Sovereign Wealth Funds Bail Out Major Banks

Robert Hsu, March 01, 2008

With the exception of my former employer Goldman Sachs, almost every major Wall Street investment and commercial bank has been hit by multibillion-dollar losses from mortgage-related business activities. Several international banking giants, including HSBC and UBS, have experienced major losses as well. Many of these firms, like Citigroup and Morgan Stanley, had to be bailed out by sovereign wealth funds from China and other Asian countries. Support from these sovereign wealth funds will prevent top-tier financial firms from going under, so it's important that we as investors know more about them.

Sovereign wealth funds (which I'll call SWFs for short) are state-owned funds that contain financial assets like stocks, bonds, property and other financial instruments. SWFs are designed to allow countries to make large-scale investments around the world.

China formed its own $200 billion sovereign wealth fund last year, which became one of the world's largest institutional investors overnight. I wasn't surprised to see China start its own SWF. China established the fund mainly to follow Singapore's example. The Chinese government has always admired the way Singapore has managed to create a market economy in a country that's ruled by an authoritarian regime. Singapore's sovereign wealth investment company, Temasek, is a leading player in Asian institutional investment circles with substantial investments in everything from shopping malls in Taipei to state-controlled banks in Beijing. China wants to copy Temasek's success with its new sovereign wealth fund, China Investment Company (CIC).

CIC started by raising $200 billion through a special bond offering paying a 5% coupon. Just because CIC has a lot of financial muscle doesn't mean that it uses its might effectively. CIC's first major investment was a 9.9% stake in U.S. private equity giant Blackstone Group, which cost the fund $3 billion last May. So far, the Blackstone investment hasn't been very profitable for China. CIC has already lost more than $1 billion on paper from its Blackstone stake.

This past December, CIC invested $5 billion in troubled Wall Street investment bank Morgan Stanley in a financial bailout package. The jury is still out on whether or not that investment will pay off for China.

CIC is run by Lo Jih-wei, a former Chinese finance ministry official. Recently, Lo explained that one-third of the sovereign wealth fund will be used to invest in the holding company of Chinese state-owned banks, another one-third will be used to clean up bad debt from state-owned banks, and the final third will be invested overseas on deals like the ones with Blackstone and Morgan Stanley.

In addition to China, there are now 28 other countries with their own sovereign wealth funds. These SWFs have combined assets of $3 trillion, mostly from fast-growing Asian economies and oil-producing Middle Eastern countries. The bull market in oil has made several Persian Gulf-based SWFs the richest institutional investors in the world. The SWFs controlled by Dubai, Abu Dhabi, Kuwait and Saudi Arabia have more than $1.5 trillion between them, dwarfing the largest private equity funds in the world. With their enormous size, these sovereign wealth funds can easily move and impact global financial markets.

The Strategies of Sovereign Wealth Funds

Since SWFs have the potential to move the markets, let's take a look at the three main investment strategies employed by these funds:

1) SWFs buy stakes in leading U.S. and European financial institutions.

The recent mortgage and housing-related losses suffered by commercial and investment banks have created a unique buying opportunity for sovereign wealth funds. Countries that are manufacturing and natural resource powerhouses are instructing their SWFs to invest in Western financial institutions because they want to gain the financial market expertise that they lack. Despite recent troubles with Western banks, there is still much for developing countries to learn from them.

Middle Eastern and Asian SWFs have rapidly become a major source of funding for Western financial institutions. In the past four months alone, Abu Dhabi Investment Authority invested in Citigroup, CIC bought into Morgan Stanley, Temasek invested in UBS, and Dubai International Capital injected funds into HSBC. In addition, both Dubai and Qatar bought large stakes (28% and 24% respectively) in the London Stock Exchange -- perhaps the leading stock exchange in the world for raising global capital.

Through investing in troubled banks, these sovereign wealth funds have stabilized financial markets during the recent credit crisis. I believe we'll see this bailout trend continue as China and oil-rich Middle Eastern countries become wealthier and seek out more strategic assets abroad.

2) SWFs buy stakes in natural resource assets and companies.

The global competition for natural resources has become one of the most important investment themes of the 21st century. CIC and many of China's leading state-owned enterprises are increasingly active in bidding for mining and energy assets around the world. For example, our own CNOOC (NYSE: CEO) made a failed bid for Unocal back in 2005. More recently, CIC and Blackstone Group have displayed interest in joining the bidding war for global mining giant Rio Tinto.

A problem with this strategy is that Western governments, led by the United States, are increasingly regulating investments from foreign SWFs. In addition to blocking CNOOC's bid for Unocal, Congress tried to stop the sale of British port management firm P&O to Dubai in 2006. P&O manages several major port facilities in the U.S., including ones in New York, New Jersey and Baltimore.

As a result of increasing political backlash in the West against SWFs, these funds are now investing aggressively in Africa and other resource-rich regions. China has sent more than $10 billion in foreign aid to African countries during the past five years, and CNOOC is a big offshore drilling investor in Nigeria. Recently, as a gesture of friendship, China launched a satellite into space for Nigeria.

This kind of aid gives countries like China and companies like CNOOC an advantage over private-sector competitors like Exxon Mobil when negotiating with resource-rich African governments.

3) SWFs are increasing their exposure to emerging markets.

Partly because of the unfriendly political climate in the West against Asian SWFs and partly because of higher investment returns, sovereign wealth funds are investing in Asian emerging markets.

In November, Istihmar -- a sovereign wealth fund controlled by the United Arab Emirates -- set up its Asian investment headquarters in Shanghai. The fund's Shanghai office is responsible for the firm's investment activities throughout Eastern Asia, including China, Korea and Vietnam. SWFs controlled by Abu Dhabi and Kuwait are also increasing their investment allocation to Asia.

Two months ago in Shanghai, I befriended the head of Dubai International Capital's Indian operations. He told me that Dubai International Capital had just invested $3 billion in Chinese infrastructure projects. The fund is planning to invest heavily in India as well.

For years to come, SWFs will continue to be a major and growing force in international finance. It will pay to carefully watch SWFs and what they do. Understanding sovereign wealth funds is important because they're quickly becoming the most powerful investors in the world. Their activities will increasingly impact national policies, financial markets and the distribution of strategic resources. While SWFs might make some unwise investments, it could pay off for investors to buy what they buy. I'll continue watching this trend and let you know if any opportunities develop from it.

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