The sovereign wealth fund sell signal

Written by James Saft | Updated: Jan 27 2008, 06:39am hrs
They may be bailing out the banking system, they certainly are bailing out errant corporate boards, but sovereign wealth funds are also likely a big, fat sell signal for investors holding shares in the companies they back.

State-run and with more than $2 trillion under management, Sovereign Wealth Funds (SWFs) have thus far ploughed at least $60 billion into propping up the balance sheets of banks stung by the US housing bust.

But there are lots of reasons to be wary: SWFs have other agendas than pure profit, are often attracted to poor value trophy investments, and may well be subsidising broken business models at banks. Add to this that they are run by governments - hardly known for ruthless efficiency and laser eyes for profit - and investors could be forgiven for running a mile.

I wouldnt want to be alongside them, said Peter Hahn, a fellow at Cass Business School in London and former senior banker at Citigroup.

Governments arent the best investors. They have other priorities.

Last week, Citigroup Inc said it was privately raising $12.5 billion after announcing a record quarterly loss of nearly $10 billion. The infusion includes nearly $7 billion from Singapore Investment Corp Pte, $3 billion from the Kuwait Investment Authority, and an undisclosed amount from Saudi Prince Alwaleed bin Talal, the banks largest individual shareholder. This follows a $7.5 billion stake sale to an Abu Dhabi fund in late 2007, since when Citigroup shares have fallen substantially.

Merrill Lynch & Co Inc said it received a $6.6 billion investment from Kuwait, the Korean Investment Corp, and Japan's Mizuho Financial Group Inc.

SWFs are typically set up by governments seeking to get better returns out of foreign reserves they are amassing, either due to natural resource riches, as in the Gulf states, or, as in China's case, an extremely successful export-based economy.

There is little data about how SWFs perform as investors. Norways fund, over $300 billion and created to invest oil revenues, has done reasonably well and does disclose, but unlike some of its newer peers it has not dabbled often in taking large stakes in individual companies.

Politicians and commentators have also expressed fear that SWFs are seeking either influence, access to resources or technology in order to advance their national agendas. Its impossible to know if this is true, but it is clear that other investors who throw their lots in with SWFs do not stand to gain in the same way.

Rockefeller center syndrome

A huge red flag is the funds predilection for trophy investments. These are the types of things, like brand name banks or fabled private equity houses, which make a big splash and are likely to impress the bosses back home.

When you have a lot of money, you tend to buy fun things, rather than just being boring and seeking to replicate economic or market growth.

Take for example China's state investment agency, which agreed in May to buy a 10% stake in private equity house Blackstone Group for $3 billion. Blackstone hit $38 per share shortly after its public offering in June and has been heading south ever since, now trading at about $18.60.

The classic case was not a sovereign fund, but Mitsubishi Estates Co, which lost about $2 billion in its investment in Rockefeller Center, before withdrawing in 1995.

With trillions to invest, it will simply be too difficult for sovereign funds to be discriminating.

The guy who all of a sudden wins the lottery is everybody's best friend, said Hahn, the former Citigroup banker. Everybody comes to him with ideas about how he should invest his money and generally he comes to regret it.

I think Wall Street will rip these people off blind. That's what Wall Street does.

But perhaps the biggest problem is that SWFs are not just repairing bank's balance sheets, they are in some cases giving them enough money to carry on with broken business models.

In the absence of their cash, some banks would be forced to make the hard choices other industries face when they fail spectacularly, abandoning business models that don't work, in favour of those that do.

In the case of some banks this might mean selling off or closing investment banking units and concentrating on high-margin, low-capital wealth management divisions. But while the funds' stakes in banks are too big to be easily sold without self-inflicted losses, they are not big enough to allow the funds to dictate strategy.

To be sure, we should probably all be thankful the sovereign funds exist and want to invest in banking. If they didnt, the credit crisis could have gotten a heck of a lot worse. But on the whole, big, newly rich and government run does not seem to me to be a recipe for high returns.