing economies (UNCTAD 2013). This amount increased to US$7 trillion as of 2014. Although the cumulative foreign direct investment (FDI) by SWFs (around US$160 billion as of 2014) remains marginal compared to the total SWF assets under management (UNCTAD 2015), given that the cross-​border

368    Investment Terms and Level of Control of China’s SWF acquisitions by SWFs normally involve purchasing shares of less than 10%, which is the threshold for an investment to be classified as FDI (UNCTAD 2008), the potential ability of colossal amounts of funds to acquire blocks of shares in large and/​or public listed firms that hold key economic resources can still heighten the anxiety of host economies over their economic interests and security. Moreover, the concerns that foreign-​funded acquisitions do not add to productive capacity, bringing in new technologies, but simply transfer ownership and control from domestic to foreign hands (UNCTAD 2000) can seem more reasonable now than ever, when the investors from abroad are not merely commercial entities (such as transnational corporations) but foreign governments which may have political incentives other than financial ones (Kern 20071). To say the least, it seems understandable to question whether governmental investors, especially those from developing countries where an efficient corporate governance regime is generally not in place, are able to manage the portfolio companies efficiently as experienced professional investment managers and bring about good financial performance (see, for example, Bernstein, Lerner, and Schoar 2013;2 Fan, Wong, and Zhang 20073). More generally, the current western world certainly finds it difficult to accept a shift in the balance of power within the global economy from their community of industrialized countries to new emerging market giants (Chaisse 2012). Many even believe that the re-​emergence of state capitalism “will replace what was thought to be a global political economy set on a trajectory of increasingly unfettered free markets” (Dixon and Monk 2012). Faced with such concerns and doubts, it is certainly pertinent for the recipient countries to carefully examine their existing regulatory framework and wisely determine the proper regulatory response toward these controversial government-​owned funds. Apparently, doing so presumes a good understanding of the characteristics and strategies of SWF investments in the first place; and in this respect, there is already a burgeoning wave of empirical research. Among other things, SWFs are compared with similar private institutional investors to unveil their particular characteristics in terms of selecting investment targets and affecting firm performance (see, for example, Bortolotti, Fotak, and Megginson 2015; Chhaochharia and Laeven 2009; Johan, Knill, and Mauck 2013; Knill, Lee, and Mauck 2012; Kotter and Lel 2011). On a smaller scale, there are also studies—​not based on broad datasets comprising many SWFs but focusing on particular SWFs or recipient countries—​that discuss the relevant governance, investments, 1   Kern points out that “little is known about the extent to which the management of SWFs is independent in its investment decision with the aim of maximizing the return of the portfolio, or whether the government on behalf of which the SWF operates actually intervenes, and whether such interventions are in any way politically motivated.” 2  Bernstein, Lerner, and Schoar point out that “if sovereign wealth funds are run by politically connected but financially inexperienced managers, we might expect that not only would they make poor choices in their home and foreign investments, but would also display poorer stock-​picking ability even looking solely at the international portfolio of the fund.” 3  Fan, Wong, and Zhang find that publicly listed companies in China with politically connected CEOs are more likely to show low degrees of professionalism, and the accounting and stock return performance of these firms falls behind those without politically connected CEOs. The reason for such differences, as the paper argues, is due to the fact that politicians may exploit companies under their control for the purposes of fulfilling objectives that are not consistent with firm value maximization.

Jing Li   369 and regulatory issues in greater detail (Becker 2010; Heaney, Li, and Valencia 2011; Rose 2013). However, neither of the two research lines has endeavoured to examine the specific contractual terms of SWF investments so far. A better knowledge of the terms of SWF investment contracts is important because it offers a basis of understanding as to whether SWFs are passive investors or whether they exert active control rights in their portfolio companies, which is a cause of concern to many. To that end, contractual terms such as percentage of equity stake acquired and voting rights attached thereto, as well as director nomination right and board representation, are highly relevant when deciding the level of direct control by an SWF investor. Additionally, it is also useful to look at the pre-​and post-​investment business activities occurring across the networks of an SWF and its portfolio companies. These could either be co-​investment in a joint venture immediately afterwards, or more long-​term collaboration between the related firms in future business opportunities. Such business activities can provide important supplemental knowledge because merely looking into the contracts may not reveal the larger picture of indirect and long-​running influence SWFs can have over portfolio firms. There were some 100 SWFs globally as of 2014 (UNCTAD 2015), among which the China Investment Corporation (CIC) certainly stood out as an attention magnet when it was created as the country’s official SWF in September 2007.4 Since recently becoming the second biggest economy in the world, China is increasingly playing an important and influential role in the global financial system.5 Being the largest FDI recipient (surpassing the US in 2014) and the third largest FDI investor (after the US and Hong Kong) globally (UNCTAD 2015), and with its world-​largest foreign exchange reserves hitting new record high at almost US$3.7 trillion as of June 2015,6 there is no doubt that China’s position as a powerful major outward investor is being rapidly and repeatedly reinforced. Against such a background, it is reasonable to assert that discussions about China are of particular importance under the topic of sovereign wealth investments, and systematic research of the contractual terms of the CIC’s investment transactions will surely expose important information on the investment characteristics and strategies of the fund. While there have already been efforts to chronicle all the CIC’s investments (e.g. Clark and Monk 2010; Koch-​Weser and Haacke 2013), the most comprehensive of which being the China Global Investment Tracker jointly published by the American Enterprise Institute and the Heritage Foundation,7 these lists usually do not reveal much more transactional information than the amount of investments and the percentages of 4  “About CIC.” China Investment Corporation. Available at http://​www.china-​inv.cn [accessed January 27, 2016]. 5  “China Overview.” The World Bank, last updated September 18, 2015. Available at http://​www. worldbank.org/​en/​country/​china/​overview [accessed January 27, 2016]. 6  “The Time-​Series Data of China’s Foreign Exchange Reserves.” People’s Bank of China, updated monthly. Available at http://​www.safe.gov.cn/​wps/​portal/​english/​Data [accessed January 27, 2016]. 7  “China Global Investment Tracker.” The American Enterprise Institute and the Heritage Foundation. Available at http://​www.aei.org/​china-​global-​investment-​tracker/​ [accessed January 27, 2016]. Note that this dataset is intended to cover large Chinese outward investments, regardless of whether they have been made by governmental agencies, state-​owned enterprises, private firms, or the SWF. As such, investments made by the CIC are only a part of the dataset.

370    Investment Terms and Level of Control of China’s SWF equity stakes purchased. Certain transactions have been discussed in more detail just because they were somehow more “high-​profile” and thus more heavily covered by the media. However, there still has not yet been a relatively complete dataset of the contractual terms of CIC investment agreements. As such, this research is motivated. Compiling a hand-​collected dataset of all CIC investment transactions from 2007 to the end of 2015, which altogether includes 61 M&As, 8 joint ventures, and 28 investments into other investment funds, this chapter empirically studies the contractual terms of these investment agreements. While the CIC is often found to hold significant but non-​controlling equity stakes, its voting rights are often restricted in the contracts it entered into with its targets. In terms of board representation, the CIC has no seats in the boards of 30 non-​ fund and non-​JV targets, while it has only installed directors in 11 targets. Although the CIC does not seem to have actively exercised much of its formal control mechanisms in its investments—​especially when compared to its wholly-​owned subsidiary Huijin—​such contrast is arguably resulted more from the practical infeasibility of doing so in minority overseas equity holdings, than from the prepared deviation of the CIC from its “strategic governmental investor” role. This being said, given the practical concern of the target firms that they cannot easily afford losing such an important investor and business partner, there are still plenty of opportunities for the CIC to extract indirect private control benefits from them in the long-​term post-​investment relationships. Combined, these findings show that forcing SWFs to remain passive in the corporate governance realm (e.g. by asking them to suspend their voting rights) may not be entirely needed or helpful. Rather, the regulators of countries hosting SWF investments should carefully consider the necessity and level of any proposed regulation directed at SWFs as a particular type of investor, which should be weighed against the volume, performance and effect of the investments in the first place. This chapter briefly reviews the relevant literature on SWFs, with a focus on their investment characteristics and strategies. This is followed by a description of the CIC with particular reference to its connections with the Chinese government. It then presents and analyzes the data of CIC investments from 2007 to 2015.

An Overview of Sovereign Wealth Funds and the Relevant Literature As a descriptive term, SWF refers to the investment funds owned or managed by state governments. According to the Santiago Principles, a set of voluntary best practice guidelines generally accepted by 26 IMF member countries with SWFs in 2008, “SWFs are special purpose investment funds or arrangements owned by the general government,” which are commonly established out of “balance of payments surpluses, official foreign currency operations, the proceeds of privatizations, fiscal surpluses, and/​or receipts resulting from commodity exports” (International Working Group of Sovereign Wealth Funds 2008). The proportion of SWFs investing in various asset classes in 2013

Jing Li   371 and 2014 is presented in Figure 16.1. When compared to other major institutional investor types, SWFs share important similarities with both pension funds and hedge funds (Bortolotti, Fotak, and Megginson 2010). Like pension funds, SWFs have long-​term investment horizons; therefore, they do not have to focus only on highly liquid securities, but can rather diversify their investments across multiple asset categories. As stand-​ alone, unregulated pools of capital managed by investment professionals, analogy is often also made between SWFs and hedge funds when they purchase large ownership stakes in foreign companies (Bortolotti, Fotak, and Megginson 2010). Furthermore, because both SWFs and hedge funds lie outside the traditional banking system, they are often criticized on the basis of not being sufficiently transparent (Koch-​Weser and Haacke 2013). Besides these similarities, SWFs do possess important distinctiveness, which is well summarized by Bortolotti, Fotak, and Megginson (2010) as follows: SWFs seems to face numerous severe restrictions on the monitoring and/​or disciplinary role they can realistically play, at least regarding their cross-​border investments in listed companies. This is largely because any posture they take other than being purely passive investors might generate political pressure or a regulatory backlash from recipient country governments. (p. 3)

The impact of SWFs on target firms can be considered in the context of the literature on large shareholders (Kotter and Lel 2011), in that SWFs are often found to take significant positions in the companies in which they invest (Dewenter, Han, and Malatesta 2010). Having large shareholders in a firm can bring both benefits and costs. On the one hand, large block ownership usually means substantial collocation of decision rights and wealth effects which, in turn, leads to superior management or monitoring. As the ownership of the investor increases, there is also greater incentive for it to increase the firm value; and to the extent that these higher cash flows are shared with minority shareholders, they

100

Proportion of Sovereign Wealth Funds (%)

90 80

82 81

86 86

2013 2014

70 60

51

50

47

54

59

57

60

40

31 33

30

24

20 10 0

NA Public Equities

Fixed Income

Private Equity

Real Estate

Infrastructure

Hedge Funds

Private Debt*

Figure 16.1  Proportion of SWFs investing in each asset class (2013 vs. 2014) Source: Preqin (2015). Data on private debt information have only been collected starting from 2014.

372    Investment Terms and Level of Control of China’s SWF constitute shared benefits of control (Holderness 2003). On the other hand, in the process of using its control rights to maximize its own welfare, the large investor can redistribute wealth—​in both efficient and inefficient ways—​from others. This cost of concentrated ownership becomes particularly important when others (such as employees or minority investors) have their own firm-​specific investments to make and these are distorted because of possible expropriation by the large investors (Shleifer and Vishny 1997). In particular, there is a non-​monotonic relationship between management ownership and firm value, which first increases, then declines, and finally rises slightly as board ownership rises. These results also apply individually to the ownership by the firm’s top officers and its outside board members (Morck, Shleifer, and Vishny 1988). When it comes to specific SWF purchase transactions, share price of the target firm would initially increase along with the transaction size, reach a maximum, and then decline. For sale transactions, abnormal returns first decrease with the fraction of the firm being divested by the SWF, reach a minimum, and then increase. Taken together, these results indicate that “firm value changes associated with SWF transactions reflect a trade-​off between gains from the monitoring or lobbying activities of the funds and losses from their extraction of private control benefits at the expense of minority shareholders” (Dewenter, Han, and Malatesta 2010). While the above-​mentioned cost-​benefit trade-​off applies to any type of block owners, the fact that a government-​controlled fund is the large investor may agitate concerns—​particularly on the costs side, and especially considering that almost half of the SWF investments since 2006 were from countries classified by The Economist as authoritarian regimes or flawed democracies (Barbary and Bortolotti 2013). More specifically, the political capture can introduce short-​run pressures on SWFs to accommodate public demands for job creation and economic stabilization within the country, thus “passing up on high net present value investments in other firms and creating product market distortions by favoring connected or poorly performing firms” (Bernstein, Lerner, and Schoar 2013). Another distortion as a result of political involvement in SWFs’ investments is the appointment of politically connected but financially inexperienced managers. This can potentially reduce the overall skill of SWF managers relative to other professionals and dilute the returns (Bernstein, Lerner, and Schoar 2009). There is also a widespread fear that SWFs will not act as strictly commercially minded investors seeking only the highest possible financial return, but will instead be commanded to invest strategically by home-​country governments for the purposes of exerting political influence (Bortolotti, Fotak, and Megginson 2015) or gaining access to foreign technology. In terms of managing investments and taking corporate governance role in invested companies, governments are generally considered to be bad operating managers. It is found that firm performance improves with privatization, while mixed public and private ownership has a negative impact on firm value because governments can impose goals (such as employment maximization) inconsistent with shareholder wealth maximization (Megginson and Netter 2001). However, it cannot be assumed that SWFs should simply stay passive and suspend their voting rights to prevent them from using a portfolio company’s corporate governance structure to influence their decisions (Gilson

Jing Li   373 and Milhaupt 2008).8 This is because the market reacts differently depending on the behavioral and structural characteristics of the SWF involved. While larger discounts and deteriorating performance are found to be associated with large investments by highly politicized SWFs, SWFs are highly heterogeneous to each other. Some funds—​ best exemplified by Norway’s Government Pension Fund Global (GPFG)—​have already succeeded in developing the necessary internal governance structures with the goal of insulating management from political interference; therefore their investments are not found to be associated with the SWF discount (Bortolotti, Fotak, and Megginson 2015). A more nuanced issue is that an SWF may not necessarily influence its portfolio company by directly playing an active corporate governance role within the firm itself, such as assuming directorships or replacing CEO or other senior management. More broadly, the opportunities for post-​investment target company business deals with firms related to, or invested by, the same SWF (or vice versa) and the potential favorable or unfavorable government regulatory decisions that may affect the target firm, are all possible events indicative of SWF’s power and influence (Dewenter, Han, and Malatesta 2010). Apparently, these events can take place even if the SWF investor agrees to forgo voting rights, or appoints no representative to the target firm’s board. Rather, what they reflect might be an (emerging) long-​term relationship between the SWF and the target company, and there is arguably still considerable room for the SWF to exert indirect but effective control if the target firm wants to build up or preserve the relationship. While recent research notes this issue and finds that, for example, SWFs are often active investors and their post-​investment activity is associated with differential long-​run abnormal returns of the target firms (Dewenter, Han, and Malatesta 2010), there still lacks a detailed case study of SWF investment contract terms, analyzed in the context of the pre-​and post-​deal activities surrounding the investment transactions. This study is thus needed to facilitate a better understanding of the content and level of control rights of SWF investments.

The China Investment Corporation (CIC) Creating an SWF is certainly not the only means that a government has when it wishes to make and manage international investments. Rather, several institutional mechanisms are available for those purposes: with traditional foreign reserves managed by central banks and/​or finance ministries at one end, stabilization funds in the middle, and SWFs at the other end (Truman 2007).9 Also, a government may—​directly or indirectly—​ own, control, or sponsor domestic entities like banks or corporations to invest in foreign 8 

Gilson and Milhaupt propose a simple corporate governance fix that “the equity of a US firm acquired by a foreign government-​controlled entity would lose its voting rights, but would regain them when transferred to non-​state ownership.” 9  In particular, SWFs may hold more diversified assets and longer investment horizons than stabilization funds, which still primarily aim at medium-​term macroeconomic stabilization purposes.

374    Investment Terms and Level of Control of China’s SWF countries.10 Even when the discussion is narrowed down to SWFs, it is worth noting that a country can have more than one such fund. As for China, the Sovereign Wealth Fund Institute (SWFI), a research organization dedicated to study SWFs, public pensions, central banks and other public investors,11 identifies four Chinese SWFs in its list of the world’s biggest SWFs; namely, the CIC, SAFE Investment Company, National Social Security Fund, and China-​Africa Development Fund.12 Among the four, however, only the CIC is acknowledged by the Chinese government as its official SWF (Koch-​Weser and Haacke 2013), which is mandated “to realize the diversification of the state’s foreign exchange assets and achieve a relatively high risk-​adjusted and long-​term rate of return, through its investment activities outside the Mainland—​principally portfolio investments with a small percentage of direct investments”.13 As such, this chapter will only focus on the CIC and not delve into the other three funds.

An Overview of the China Investment Corporation As of the end of 2014, the CIC’s total assets exceeded US$740 billion (CIC 2015). According to the ranking of the SWFI, it is the world’s largest non-​commodity SWF and generally the third largest SWF as of December 2015, ranking after Norway’s GPFG, and UAE’s Abu Dhabi Investment Authority.14 The CIC began in 2007 and is still a young fund when compared to the world’s other major SWFs. While being the official entity mandated by the central government to invest and manage China’s gigantic foreign exchange reserves, it certainly assumes great responsibility and thus has established itself as one of the most important SWFs globally. Also, considering China is the world’s second largest economy and the world’s largest authoritarian regime (The Economist Intelligence Unit 2015),15 people have reason to be concerned that the Chinese superpower is now acting as the entrepreneur itself by making overseas investments through the CIC. This is noted as reflecting a form of so-​called “state capitalism” or “new mercantilism”, where the country is the unit whose value is to be maximized, with a corresponding increase in the role of 10 

Although the official SWF of China is the CIC, a number of gigantic state-​owned corporations, banks, and even the government itself are often identified in the media to have been involved in overseas investment transactions. A comprehensive list of China outward investments is provided by the China Global Investment Tracker (see footnote 7). 11  “Sovereign Wealth Fund Institute—​About Us.” Sovereign Wealth Fund Institute. Available at http://​ www.swfinstitute.org/​about/​ [accessed January 27, 2016]. 12  “Largest Sovereign Wealth Funds by Assets under Management.” Sovereign Wealth Fund Institute, last updated December 2015. Available at http://​www.swfinstitute.org/​sovereign-​wealth-​fund-​rankings/​ [accessed January 27, 2016]. 13  “China Investment Corporation Announces the Establishment of a Wholly-​Owned Subsidiary in Hong Kong.” China Investment Corporation. Available at http://​www.china-​inv.cn [accessed January 27, 2016]. 14  See footnote 12. 15  In 2014, China ranked 144 among the 167 countries covered in The Economist Intelligence Unit’s Democracy Index, and was classified into the authoritarian group.

Jing Li   375 the national government as a direct participant in, and coordinator of, the effort to ensure that company-​level behavior results in country-​level maximization of economic, social, and political benefits (Gilson and Milhaupt 2008). This is in contrast to the long-​believed faith of the developed economies—​namely, free trade and competition among companies increases GDP at the national level, and it should be the market that polices the tautology. Interestingly, the above-​mentioned notions are at odds with the CIC’s own proclamations, which state that despite being wholly state-​owned, it is a market-​oriented entity and “shall separate its commercial activities from governmental functions, make its business decisions independently and operate based on commercial grounds”.16 In order to better comprehend the extent to which the Chinese central government plays a role in directing and participating in the CIC’s investments, an overview the CIC’s formal governance framework and investment philosophies is presented in Figure 16.2. Table 16.1 also provides background information on the CIC’s relationship with the Chinese central government.

Board of Directors

Board of Supervisors

Remuneration Committee Executive Committee

Supervisory Committee

International Advisory Council

Audit Committee

Office of Board of Supervisors / Internal Audit Department CIC

CIC International

Investment Departments

Operational and Management Departments

CIC Capital

Investment Departments

Operational and Management Departments

Central Huijin

Overseas Offices

Figure 16.2  Organizational structure of the CIC Source: Adapted from CIC.17

16  “Articles of Association (Abstract).” China Investment Corporation. Available at http://​www.china-​ inv.cn [accessed January 27, 2016]. 17  “Organizational Structure.” China Investment Corporation. Available at http://​www.china-​inv. cn[accessed January 27, 2016].

CIC

CIC International Co., Ltd. (CIC Central Huijin Investment Ltd. (Huijin) International)

CIC Capital Corporation (CIC Capital)

Date of Inception

September 29, 2007

December 2003

September 28, 2011

January 2015

Capitalization

CIC’s registered capital is US$200 billion. The funding of CIC was done through issuing special bonds worth RMB1.55 trillion by the Ministry of Finance. These funds were, in turn, used to acquire approximately US$200 billion of China’s foreign exchange reserves which formed the foundation of CIC’s registered capital.

In September 2007, the Ministry of Finance issued special treasury bonds and acquired all shares of Huijin from the People’s Bank of China. The acquired shares were then injected as part of its initial capital contribution into CIC.

US$30 billion was injected into CIC Not disclosed International in December 2011. As of 2012, a total of US$49 billion had been provided to the company.

Shareholder

The State Council

CIC Huijin’s principal shareholder rights are exercised by the State Council.

CIC

CIC

Subsidiaries

Huijin CIC International CIC Capital

None

CIC International (Hong Kong) Co., Ltd. CIC Toronto Representative Office (closed as of December 2015)

None

Investment Objectives

Carrying out an active and steady operation; maximizing the shareholder’s interests within an acceptable scope of risks; and continuously improving corporate governance in the state-​owned major financial institutions that it controls.

Acting as an investor on behalf of the State to achieve the goal of preserving and enhancing the value of state-​owned financial assets.

Inherits CIC’s investment objectives.

Refining CIC’s overall portfolio management; enhancing investment in long-​ term assets.

376    Investment Terms and Level of Control of China’s SWF

Table 16.1  Investment Principles of the China Investment Corporation and its Subsidiaries

Investment Approach

Holding, managing, and investing mandated assets to maximize shareholder value; usually not taking controlling role or seeking to influence operations of portfolio firms; being committed to investing long-​term.

Does not intervene in the day-​to-​day Inherits CIC’s investment business operations of its portfolio approaches. firms.

Pursuing a market-​ oriented commercial approach with a global reach; specializing in making direct overseas investments.

Investment Scope

Investments not limited to any particular sector, geography, or asset class and include equity, fixed income, and alternative assets in both developed and emerging markets; equity investments in domestic financial institutions to be made primarily through Huijin; does not actively seek investment in domestic non-​financial enterprises, with the exceptions of purchasing overseas listed stocks, passive shareholdings and other circumstances as approved by the relevant governmental authorities.

Making domestic equity investments in major state-​owned financial enterprises; exercising its shareholder rights to the extent of its capital contribution.

Focusing on making bilateral and multilateral fund investments to cover CIC’s overseas business together with CIC International.

Investing and managing capital outside Mainland China, covering the CIC’s overseas business together with CIC Capital.

Source: Compiled based on the official websites of the CIC (http://​www.china-​inv.cn/​) and Huijin (http://​www.huijin-​inv.cn/​), as well as the relevant CIC annual reports.

Jing Li   377

378    Investment Terms and Level of Control of China’s SWF

The China Investment Corporation’s Strong Connections with China’s Government While the CIC stresses that it operates with independence and its investment decisions are based on the economics of each deal, it remains directly accountable to the State Council,18 which is China’s highest executive and administrative body. Most obviously, this is reflected in the fact that the appointment and removal of directors into and from the CIC’s board, which is its ultimate decision-​making organ,19 shall be subject to the State Council’s approval. In particular, the CIC’s board should have one chairman and may have one vice-​chairman, both of whom must be appointed by the State Council.20 The board of directors and senior executives are monitored by the board of supervisors, whose chairman must again be appointed by the State Council from the supervisors.21 Similarly, the State Council also appoints all the members of Huijin’s board of directors and board of supervisors.22 The fact that the CIC is answerable directly to China’s top central governmental organ actually confers it with a cabinet ministerial standing (Bu 2010). In reality, the senior officers of the CIC are in constant contact with the high officials of the other relevant ministry-​level authorities in terms of responding to government, reporting on actions taken, and negotiating investments in accordance with government policy, so that all of these individuals effectively owe their careers to the Communist Party and the government (Clark and Monk 2010, p. 15). Based on the information disclosed on the official websites of the CIC and Huijin (in particular the relevant press releases on personnel appointments and removals), as well as in the CIC annual reports from 2008 to 2014, a total of 50 people have served on the board of directors, board of supervisors, and executive committee of the CIC and Huijin, among whom 27 were in office as of December 2015. By examining the current, former and/​or latter roles of these directors, supervisors, and senior officers, one can reasonably infer that the central government is able to sustain effective control of the CIC because almost all of its key personnel have followed typical “political official career paths.” Except for the CIC’s Chief Strategy Officer (Mr Zhou Yuan) and Chief Information Officer (Mr Hua Hua), all of the remaining 48 people that are working, or have worked, for the CIC and Huijin have either served as governmental officials in various governmental authorities, or at least worked at one or more state-​owned financial institutions. In particular, it is worth noting that all the non-​executive directors of the CIC have been in-​office senior officials concurrently working at certain important

18 See id. (pointing out that the State Council exercises shareholder’s rights on behalf of the State in

the CIC). 19  “Articles of Association (Abstract).” China Investment Corporation. Available at http://​www.china-​ inv.cn [accessed January 27, 2016]. 20  Id. 21  Id. 22  “Articles of Association (Abstract).” Central Huijin Investment Ltd. Available at http://​www.huijin-​ inv.cn [accessed January 27, 2016].

Jing Li   379 economic, financial and foreign exchange regulatory authorities at the equal ministry level, such as the National Development and Reform Commission, the Ministry of Finance, the Ministry of Commerce, the People’s Bank of China, and the State Administration of Foreign Exchange. As for the senior managers, while they do act in accordance with their roles and report to the chairman and CEO in the first instance, ultimately they must be accountable to the State Council, which is the one and only shareholder of the CIC. As such, it is logical to infer that the decisions taken by the CIC are the results of compromise and consultation among the various government institutions involved (Clark and Monk 2010, p. 15). The CIC positions taken by former or current governmental officials are pragmatically and essentially “job-​rotations” that are part of their career paths within the Communist Party. In this sense, the CIC’s adoption of the Santiago Principles may be less about a substantive effort to police its internal governance according to the guidelines generally accepted there, but more about claiming external legitimacy, which is part of a more general process of “normalizing” relationships with the West. The commitment to western institutional “forms” should therefore not be taken to represent a similar functional allocation of powers and responsibilities consistent with the practice in many western investment agencies (Clark and Monk 2010, p. 23). A more realistic description of the CIC is that “it is an arm of the Chinese government just like other state-​owned enterprises concerned with its resource needs and its status as a global power” (Clark and Monk 2010, p. 19).

Data and Discussion Despite the fact that the CIC labels itself as a long-​term financial investor that does not seek control rights in its portfolio companies, the fact that it is overwhelmingly staffed with former or current governmental officials and must ultimately be accountable to the State Council does cause the outside world to question otherwise. Has the CIC been rigorously complying with its formal investment principles in practice, or was it actually able to influence, either directly or indirectly, the business operations of the companies it invested in? In order to shed light on these questions, we now turn to the investment transactions made by the CIC from its inception in 2007 to the end of 2015 through collecting and studying the key contractual terms of the investment agreements to the extent available. These are then discussed in the context of the relevant events and dealings surrounding these transactions, in order to offer a thorough understanding of the content and level of the CIC’s control and influence in its portfolio companies.

Data Collection and Description Starting as early as 2008, the CIC published annual reports where it disclosed, among other things, relevant financial information such as asset allocation and the rate of return

380    Investment Terms and Level of Control of China’s SWF of its overseas portfolio for the past year (Koch-​Weser and Haacke 2013). This said, it is worth noting that such disclosure does not include an exhaustive list of the CIC’s investments during that particular year, but is rather made in a manner to give examples thereof. In the absence of a comprehensive collection of the historical investment transactions from the official source, the China Global Investment Tracker—​jointly published by the American Enterprise Institute and the Heritage Foundation—​so far remains the only publicly available dataset of large (i.e. valued at more than US$100 million) Chinese outward investments and construction contracts worldwide, both failed and successful, in all industries since January 1, 2005.23 This list is double-​checked and modified by: (1) searching the official websites and public announcements of the relevant transaction parties and various news sources to ensure the accuracy of these entries; (2) going through the “company deals” records of the CIC in Thomson Reuters’ Thomson One database from 2007 to 2015 (inclusive), as well as all the deals mentioned in the CIC’s annual reports and press releases, to see whether this list missed some transactions and thus could be supplemented; and (3) running a search on Dow Jones Factiva database to capture those deals that took place during the period from July 1, 2015 to December 31, 2015, which might still be too recent to be recorded in any of the ready databases. The above-​mentioned efforts finally generate a list containing an aggregate of 69 CIC transactions (excluding investments into asset management funds), among which 61 were acquisitions, and the remaining eight were joint ventures. All of these 69 transactions were executed and completed directly between the CIC (or one or more of its subsidiaries, investment vehicles or agents) and the target, thus excluding deals that were merely rumored or later suspended, and deals that only indirectly involved the CIC as an investor.24 In addition to the 69 deals mentioned above, a 2013 policy paper from the US–​China Economic and Security Review Commission also identified the CIC as having provided financing into 18 investment fund vehicles (Koch-​Weser and Haacke 2013). After applying similar refining methods, the final list consists of 28 fund investments by the CIC in the period of 2007–​15. Put together, these 97 transactions constitute the full sample of CIC investments from 2007 to 2015, which serves as the basis for hand-​collecting the data on investment contract terms as well as pre-​and-​post-​transaction events relevant to the CIC’s control and influence. Tables 16.2–​16.4 enumerate these 97 transactions.

General Characteristics of the Investments As shown in Tables 16.2–​16.4, the CIC has invested in 23 different countries or regions in all of the 97 transactions, among which 12 are developed and the remaining 11 are 23 

See footnote 7, and by downloading the full dataset. For example, according to the 13-​D and 13-​G filings with the US Securities Exchange Commission, the CIC had indirect control rights in three companies—​namely, General Growth Properties, Inc., The Howard Hughes Corporation, and Rouse Properties, Invc., by virtue of its investment in Brookfield, a Canadian private equity fund. 24 

Table 16.2 Major China Investment Corporation Investments (2007–​15) Time of Investment Target Name

Target Location

1

May2007

Blackstone Group LP

US

2

Nov2007

3

4

Ownership of CIC Relative to other Shareholders

Target Sector

Target Subsector

Percentage of Value (US$ M) Ownership

Number of Directors

Finance

Investment

3,000

9.3% of outstanding common units (without voting rights)

As of March 2008, the 0 only 5%-​and-​above beneficial owner of common units with voting rights was AXA Financial, Inc. (23%) (2007 annual report).

China Railway China Group Limited

Transport

Railway

100 (HK$ 780)

0.7% of the company’s outstanding shares

Unknown

Dec 2007

Morgan Stanley

US

Finance

Investment

5,579

9.86% CIC’s ownership shall be no more than 9.9%.

As of April 2008, 0 Morgan Stanley only had one 5%-​and-​ above shareholder, State Street Bank and Trust Company (12.97%) (2008 proxy statement).

Mar 2008

Visa Inc.

US

Finance

Business services

100

Unknown

Unknown

Note CIC’s holding was raised to 12.5% on October 2008 by renewing the investment agreement.

0

Bailout transaction

0

(Continued)

381

382

Table 16.2 (Continued) Time of Investment Target Name

Target Location

5

Jun 2009

CITIC Capital

6

Jun 2009

7

Jun 2009

Ownership of CIC Relative to other Shareholders

Target Sector

Target Subsector

Percentage of Value (US$ M) Ownership

Number of Directors

China

Finance

Investment

Undisclosed

40%

CIC is the single largest shareholder; but effectively CITIC Group Corporation is the controlling shareholder as it owns 60% of CITIC Capital through two of its subsidiaries.

1 (Nov. 2009–​ present) (Board size unknown)

Qatar Investment Authority subscribed new shares in August 2012 and ended up owning 22.22%, diluting the ownership of CIC’s to 31.11%, and CITIC Group Corporation to 42.78%.

Blackrock

US

Finance

Investment

2,800 (together with other investors)

Less than 3%

Unknown

0

Supportive transaction

Goodman Group

Australia

Real estate

Property

159 (AUD 200)

Not more N/​A than 19.9% of Goodman’s stapled securities, after exercising BOTH the call options and the converting the preferred securities issued in the August 2009 transaction below.

N/​A

Bailout transaction (Bridge loan, with the options to buy Goodman’s stapled securities within a two-​year term) CIC exercised the option in May 2011 for a consideration of AUD 78.5 million.

Note

8

Jul 2009

Teck Resources Canada Ltd

Metals

9

Jul 2009

Diageo

UK

10

Aug 2009

Goodman Group

Australia

Copper

1,500

CIC subscribed class-​B shares, holding 17.2% equity stake but only 6.7% voting interests CIC will not acquire additional securities of Teck (other than pursuant to its anti-​dilution rights)

Upon completion of the transaction, Teck A shareholders as a group will hold 61.8% voting interest, and Temagami Mining Company Limited will hold 28.5% voting interest.

Manufacturing Beverages

368 (GBP 224)

1%

As of August 2009, 0 the 3%-​and-​above shareholders in Diageo were Capital Research and Management Company, holding 4.99%; and Legal & General Group Plc, holding 4.12% (2009 annual report).

Real estate

396.3 (AUD 500)

10.99% (after the CIC is and remains the conversion and largest shareholder the exercise of (2015 annual report). call option) (2011 annual report).

Property

1 out of 14 Bailout transaction directors (Apr. 2010–​present)

383

0 (CIC can nominate 1 director into the board, subject to CIC holding a minimum of 10% of Goodman).

Bailout transaction CIC converted its preference shares into stapled securities in December 2010. CIC sold 6.9% of its stake in December 2012.

(Continued)

384

Table 16.2 (Continued) Time of Investment Target Name

Target Location

Target Sector

Target Subsector

Percentage of Value (US$ M) Ownership

11

Aug 2009

Songbird Estates PLC

UK

Real estate

Property

1,730 (GBP 1,030) (together with other investors)

12

Sep 2009

Noble Group Ltd

HK

Agriculture

13

Sep 2009

PT Bumi Indonesia Resources Tbk

Energy

Ownership of CIC Relative to other Shareholders

Number of Directors

Note

14.72% of issued ordinary share capital, and 45% of issued preference share capital.

As of March 2010, the other 3%-​and-​ above ordinary shareholders of Songbirds were: Qatar (23.96%), Glick (23.95%), Morgan Stanley (9.34%). Qatar holds the other 55% of preference shares (2009 annual report).

0 (CIC can appoint up to 3 directors)

Wholesaler 850 of agricultural raw materials & commodities

14.91%

CIC is the second largest shareholder, after Noble Temple Trading Inc (23.81%) and before Lexdale International Limited (9.26%) (2009 annual report).

1 out of 14 CIC sold 4.5% directors shares in September (May 2014. 2011–​present)

Coal

N/​A

N/​A

N/​A

1,900

Bailout transaction (combination of preference shares, ordinary shares, warrants, and a loan) Songbird was acquired in whole in March 2015 and ceased operating as of April 2015.

Bailout transaction. The US$1,900 million was provided to Bumi as a loan. The debt balance can be settled with Bumi’s equity holdings in a number of its subsidiaries.

US$600 million was repaid in 2011. One settlement happened in July 2014 (see later entry of this table). 14

Sep 2009

JSC Kazakhstan Energy KazMunaiGas Exploration Production

15

Oct 2009

Poly (Hong Kong) Investments Ltd

16

Oct 2009

Nobel Holdings Russia Investments Ltd

Energy

17

Oct 2009

SouthGobi Canada Energy Resources Ltd

Energy

China

Oil and gas

939

11%

The company 0 has a controlling shareholder NC KMG (61.36%) (2009 annual report).

53 (HKD 408.6)

2.3%

Unknown

0

Oil & gas

300

45%

CIC: 45%; Kaisun Energy Group Limited: 5%; and Nobel: 50%.

Unknown

Coal

500

13% (after CIC’s conversion of half of the debenture into common shares in March 2010)

The only two 10%-​and-​above shareholders of SouthGobi were Ivanhoe Mines Ltd (57%) and CIC (13.6%) (2010 annual report).

0 Supportive (CIC can transaction nominate 1 director if it holds at least 15%).

Conglomerate

Supportive transaction

385

(Continued)

386

Table 16.2 (Continued) Time of Investment Target Name

Target Location

18

Oct 2009

Iron Mining International Ltd /​Hong Kong Lung Ming Investment Holdings

19

Nov 2009

20

Nov 2009

Ownership of CIC Relative to other Shareholders

Target Sector

Target Subsector

Percentage of Value (US$ M) Ownership

Number of Directors

Mongolia

Energy

Iron

500 to 700

33%

Ownership of Iron Unknown Mining International Ltd as of April 2012: 1/​3–​CIC, 1/​3–​ Boldtumur Eruu Gol LLC, and 1/​3–​Lung Ming.25

Supportive transaction

AES Corp

US

Energy

Electrical power

1,581

15%

CIC is the largest shareholder in AES (15.99%) (Proxy statement February 2011).

CIC’s ownership was reduced to 8.29% as of December 2013 as a result of selling shares back to AES and to the market. CIC’s stake in AES was reduced to 0.06% as of May 2015 as a result of selling its shares back to AES and to the market.

China Longyuan Power Group

China

Energy

Wind power 400 (HKD 3,100)

5.32%

CIC is the second 0 largest shareholder, (5.09%), after Guodian Group (63.68%) (2009 annual report).

1 out of 11 directors (Dec. 2011–​ Feb. 2015, per resignation) (CIC can nominate 1 director if it holds at least 5%).

Note

CIC sold its shares in March and October 2013 and its interests fell to 4.85%.

21

Nov 2009

GCL-​Poly Energy Holdings Ltd

22

Feb 2010

23

China

Energy

Solar 717 (HKD photovoltaic 5,500)

Apax Partners UK Worldwide LLP

Finance

Investment

May 2010

Penn West Energy Trust

Canada

Energy

24

Jun 2010

Chesapeake Energy Corp.

US

25

Dec 2010

Banco BTG Brazil Pactual Group

20.09%

CIC was the second largest shareholder (20.09%), after GCL-​ Poly’s chairman (2010 annual report).

2 out of 12 directors (Dec. 2009–​ Jan. 2014) (CIC may appoint 2 directors if it holds more than 12%; and 1 if it holds between 5% and 12%)

115 rumored 2.3%

Unknown

Unknown

Oil & gas

435

5.3%

Unknown

0

Energy

Oil & gas

200

Unknown

Unknown

0

Finance

Investment

300

3.11%

The December 2010 investors (including CIC) and some other people collectively represent around 2.2% of the voting power of BTG Pactual Participations. BTG GP (controlled by the firm’s chairman & CEO) owns 95.4% of the voting power.

0 (So long as CIC holds at least 50% of the equity originally purchased in 2010, it can nominate 1 director in 2012 and 2013).

CIC sold 7.75% shares in June 2013 and another 7.75% in January 2014, resulting its ownership being reduced to 4.5%.

387

(Continued) 25 

“Haranga Resources Ltd (HAR.ASX), Iron Ore in Mongolia with Nearby Infrastructure in Place.” Foster Stockbroking Equity Research Metals & Mining, p. 6. Available at http://​www.haranga.com/​uploads/​asx/​pdf/​FosterStockbroking12Apr12.pdf [accessed January 27, 2016].

388

Table 16.2 (Continued) Time of Investment Target Name

Target Location

Target Sector

Target Subsector

Percentage of Value (US$ M) Ownership

Ownership of CIC Relative to other Shareholders

Number of Directors

Note

In Banco BTG Pactual SA, the December 2010 Investors are part of the free float, which is only 16.7% of the voting rights (BTG Pactual website). 26

Dec 2010

Northstar Indonesia Tambang Persada Ltd (holds 40% in PT. Delta DuniaMakmur Tbk, which holds BUMA)

Energy

Coal

73

8% (in BUMA)

Unknown Unknown After the transaction, Northstar Equity Partners continues to retain voting rights and a controlling interest in Northstar Tambang Persada Ltd.

27

Feb 2011

VTB Group

Russia

Finance

Banking

100

Unknown (the investor group bought around 10% altogether)

Federal Agency 0 for State Property Management: 75.5%; foreign institutional investors in total: 17%

28

Feb 2011

Morgan Stanley real estate loan portfolio

Japan

Real estate

Property

385

N/​A

N/​A

N/​A

The target is a distressed asset portfolio.

29

Apr 2011

China Lumena China New Materials

Materials

30

Apr 2011

Semiconductor China Manufacturing International Corporation (SMIC)

31

Jul 2011

Enogex Holdings, LLC

US

Thenardite

90

6.41% (2011 annual report)

CIC was the second largest shareholder (6.41%), after Mr Suo Lang Duo Ji (33.53%) (2011 annual report).

0

Supportive transaction. The company is in middle of insolvency proceedings as a result of a winding up petition dated in January 2015.

Manufacturing Semi-​ conductor

250

13.6%

CIC was the second largest shareholder in the SMIC (11.27%), after Datang Telecom Technology & Industry Holdings Co., Ltd (19.27%) (2012 annual report).

2 out of 10 directors (Prof. Law­ rence J. Lau, Jul. 2011–​Dec. 2014, per resignation) Mr Zhang Wenyi, Jul. 2011–​Mar. 2015, per resignation) (CIC can nominate 1 director)

CIC’s ownership was diluted to 8.05% (third largest shareholder) after the subscription of new capital by the National Integrated Circuit Industry Investment Fund in June 2015 (2015 semi-​annual report).

Energy

518 Unknown (altogether by the investor group)

Natural gas

389

Enogex Holdings, LLC Unknown is a joint venture set up by OGE Energy Corp. (owning 90.1%) and ArcLight Capital (owning 9.9%) in October 2010. The investor group (including CIC) was brought in by ArcLight to support its investment in Enogex Holdings.

Supportive transaction

(Continued)

390

Table 16.2 (Continued) Time of Investment Target Name

Target Location

32

Aug 2011

Diamond S Shipping LLC

33

Sep 2011

34

Oct 2011

Ownership of CIC Relative to other Shareholders

Target Sector

Target Subsector

Percentage of Value (US$ M) Ownership

Number of Directors

US

Transport

Shipping

100

10.5%

The company has five 0 shareholders with 5%-​ and-​above ownership interests: WL Ross Group, LP (32.2%); First Reserve Management, LP (27.2%); CarVal Investors, LLC (18.3%); CIC (8.6%); and Siguler Guff Advisers, LLC (6.4%). (S-​1 registration statement, February 2014).

Supportive transaction

AES-​VCM Mong Duong Power Co.

Vietnam

Energy

Coal

93

19%

AES: 51%, and Posco Energy 30% (website of AES-​VCM Mong Duong Power).

Unknown

Supportive transaction

GDF SUEZ Exploration & Production (E&P) Business; and Train 1 of the Atlantic LNG liquefaction plant

France; Energy Atlantic LNG liquefac­ tion plant located in Trinidad and Tobago

Oil & gas

4,000 (E&P business for 3,150, Atlantic LNG liquefaction plant for 850)

30% of GDF SUEZ E&P, and 10% stake in the train 1 of the Atlantic LNG liquefaction plant in Trinidad and Tobago.

The rest of GDF SUEZ E&P is owned by GDF SUEZ Group (GDF SUEZ E&P website).

2 out of 7 Bailout transaction directors in GDF SUEZ E&P

Note

391

35

Oct 2011

Horizon Roads Australia (Connection East)

Transport

Tollway

270 (AUD 300)

13.84%

Unknown

1 out of 9 directors

36

Dec 2011

Shanduka South Group (Pty) Ltd Africa

Finance

Investment

243 (ZAR 2,000)

25.73%

CIC is the second largest investor (25.73%), after Tshivhase (29.63%) (Shanduka’s website).

2 out of 11 directors (Mar. 2012–​present)

37

Jan 2012

Kemble Water UK Holdings (Thames Water’s parent company)

Utilities

Water and waste manage-​ ment

276

8.68%

Unknown

1 out of 16 directors (Oct. 2012–​ Jul. 2014, per resignation)

38

Feb 2012

EIG Global Energy Partners LLC

US

Finance

Investment (Private equity focusing on energy resources)

Undisclosed

3% rumored

Unknown

Unknown

39

Feb 2012

Sunshine Oilsands

Canada

Energy

Oil

150

7.43%

CIC is the second 0 largest shareholder (8.45%), after Orient International Resources Group Limited (9.42%) (2012 annual report).

Supportive transaction (after the transaction ConnectionEast was privatized and delisted from ASX).

(Continued)

392

Table 16.2 (Continued) Time of Investment Target Name

Target Location

40

Apr 2012

Polyus Gold International Ltd

41

May 2012

42

43

Ownership of CIC Relative to other Shareholders

Target Sector

Target Subsector

Percentage of Value (US$ M) Ownership

Number of Directors

Russia

Metals

Gold

425

5% less 1 share

As of 2012 year 0 end, Polyus’s voting rights were held as follows: Mr Suleiman Kerimov (40.22%); Mr Mikhail Prokhorov (37.78%); CIC (4.99%); and JSC VTB Bank (3.65%) (2012 annual report).

EP Energy

US

Energy

Oil & gas

300

9.9%

Unknown

0

Jun 2012

Eutelsat Communica­ tions SA

France

Technology

Telecom

490 (EUR 385.2)

7%

As of 30 June 2012, CIC was the third largest shareholder of Eutelsat, after Fonds Stratégique d’Investissement (25.62%) and Abertis Telecom S.A.U. (8.35%) (Eutelsat reference document, 2012–​2013).

0

Aug 2012

Cheniere Energy

US

Energy

Natural gas

500 (rumored)

Unknown

Unknown

0

Note

393

44

Oct 2012

Alibaba Group China Holding Ltd

Services

Online shopping

1,000 (rumored, the whole investor group invested US$1,688)

3.93% (the Unknown investor group altogether) (F-​1/​ A registration statement, September 2014)

0

Supportive transaction

45

Oct 2012

FGP Topco Ltd (parent company of Heathrow Airport Holdings Ltd)

UK

Transport

Aviation

730 (GBP 450)

10%

As of December 2012 1 out of 15 (after Qatar Investment directors Authority acquired shares in FGP), the shareholders in FGP were: Ferrovial (33.65%), Qatar Investment Authority (20%), Britannia Airport Partners (13.29%), GIC (11.88%), Alinda (11.18%), and CIC (10%).

46

Nov 2012

Deutsche Bank UK Headquarters

UK

Real estate

Property

392 (GBP 245)

N/​A

N/​A

N/​A

The target is a 312,000 square feet office block.

47

Nov 2012

Uralkali

Russia

Agriculture

Fertilizer

Undisclosed

12.5%

As of 2013 year end, CIC is the third largest shareholder in the company, after ONEXIM Group (21.75%), and Uralchem OJSC (19.99%) (Uralkali website).

0

CIC invested by purchasing convertible bonds, which were converted into 12.5% equity in September 2013. CIC sold its 12.5% back to the company in September 2015.

(Continued)

394

Table 16.2 (Continued) Time of Investment Target Name

Target Location

Target Sector

48

Dec 2012

Moscow Exchange

Russia

49

Feb 2013

50

Oct 2013

Ownership of CIC Relative to other Shareholders

Target Subsector

Percentage of Value (US$ M) Ownership

Finance

Securities exchange & services

100

4.58%

CIC is the fifth largest shareholder as of September 30, 2015 (5.6%), after Central Bank of Russia (11.77%), Sberbank (9.99%), Vneshekonbank (8.4%), and EBRD (6.06%) (Moscow Exchange website).

0

Windfield Australia Holdings Pty Ltd (SPV created to acquire Talison Lithium)

Metals

Lithium

294.35 (CAD 300)

35%

The remaining 65% is owned by Tianqi Group.

Unknown

SIIC Environment Holdings Ltd

Utilities

Water 44.52 (SGD purification, 56.1) supply and waste treatment, and related facilities

7.68%

The company has a 0 controlling shareholder, i.e., Shanghai Industrial Holdings Limited (“SIHL”), which owns 50.79% of the company after the transaction. SHIL is indirectly controlled by the Shanghai Government.

China

Number of Directors

Note

Supportive transaction

51

Nov 2013

Chiswick Park London

UK

Real estate

Property

1,280 (GBP 780)

N/​A

N/​A

N/​A

The target is an office park.

52

Nov 2013

Centennial Plaza

Australia

Real estate

Property

280 (AUD 305)

N/​A

N/​A

N/​A

The target is an office block in Sydney.

53

Mar 2014

Sodrugestvo Group SA

Luxemburg Agriculture

Agricultural 200 Unknown processor & (altogether by trader the investor group)

Unknown

0

54

Apr 2014

iKang Healthcare Group Inc

China

Services

Healthcare

40

4.6%

Unknown

0

55

Jul 2014

Kaltim Prima Coal (subsidiary of PT Bumi)

Indonesia

Energy

Coal

1357

19%

Unknown

Unknown

Settlement transaction in connection with the September 2009 loan from CIC to Bumi. After this transaction, the debt balance was reduced to US$1,039 million.

56

Feb 2015

Meguro Gajoen Japan Complex

Real estate

Property

1,200 (JPY 140,000)

N/​A

N/​A

N/​A

The target is a commercial property complex in Tokyo.

(Continued)

395

396 Table 16.2 (Continued) Time of Investment Target Name

Target Location

Target Sector

Target Subsector

Percentage of Value (US$ M) Ownership

Ownership of CIC Relative to other Shareholders

Number of Directors

57

Jul 2015

10 shopping France and Real estate centers Belgium purchased from CBRE Global Investors

Property

1,445 (EUR 1,300)

N/​A

N/​A

N/​A

58

Jul 2015

Investa Australia Property Trust portfolio

Real estate

Property

1,789 (AUD 2,450)

N/​A

N/​A

N/​A

59

Aug 2015

Tank & Rast Germany Holding GmbH

Transport

Gas & service 3,840 (EUR Unknown stations 3,500) (altogether by the investor group)

Unknown

0

60

Aug 2015

GrabTaxi

Technology

Software & IT 350 Unknown Services (altogether by the investor group)

Unknown

Unknown

Singapore

Note

The target consists of a portfolio of nine office towers.

61

Time of Investment Target Name

Target Location

Target Sector

Sep 2015

China

Technology

Didi Kuaidi

Target Subsector

Percentage of Value (US$ M) Ownership

Software & IT 3,000 Unknown Services (altogether by the investor group)

Ownership of CIC Relative to other Shareholders

Number of Directors

Unknown

Unknown

Note This is an E round private equity investment transaction.

(As of December 31, 2015, Excluding Joint Ventures and Investments in Fund Vehicles, N = 61) Notes: (1) The time of investment for each of the transactions is generally set at the time when a transaction is officially announced by the parties involved therein, or the date of executing definitive investment agreements. When neither of the above is available, the time of investment mentioned in media anecdotes is used. I do not record, for example, the time when only non-​binding letters of intent are signed, the time when an already-​executed transaction is completed, or the time when convertible bonds are converted into common equity.26 (2) Follow-​on capital investments based on the same terms of an earlier transaction are not separately enumerated in my sample.27 (3) When the “Ownership of CIC Relative to other Shareholders” column is marked as “unknown”, it means that the target is either a closed company and thus does not disclose its ownership structure, or CIC’s ownership there is too small to be disclosed and thus not able to be compared with other shareholders. (4) 0 in the column of “Number of Directors” means that CIC has not had any board representation throughout its investment. Otherwise, the time frame of the directorship(s) is given. (5) For the value of investment, I use, to the extent possible, the numbers indicated in the official public announcements of the transactions, or in the definitive investment agreements. When neither of the above is available, the amount of investment mentioned in media anecdotes is recorded. (6) A “supportive transaction” means that the concerned transaction was to support certain undertakings of the target firm (e.g. to raise funds to acquire another firm or to pursue some project). A “bailout transaction” means that the concerned target firm was in heavy indebtedness or could even be on the edge of bankruptcy, and the CIC was imported as a bailout investor to save it.

397

26  For example, the CIC invested in Uralkali in November 2012 by purchasing convertible bonds from the target. See “Private issue of exchangeable unlisted bonds due 2014 (the ‘Bonds’),” Uralkali. Available at http://​www.uralkali.com/​press_​center/​company_​news/​item4116/​ [accessed January 27, 2016]. In September 2013, such bonds were converted into 12.5% equity in the target. See “Changes in Uralkali Shareholder Structure,” Uralkali. Available at http://​www.uralkali.com/​press_​center/​company_​news/​20130924/​ [accessed January 27, 2016]. Chengdong Investment Corporation is one of the CIC’s investment vehicles. Apparently, the time of investment for this transaction should be November 2012 and not September 2013; and the entry in the China Global Investment Tracker database is therefore incorrect. 27  For example, the CIC invested US$5.6 billion into Morgan Stanley in December 2007 in exchange for an ownership of 9.86%. In June 2009, the CIC followed up the investment in order to bring its equity ownership back to 9.86%, which was diluted to 7.68% after the October 2008 investment by Mitsubishi UFJ Financial Group into Morgan Stanley. See “CIC purchases $1.2 billion Morgan Stanley common stock,” China Investment Corporation. Available at http://​www.china-​inv.cn [accessed January 27, 2016]. But this June 2009 follow-​on transaction was not listed in my sample.

398

Table 16.3 Major China Investment Corporation-​Invested Joint Ventures (2007–​15) Time of Transaction

Location Name of Main of Main JV JV Partner Partner

JV Partner Sector

JV Partner Subsector

Value of CIC’s Contribution JV Ownership (US$ mil.) Structure

Managing Partner & Board Representation

Purpose of Creating the JV

Transactions Related to the JV

1

Nov 2009

GCL-​Poly Energy Holdings Ltd

China

Energy

Solar photovoltaic

500

CIC: 49%; GCL Ploy: 51%

GCL Poly CIC can appoint 2 out of 5 directors. Normal matters are decided by simple majority. A list of reserved matters would require affirmative vote of one CIC director.

To jointly invest in and develop photovoltaic electricity generation business.

2

Feb 2010

Intel Capital

US

Finance

Investment

N/​A

N/​A

N/​A This JV is a loose collaboration for the partners to work together.

To pair the resources of CIC with the technology expertise of Intel Capital to explore investments outside China, seeking cross border opportunities that will benefit both the US and China.

3

May 2010

Penn West Energy Trust

Canada

Energy

Oil & gas

799.73 (CAD CIC: 45%; 817) Penn West: 55%

Penn West

To jointly develop Penn West’s bitumen assets located in the Peace River area of Canada.

Concurrent with this JV transaction, CIC purchased 5% of Penn West’s trust units (see Table 16.2).

4

Dec 2011

Global Logistic Singapore Properties Limited (GLP)

Real estate

Logistics facilities

272.9

GLP

To purchase 15 logistics facilities from LaSalle Investment Management in Japan.

GLP sold 16.7% of its interests in the JV to the clients of CBRE Global Multi Manager in October 2012.

CIC: 50%; GLP: 50%

Completion of the JV took place the same time as the closing of CIC subscribing GCL Poly’s shares (see Table 16.2).

5

Nov 2012

GLP

Singapore

Real estate

Logistics facilities

Unknown

6

Sep 2015

State General Reserve Fund of the Sultanate of Oman (SGRF)

Turkey

Finance

Investment

940.128 (TRY Consortium of 2,843) three Chinese companies: 65% (China Ocean Shipping Company: 26%, China Merchants Holdings: 26%, and CIC: 13%); SGRF: 35%

7

Oct 2015

Carnival Corporation & PLC

UK-​US

Travel & leisure

Cruise vacation Unknown

8

Nov 2015

Železara Smederevo d.o.o. (wholly owned by the Serbian government)

Serbia

Metals

Steel

399

(As of December 31, 2015, N = 8)

Unknown

CIC: 34.2%; GLP: 34.2%; Government of Singapore Investment Corporation: 20%; Canada Pension Plan Investment Board: 11.6%

GLP

To buy portfolios of logistics facilities from Prosperitas in Brazil.

Joint management Consortium can appoint 4 directors, and SGRF the remaining 2.

To engage in owning and operating Turkey’s third largest container terminal Kumport.

Unknown

Unknown

To launch the first word-​ class multi-​ship domestic cruise brand in the Chinese market.

Unknown

Unknown

CIC forms a consortium with China’s HeSteel Group with a view to invest in Serbia’s steel sector, in particular to improve and modernize the production procedure and portfolio of Železara Smederevo.

CIC and HeSteel has signed a memorandum in March 2015 to cooperate with each other in overseas investment projects in the steel sector.

400

Table 16.4 Major China Investment Corporation Investments into Fund Vehicles (2007–​15) Year

Month

Fund Name

Fund Nature

Fund Manager Country

Investment Value (US$ Mil.)

Fund Value (US$ Mil.)

Fund’s Planned Terms on CIC’s Investments Control Rights

1

2008

April

Unknown

Private equity–​ buyout fund

JC Flowers

US

3,200

4,000

Less likely to invest in large financial institutions than in smaller banks and brokerages.

2

2008

Early in 2008

Invesco Aim Liquid Assets Portfolio

Money market mutual fund

Invesco

US

2,100

Unknown

3

2008

Early in 2008

JP Morgan Prime Money market Money Market mutual fund Fund

JP Morgan

US

2,300

Unknown

4

2008

Early in 2008

DWS Money Market Trust

Money market mutual fund

Deutsche Asset Management

US

1,500

Unknown

5

2008

September

Reserve Primary Fund

Money market mutual fund

US

5,400

Unknown

No involvement of CIC in regular management, but JC Flowers will brief it on some significant investments in advance. Enjoys more favorable terms than the standard ones for investors.

CIC acquired 11.1% as of the fund’s shares.

6

2009

March

Morgan Stanley Real Estate Fund VII Global

International Morgan property Stanley investment fund

US

800

6,000

7

2009

June

Unknown

Fund of hedge funds

Blackstone

US

500

Unknown

8

2009

June

Unknown

Hedge fund

Morgan Stanley

US

Unknown

Unknown

9

2009

August

Unknown

Hedge fund (fixed assets)

Capula Investment Management LLP

UK

200

Unknown

10

2009

September

Unknown

Hedge fund

Oaktree Capital Management LP

US

1,000

Unknown

In distressed debt and other fixed-​income assets.

11

2009

September

Unknown

Real estate fund

Goldman Sachs

US

600–​700

Unknown

In US distressed assets ranging from real estate to infrastructure.

12

2010

February

SPDR Gold Trust

World’s largest State Street physically backed Global gold exchange Advisors traded fund (ETF)

US

156

Unknown

13

2010

February

US Oil Fund

Commodity ETF

US

79

Unknown

401

United States Commodity Funds LLC

CIC owns 0.4% of the Trust’s total shares. Crude oil futures

402

Table 16.4 (Continued) Year

Month

Fund Name

Fund Nature

Fund Manager Country

Investment Value (US$ Mil.)

Fund Value (US$ Mil.)

14

2010

February

Apax Europe VII

Private equity–​buyout

Apax Partners

UK

956 (EUR 685)

1,550 (EUR 1,120)

15

2010

February

Unknown

Private equity

Lexington Partners

US

500

Unknown

CIC’s investment is managed through special accounts, kept separate from the main funds of the managers.

16

2010

February

Unknown

Private equity

Pantheon Ventures

US

500

Unknown

Same as above

17

2010

February

Unknown

Private equity

Goldman Sachs

US

500

Unknown

Same as above

18

2010

March

Brookfield Retail Holdings III LLC (BRH III)

Private equity

Brookfield Asset Management

Canada

Unknown

Unknown

28

  See footnote 24.

Fund’s Planned Terms on CIC’s Investments Control Rights

General Growth Properties, Inc; The Howard Hughes Corporation; and Rouse Properties, Invc28

Two of CIC’s subsidiaries hold a collective 99.499848% ownership interest in BRH III. These subsidiaries are able to appoint and remove directors of BRH III.

403

Fund Value (US$ Mil.)

Fund’s Planned Terms on CIC’s Investments Control Rights

Australia 156.24

1,260 (AUD 1,400)

The fund was established to acquire and hold the portfolio of ING Industrial Fund (which was delisted from ASX after this transaction).

Diversified, Deutsche actively-​ Asset managed closed-​ Management end mutual fund

US

Unknown

Unknown

Unknown

Private equity

Blackrock

US

200

Unknown

Invests both domestically and overseas, according to different sources.

A Capital China Outbound Fund

Private equity–​ growth fund

A Capital

Belgium

Unknown

250–​500

Take minority stakes alongside Chinese companies in midsized European companies with strong potential in China.

Year

Month

Fund Name

Fund Nature

Fund Manager Country

19

2011

March

Goodman Trust Australia (GTA)

Real estate fund

Goodman

20

2011

December

New Germany Fund Inc.

21

2012

April

22

2012

May

Investment Value (US$ Mil.)

GTA is owned by Goodman (19.9%), CPPIB (42.5%), APG (25.2%) and CIC (12.4%).

CIC owns 5% of the fund.

The fund is a joint collaboration between CIC and the Belgian Federal Holding and Investment Company.

(Continued)

404

Table 16.4 (Continued) Investment Value (US$ Mil.)

Fund Value (US$ Mil.)

Russian Direct Russia Investment Fund (RDIF)

1,000 (another 1,000 by RDIF, the rest from third party investors)

3,000–​4,000 Equity investments primarily in Russian economy.

Private equity

RRJ Capital

Hong Kong

Unknown

3,500

Private equity–​ growth fund

WestSummit Capital (based in Beijing) and Atlantic Bridge (based in Dubin)

Ireland

Unknown (equal Unknown commitments from National Pensions Reserve Fund of Ireland and CIC, respectively)

Year

Month

Fund Name

Fund Nature

23

2012

June

Russia–​China Private equity Investment Fund

24

2013

February

RRJ Capital Master Fund II

25

2014

January

China Ireland Technology Growth Capital Fund

Fund Manager Country

Fund’s Planned Terms on CIC’s Investments Control Rights The fund is a joint collaboration between CIC and RDIF. A CIC representative (Mr. Hu Bing) serves as the fund’s co-​CEO.

Focuses on China, Southeast Asia, and the US energy sector. Make minority equity investments in fast-​growing technology companies in Ireland that have a substantial presence or strategic interest in China, and in Chinese

The fund is a joint collaboration between CIC and the National Pensions Reserve Fund of Ireland.

companies that have a substantial presence or strategic interest in establishing a presence in Ireland as a gateway into the broader European market. 26

2014

December

China–​Mexico Unknown Investment Fund

Unknown

Mexico

Unknown

2,400

Support infrastructure, mining, and energy projects.

27

2014

December

Silk Road Fund I

Ms Jin Qi

China

500

10,000

Seek investment opportunities and provide investment and financing services to “Belt and Road” initiatives.

Private equity–​ long term

405

The fund is organized as a company. The relevant capital contribution percentages are: foreign exchange reserves: 65%; CIC: 15%; Export-Import Bank of China: 15%; and China Development Bank: 5%.

(Continued)

406

Table 16.4 (Continued)

28

Year

Month

Fund Name

Fund Nature

Fund Manager Country

2015

October

AGIC Industrial Promotion Capital

Private equity–​ growth fund

AGIC Group /​ Mr Henry Cai

(As of December 31, 2015, N = 28)

Investment Value (US$ Mil.)

Germany Unknown

Fund Value (US$ Mil.)

Fund’s Planned Terms on CIC’s Investments Control Rights

1,000

Invest in SMEs in German-​ speaking countries and help them form partnerships with industrial companies in China whose technological capabilities they can improve.

Jing Li   407 developing economies. In both the samples of non-​fund investments and fund investments, the US was the most frequent destination, followed by China itself;29 see Table 16.5. For the 65 targets presented in the first pie chart of Figure 16.3, I generally used the industry sectors designated to them in the China Global Investment Tracker dataset. For those firms that are not covered there, I searched their official websites to designate the industry sector. Obviously, the CIC’s investments heavily cluster in energy (especially oil and natural gas) and finance firms, which count for almost half of all its portfolio companies. For the firms and securities included in the CIC’s 2010 13-​F filing (second pie chart), I checked their US Standard Industrial Classification (SIC) codes and used the major group divisions30 to designate their industry sectors. Similarly, the CIC’s 13-​F investments also heavily cluster in certain industry groups, particularly manufacturing, finance, and mining. Note that, besides the ten firms that fall directly

Table 16.5 Geography of the China Investment Corporation’s Investments (N=97) M&A Investments

JV Investments

Fund Investments

Number of Developed Economies

11 (Australia, Belgium, Canada, France, Germany, Hong Kong, Japan, Luxemburg, Singapore, UK, US)

4 (Canada, Singapore, UK, US)

8 (Australia, Belgium, Canada, Germany, Hong Kong, Ireland, UK, US)

Number of Transactions there

37 (Australia 6, Belgium 1, Canada 4, France 2, Germany 1, Hong Kong 1, Japan 2, Luxemburg 1, Singapore 1, UK 7, US 11)

5 (Canada 1, Singapore 2, UK 1, US 1)

25 (Australia 1, Belgium 1, Canada 1, Germany 1, Hong Kong 1, Ireland 1, UK 2, US 17)

Number of Developing Economies

8 (Brazil, China, Indonesia, Kazakhstan, Mongolia, Russia, South Africa, Vietnam)

3 (China, Turkey, Serbia)

3 (China, Mexico, Russia)

Number of Transactions there

24 (Brazil 1, China 11, Indonesia 3, Kazakhstan 1, Mongolia 1, Russia 5, South Africa 1, Vietnam 1)

3 (China 1, Turkey 1, Serbia 1)

3 (China 1, Mexico 1, Russia 1)

29 

GCL-​Poly Energy Holdings Ltd. is counted once as it appears in both the M&A sample and the JV sample. 30  These are decided by the first two digits of the four-​digit SIC codes. See “SIC Division Structure.” United States Department of Labor. Available at https://​www.osha.gov/​pls/​imis/​sic_​manual.html [accessed January 27, 2016].

408    Investment Terms and Level of Control of China’s SWF Travel & leisure 1

Utilities Agriculture; 3 2

Transport 6

Conglomerate 1

Technology 3 Services 2

Energy 18

Real estate 10

Materials 1 Metals 4 Manufacturing 2

Services 2

Finance 12

Mining 10

Finance, Insurance and Real Estate 19

Construction 2

Retail Trade 2 Transportation, Communications, Electric, Gas, and Sanitary Services 5

Manufacturing 25

Figure 16.3  Industry sector distribution of the CIC’s investments Note: The first pie chart is based on CIC’s non-fund investments (presented in Tables 16.2–16.4 above); including altogether 65 different targets after removing repeated ones. The second pie chart is based on the CIC’s 13-F investments (filed with the SEC as of February 5, 2010); covering 65 different securities after removing repeated ones and those securities that do not have SIC codes.

Jing Li   409 into the mining group, there are also four firms in the manufacturing group that are actually engaged in energy-​and-​resource-​related businesses according to their sub-​ sector codes.31,32 Therefore, while the CIC officially claims itself to be a financial investor that operates on a commercial basis, the industry sector distribution of its past investments actually presents a quite different story. The CIC is seen to have heavily invested both upstream, in resources, and downstream, in utilities and logistics sectors. Regardless of whether the investment transactions are commercially sensible or not, they are highly strategic in nature as they target areas in which China’s economy has structural weaknesses (Koch-​Weser and Haacke 2013). The CIC’s investment pattern suggests that in addition to its role as portfolio investor, it is also being utilized as a tool to ensure the access to raw materials, as part of China’s broader economic development and energy needs (Dixon and Monk 2012). Actually, the CIC itself has also admitted that when choosing potential investment targets, it tends to invest in companies that will benefit from the “China factor” and take advantage of the potential growth of the Chinese economy (CIC 2011). To support this, the 2009 investment in Canada’s Teck Resources was cited as an example. Teck is Canada’s largest diversified resource company whose major products include copper, steelmaking coal (coke), zinc, and energy.33 Since China is undergoing a profound process of urbanization and industrialization and needs vast quantities of energy and resources to do so, it is the largest consumer of Teck’s goods.34 The deal was considered to have enabled both sides to work closely together and identify future opportunities of mutual interest.35 A similar example is the CIC’s 2009 investment in Hong Kong-​based commodity supplier Noble Group. Given China’s position as the world’s biggest buyer of commodities—​including soybeans, soybean oil, cotton, iron ore, aluminium, copper, and zinc—​the CIC’s acquisition of a significant equity stake in Noble is surely of great strategic value, as “what China needs, Noble helps to provide” (Park 2009).

31  These four firms are: Precision Castparts Corp. (3320, manufacturing: iron and steel foundries); Smith Intl Inc. (3533, manufacturing: oil and gas filed machinery and equipment); Tesoro Corp. (2911, manufacturing: petroleum refining); and Valero Energy Corp. (2911, manufacturing: petroleum refining). 32  “Form 13-​F Filed as of 20100205.” China Investment Corporation. Available at http://​www.sec. gov/​Archives/​edgar/​data/​1468702/​000095012310009135/​0000950123-​10-​009135.txt [accessed January 27, 2016]. 33 “About.” Teck Resources Ltd. Available at https://​www.teck.com/​Generic.aspx?PAGE=Teck+Site%2f About+&portalName=tc [accessed January 27, 2016]. 34  “Annual Report 2009.” Teck Resources Ltd. Available at http://​www.teck.com/​media/​Investors-​ Teck_​2009_​Annual_​Report_​T5.1.1.pdf p. 9[accessed January 27, 2016]. 35  Id., p. 7.

410    Investment Terms and Level of Control of China’s SWF

Direct Control in the China Investment Corporation’s Investments Level of Ownership, Voting Rights, Director Nomination Rights and Board Representation of the China Investment Corporation’s Non-​Fund and Non-​JV Investments The very first mechanism of direct control that a shareholder has is its level of ownership and the attached right to vote on important matters relating to the business (Velasco 2006). In addition, shareholders can often also nominate potential candidates into the board, “as a means to make voting rights more useful by limiting the informational and transaction costs of evaluating candidates, and permitting large electoral groups to vote on a limited number of viable candidacies” (Hamermesh 2014). These formal elements of corporate governance are of great importance because an SWF’s informal influence depends ultimately on its ability to vote (Gilson and Milhaupt 2008). In order to get a picture of the level and change of ownership, voting rights, director nomination rights, and board representation, I looked at the contractual terms of the 61 non-​JV and non-​ fund investment transactions made by the CIC as well as the target firm board composition from 2007 to 2015 year end. The data are collected to the largest extent possible from the official transactional documents, periodical financial reports, and prospectuses, which are available for those target firms that are either public or about to go public as of the time of transaction. Additionally, I also look at the public announcements made by the targets or the CIC about the transactions, where a brief summary of the key deal terms may be provided, even when the full investment agreements are not disclosed. These data are supported or double-​checked with the target firms’ official websites and media anecdotes—​they are particularly useful when the targets are private companies, which are generally not subject to statutory disclosure obligations. In terms of the level of ownership, the CIC typically acquired significant but non-​ controlling stakes in target companies (see Table 16.6). Despite its often large shareholding percentages, the CIC’s voting rights in its target firms are, to the extent that the relevant information is available or applicable, very much restricted. In particular, it explicitly gave up the right to vote when entering into the investment agreements with seven firms: Blackstone, Morgan Stanley, Chesapeake Energy, Northstar Tambang Persada Ltd, EIG Global Energy Partners, Cheniere Energy, and Alibaba Group. In another five firms its voting rights are limited in different ways; for example, by setting out certain specific items it is entitled to vote on (Goodman Group), by requiring it to vote according to certain directions or recommendations (AES Corp), by issuing to it a different class of securities carrying a smaller number of votes (Teck Resources) or (carrying) no voting rights at all (Songbird Estates)36, or by capping its voting rights at a

36 

Note that in Songbirds Estates, the CIC holds not only preference shares but also ordinary shares, and only its preferences shares are without voting rights.

Jing Li   411 Table 16.6 Overview of the China Investment Corporation’s Ownership and Direct Control Rights in its Non-​Fund and Non-​JV Investments (N=61) Number of Targets Ownership Percentage 0 ≤ 5%

11

5% ≤ 10%

12

10% ≤ 15%

10

15% ≤ 20%

3

>20%

7

Board Representation No board representation Among which, CIC had right to nominate/​appoint director(s) but did not With board representation

30 4 11

Note: the number of targets in each category is counted only to the extent that the relevant information is available or applicable; therefore the numbers do not add up to 61.

maximum percentage (SouthGobi). Among all the 61 investment transactions, there are only two targets where one can clearly figure out that the CIC have secured for itself full voting rights—​namely, China Lumena New Materials37 and SMIC, both being Chinese firms. Similarly, the CIC has no direct control in the targets’ boards either. The number of firms where the CIC does not have a board seat is almost three times that of the firms where it is indeed represented on the board (see Table 16.6). There are four cases where the CIC has no board seat despite the fact that the investment agreements with the targets,—​Goodman Group, Songbird Estates, SouthGobi, and Banco BTG Pactual—​explicitly allowed it to nominate or appoint director(s) onto their boards. A closer look at the CIC’s board representation, together with its ownership relative to the other major shareholders in the target firms, generates even more interesting findings, which are presented in Table 16.7. While a shareholder cannot logically secure itself a board seat when its ownership is too small (e.g. where the CIC only holds 1% of Diageo and 3.11% of Banco BTG Pactual), this is apparently not the major reason explaining the CIC’s generally low level of board representation in its target firms. In contrast, the CIC is among the biggest shareholders in

37 

Although the voting rights will only be available to the CIC when its converts its convertible bonds into shares.

412    Investment Terms and Level of Control of China’s SWF Table 16.7 The China Investment Corporation’s Board Representation vis-​à-​vis its Relative Ownership in Target Firms (N=25) Number of Targets No board representation

16

CIC is one of the biggest shareholders but has no board seat

9

CIC’s shareholding is simply too small to have a board seat

2

No board seat because of absolute controlling shareholder(s)

5

With board representation CIC is or is among the biggest shareholders

9 638

Note: Here the sample consists of 25 non-​fund and non-​JV target firms, in which the CIC did not give up its voting rights, and there is information available both about CIC’s ownership relative to other shareholders and CIC’s board representation.

nine firms,39 none of which has one or more shareholders beneficially owning more than 50% shares and thus can elect the entire board without concurrence of the other shareholders of the company,40 while it still does not hold any seat in the board thereof. It is worth noting that, although the CIC does not directly have a director in Sunshine Oilsands (despite being its second largest shareholder), China Life, the largest state-​ owned commercial insurance group in Mainland China,41 and BOCGI, the overseas investment arm of the state-​owned Bank of China, co-​invested with the CIC and each of them has a seat on the board of Sunshine Oilsands.42 Arguably, such board seats taken by large Chinese SOEs may indirectly compensate for the CIC’s absence in the targets because, fundamentally, these directors should all speak for the interests of the Chinese government, which decides the career of the officials and owns the investing SOEs.

38 

These six firms are: CITIC Capital, Noble Group, AES Corp., GCL-​Poly Energy Holdings, SMIC, and Shanduka Group. CIC also installed directors in Teck Resources, where it has only 6.7% voting right despite having 17.2% economic ownership; in GDF SUEZ E&P, where it and GDF SUEZ Group own 30% and 70%, respectively, and in FGP Topco Ltd (Heathrow Airport’s parent company), where it holds 10% but actually is the smallest shareholder. 39  These nine firms are: Goodman Group, Songbird Estates, China Lumena New Materials, Diamond S Shipping, Sunshine Oilsands, Polyus Gold, Eutelsat Communications, Uralkali, and Moscow Exchange. 40  The five firms that had absolute controlling shareholder(s) and the CIC was thus not represented in their boards are: SouthGobi, JSC KazMunaiGas Exploration Production, China Longyuan Power Group, VTB Group, and SIIC Environment Holdings. 41  “About Us.” China Life. available at https://​www.chinalife.com.cn/​publish/​yw/​index.html [accessed January 27, 2016]. 42  See “Board of Directors,” Sunshine Oilsands, accessed at http://​www.sunshineoilsands.com/​about-​ us/​board-​of-​directors.html and at http://​www.sunshineoilsands.com/​mr-​tingan-​liu.html on January 27, 2016.

Jing Li   413 The next important question to ask is: to the extent that the CIC has direct control power in the form of voting rights and/​or board seats, whether or not it has actively exercised such control in target companies? To answer this, I searched all the news articles about the CIC in the Dow Jones Factiva database from September 2007 (when the CIC was incorporated) to December 2015, combined with the key words of “vote,” “approve,” “propose,” and “reject” (and their different conjugations). According to the findings, the CIC has not been identified as voting in favor or against certain issues in either annual shareholder meetings or board meetings. Furthermore, there is no record of the CIC making any proposal to vote in any shareholder or board meeting. Such findings should be carefully construed. It might seem too abrupt to conclude from them that the CIC is passive and does not exercise its key control rights as a shareholder. Even if the CIC indeed voted in shareholder or board meetings, this fact may not necessarily be disclosed in voting outcome announcements or board resolution announcements, which only publish the overall percentages of votes for each of the relevant agenda items. Another important source that could disclose how exactly certain shareholders or directors voted or voiced on certain issues is the insiders of the relevant target firms or people close to their boards, who may talk about this when they are interviewed by journalists. But again, such anecdotes are largely not caught by the Factiva search, except for one case detailed in Box 16.1.

Direct Control Rights in the China Investment Corporation’s JV Investments and Fund Investments As seen in Table 16.3, the CIC typically holds minority equity stakes in the JVs it invested in. Consistent with this, and similar to its direct acquisition transactions, the CIC has not been keen to retain management rights either, largely leaving JVs managed by their partners and only takes minority board seats. As to its investments in fund vehicles, previous research has found that SWFs may be financially motivated to inject capital into private equity as a result of their underperformance in the public markets in order to further diversify their portfolio holdings in the interest of increasing earnings (Johan, Knill, and Mauck 2013). Given that less regulation and disclosure is imposed on private equity, investing in secondary markets also brings the advantage of helping an SWF like the CIC to mitigate the political backlash against it injecting capital into high-​profiled public companies (Sender 2008), and making it less vulnerable to domestic criticism if its investments go sour. Usually, as one of the major investors, the CIC is able to use its size to win special terms from private equity groups, including lower fees and transfer of knowledge on specialist markets (Arnold 2010). Examples in Table 16.4 include private equity funds formed with JC Flowers, Lexington Partners, Goldman Sachs, and Pantheon Ventures. In its more recent investments, typically from 2012, the CIC is identified as having gone from merely investing in private equity funds to creating funds to meet both its needs and China’s strategic imperatives (Sender 2012). Capital China Outbound Fund, Russia-​China Investment Fund, China Ireland Technology Growth Capital Fund, China-​Mexico Investment Fund, as well as the brand new Silk Road Fund I set up in 2015, are all examples supporting this observation.

414    Investment Terms and Level of Control of China’s SWF

Box 16.1 The China Investment Corporation’s Role in SMIC On June 29, 2011, Semiconductor Manufacturing International Corporation held its annual general meeting where one of the agenda items was to decide the re-​election of directors. The poll result for re-​electing Mr David N.K. Wang, SMIC’s chief executive, was that only 41.79% of the votes were cast in favor, and Mr Wang failed to be re-​appointed onto the board.43 According to media anecdotes, the direct reason for the failure of Mr Wang’s re-​election was that despite smaller shareholders, such as Taiwan Semiconductor Manufacturing Company Limited, Walden International, and New Enterprise Associates, voted in favor of him, Datang Telecom Technology & Industry Holdings Co., Ltd (Datang)—the largest shareholders of the company—​voted against, while the CIC and Shanghai Industrial Investment (Holdings) Co., Ltd—​the second and third largest shareholders—​abstained from voting. Datang voted against Mr Wang because it wanted to campaign for Simon Yang, SMIC’s chief operating officer, to replace Mr Wang as chief executive. Three days later, in an urgently convened interim board meeting, Mr Zhang Wenyi, who was the former chairman of SMIC’s smaller rival Shanghai Huahong, and also the former vice-​minister of China’s Ministry of Electronics Industry, and who was just elected to the board of SMIC (as of June 30, 2011) as an independent non-​executive director, was nominated by the CIC as a candidate to fill the vacated executive director position. This happened when, according to the CIC’s investment agreement, it could only nominate one director, and at that time it had already Mr Lawrence Juen-​Yee as a non-​executive director on SMIC’s board. Datang was initially against Zhang’s election, giving the reason of “potential competition between Huahong and SMIC,” and its two board representatives voted for Simon Yang to be the executive director to replace Wang. Zhang finally managed to be elected as the executive director, and was appointed as the acting CEO of the company.44 This was seen by the outside as a compromise between Datang and SMIC’s overseas shareholders: the former agreed that Zhang would become the new chairman of SMIC’s board, while the latter agreed upon the resignation of Wang, which took effect as of July 13, 2011. This drama represented a public feud between two state-​owned shareholders of SMIC, which began when Jiang Shangzhou, SMIC’s former chairman, died on June 27, 2011. Datang was brought into SMIC in 2008 and soon increased its stake to 19.4%, making it SMIC’s largest shareholder. It was reported that Datang had wanted to fully consolidate SMIC to create a vertically-​integrated telecom technology company, but such ambitions received a blow when the well-​connected Mr Jiang, a former government official, brought in the CIC as the second largest shareholder with a 13.6% stake. Source: Summarized from Wang (2011), Wan (2011), and Hille and Kwong (2011).

43 

“Annual General Meeting Held on June 29, 2011 Poll Results.” Semiconductor Manufacturing International Corporation. Available at http://​www.smics.com/​attachment/​201107251154271_​en.pdf [accessed January 27, 2016]. 44  “Appointment of Chairman, Redesignation of Director and Independent Non-​Executive Director, Resignation of Chief Executive Officer, Appointment of Acting Chief Executive Officer and Authorised Representative, Clarification Announcement, Resumption of Trading.” Semiconductor Manufacturing International Corporation. Available at http://​www.smics.com/​attachment/​20110715201701001240916_​ en.pdf [accessed January 27, 2016].

Jing Li   415

Indirect Control of the China Investment Corporation in its Investment Targets So far, it has been shown that the CIC has limited direct control rights in its investment targets: its voting rights are often restricted, and it has been a rule rather than a exception that it is not represented on targets’ boards, even if it was contractually allowed to nominate directors in the first place. This being said, one must note that using formal corporate governance mechanisms to influence a portfolio company’s decision-​making is not the only way an SWF can seek to secure a strategic advantage from a portfolio firm (Gilson and Milhaupt 2008). Given that the CIC is generally committed to investing long-​term instead of seeking quick exits from its portfolio companies, there could be ample post-​investment opportunities for it to influence a target firm, which does not have to happen in a formal corporate governance framework but can, rather, derive from the lasting strategic relationship between the target firm and the CIC. I now focus on the related business transactions or dealings, by and among firms, from the targets or the CIC’s network, that may take place before or after a particular CIC investment. Table 16.8 presents a list of examples of these network transactions, collected as of 2015 year end from media anecdotes and announcements of the relevant firms. This list is not exhaustive and it neither means to capture the network transactions relating to all of the CIC’s targets, nor to enumerate all the relevant business dealings of each of the included target firms; it only covers the major representative transactions. The examples in Table 16.8 show that the CIC and many of its target firms often maintain active business contacts after direct CIC investments have taken place; in some cases the business dealings, direct or indirect, started beforehand. Typically, investment by the CIC opens or strengthens a target firm’s business in China, which is a very big and important market. While it is true that nowadays, the Chinese economy policy process is no longer monopolized solely by political elites but with non-​state actors—​particularly those from the business world and even with the scholarly community playing a greater role (Kennedy 2007, p. 39)—​the Chinese government is still deeply involved in the economy. For one thing, it has important sources of leverage over China’s state-​ owned enterprises (Kennedy 2007, p. 42), which are seen as the vehicles for implementing the government’s industrial policies. Although for the past two decades, SOEs appear to have retreated from the more competitive and labor-​intensive industries, they still play a dominant role in core industries, such as petroleum, coking, nuclear fuel, raw chemical material, transport equipment, as well as mining and supply of electric and heat power, gas and water (OECD 2009). These industries coincide to a large extent with the sector distribution of the CIC’s investments, which heavily concentrate on energy and resources firms, and to a lesser extent on transport and utilities firms. Arguably, this supports the claim that China’s foreign relations are often tied to its desire to open new markets to Chinese imports and also to access resources to fuel China’s continued economic growth (Kilpatrick 2007). Moreover, the government heavily scrutinizes foreign

416    Investment Terms and Level of Control of China’s SWF Table 16.8 Examples of Long-​Term China Investment Corporation–​Target Collaborative Relationship Blackstone

CIC bought 9.3% of Blackstone’s common units in May 2007. Blackstone opened its Beijing representative office in August 2008. CIC invested US$500 million in a fund of hedge fund managed by Blackstone in June 2009. CIC co-​invested with Blackstone in Cheniere Energy in August 2012. Blackstone sold London office park Chiswick Park to CIC in November 2013, and continued to act as the asset manager for CIC in the premise.

Morgan Stanley

CIC invested in Morgan Stanley in December 2007. CIC committed US$800 million in Morgan Stanley Real Estate Fund VII Global in March 2009; and in June 2009, it was identified to have ventured into hedge-​ fund investing by earmarking money to be seen by Morgan Stanley’s asset management unit. In 2011 CIC invested in Morgan Stanley’s Japanese real estate loan portfolio. In July 2015, CIC bought Investa Property Group’s portfolio of nine office towers in Australia from Morgan Stanley.

Teck Resources

CIC’s July 2009 investment in Teck Resources laid the groundwork for CIC’s entry into Canada. Mr Felix Chee, who basically facilitated CIC-​Teck deal, was appointed as the CIC director in Teck’s board, and later also became the Chief Representative of the very first overseas representative office of CIC, which was set up in January 2011 in Toronto. This investment has also allowed Teck to advance business with Chinese companies such as Jiangxi Copper Co., China’s largest integrated copper producer, which imported in October 2010 over 60,000 tons of copper ore concentrates from Teck’s copper mine in Chile. In 2012, China accounted for over 25% of Teck’s total revenues and became its biggest market. Teck opened in April 2013 an office in Shanghai to further strengthen its business ties in China.

Diageo

Diageo bought interests in two Chinese wine producers in 2007. CIC invested in Diageo in July 2009.

Goodman Group

Together with CIC’s August 2009 AUD500 million investment into Goodman, CIC and Goodman also signed a Relationship Agreement where the parties will work together to explore a range of opportunities including: • Participation in new acquisitions • Acquisition of assets currently held on Goodman’s balance sheet • Participation in significant private and public market situations across Goodman’s platform • CIC working with Goodman to grow its business globally. CIC invested in Goodman Trust Australia in March 2011 to help the fund acquire and privatize ING Industrial Fund.

Noble Group

CIC invested in Noble in September 2009. COFCO, a state-​owned supplier of diversified products and services in China’s agricultural products and food industry, formed a joint venture with Noble in 2014. Mr Yu Xubo, President of COFCO, was nominated by CIC as a director to Noble’s board as from June 2015.

Jing Li   417 Table 16.8 (Continued) AES Corp

CIC invested in AES in November 2009. In addition, it also signed a letter of intent to invest 35% into AES Wind Generation, but this project did not proceed as planned and the LOI lapsed in June 2010. In September 2011, CIC helped AES by buying a 19% stake in the AES-​VCM Mong Duong Power Co., Ltd in Vietnam, so that AES could raise funds for constructing the power plant.

Diamond S Shipping

CIC and Wilbur L. Ross Jr co-​invested in China Longyuan in November 2009. In August 2011, CIC invested in Diamond S Shipping, which was founded by WL Ross & Co. LLC.

Apax

In February 2010, CIC invested in both Apax Partners Worldwide LLP (acquiring 2.3% stake), and Apax Europe VII (with the amount of EUR685 million), a private equity fund managed by Apax.

VTB Group & Russian Direct Investment Fund

CIC invested in VTB Group in February 2011. After that, they co-​invested in Polyus (April 2012), Urakali (November 2012), and Moscow Exchange (December 2012). These investments were likely to be brought to CIC by VTB (in the case of Moscow Exchange by RDIF, which is Russia’s SWF and 100% owned by VTB). In June 2012, CIC invested in Russia–​China Investment Fund, a fund managed by RDIF, and VTB is the strategic partner of the fund. In October 2013, VTB and China National Petroleum Corporation (CNPC) signed a memorandum of understanding on mutual business cooperation, under which VTB Group will provide CNPC with a range of products and services to support the Chinese company’s business development activities across Russia and the CIS, particularly in Kazakhstan and Azerbaijan. In March 2014, RDIF, together with CIC and a Middle Eastern SWF, invested US$200 million in Sodrugestvo Group SA. In September 2015, RDIF, CIC and several other private equity funds, invested in Didi Kuaidi.

SMIC

CIC invested in SMIC in April 2011. According to SMIC’s 2012 annual report, SMIC and CIC had (or proposed) a joint venture: “In addition, an advance of US$3.9 million was made in 2011 to Zhongxin Xiecheng Investment (Beijing) Corporation Limited in conjunction with a joint venture between China Investment Corporation and the Company. The advance converted to capital of the new company after it was formed in 2012.”

GDF SUEZ (Renamed ENGIE as from April 2015)

Along with the October 2011 investment transaction, GDF SUEZ and CIC also agreed to cooperate on a non-​exclusive basis in three areas in the Asia-​Pacific region: • Joint investment opportunities in existing and new energy-​related projects • Financing cooperation in new projects • Commercial sponsorship and support to GDF SUEZ. As part of the development of its activities in the region, GDF SUEZ signed with CNOOC a cooperation agreement in the LNG sector. In 2012, GDF SUEZ began a cooperation agreement with PetroChina to explore the upstream gas potential in Qatar, then extended the agreement to gas storage in China in 2013.

(Continued)

Table 16.8 (Continued) In April 2013, GDF SUEZ signed several significant agreements with Chinese partners in the field of natural gas storage, the provision of LNG regasification facilities and the environment. ENGIE signed in 2014 two major cooperation agreements to develop energy projects in Beijing and Shanghai, respectively. In January 2015, ENGIE and Sichuan Energy Investment Distributed Energy Systems created a joint venture to jointly develop and operate Guangan Huixiang Innovation Park Distributed Energy Project, the first distributed energy project in an industry park in Southwest China. In June 2015, ENGIE signed a memorandum of understanding with CIC to reinforce their cooperation in the following areas: • Co-​investment in large energy projects, particularly renewable energy projects in fast developing countries • Cooperation in new technologies and in energy efficiency fields, especially in China. Shanduka Group

CIC’s December 2011 investment in Shanduka Group allows both sides to jointly explore future investment opportunities in South Africa and other parts of Africa.

EIG Global Energy Partners

In February 2012, CIC purchased a minority stake in EIG Global Energy Partners. CIC is also an investor in funds managed by EIG.

Sunshine Oilsands

Sunshine Oilsands entered into a memorandum of understanding in February 2012 with Sinopec, one of the major state-​owned petroleum and petrochemical groups in China, with a view to form a strategic alliance and carry out strategic cooperation. Sinopec partnered with CIC in evaluating the opportunity.

CBRE Global Investors

In October 2012, GLP sold 16.7% of its JV interests in the JV formed with CIC in Japan to the clients of CBRE Global Multi Manager.

CIC invested together with EIG Global Energy Partners and other investors in Sunshine Oilsands in February 2012.

In July 2015, CBRE Global Investors sold a portfolio of ten shopping centers in France and Belgium to CIC. Uralkali

CIC invested in Uralkali in November 2012. In April 2015, Industrial and Commercial Bank of China and China Construction Bank, both controlled by CIC’s subsidiary Huijin, jointly extended a US$530 million loan to the company.

RRJ Capital

CIC invested in RRJ Capital’s second fund in February 2013. In October 2013, RRJ Capital, together with CIC and three other Chinese investors, invested in the new share issue of SIIC Environment Holdings Ltd. RRJ Capital is the only non-​Chinese investor in this transaction.

Didi Kuaidi

In August 2015, Didi Kuaidi joined CIC to invest in Singapore’s taxi hiring app GrabTaxi. CIC invested in Didi Kuaidi in its round E fund raising in September 2015.

Mirvac

In December 2015, Mirvac formed a joint venture with a subsidiary of Chinese insurance giant Ping An to develop residential projects in Australian cities. In the meantime, Mirvac was appointed as the asset manager of the Investa Property Trust portfolio, which CIC bought from Morgan Stanely in July 2015.

Source: Collected as of December 2015 from media anecdotes and press releases of the relevant firms.

Jing Li   419 investments, which are often made to comply with mandatory equity ownership thresholds as well as undergo lengthy governmental approval procedures and other political bureaucracies, especially in those restricted industries (US Department of State 2013). But even in those lines of businesses where few specific investment limitations are present in writing, there is still a tremendous amount of government influence on who gets to invest, and under what terms (both at the provincial and central government level) (Solarz 2007). As such, if a foreign firm wishes to do business in China, it is vital for it to sustain a good relationship with the government. Following this line of reasoning, the opportunity to have the CIC as an investor apparently bears significance to a target firm. The CIC’s status as an important state-​ owned enterprise under the direct leadership of the State Council underscores its influence among the highest level of Chinese governmental bureaucracies. A  target firm thus would have real incentive to maintain a good post-​investment relationship with the CIC, as the image of a trustful business partner of the official state investment company will not only facilitate further dealings with Chinese governmental officials, but also help bring about more potential business opportunities with key Chinese SOEs, as was the case with Teck Resources and GDF SUEZ (see Table 16.8). The role played by the CIC there is best described by Mr Gérard Mestrallet, Chairman and CEO of GDF SUEZ, when commenting on the execution of significant agreements with Chinese parties in 2013: The signing of these agreements is proof of our commitment to China, further strengthened in recent years thanks to our partnership with the Chinese sovereign fund CIC. It enables us to increase and diversify GDF SUEZ’s activities in this country, where the Group has a strong presence in the environmental sector and is experiencing growth in the energy and energy services sectors.45

In addition to helping open up and strengthen business ties with the Chinese market, the CIC often actively collaborates with its targets in potential investments into related business projects. When asked about the CIC investment in its 2009 Q3 earnings conference call, Mr Paul Hanrahan, then president and CEO of AES Corporation, stated: “Potentially to the extent there are larger transactions, what we would likely do is [to] go to [CIC] with the opportunities for the large transactions and see if they would want to become, on a case by case basis, a joint venture partner, particularly for big investments where we think that makes sense.”46 Indeed, this statement well describes how the post-​investment CIC-​target collaboration can take place. Such collaborative relationship could have already been agreed in the form of a strategic cooperation agreement

45 

“China: GDF SUEZ develops its presence in natural gas storage, LNG and the environment.” gdf suez. Available at http://​www.gdfsuez.com/​en/​journalists/​press-​releases/​china-​gdf-​suez-​develops-​its-​ presence-​in-​natural-​gas-​storage-​lng-​and-​the-​environment/​ [accessed January 27, 2016]. 46  “Q3 2009 AES Corporation Earnings Conference Call—​Final.” AES Corporation, accessed from Factiva.

420    Investment Terms and Level of Control of China’s SWF when the relevant CIC investment took place, but it could also be gradually developed in the years following the CIC investment, as occurred with Blackstone, Morgan Stanley, and most expressively with Russia’s large state-​owned bank VTB Group. While the CIC also benefited from these collaborative relationships with its portfolio firms—​in that it was introduced into their networks and could thus access good new business opportunities in foreign countries—​the CIC could still have an important say in these relationships being a deep-​pocketed investor or co-​investor ready to expend large amounts of capital into the projects. This again qualifies as a sound reason for a CIC portfolio company to respect this cash-​rich business partner and maintain a good long-​term relationship with it after the direct investment happens. To summarize, it is thus reasonable to say that the ability of the CIC to smoothen for its portfolio companies the progress of doing and enlarging their potential business in China, combined with the network transactions where it co-​invests and cooperates with the portfolio companies as a valuable business partner, provides opportunities for it to extract potential private control benefits from its target firms. Such control benefits are indirect as they are realized without the CIC necessarily possessing or making use of formal control rights such as voting and board seats in the portfolio firms; yet they can still be influential because they are derived from long-​term business relationships where both sides practically cannot afford losing each other, and especially not the CIC if the concerned target firms have established, or intend to establish, active business in China.

Huijin Investments After discussing both the direct and indirect control rights of the CIC in its portfolio companies, I now focus on Huijin, the CIC’s wholly-​owned subsidiary. Table 16.9 presents the direct equity holdings of Huijin in 18 state-​owned financial institutions as of the first half of 2015. This list was originally published on Huijin’s official website,47 and I supplement it by checking the portfolio companies’ 2015 semi-​annual reports or their official websites to reveal Huijin’s comparative ownership percentages relative to the other major shareholders (holding 5% and above) in them. It can be seen that Huijin typically holds significant equity stake, in some cases even absolute controlling stake, and thus is almost always the largest shareholder in its portfolio companies. Huijin’s monitoring role is further fortified by the directors and supervisors it has appointed into the

47 

See “Investments.” Central Huijin Investment Ltd. Available at http://​www.huijin-​inv.cn [accessed January 27, 2016]. To be sure, Huijin also holds shares in many other companies than the ones in the list, especially as a result of the market rescue in August 2015, where Huijin took over the shares of many listed companies originally bought and held by China Securities Finance Corporation (CSF) for the purpose of restoring market stability after the Shanghai Composite index fell over 40% from its seven-​ year high on June 12 till late August. According to the figures compiled from the third quarterly financial statements of listed companies, which are required to disclose their 10 largest shareholders, CSF and Huijin were identified as holding as much as 6% of China’s whole stock market. (See Wildau 2015.)

Table 16.9 Huijin’s Direct Investments Total Number of Directors & Board Structure

Total Number Number of Huijin Number of of Huijin Directors* Supervisors Supervisors*

Core Company Name Business

Huijin’s Ownership Other SHs (>5%)

1

China Development Bank Corporation

Banking

47.63%

Ministry of Finance Total: 11 (MOF), 50.18% Executives: 2; Non-​executives: 8; Independent non-​executives: 1

Unknown

2

Industrial and Commercial Bank of China Limited

Banking

34.71%

MOF, 33.11%

Total: 16 Executives: 4; Non-​executives: 6; Independent non-​executives: 6

3

Agricultural Bank Banking of China Limited

40.03%

MOF, 39.21%

4

Bank of China Limited

64.02%

None

Banking

5

Directors & Supervisors Otherwise Related to Huijin /​ CIC**

Unknown

Mr Hu Huaibang, executive chairman of the company since April 2013, served as the chairman of CIC’s supervisory board from September 2007 to September 2008.

3 (all 6 non-​executives) All have board committee seats.

0

None

Total: 15 Executives: 4; Non-​executives: 6; Independent non-​executives: 5

6 (all 7 non-​executives) All have board committee seats.

0

Mr Liu Shiyu, executive chairman of the company since December 2014, served as a non-​ executive director of CIC from September 2007 to March 2013.

Total: 13 Executives: 2; Non-​executives: 6; Independent non-​executives: 5

0

0

None

7

(Continued)

Table 16.8 (Continued) Total Number of Directors & Board Structure

Total Number Number of Huijin Number of of Huijin Directors* Supervisors Supervisors*

Directors & Supervisors Otherwise Related to Huijin /​ CIC**

Core Company Name Business

Huijin’s Ownership Other SHs (>5%)

5

China Construction Bank Corporation

57.11%

Temasek, 7.15%

Total: 16 Executives: 4; Non-​executives: 6; Independent non-​executives: 6

1 (non-​executive) Has board committee seat.

8

1

None

6

China Everbright Investment Group Ltd.

55.67%

MOF: 44.33%

Unknown

Unknown

Unknown

Unknown

Unknown

7

China Everbright Banking Bank Co., Ltd.

21.96%

China Everbright Total: 18 Group Ltd: 23.69% Executives: 2; Non-​ executives: 10; Independent non-​executives: 6

6 (all 9 non-​executives) All have board committee seats.

None

Mr Li Xin, chairman of the company’s supervisory board since June 2015, works concurrently as the employee director in CIC. Mr Yu Erniu, outside supervisor of the company since November 2012, served as the employee director in CIC from September 2007 to July 2009.

8

China Export & Insurance Credit Insurance Corporation

73.63%

Unknown

Unknown

Unknown

Unknown

Banking

Unknown

Unknown

9

China Reinsurance (Group) Corporation

Insurance

84.91%

MOF, 15.09%

Total: 10 Executives: 4; Non-​executives: 2; Independent non-​executives: 4

1 (executive) 5 Vice president & chief compliance officer

1

Mr Li Peiyu, executive chairman of the company, used to be the director of CIC’s Alternative Asset Investment Department. Mr Wei Shiping, supervisor of the company, works concurrently as the senior manager of CIC’s Finance Department. Mr Zhu Yong, supervisor of the company, works concurrently as the secretariat of CIC’s supervisory board.

10

New China Life Insurance Co., Ltd

Insurance

31.34%

Baosteel Group Corporation, 15.11%

Total: 13 Executives: 2; Non-​executives: 5; Independent non-​executives: 6

3 (all 7 non-​executives) All have board committee seats.

0

Ms Ai Bo, supervisor of the company since January 2010, works concurrently as the senior manager of CIC’s Discipline Inspection Committee.

11

China Jianyin Investment Limited

Investment

100%

None

Unknown

Unknown

Unknown

Unknown

Unknown

(Continued)

Table 16.8 (Continued) Total Number Number of Huijin Number of of Huijin Directors* Supervisors Supervisors*

Directors & Supervisors Otherwise Related to Huijin /​ CIC**

Core Company Name Business

Huijin’s Ownership Other SHs (>5%)

Total Number of Directors & Board Structure

12

China Galaxy Financial Holdings Co., Ltd.

Investment

78.57%

MOF, 21.43%

Unknown

1 (non-​executive) Board chairman

Unknown

Unknown

Mr Xu Guoping, vice general manager of the company, used to work as the director of China Construction Bank Department at Huijin.

13

Shenwan Hongyuan Group Co., Ltd.

Investment

25.03%

China Jianyin Investment Limited, 32.89%; Shanghai Jiushi Corporation, 6.05%

Total: 9 Executives: 1; Non-​executives: 5; Independent non-​executives: 3

1 (non-​executive) Has board committee seat.

9

0

Mr Feng Rong, non-​executive vice chairman of the company since February 2015, used to work in Huijin.

14

China International Capital Co., Ltd.

Securities

43.17%

Shareholding as of November 2015 (after the company’s HK main board listing): CIC, 28.45%; GIC, 11.82%; TPG Asia V Delaware, L.P., 7.45%; KKR Institutions Investments L.P., 7.23%; China National Investment and Guaranty Co., Ltd., 5.53%; and

Total: 11 Executives: 1; Non-​executives: 6; Independent non-​executives: 4

2 (both 3 non-​executives) Both have board committee seats.

0

None

Mingly Corporation, 5.31% 15

China Securities Securities Co., Ltd.

40%

Beijing State-​ Owned Capital Operation and Management Center, 45%; Century Golden Resources Group, 8%; and CITIC Securities Co., Ltd., 7%

Total: 13 Executives: 1; Non-​executives: 8; Independent non-​executives: 4

Unknown

6

Unknown

Unknown

16

China Investment Securities Co., Ltd

100%

None

Unknown

Unknown

Unknown

Unknown

Mr Hu Changsheng, the company’s president and vice chairman, used to work as the director of Capital Market Department and Non-​Banking Department in Huijin.

17

Jiantou Asset 70% Zhongxin Assets management Management Co, Ltd.

Unknown

Unknown

Unknown

Unknown

Unknown

Unknown

18

Guotai Junan Investment Management Co., Ltd.

Unknown

Unknown

Unknown

Unknown

Unknown

Unknown

Securities

Asset 14.54% management

Notes: * A director or supervisor is considered as a Huijin representative if he/​she sits on a portfolio company’s relevant board and also works in Huijin. ** A director or supervisor is not a formal Huijin representative but is otherwise related to Huijin/​CIC if the person has worked in either of these two companies, or is concurrently working in CIC. (As of June 30, 2015, N=18)

426    Investment Terms and Level of Control of China’s SWF companies—​and to the extent the relevant information is available, all of these directors have seats in important board committees. In addition, Huijin is presumably also able to cast indirect influence, at least in eight of the 18 companies, via the directors and supervisors that are not formally installed by but are still somehow related to it, typically as a result of the previous or concurrent high positions held by them at Huijin or the CIC. These people are usually referred to in media as having a “Huijin/​CIC background/​root” (see, for example, Geng 2009; Li 2010). Arguably, such a phenomenon provides further support for the argument made already—​namely, that the different positions in the CIC, Huijin, and other SOEs such as the financial institutions listed here are essentially just “job-​rotations” for them, and they follow a career path more as governmental officials than as businessmen. In an interview in 2013, Mr Ding Xuedong, chairman of both the CIC and Huijin, admitted that Huijin has two major mandates: one the one hand, it shall serve as a platform for the capitalization and restructuring of state-​owned financial institutions; on the other, it shall act as an activist shareholder representative for the state, and work to the end of stable and sustained development of these institutions (Wu 2013). This is done essentially by appointing directors. According to Ding, Huijin had installed over 100 directors onto the boards of its portfolio firms as of 2013. While remaining as the employees of Huijin,48 these seconded directors would work full time at the portfolio companies for a maximum of six years, and they usually took up a certain number of board seats such that they could retain veto rights on material issues. Overall, these directors have been able to act as an effective counterbalance to the incumbent management of the portfolio firms—​the number of objections and abstain votes cast by Huijin’s directors took up around two-​thirds of all such votes in portfolio firms’ board meetings, and they have been able to speak out especially on such issues as mergers and acquisitions, procurement of fixed assets, and executive compensation (Wu 2013). In addition to directly taking board seats and casting votes, Huijin has also actively exercised its shareholder rights via indirect approaches. According to Mr Zhang Hong’an, Huijin’s vice-​general manager, this is done typically by sending letters to the management, and also by meeting and discussing with the management about certain matters. These approaches are also effective because portfolio firms tend to take them seriously and respond to the raised questions in a timely manner (Sun 2015). It is thus interesting to see that the CIC and Huijin, whose key directors and supervisors to a large extent overlap,49 maintain drastically divergent approaches toward how to exercise shareholder rights in their portfolio firms. While the CIC is a passive shareholder with respect to its formal rights, and influences its portfolio firms rather indirectly

48  These directors are typically hired by Huijin via open recruiting advertisements. To the extent of the information published on its website http://​www.huijin-​inv.cn, such advertisements can be found for years 2014, 2009, and 2008. 49  According to the official websites of the CIC and Huijin as of 2015 year end, Mr Ding Xuedong is the chairman of the boards of directors, Mr Guo Haoda is the chairman of the boards of supervisors, and Mr Cui Guangqing is the supervisor representative for employees in both companies.

Jing Li   427

Box 16.2 The China Investment Corporation’s Portfolio Construction The CIC continues to use a three-​layer asset allocation framework, comprising of strategic asset allocation, policy portfolio and tactical asset allocation. To start with, it determines its allocation of assets according to the long-​term return and risk preference, which serve as long-​term, sustained and stable guidance for investment by distinguishing the areas of allocation for all types of assets. With a three-​year time horizon, the policy portfolio acts as an anchor for investment activities and portfolio rebalancing. Moreover, it also adjusts tactical asset allocation based on mid-​and short-​term incidents, asset evaluation and risk factors of the actual portfolio. Guided by strategic asset allocation plan and prudential risk management principles, the CIC invests in a wide range of financial products globally, including public equity, fixed income, absolute return, long-​term investments, and cash and others. Source: Adapted from CIC (2015).

through long-​term network relationships, Huijin is quite an activist investor, both in terms of direct and indirect control rights. This is readily explained by the fact that Huijin is exclusively mandated to hold interest on behalf of the Chinese government in state-​ owned financial assets and to preserve and enhance their value (see Table 16.1). One may argue as to whether such seemingly divergence really stands for a substantive disparity in investment strategies. When asked to comment on the so-​called “Huijin business model”, Mr Zhang Hong’an admits that the company is essentially intended to work as a “node” at which the government’s administrative intervention orders are translated and implemented into the portfolio firms through market means (Sun 2015). In this sense and as previously argued, the CIC is no different. With the bulk of its equity holdings being substantial but still minority, and also located overseas, it is apparently less feasible for the CIC to exercise the same level of direct activism as Huijin in each of its portfolio firms. A more practicable approach would be to maintain a strategic orientation when building up the overall portfolio. This is done, to the extent of the focus of this chapter, typically through the sector distribution of its equity investments; and to a greater extent, through the overall allocation across different classes of assets. See Box 16.2.

Conclusion Using a hand-​collected dataset consisting of 61 M&As, 8 JVs and 28 fund investments made by the CIC from 2007 to the end of 2015, this chapter analyzes important direct control rights, such as level of ownership and voting rights, as well as director nomination and board representation, of the CIC in its target firms. It is found that the CIC usually holds significant but non-​controlling equity stakes, clustering in the range of 5% to 20%, thus making it the largest or one of the largest blockholders of the companies. In contrast to the big equity blocks that it holds, the CIC’s voting rights are often restricted in the investment contracts it enters into with the targets (to the extent the

428    Investment Terms and Level of Control of China’s SWF relevant information available). It explicitly gave up its voting rights in seven firms and in another five firms its voting rights were either limited in different ways or capped to certain percentages. In terms of board representation, the CIC has no seats on the boards of 30 targets, while it has only installed directors in 11 targets. It is worth noting that the CIC’s absence on target boards is often not because of its small shareholding or the existence of absolute controlling shareholder(s) there; rather, the CIC is often among the biggest shareholders and/​or was vested with the right to nominate director(s) explicitly by the investment agreements. Except for SMIC, a Chinese company in which the CIC is the second largest shareholder, there is no evidence of it pursuing shareholder activism by exercising its voting rights or bringing up proposals, either in shareholder or board meetings of the portfolio companies. This is in sharp contrast with Huijin, the CIC’s wholly-​owned subsidiary that acts as a rather activist shareholder in its portfolio firms, both through direct and indirect control measures. Arguably, such disparity is resulted more from the practical infeasibility to exercise the same amount of formal control in minority overseas equity holdings, than from the prepared deviation of the CIC from its “strategic governmental investor” role. Although the CIC does not seem to have actively exercised its formal control rights, it is not warranted to conclude that it is largely a passive investor with little control over its target firms. To the contrary, the pre-​and post-​transaction business dealings happened across the networks of the CIC and its targets show that, practically, it is often not necessary for the CIC to possess or use formal corporate governance tools to exert control over its targets. Rather, the fact that it is a cash-​rich investor and is often among the shareholders with the largest economic ownership in the portfolio companies, combined with its profound connections with the Chinese government—​which plays an overarching role in China’s economy—​makes it a powerful business partner for firms wishing to pursue future cooperation and co-​investment projects, as well as firms expecting to enter and grow in the Chinese market. Because the target firms cannot easily afford to lose such an important investor and business partner, there are plenty of opportunities for the CIC to extract indirect private control benefits from them in the long-​term post-​investment relationships. These findings about the CIC’s investments and control rights in its portfolio companies may shed light on the highly controvertial issue of SWF regulation. It can be inferred that forcing SWFs to remain passive in the corporate governance realm by, for example, asking them to suspend their voting rights, can often be unnecessary because the investment agreements between an SWF and its targets could have already installed certain contractual restrictions to that end. More importantly, for an SWF that holds non-​controlling but significant economic ownership, formal corporate governance mechanisms are not the only set of means that it can employ to influence the target firms. Rather, the long-​term collaborative relationship between the two sides can create many opportunities for the SWF to secure strategic control benefits over target firms, while such indirect control cannot be captured by simply suspending the SWF’s formal corporate governance rights. Therefore, the regulators of countries hosting SWF

Jing Li   429 investments have good reasons to first examine their existing laws and regulations and consider carefully the necessity and level of regulation they are going to propose for SWFs as a particular group of investors since regulatory measures rushed out of short-​ term fad or political pressure may backfire for protectionism in the long run.

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Chapter 17

Strangers A re Not All Dang e r Sovereign Wealth Fund Investment in the Energy Industry Di Wang

Sovereign wealth funds (SWFs) are large pools of capital owned and controlled by governments and invested in domestic and foreign markets. In recent years, SWFs have grown rapidly in number and size. The growth of SWFs has raised many policy debates over their potential politicized nature. Indeed, the fact that SWFs are owned and controlled by governments, and have large and continuous sources of funding, raises the concern that SWFs may use their portfolios to achieve certain political objectives (see, for example, Gieve 2008; Summers 2007). This is particularly true when SWFs invest in strategic industries. However, strategic interests vary from country to country. Hence, SWFs’ investment preferences resulting from these strategic interests can be quite different from each other, even in commonly considered strategic industries. In order to study the heterogeneity within SWF groups, this chapter investigates the role of state ownership in SWF investment in strategic industries, paying particular attention to the energy industry. My focus on the energy industry stems from several considerations. First, SWFs have been actively participating in energy investments since the early 1990s. More than $76 billion has been invested in energy assets and companies in the past five years by SWFs across the world, and more investments will be required to meet the expected energy demand growth (Finley 2012). Observers have predicted that the rising investment trend will continue, in particular in China, Japan, and the EU (Clark 2011). Therefore, the strategic value of the energy industry is generally agreed upon, even though what constitutes a strategic industry depends on a nation’s level of economic development, its political institutions and other factors.

434    Strangers Are Not All Danger Second, investments in the energy industry generate significant implications for political leaders, both economically and politically. In economic terms, energy is the most basic power source of economic activities. Particularly for resource-​scarce countries, energy security is often viewed as a bottleneck for economic development. In order to secure energy supplies, overseas investments in the energy industry from these resource-​poor countries have been increasing. For resource abundant countries, natural resource ownership exposes them to economic volatility, which could have an adverse impact on economic growth. In political terms, international cooperation and conflicts in the world today are rooted in resource politics. This is illustrated by Daniel Yergin’s famous quote, “oil consists of 10% economy and 90% politics” in his observation of the energy industry in the 1930s.1 For example, previous scholars have long recognized the close relationship between natural resources and violent activities. On the one hand, armed conflict is a means to gain access to valuable resources (Berdal and Malone 2000; Keen 1998). On the other hand, natural resources give rise to armed conflict not only by financing belligerents (Collier and Hoeffler 2002; Fearon 2004), but also by weakening the ability of political institutions to peacefully resolve conflicts. Contrary to the conventional wisdom that abundant resources bolster economic growth and thus promote political stability, the resource curse literature provides evidence that countries with abundant natural resources are associated with a higher risk of political instability and armed conflict (Collier 2000; Ross 1999). Meanwhile, energy is also of great importance to energy-​poor countries and this influences their SWF investment behaviors. For example, China’s hunt for oil has shaped its foreign policy toward its neighbors (such as Russia) and regions as far as sub-​Saharan Africa and Latin America. Consequently, when the SWF becomes a foreign policy tool in the energy field, the strategic importance of energy makes the foreign investments in this industry more complicated and politically sensitive. In sum, the energy industry is one of the most strategic sectors. However, I argue that SWFs engage in energy investment in various manners, depending on the level of energy resources in their home countries. Countries with SWFs generally fall into two categories: energy-​rich and energy-​poor. From the home country’s perspective, SWFs from the energy-​poor countries are more likely to invest in the energy industry than SWFs from the energy-​rich countries due to the concern over energy security. Moreover, SWFs from energy-​poor countries should be more likely to invest in the energy industry than private investors from the same energy-​poor countries. Turning to the host country’s perspective, due to the strategic importance of the energy industry, foreign investment in this industry is likely to face more resistance by the host country government. The resistance would be even higher with the deterioration of bilateral relations between the home and host countries. Moreover, because energy-​poor countries have incentives 1 

Daniel Yergin, chairman of the Cambridge Energy Research Associates (CERA) and a celebrity of the international oil industry, offered this statement to describe the European oil market at that time.

Di Wang   435 to invest in the energy industry not based solely on financial motivation, SWFs from energy-​poor countries are likely to encounter closer scrutiny by the host governments and thus are more sensitive to the bilateral relations between the home and host countries than other investors. To subject these arguments to empirical tests, I  evaluate quantitatively the determinants of SWFs’ likelihood of investing in the energy industry by using data of 6,382 cross-​border acquisitions (with 713 deals in energy industry) from 1992 to 2012. The statistical findings largely support my theoretical expectations. This chapter discusses the key motivations of SWF investments in strategic industries and elaborates my argument on SWF investments in the energy industry. It then gives details of the research design and reports the empirical results before concluding with a discussion of the implications of my findings.

Theoretical Framework of Sovereign Wealth Fund Investments in the Energy Industry Scholars in both international political economy and international business have recognized that firms in strategic industries require specific theoretical consideration and empirical analysis (Mahon and Murray 1981; Reger, Duhaime, and Stimpert 1992), especially when it comes to studying their impact on conflict initiation (Dorussen 2006; Li and Reuveny 2011), patterns of international expansion and their exposure to regulatory risk in different countries (Delios and Henisz 2003). In what follows, I first summarize the motivation of SWF investments in strategic industries. I then contextualize my argument in the case of the energy industry.

The Motivations of Sovereign Wealth Fund Investments in Strategic Industries Before outlining the motivations of SWF investments in the strategic sector, it is important to specify the definition of strategic industry. Earlier studies use this concept to describe industries of military significance—​in other words, the extent to which goods can, directly or indirectly, contribute to the adversary’s military power. They typically include financial, mining, steel, telecommunications, transportation, utilities, oil, and military-​related production (Megginson, Nash, and Randenborgh 1994; Megginson, Nash, Netter, and Poulsen 2004). However, some scholars claim that it is difficult to identify a priori if an industry is strategic, because any industry is strategic if it is needed to pursue a given strategy and has no substitutes (e.g. Baldwin 1989; Førland 1991). In

436    Strangers Are Not All Danger the context of SWF investment, strategic sectors generally include natural resources, defense or other politically sensitive industries. I use this last one as the working definition in this study. In this chapter, I argue that SWFs may undertake foreign investments in strategic industries to facilitate national economic development or enhance political influence abroad. First, governments may make extensive use of strategic SWF investment to promote the national economic development. One prominent example is China’s use of one of its SWFs—​the China Investment Corporation (CIC)—​as an instrument to pursue national raw materials policy. The CIC seeks access to raw materials and energy to ensure it satisfies rapidly growing domestic energy demands in manufacturing and infrastructure industries (Miracky, Barbary, Fotak and Bortolotti 2009). In addition, governments are also interested in gaining access to intangible resources in order to promote their national economies. For example, partnering with foreign companies may provide opportunities for gaining knowledge and developing expertise in a particular industry. We observe that SWFs’ investments by Abu Dhabi, Dubai, and Qatar are considered strategic tools to promote the development of their respective aerospace sectors (Haberly 2011). The second and perhaps more prominent concern about SWF investments in host countries is that SWFs may acquire strategic assets as a foreign policy tool. That is, SWF investments with non-​financial motivations could affect national security, especially when investments are in the defense industry, public and private infrastructure, high technology, financial markets, or natural resources. In one instance, by investing in the Myanmar Fund in 1995, Singapore used its SWFs as a diplomatic tool to open channels to Burma (Balding 2012). In a more recent instance, the Qatar Investment Authority and the Olayan Group of Saudi Arabia cooperated with IDB Holdings of Israel to invest in an emerging markets fund in 2010 (Financial Times 2010). Although the investment giants of Qatar and Saudi Arabia do not need IDB’s capital to launch the fund, their decision to involve an Israeli company may signal their readiness to cooperate with Israel (Avissar 2010).

The Classification of Sovereign Wealth Funds As noted earlier, the energy industry provides a useful context for SWF investment research. This is because energy security has become central to international relations due to the increasing demand and competition for geographically concentrated resources, the concerns with resource scarcity, the fear of depletion in the near future, as well as the potential social and political effects of climate change (Vivoda 2010). Due to the strategic importance of energy, SWF investment in this industry raises a number of geopolitical concerns. For example, a host country may be worried if a foreign country’s SWF takes a controlling stake in a large oil company, thereby giving it the power to redirect natural resources to the SWF’s home country, or sell these resources at a discounted price. A more urgent concern is that giving a potential belligerent access to scarce and

Di Wang   437 strategically important energy resources helps to strengthen the military capabilities of the home country, which may be used against the host country in the event of a militarized conflict. Moreover, the energy industry allows us to analyze the objectives of SWFs by comparing different investment behaviors among SWFs and within the same home country. To do so, we need to first differentiate between two types of SWFs according to their countries’ energy resource endowment: countries that are rich in energy resources and countries that are not. To measure the energy resource endowment, I use the average net energy imports as a percentage of energy use. Energy use refers to consumption of primary energy before transformation to other end-​use fuels, which is equal to indigenous production plus imports and stock changes, minus exports and fuels supplied to ships and aircraft engaged in international transport. A negative value of the average net energy imports as a percentage of energy use indicates that the country is a net exporter and thus is energy-​rich, whereas a positive value indicates that a country is an importer and energy-​poor. Table 17.1 provides a breakdown of SWF countries in my sample.2 The energy-​rich countries are Kazakhstan, Kuwait, Libya, Oman, Qatar, and the United Arab Emirates (UAE), whereas the energy-​poor countries include China, Singapore, Malaysia, and South Korea.3 From the home country’s perspective, the difference in energy resource endowment makes SWFs from energy-​rich and energy-​poor countries fundamentally different in their concern over energy security. As a result, the energy endowment of the countries induces SWFs to have different investment preferences in the energy industry, as elaborated in the next section.

Comparing Sovereign Wealth Funds from  Two Types of Countries The literature of international business research suggests that firms engage in foreign direct investment (FDI) not only to exploit their existing assets in host countries through FDI, but also to learn or gain access to strategic assets (such as technology, 2 

The procedure of sample selection will be discussed in more details later. In Column (7) of Table 17.1, I report another classification obtained from the Sovereign Wealth Fund Institute (SWFI) website. This website classifies countries that established SWFs into two groups according to the source of the foreign exchange assets: SWFs from commodity countries, which are funded by commodity exports that are either owned or taxed by the government, and SWFs from non-​ commodity countries, which are usually established through transfers from the official foreign exchange reserves. It shows that all the energy-​rich countries are commodity countries except for Malaysia. While Malaysia is a net energy exporter, its Khazanah Nasional is classified as a non-​commodity SWF because it is partly financed by government debt (Lyons 2008) instead of commodity revenues. Since I focus only on energy, the classification according to their energy resource endowment fits my theory better, and will be employed in this study. 3 

(1)

(3)

(4)

(5)

SWF Country

Net Energy Fuel Exports (% of Imports (% of Merchandise Energy Use) Exports)

SWF Investments

Total Energy Investments

SWF Energy Investments Classification in this Study

Classification obtained from SWFI

Singapore

98.45

11.98

275

201

30

Energy-​poor countries

Non-​commodity

South Korea

80.90

7.02

2

97

1

Energy-​poor countries

Non-​commodity

China

8.30

1.78

25

190

10

Energy-​poor countries

Non-​commodity

Malaysia

–​47.56

11.95

14

107

0

Energy-​rich countries

Non-​commodity

Kazakhstan

–​117.42

67.16

27

21

5

Energy-​rich countries

Commodity

UAE

–​252.78

65.99

91

61

13

Energy-​rich countries

Commodity

Oman

–​365.45

82.89

5

9

0

Energy-​rich countries

Commodity

Qatar

–​451.26

82.82

43

3

0

Energy-​rich countries

Commodity

Libya

–​452.59

97.19

3

4

2

Energy-​rich countries

Commodity

Kuwait

–​454.35

94.36

5

20

1

Energy-​rich countries

Commodity

490

713

62

Total

(2)

(6)

(7)

438    Strangers Are Not All Danger

Table 17.1 Categorization of Soverign Wealth Fund Countries

Di Wang   439 marketing, and management expertise) available in the host country (e.g. Dunning and Narula 1995; Kumar 1998). The former form of FDI is called asset-​exploiting FDI, whereas the latter is strategic asset-​seeking FDI. With this background, I  argue that SWFs from energy-​poor countries invest in the energy industry for asset seeking. This is because SWFs are funded by large current account surpluses. These exports mainly come from the manufacturing industry, or from transportation, information or communication technology sectors, which all require substantial amounts of energy or electricity as inputs. As a consequence, concern for energy security is explicitly placed at the top level of the government agenda in these countries. As stressed in the Chinese government’s Twelfth Five-​Year Plan (Xinhuanet 2011) and the Twelfth Five-​Year Plan of Energy (State Council of the PRC 2013), the government should actively participate in overseas exploitation of energy resources, expand energy trade and technical cooperation and improve transportation, finance and other abilities in order to jointly safeguard global energy security. Therefore, from the perspective of the Chinese government, the SWFs’ overseas investments in the energy industry will accelerate the realization of the “going global” and energy-​related strategy of the Twelfth Five-​Year Plan (Sun, Wang, and Clark 2014). In order to meet the increasing demand for energy in energy-​poor countries, these countries invest in energy for the purpose of gaining access to energy resources. For example, Singapore’s SWF, Temasek, set up an investment unit focused on liquefied natural gas (LNG) in 2013, reflecting the SWF’s growing portfolio of energy assets and underscoring the increasing importance of LNG as a relatively clean-​burning energy source (Wong 2013). LNG is an area where Singapore sees an opportunity, because although Singapore does not have any gas fields of its own, it wants to be a center for storage and shipment of the fuel. Thus, the energy investments by SWFs helps effectively enhance energy security and functions as a hedge against the risk of global energy prices rising. Moreover, SWFs from energy-​poor countries may also aim to gain access to technology and expertise to develop energy production at home. Because industrialized economies such as the US have effective regulations governing the export of dual-​use and other strategically sensitive items, the transfer of the technology and expertise is particularly important when investing in the Middle East and Africa. For instance, China and Saudi Arabia signed an oil cooperation agreement that inaugurated a “strategic oil partnership” between the two countries in 1999. Some researchers and officials who are familiar with upstream oil and gas production in China suggest that Saudi Aramco, a Saudi national oil company, may have been a source of advanced technology and expertise that has enabled Chinese energy companies to improve their production from and management of existing fields at home (Leverett and Bader 2005). In contrast, SWFs from energy-​rich countries may have different investment preferences. The energy-​rich countries do not face challenges to security of oil supplies as their energy-​poor counterparts do. Instead, these countries face two other challenges. First, natural resources are exhaustible, and their consumption and export leads to their depletion. Second, the international market for commodities is characterized by a high

440    Strangers Are Not All Danger level of price volatility. Accordingly, energy-​rich countries may wish to diversify their economies from natural resources. Given these challenges, SWFs from energy-​rich countries can help them diversify their economies. Since a surge in resource exports leads to a real appreciation of the country’s exchange rate and this hurts other exporters and producers in import-​ competing sectors, the UAE, for example, has used SWFs for rapid diversification of its economy away from oil toward tourism, aerospace and finance. Such a diversification motive is as legitimate as the desire to raise the efficiency of its economy through acquiring stakes in leading global companies (Reisen 2008). Given their lack of concern about energy security and the intention to diversify, SWFs investing on behalf of an energy-​ rich home country may not invest in the energy industry as much as SWFs from energy-​ poor countries do. In sum, I argue that SWFs from energy-​poor countries have different incentives than do SWFs from energy-​rich countries for their investment in the energy industry. Thus, my theoretical framework generates the following hypothesis: Hypothesis 1: SWFs from energy-​poor countries are more likely to invest in the energy industry than SWFs from energy-​rich countries.

Comparing Sovereign Wealth Funds and Private Investors As discussed earlier, SWFs from energy-​poor countries are likely to invest in the energy industry in order to mitigate energy security concerns at home; such investments are not just economically but also politically motivated. Whereas for SWFs, political objectives sometimes dominate economic objectives in foreign investments, that is less so for private investors. Given SWFs’ political objectives, I further argue that investment behaviors of SWFs and private investors are different even within the same energy-​poor countries. To begin with, SWFs can be required to serve the political mandates of the home government. The logic is similar to that of government ownership in some domestic enterprises. First, governments may be involved in strategic industries such as oil and gas, telecommunications, and banking because those industries are too important to be left in the hands of the private sector. Second, governments may step in to correct market failures. For instance, state-​owned enterprises (SOEs) may be created in order to provide public goods or support research and development (R&D) activities. Third, state ownership can be a response to social welfare and stability issues. Furthermore, governments may establish SOEs to safeguard employment because large layoffs could significantly affect the stability of the national economy. As a consequence, firms with dominant state ownership are generally operated for government objectives instead of profit maximization. In the same way, SWFs from energy-​poor countries are likely to invest in foreign energy firms in order to pursue energy security on behalf of the home country.

Di Wang   441 In contrast, private investors are less willing to sacrifice their profit for the sake of the national interests of the home country than are SWFs. Unlike SWFs, which are part of the home government, private firms are structurally separate from the government (Cui and Jiang 2012). As a result, the profit-​seeking firms may not always align with government interests (DiMaggio 1988; Oliver 1991). Moreover, in practice, private investors receive fewer economic benefits from the government than SWFs do; thus they have fewer incentives to pursue government objectives and bear the associated risks and costs by themselves. Hence, the investments by private investors are more likely to be determined by the market process. Given the different objectives of private investors and SWFs, I generate the following hypothesis: Hypothesis 2: SWFs from energy-​poor countries are more likely to invest in the energy industry than private investors from the same energy-​poor countries.

The Effect of Bilateral Relations on Energy Investment While energy-​poor countries have an interest in investing in energy industry, we have to also consider the perspective of the host country, because a cross-​border acquisition in the energy industry is likely to face resistance from the host countries. For acquisitions engaged in by SWFs from energy-​poor countries, such political or public resistance could be strong, due to the host country’s fear that the investments are being used as the means to pursue energy security. My theoretical argument is based on two premises. First, foreign investments in politically sensitive industries are more closely watched by host governments than investments in other industries (Zhang and He 2009). In particular, if the operation of a target firm involves military production, infrastructure, or natural resources, the acquisition of this firm may be blocked by political forces. For instance, the US government requires that transactions involving regulated industries should prepare to submit for extra layers of approvals after review by the Committee on Foreign Investment in the United States (CFIUS) (Wachtell et  al. 2008). These regulated industries include energy, public utilities, gaming, insurance, telecommunications, financial institutions, defense, etc. Due to the strategic importance of the energy industry, foreign investment in this industry would be closely watched by the host government. The second premise is that friendly states pose less of a security threat to each other. The underlying logic is derived from several fundamental arguments in the international relations literature. First, international anarchy is the principal force shaping the motivations and behaviors of states (Waltz 1959). States that operate in an anarchical system must be concerned first with survival before anything else. Second, because gains from economic exchanges between states can turn into military, security or other advantages, economic exchanges such as international trade can generate security externalities (Gowa 1989, 1994). If improvement in military power occurs for one side

442    Strangers Are Not All Danger of a pair of potential adversaries, a state concerned about its survival would be more cautious in its economic activities with its adversary (Gowa and Mansfield 1993). It is clear, then, that states have incentives to use economic statecraft to reward friends and punish foes (Mastanduno 1998; Skalnes 2000). Host countries therefore tend to encourage trade and investments with political allies; for example, by granting subsidization of political-​risk insurance (e.g. Overseas Private Investment Corporation in the United States) and access to capital (e.g. state banks in China). In addition, they often impose additional barriers and restrictions on trade and investment with political adversaries—​ such as sanctions (Biglaiser and Lektzian 2011). Therefore, better bilateral relations would reduce barriers to foreign entry in the energy industry and increase the likelihood of acquisition success. Chinese investment in Canada provides an excellent example. For most of the previous decades, diplomatic ties between the two countries remained limited, and China did not actively invest in the Canadian energy industry. With the strengthening of bilateral relations since 2009, China’s SWF and state-​owned oil companies rapidly increased their investment in the Canadian energy and mining sectors (Castelli and Scacciavillani 2012, pp. 143–​4). As a result, I have the following hypothesis concerning the role of bilateral relations on SWF investment in the energy industry: Hypothesis 3: Foreign investors from countries that have better bilateral relations with the host country are more likely to invest in the host country’s energy industry. I argue that SWFs from energy-​poor countries are more sensitive to the bilateral relations between the home and host countries when investing in a foreign energy firm. When they invest in the energy industry overseas, SWFs from energy-​poor countries can be perceived by the host countries not simply as business entities being driven by profit maximization, but as political actors pursuing energy security for the home country. This concern by the host country is most prominent when the home and host countries have hostile political relations. If SWFs from energy-​poor countries seek to enter a hostile host country, the latter would worry that giving a potentially belligerent country access to scarce and strategically important energy resources could lead to a dangerous increase in military capabilities of the home country; in turn, giving the home country a military advantage against the host country if the two states go to war. Driven by this national security concern, hostile host countries are more inclined to adopt policies to discriminate against SWFs from energy-​poor countries. As a result, SWFs from energy-​ poor countries prefer to invest in the energy industry of the host countries with which they have better bilateral relations. This observation generates the following testable hypothesis: Hypothesis 4: Better bilateral relations have a stronger positive effect on the likelihood of energy investments by SWFs from energy-​poor countries than on the likelihood of those by other types of investors.

Di Wang   443

Empirical Strategy This section first describes the data used in the empirical analysis that was performed to test my four hypotheses, specifically the date collection procedure as well as the measures of dependent and independent variables. I  then outline the specification of the empirical model.

Data Collection Procedure My data collection followed a three-​step procedure. As a first step, I collected acquisition data in all the countries by searching the SDC Platinum database with a positive value for the data point “Buyside Sovereign Wealth Fund Involvement Flag”.4 As shown in Table 17.2, I ranked the acquirer countries by the number of SWF acquisitions, and concentrated on the top ten active SWF countries that have at least ten cross-​border acquisitions by SWFs. 5 As shown in Column 4 of Table 17.2, this captures 96.85% of the SWF transactions. SWFs often invest through a myriad of subsidiaries. Thus in my second step, I used the Sovereign Wealth Fund Institute (SWFI) list of SWFs and gathered all ownership information for these funds from Bureau van Dijk’s Orbis database to identify the subsidiaries of SWFs. Then I obtained cross-​border acquisition data by SWFs and their majority-​owned subsidiaries (in which an SWF has at least a 50% ownership stake) from Zephyr and Capital IQ database. Finally, I combined the transaction data from the three data sources (SDC, Zephyr, and Capital IQ) and deleted the duplicate observations. Since I am interested in the role of bilateral political factors in SWF investment decisions, I only considered cross-​border deals. I applied a number of filters commonly used in the M&A literature (Gaspar, Massa, and Matos 2005, Betton, Eckbo, and Thorburn 2008). I excluded divestitures,6 spin-​offs,7 repurchases,8 self-​tenders,9 acquisitions with total assets of less than US$10 million and the fractional stake in the target less than 5%, and targets from tax havens.

4 

The role of SWFs in most cases includes acquirer and its immediate, intermediate, or ultimate parent. In some cases, the SWF also plays a role on the target side. 5  Those with fewer acquisitions are not considered because otherwise it is hard to compare SWF with private investors from the same home country. 6  Divestiture means the partial or full disposal of a business unit through sale, exchange, closure or bankruptcy. 7  Spin-​off means divisions of companies that then become independent businesses with assets, employees, intellectual property, technology, or existing products that are taken from the parent company. 8  Repurchase means that a company buys back its own shares from the marketplace, reducing the number of outstanding shares. 9  Self-​tender means that a company buys back its own shares through a tender offer for a price well above fair market value.

444    Strangers Are Not All Danger Table 17.2 Number of Deals Acquired by Soverign Wealth Funds during 1981–​2012

ID

SWF Country

Number of Deals Acquired by SWFs

Cumulative Percentage of all SWF Deals

Included in the Sample SWF Country

1

Singapore

528

50.43%

√

2

United Arab Emirates

173

16.52%

√

3

Malaysia

102

9.74%

√

4

Qatar

78

7.45%

√

5

China

63

6.02%

√

6

Kuwait

18

1.72%

√

7

Oman

15

1.43%

√

8

Libya

14

1.34%

√

9

Kazakhstan

13

1.24%

√

10

South Korea

10

0.96%

√

11

Australia

7

0.67%

12

Brunei

7

0.67%

13

Canada

4

0.38%

14

Papua New Guinea

3

0.29%

15

United States

3

0.29%

16

Russian Fed

1

0.10%

17

Ireland-​Rep

2

0.19%

18

New Zealand

2

0.19%

19

Norway

2

0.19%

20

Hong Kong

1

0.10%

21

Sri Lanka

1

0.10%

1047

100%

Total Source: data obtained from SDC database

Although Abu Dhabi undertook the first SWF investment in the energy industry in 1987,10 I restrict my sample period to 1992–​2012 because the majority of SWFs have only actively participated in the energy industry since 1992. The final dataset covers 6,382 acquisitions (both SWF and private investments) from ten SWF acquirer countries over the period of 1992–​2012.

10 

The Abu Dhabi Investment Authority (ADIA) bought a 5% stake in the French oil company Total.

Di Wang   445

Dependent Variable The dependent variable is a dummy variable energy firm. It was coded as one if the target firm is in the energy industry, and zero otherwise. The pie chart in Figure 17.1 shows the distribution of industries that received cross-​border acquisitions by SWFs from ten countries between 1992 and 2012. The industries that received the most SWF investments were finance (208 deals), services (81), and manufacturing industries (78). Energy industry is the fourth largest industry in which SWFs choose to invest in terms of number of deals. As shown in Column (5) of Table 17.1, 62 acquisitions were allocated to energy industries, with 30 from Singapore, 13 deals from UAE, and ten from China. Figure 17.1 also presents a pie chart based on the total values in the industry. The total transaction value in energy industry is US$19,552 million, the second highest ranking only after the finance industry (US$53,781 million). Hence, we can argue that energy is an attractive industry for cross-​border investments by SWFs. As noted earlier, I classify SWF sponsoring countries into two groups: energy-​rich and energy-​poor countries. The countries in the former group in my dataset are Kazakhstan, Kuwait, Libya, Oman, Qatar, and UAE, whereas the latter include China, Singapore, Malaysia, and South Korea. Table 17.3 reports the summary statistics on the energy investments by the four types of investors separately; that is, SWFs from energy-​poor countries, private investors from energy-​poor countries, SWFs from energy-​rich countries, and private investors from energy-​rich countries. Several results stand out. First, it is clear that in energy-​ poor countries, the proportion of energy investments to the total number of deals by SWFs (12.84%) is larger than that by private counterparts (10.22%). In energy-​rich countries, this proportion by SWFs (12.32%) is slightly lower than that by private investors (13.62%). As shown in Column (5) of Table 17.1, the Singapore SWFs are the most heavily represented in my sample of energy investments. Temasek and Government of Singapore Investment Corporation (GIC) together account for half of the SWF investments in the energy industry. This is not surprising because Singapore is almost completely reliant on energy imports (98%, see Column (1) of Table 17.1), especially from neighboring Indonesia and Malaysia. Accordingly, this is consistent with my earlier argument that SWFs from energy-​poor countries tend to invest in energy industries in order to ensure long-​term energy security. Second, perhaps the most noteworthy differences are that the cumulative deal values by private investments in energy industries as a proportion of total deals is about twice as much as that by SWFs. Nonetheless, this result should be interpreted with caution. As shown in Table 17.3, about 31% of energy deals by SWFs have missing deal values, resulting in an understatement of the value of all investments.11 Consequently, I do not use deal value as a dependent variable in the main models.12 11 

The percentage of transactions with missing deal values in energy industries is the highest for private investors in energy-​rich countries (50.93%) and the lowest for SWFs from energy-​poor countries (20.93%). This suggests that SWFs tend to disclose more information compared to private investors in both types of countries. 12  A robustness check shows that the results remain the same using deal value as a dependent variable.

446    Strangers Are Not All Danger Panel A. By number of deals

Others Transportation & Public Utilities

Finance Energy

Manufacturing Services

Panel B. By deal value Transportation & Public Utilities

Others

Finance Manufacturing

Energy

Figure 17.1  Industry distribution of SWF investments

Since the dependent variable is dichotomies, I employ logit regression and robust standard errors. I also include year-​fixed effects to control for some unobservable factors driving energy investments in a particular year, as we observe greater numbers of energy investments in certain years.

Di Wang   447 Table 17.3 Summary Statistics of Energy Investments EP SWFs

EP Private

ER SWFs

ER Private

Number of deals Energy deals

43

570

26

108

Total deals

335

5576

211

793

Proportion

12.84%

10.22%

12.32%

13.62%

Number of deals with a missing deal value Energy deals with a missing deal value

9

130

8

55

Total energy deals

43

570

26

108

Proportion

20.93%

22.81%

30.77%

50.93%

Energy deals

11468.62

56747.1

7657.472

13257.77

Total deals

64042.34

148681

47388.47

54025.75

Proportion

17.91%

38.17%

16.16%

24.54%

Cumulative deal value

Note: “EP Private” denotes private investors from energy-​poor countries; “EP SWFs” denotes SWFs from energy-​poor countries; “ER Private” denotes private investors from energy-​rich countries; and “ER SWFs” denotes SWFs from energy-​rich countries.

Independent Variables The main independent variables of interest in Model 1 are three dummy variables indicating three types of investors: SWFs from energy-​rich countries, private investors from energy-​rich countries, and private investors from energy-​poor countries. SWFs from energy-​rich countries was coded one if the acquirer was an SWF from an energy-​ rich country, zero otherwise. The other two variables were coded in a similar manner. According to Hypotheses 1 and 2, I expect that SWFs from energy-​poor countries are more likely to invest in the energy industry than are the other three types of investors. Hence, I omitted the dummy variable SWFs from energy-​poor countries because I use it as the reference category. As a result, the coefficient estimates of the other investors dummies should be interpreted as their likelihood to invest in the energy industry relative to SWFs from energy-​poor countries, I expect negative coefficient estimates of these three types of investors based on my theoretical arguments above. In order to assess the impact of bilateral relations on energy investment, I include diplomatic risks. My measure of diplomatic risks employs the events data—​Global Data on Events, Location and Tone (GDELT). To aggregate daily events recorded in the dataset, one needs to take into account the level of conflict or cooperation embodied in each event case. Therefore, the day-​by-​day interactions are separately transformed into two annual flows of cooperation and conflict using the Goldstein (1992) scale. This scale

448    Strangers Are Not All Danger gives weights between 0 and +10 (respectively 0 and –​10) to each category of events according to the amount of cooperation (or conflict) embodied in each event case. Both indicators are then combined into a single net indicator of dyadic political relations between country i and country j at time t following the transformation defined by Desbordes (2012): Diplomaticrisksijt = −



∑ f coop wcoop + ∑ f conf wconf

∑ f coop + ∑ f conf + fneut

(1)

in which f and w stand respectively for the frequency and the weight of a given event. As suggested by Hypothesis 3, I expect that the coefficient of diplomatic risks is negative and statistically significant. Furthermore, to test Hypothesis 4, I generate an interaction term of SWFs from energy-​poor countries and diplomatic risks. Control variables include macroeconomic (home country’s energy use per capita, host country’s GDP and fuel exports, as well as crude oil price), political (host country’s political regime) and deal-​level variables. First, to test whether energy investments are driven by the energy needs of the home country, I  construct a variable capturing the energy security of the home country. There are several indicators to capture energy security,13 and I use energy use per capita to capture energy security because energy intensity of the economy is the most relevant for the size of impacts of energy shortages. I also include the host country’s GDP because it is robustly associated with FDI in a number of studies and is a common indicator of market size in host economies. The expectation is that its coefficient will be positive. For another macroeconomic control, I examine whether the abundance of natural resources in the host country influences the likelihood of energy investments. To that end, I use a measure of fuel exports as a percentage of merchandise exports that is taken from the World Bank’s World Development Indicators. Some recent work suggests that instead of export shares, studies of natural resources should use indices of resource endowments; that is, how much is under the ground (Brunnschweiler and Bulte 2008). However, as noted by Kolstad and Wiig (2012), natural resource rents are more attractive to investors than are the resources in the ground. Therefore, export shares are a better proxy than resource endowment. I expect that the presence of natural resources in the host country increases the likelihood of investments in energy industries. Crude oil price represents an important factor in energy investments. Prices give an indication of the supply in relation to demand, reflecting scarcity and thus depletion of energy resources. Due to oil being a dominant energy carrier in most parts of the world, oil price is seen as a crucial indicator in the energy market (Kruyt, van Vuuren,

13 

See Kruyt, van Vuuren, De Vries, and Groenenberg (2009) for an extensive review on indicators for energy security.

Di Wang   449 De Vries, and Groenenberg 2009). The data is obtained from BP Statistical Review of World Energy 2014. Political institutions in host countries have long been believed to be conductive to FDI (Busse 2003; Jensen 2003). This is more important to energy investments because host governments control either the actual energy supply or the conditions under which investors develop the energy fields. Accordingly, energy investments may be related to political regimes in host countries. More specifically, democratic countries offer better property rights protection than authoritarian regimes (Li and Resnick 2003), thereby reducing risks and uncertainty—​this is particularly important for energy investments. Thus, I include a variable host country’s political regime that measures the degree of the democratic regime. The index is taken from the Polity IV project and ranges from –​10 (fully autocratic) to +10 (fully democratic). Finally, I include a dummy variable multiple acquirers to control for the possible effects of joint ventures. The variable was coded one if the firm is acquired by a joint venture, and zero if the firm was unilaterally acquired by an investor. Since investment in energy industries usually takes a great deal of capital and a “matching appetite for risk” (The Economist 1998), I expect that multiple acquirers are more likely to invest in energy firms.

Empirical Results I report the results of logit models in Table 17.4. In Model (1), the coefficient estimates of SWFs from energy-​rich countries, private investors from energy-​rich countries, and private investors from energy-​poor countries are negative and statistically significant. Substantively, the estimates of these dummy variables indicate that energy investments are less likely to be acquired by energy-​rich SWFs, energy-​rich private investors and energy-​poor private investors, compared to energy-​poor SWFs (the reference category). This finding provides supporting evidence to Hypotheses 1 and 2. Figure 17.2 plots the marginal effects of each type of acquirer. It shows that the probability of energy investment is the highest for SWFs from energy-​poor countries. Compared to SWFs from energy-​poor countries, SWFs from energy-​rich countries and private investors from energy-​poor countries are less likely to invest in the energy industry by 7% and 5%, respectively. With respect to the impact of bilateral relations between the home and host countries, the various specifications in Table 17.4 all suggest that a lower level of diplomatic risk (i.e. better bilateral relations) is more likely to be associated with energy investment. Substantively, the move from the lowest to the highest levels of diplomatic risks (i.e. worse bilateral relations) in the sample lowers the probability of energy investment by 8.9 percentage points (from 11.4% to 2.5%), which is a 78% decrease in probability. Thus, Hypothesis 3 is strongly supported. To assess the moderating effect of bilateral relations, I include only the dummy variable for SWFs from energy-​poor countries and its interaction with bilateral relations in Model 2. This model specification allows me to test Hypothesis 4 regarding the relative importance

450    Strangers Are Not All Danger of bilateral relations for SWFs from energy-​poor countries. The interaction term is positive and statistically significant. Figure 17.3 plots the predictive margins of energy-​poor SWFs with 95% confidence intervals. It shows that the negative effect of diplomatic risks on energy investment is stronger when the target firm is acquired by an SWF from energy-​poor

ER SWF

ER Private

EP Private

−.12

−.1

−.08

−.06

−.04

−.02

Figure 17.2  Marginal effects of each type of acquirer relative to EP SWF based on Model 1

Probability of Energy Investment

.8

.6

.4

.2

0 -7

-5

-3

-1

1

3

5

7

Diplomatic risks Investors other than EP SWF

EP SWF

Figure 17.3  Predictive margins of EP SWFs with 95% confidence intervals

9

Di Wang   451 countries than by other types of investors, although the two confidence intervals overlap a little. These results suggest that bilateral relations do help SWFs from energy-​poor countries in cross-​border acquisitions, which is consistent with my hypothesis. The results of most of the control variables are consistent with my expectation. Across all models, multiple acquirers increase the likelihood of energy investments. The effect of oil price is positive and statistically significant, showing that a rise in the real price of crude oil seems to make foreign investors more interested in the energy industry. Table 17.4  The Logit Estimates of the Likelihood of Energy Investments Variables

Model (1)

SWFs from energy-​rich countries

–​0.801*** (0.296)

Private investors from energy-​rich countries

–​0.568*** (0.194)

Private investors from energy-​poor countries

–​0.556*** (0.151)

SWFs from energy-​poor countries Diplomatic risks

Model (2)

–​0.393 (0.516) -​0.0907** (0.0446)

Diplomatic risks×SWFs from energy-​poor countries

–​0.0775* (0.0450) –​0.301* (0.181)

Multiple acquirers

0.449*** (0.156)

0.449*** (0.157)

Real oil price

0.257*** (0.0887)

0.252*** (0.0882)

Energy use per capita (i)

–​1.541*** (0.137)

–​1.552*** (0.137)

Fuel exports (j)

0.577*** (0.0535)

0.580*** (0.0536)

GDP(j)

–​0.107*** (0.0377)

–​0.107*** (0.0378)

Political regime(j)

0.0698*** (0.0106)

0.0698*** (0.0104)

Year fixed effects

Yes

Yes

Constant

–​26.59*** (10.32)

–​26.54*** (10.27)

Observations

6,382

6,382

Note: ***p