Archive for February, 2011

Stabilization Funds in an Era of Instability

Ashby Monk

With so many SWF sponsors in the MENA region facing a growing level of political uncertainty, I thought a post that revisited the inspiration and rationale for the creation of SWFs in these countries could be of particular interest. After all, among the countries currently reported to be experiencing some modicum of political turmoil in the MENA region, Algeria, Bahrain, Kuwait, Iran, Libya, Palestine and Qatar all have SWFs. Why is this interesting? Because SWFs exist to preserve, bolster and sustain existing institutions, orders and regimes. In other words, should we question whether these “stabilization funds” (broadly defined) are anti-revolutionary? Or are they beacons of financial modernity that encourage some of the reform-minded uprisings? Or none of the above? My thoughts:

Despite what you have been told, the main impetus for SWFs is NOT just to manage foreign exchange reserves, diversify commodity rents or invest pension wealth. OK. I acknowledge that the funds will tell you that they exist for these reason (and a few more). But they really don’t. Ultimately, SWFs exist to insulate domestic economies from the external forces that might disrupt domestic plans or discount domestic institutions. A SWF can help protect against a commodity price collapse, a mortality improvement, a diminishing tax base, or even a currency crisis (among many other things). In theory at least, a sponsor wields its SWF as a buffer against the risks to autonomy and sovereignty in a global economy.

As such, SWFs arise out of growing international cooperation and greater integration of nation-states into the global economy. Indeed, in the past few decades, countries have been opening themselves up to these global forces like never before. Policymakers also increasingly recognize this opening as an unambiguous threat to their sovereignty and autonomy. And some political elites only engage in this cooperation and integration because they know that have a ready buffer against the external economic forces that might otherwise force convergence: the SWF. Though globalization and financialization offer much in the way of benefits (if they didn’t, why would anybody bother), they also sow many of the seeds of future crises. These crises threaten the domestic plans, institutions and agendas of those countries that have come to rely on global markets for their well-being.

And so, the rise of SWFs is necessarily a part of this give and take between states and markets, as government bureaucrats and policymakers use SWFs as tools for managing and even preventing imminent and future crises. In this way, SWFs are a form of self-insurance, a coping mechanism for dealing with the external uncertainties that come with joining global markets. SWFs offer policymakers a chance to make reliable and consistent plans in an environment that is increasingly subject to volatility and market-based short-termism.

So, with that brief explanation, let’s return to the main questions that motivated this entry. What role could SWFs play in stabilizing the MENA’s unstable political environment? Quick answer: Not much.

Given that these funds are about preserving the authority of the state and, to a certain extent, maintaining domestic institutions and norms, it is reasonable to suspect that these funds might thwart revolutionary forces and bolster the position of the state. However, as I see it, the funds only bolster the authority of the state against external forces (read markets, multilaterals or foreigners). So I don’t see how the leadership under threat can use these self-insurance policies for muting the current domestic uncertainty. Obviously, the political elites could potentially use the stored wealth to buy off the domestic populace. But, beyond that, I’m not sure how else these funds could be recruited to stop the current turmoil.

In fact, the existence of these stabilization funds may have unwittingly contributed to some of the current instability. How’s that? Well, they perpetuate domestic institutions and norms that might not prioritize policies focused on economic growth and job creation (specifically for young adults). By that I mean that without SWFs, the forces of globalization might have pushed these governments into difficult economic changes years ago, which could have prevented the current uprisings. But this is just one possible scenario among many, and it is not entirely sound (as Tunisia and Egypt, who both lack SWFs, show us).

While I don’t have all the answers, I hope you can at least see why I sat down to write this post. SWFs were set up as a buffer against unwanted influences and forces of the outside world. In some cases, this has been universally good, as, for example, smoothing volatile resource rents allows for long-term budget planning. However, the other side of the coin is that there may have been missed opportunities related to how global capitalist forces drive domestic reforms.

Anyway, I clearly still have some thinking to do on the subject. But if some of these ideas are of interest, check out this paper I wrote a while back.

Guest Blog: What Others Can Learn From SWFs

Thomas F. Connolly
I wanted to start by thanking Ashby for allowing me to be a guest blogger on his fine website.  I’m an avid reader and find it insightful, focused and excellent.  When I started thinking about the many topics that I could cover, it seemed obvious to concentrate on Middle Eastern SWFs and to focus on providing some impressions of what others could learn from these important organizations.

I moved from New York to Abu Dhabi over ten years ago and have been involved with SWFs in the Middle East region for this entire time.  I worked with a SWF for over seven years and since this time have been working with BNY Mellon Asset Management, partnering with SWFs in the MEA region.  I have certainly been exposed to a number of issues and have witnessed a significant evolution in these organizations over this time.  I’ll try to address these improvements and successes one by one:

Developing local investment talent: This has always been a critical issue for all MEA SWFs and one that I can assure you they take very seriously.  When I see the way that these funds spend time and money identifying and nurturing talent, or the way they meticulously design and implement programs to train their staff, it’s clear that this is a great priority for them.  The Gulf SWFs have entire departments with significant budgets devoted to training and development and they are well organized to accomplish this task.  Each SWF executes this task differently, but I can assure you that none of them lack commitment in this area.  I am also impressed by the continuous improvement I’ve seen in training and development over the years. In my experience, I’ve not seen any other investment firms that come close to this level of commitment in the area of training and development.

Long Term Focus: This is one area that I think MEA SWFs have made the greatest improvements over the years.  There are a number of challenges to executing a truly long-term strategy, and I think the SWFs in the Middle East have made great progress here.  I have seen real evidence that SWFs have become more sophisticated at working with the asset management community, thus enabling them to take a longer term focus with their partners.  They have also set up new departments to invest in longer term asset classes that better suit their investment horizons.  I think this area remains a challenge despite these improvements due to pressures to succeed and to monitor performance.  Whether it’s internal investment teams or external asset management partners, it’s difficult to take a longer term horizon and to have the patience to allow a longer term strategy to bear fruit, especially if the investment underperforms in the shorter term.

Asset Allocation: The Middle Eastern SWFs have become well known around the world for a number of reasons.  Certainly the fact that they’ve been around for so long and their large asset size are contributing factors, but I think their adeptness at Asset Allocation has also captured the fascination of the world.  My impression is that they value this part of the investment process above all others and they don’t change their asset allocation decisions frequently.  I know SWFs in the Middle East have been able to add value in this area and I know the rest of the world could learn from this approach.  Whether or not it is all down to particularly talented individuals is a matter for discussion, but I think these SWFs have organized and positioned themselves well over the years to profit from Asset Allocation.

Investing “far from the herd”: When I moved to the Gulf from New York, I immediately noticed the feeling of being “far from the buzz/information.”  This caused me to change my investment approach and I think it led me to becoming a better and more successful investor.  I think this situation was a micro example of the isolation that all SWFs experience (despite having the financial elite of the world regularly beating a path to their door!).  Being far from the information allows an investor to take a longer view and to do better analysis by not being bombarded with short term noise.  MEA SWFs have learned to use this to their advantage over the years, and I’m certain that it’s improved their results.

Multinational work force: Each SWF in the Middle East has a different approach to using expatriate staff.  Whether the SWF has a high proportion of expat staff from around the world or not, all of the MEA SWFs have a truly international focus.  They all have a tremendous exposure to different parts of the world through their portfolios, but they also travel extensively and work with investment partners in all regions of the globe.  This tremendous exposure helps them to have a much broader, more all-encompassing view of the world, and I think it fits well with a number of the other points mentioned here. One example is the attitude of SWFs to the Emerging Markets.  I think most of them benefited from EM exposure to a greater extent than investors in developed markets and a contributing factor to this is likely the global view that these SWFs have.

Leveraging partnerships with the AM community: I have witnessed how SWFs partner with the Asset Management community from the inside and from the outside.  When I worked at a SWF, I remember being struck by how little even some of the top asset managers really understood about the needs of SWFs.  Despite this, there is clearly no lack of understanding of these needs from WITHIN the SWFs.  SWFs have significant expectations of asset management firms that exceed the obvious criteria to “manage our money well”.  I think investors around the world can learn from this singularity of purpose that you see in the SWFs.  They know exactly what they want from their asset management partners and they aren’t afraid to ask for it. 

Using their “rainy day fund” wisely: Although most SWFs were set up as “rainy day funds”, the credit crisis presented a more immediate opportunity for these funds to test their ability to provide stability to the financial systems of their respective countries.  I think the SWFs in the Middle East were excellent tools for their respective governments during this difficult time.  It’s not hard to imagine what could have happened in these countries (and indeed the entire global financial system) had these SWFs not been available to add liquidity and stability to the financial system at such a critical time.  I think it’s difficult to argue that this period was not an unquestioned success for the SWFs as providers of stability.  It’s no coincidence that arguments that SWFs were potential “destabilizers to the financial system” that were being tabled before the crisis are no longer heard.

Thomas F. Connolly, CFA, is Managing Director for MEA at BNY Mellon Asset Management.

Guest Blog: Infrastructure Sensitivities and SWFs

Rajiv Sharma

Many thanks to Ashby for the opportunity to contribute to this blog. I thought I would add to the discussion about SWF’s and infrastructure investing including the debate over whether to invest directly or through fund managers.

As Ashby mentions, while it does seem obvious for SWF’s to invest directly and make the most of their strategic advantage, there are a number of factors that might prohibit them from doing so. I would like to elaborate on one of these factors with a couple of examples.

When entering into an infrastructure investment transaction, an investor must realise that there is significant reputation risk if anything goes wrong. This is especially important for infrastructure investments because of the wide reaching political, social, economic and environmental implications. The risks and threat to reputation are very real for infrastructure investments, which has affected sovereign wealth funds when approaching the field.

For example, the international gateway airport to NZ, Auckland International Airport was subjected to two significant, and as it turned out highly publicised, takeover attempts firstly by the sovereign backed institution Dubai Aerospace Enterprise (DAE) and secondly by CPP Investment Board.

The DAE bid failed to get very far in the bid process despite being the better financial offering for shareholders. In fact, the bid was unanimously backed by Auckland Airport’s board, which was impressed by the potential upside in value that DAE could bring to aeronautical activities of the airport, bringing in tourists from the Middle East, India and China. Following the announcement of the bid by DAE, media interest grew, sparking significant public outcry over foreign ownership of one of the country’s strategic infrastructure assets. At the time, the primary shareholder in the DAE airports division (which no longer exists) was the Government of Dubai. This was compounded by government officials expressing publically xenophobic comments about the proposed foreign ownership. While DAE was acutely aware of wanting to succeed in its takeover intentions, being a sovereign backed fund, it only wanted to succeed if its proposal was supported by the public and government officials. Due to the negative political and public attention that seemed to cloud over the takeover proceedings, the company was forced to pull out of their merger proposal before shareholders had had a chance to vote on it.

As for the CPP Investment Board bid, it failed at the last hurdle due to a veto by the relevant government minister. This has had repercussions for foreign investment into NZ.

The Auckland International Airport case highlights the strong emotional and nationalistic appeal associated with infrastructure assets, and the need for investors to take into account the wider stakeholder interests. It could be argued that DAE did not sufficiently consult local body councils and central government officials with both parties, failing to understand the drivers behind each other leading to negative, unwarranted speculation.

In such examples, it would clearly be more appropriate for a fund manager to approach the takeover bid as they would be a lot less sensitive to public outcry and especially in a foreign takeover situation would spark a much less nationalistic reaction to their motives. An experienced infrastructure fund manager that could draw upon a number of different investors, undeterred by xenophobic comments, would arguably get a lot further in a bid process with a greater chance of achieving a successful outcome.

Another asset that has been observed to be too sensitive to public outcry was the Chicago Parking meter privatisation in 2008. I recently heard one particular SWF official complain that, despite the relatively successful financial performance of the investment, they would not want to invest directly into the asset because of the public outcry over the privatisation process, rate increases and malfunctioning meters causing excessive tickets to be issued. By investing discretely through a fund manager, the SWF is not directly exposed to any associated controversies that might come up, with the fund manager holding more responsibility for the investment.

So it seems as though the reputation risk of infrastructure investments is a genuine consideration for SWFs and affects how they approach investing into infrastructure assets. The sensitivity of SWF’s to stakeholder outcry can affect the success achieved by investing into infrastructure assets, which is likely to encourage certain funds to favour the indirect fund manager route.

Mr. Rajiv Sharma is a doctoral candidate in economic geography at the University of Oxford.

Guest Blog: Who owns SWFs?

Angela Cummine

You could not be blamed for wondering why we need a blog post dedicated to SWF ownership.  This is one aspect of the burgeoning SWF debate that may be considered fairly settled.  Everyone knows these entities are government owned. The funds described themselves as such in the Santiago Principles, defining SWFs as entities ‘owned by general government’. Academia, industry analysts and policy commentators echo this definition ad nauseam but with a little variety, referring to SWFs as ‘state-owned’, ‘government-owned’ or owned by ‘the nation’ in which they reside.  To a political scientist, the terms ‘state’, ‘government’ and ‘nation’ are all distinct concepts, referring to unique entities.  In the SWF debate, there is a sense that all these terms are used synonymously, as proxies for a more abstract idea of public ownership.  Case closed.

But things are not so simple.  Despite the apparent ‘public ownership’ consensus, it is often not clear in what way the public of a given host country ‘owns’ its SWF.  If we adopt the Santiago Principle position – that SWFs are ‘owned by the general government’ – then does this mean the executive apparatus of the state owns these funds? Is this something different from state ownership?  And where a fund is set up using resource wealth and the citizens of a nation are considered the ultimate owners of those resources, how does this ownership claim interact with that of a host government’s claim to be the legally recognized owner of a SWF?  Do citizens have a trumping right to this wealth over governments? Or are they one in the same claim?

In case this is all too philosophical, we can use a real world example to illustrate how the distinctions play out.  The Australian Future Fund was set up using trade surpluses derived from resource windfalls. The funds are set aside until 2020, at which point they may be drawn down to meet unfunded public pension liabilities of Commonwealth public servants.  In other words, one particular government – the Federal government (as opposed to the eight state and territory governments) – used national resource windfalls to discharge its liabilities as an employer.  But what if the Future Fund was considered to be ‘state-owned’ as opposed to government owned?  Would these funds have to be invested in a manner that would benefit the state as a continuous entity, for instance by investing in national infrastructure or the national welfare system, rather than a particular government who will face these fiscal challenges?  Alternatively, if Australian citizens are seen as the ultimate owners of the resources which produced these windfalls – and there is a growing chorus of business and political leaders in Australia who refer to Australian minerals as the people’s property in order to justify the establishment of a Future Savings fund – then should this money be prioritized for distribution to individuals through tax relief or dividends?

As part of the recently reignited debate in Australia on whether to set up a dedicated Resources savings Fund, comments by the head of Australia’s Commonwealth Bank, Ralph Norris, highlight the different potential beneficiaries of SWF ownership:

”Mining companies are recovering resources that are the natural endowment of Australians, and therefore Australia … should look to get some return.”

The comment includes an explicit reference to citizen’s owning natural resources, and an implicit inference that in the absence of an SWF for resource windfall, the government of the day (as opposed to the nation Australia) is unfairly reaping the windfall benefits.

Of course, if we consider ‘government’ to be the agent of the people, then the conundrum is diluted.  If what is meant when we say something is government owned is that it is actually the property of citizens, either individually or collectively and that governments simply hold these funds on trust for the citizenry, their principal, then recognizing that resources are the property of the people and that SWFs holding resource wealth are ‘government owned’ presents no dilemma.  Use of this capital by government to help do its job efficiently is ultimately government acting in the people’s best interest.  The resource capital is being used to benefit the citizenry.

If only it were that straight-forward. For a start, it is not the case that when we think of government, it simply boils down to the sum of its parts. Government, in its most intuitive sense, is of course a representative institution of ‘the people’.  But anyone familiar with institutional theory knows that institutions regularly take on a set of interests distinct from those of its founding members whose interests it is supposed to further – sometimes referred to as institutional dysfunction.  Government as an institution regularly conducts affairs that could be more easily understood as representing its own interests as a principal. It has overheads and responsibilities that attach to it which may require consideration of its institutional interest distinct from the public interest.  It has concerns as an employer, contractor and financial entity that may be formed with little regard to the people it represents. We can therefore consider government as a unique, stand alone entity separate from its core identity as the representative of the people.

For this reason, we know it means something in particular to say a fund is government-owned.  But what exactly is meant is not clear.  As more demands are made on how SWFs should distribute their capital, it will be vital to clarify precisely what is meant by government in the SWF ownership context. 

Angela Cummine is a doctoral candidate at the University of Oxford.

Guest Blog: Should SWFs Care about Development?

Adam Dixon

I would assume that most readers of this blog would agree that getting investment governance right is easier said than done. Ensuring clarity of mission over time, developing decision-making structures that can operate in real-time, having the right talent, and learning from past experiences, etc., all require a concerted amount of effort and thought within any institutional investor. And even if a fund gets the governance right, there is still no guarantee that a premium on the market will be generated.

So when someone makes the suggestion that institutional investors — and here I’m talking in particular about public pension funds and sovereign wealth funds — operate with specific political and social objectives in mind, it is easy to see why objections are made. Indeed, expanding the mission of a fund beyond the simple premise of maintaining wealth over time can easily erode value, as has happened on numerous occasions when investments are politicized. (Note: I don’t consider ESG factors as being representative of politicization, because, if applied correctly, I do think they can contribute to long-term value).

I would class a concern with “development” in emerging and developing economies as another objective that could easily muddle and complicate a funds long-term financial health. Given the financial resources that SWFs have, and that many come from emerging and developing economies, the pressure to focus on development (broadly speaking) is undoubtedly high. So my question is, should they? The short answer: well, sort of. (And let’s be honest, what’s the point of finance if it doesn’t support economic growth and development?)

On the one hand, a SWF can facilitate development within its home country as part of a broader project of institutional development (and here I’m talking about all the policy trappings of a modern economy that support productive efficiency, macroeconomic stability, and a capable and active workforce). In this model, the SWF is simply a piece of a much larger puzzle. Mitigating Dutch disease through international investment or stabilizing government revenues, are just a couple of the ways a SWF supports development. So, it doesn’t have to prioritize development in its investments because its existence does so implicitly.

If, on the other hand, a SWF does make investments purportedly aimed at economic development, but which are clearly loss making, then the SWF actually undermines its original development objectives. By engaging in loss-making investments, even if they are for the greater good, SWFs will inevitably be dismantled since the rational for their creation was generally to make returns. In the midst of the most recent financial crisis, many sponsors began reconsidering their SWFs existing…even Norway!

This is not to say that sovereign sponsors (i.e. the nation-states) shouldn’t direct funds toward local economic development projects. They should. However, it is better to have multiple entities with specific mandates that they can fulfill. A SWF is a fund designed to make money in financial markets. It is purpose built for this job. If a country wants to facilitate local development, perhaps it’s better to set up a development agency of some kind.

Dr. Adam Dixon is an Assistant Professor at the University of Bristol.


Guest Blog: Infrastructure – Direct Deals, Club Deals, and New Technology Platform!

Ryan Orr

Recently the State of Queensland sold the Port of Brisbane to a consortium comprising QIC, IFM, GIP, and ADIA for around A$2bn. The port sale is part of Queensland’s ongoing infrastructure privatisation program which includes a listing of Queensland Rail’s freight business, and the sale of a motorway network in Brisbane, and a coal port in North Queensland.

Why are large pension and sovereign wealth funds increasingly investing on a direct basis?   The answer is multi-faceted.  They desire to better align investment decisions with long-term objectives.  They are learning that they have a comparative advantage, in terms of time horizon and check-writing capability.  They want to control assets that they intend to hold for the long-term.  And they are frustrated with carry-based incentive structures that incentivize risky asset selection and excessive leverage, and flat management fees that do not adjust with actual management expenses.

Going direct is not viewed as an appropriate strategy for the more opportunistic plays – such as greenfield development – but it is viewed as a superior model for “core” infrastructure, which is operating, lower-risk, stable, and governed by stable regulatory regimes.

A handful of the pioneering pensions and sovereign wealth funds have already developed internal capabilities to source, structure, and asset-manage large multi-billion dollar “core” infrastructure assets.   Another group of 10 to 20 institutions is in the wings, already sourcing co-investments, and could eventually develop the capabilities to structure direct deals and lead consortia themselves.

Does this trend spell the end of third-party managed funds?  Definitely not.  Smaller institutions will always need the help of third-party fund managers.  And larger institutions who were early to the direct foray are quickly realizing the value of third-party fund managers too.  Bidding on highly politicized privatizations, investing in far-flung emerging markets, and entering sectors where specialist skills are required all present such scenarios.  Third-party fund managers also provide a valuable source of large co-investment opportunities.

As a growing number of funds in-source their infrastructure investment practices, there is a growing tendency among “direct investors” to work together in clubs. The rationale for “clubbing” includes:  splitting up large deals without exceeding capital constraints; sharing talent, due diligence and research costs within a bigger group;  negotiating better terms by reducing competition;  and ensuring local knowledge when investing in international markets.

Despite the trend in this direction, club deals are actually quite difficult to organize and coordinate. The big challenge for the “leaders” – both pensions and third-party fund managers — who have done a number of these deals lies in finding “reliable partners” who can be trusted to share the burden of due diligence activities and expenses, and who are sure to ante up for their share of the investment on the day of financial closing. Moreover, there is great variation across institutions in terms of availability of resources, staffing, sophistication, risk-return profiles, strategic priorities, and decision-making processes.   These factors constrain successful club deals.

In general, club deals have worked the best when institutions bring complementary resources, skills, experience, knowledge, perspectives, relationships, locational advantages, and other kinds of “comparative advantages” to the table. This ensures the investors feel as though they are receiving a “fair exchange” for their inputs and that there is a “real economic rationale” for working together.

Despite the growing trend of direct and club investing, institutions lack a formal mechanism to seek out partners and to explore potential alignment of investment objectives.  We are thus confronted once again with the need for intermediation. As we know, financial intermediaries are crucial for the development of new markets and bringing buyers and sellers together.

‘Market-making’ firms come in various types, and one of the most basic types are the exchanges and bulletin board systems where buyers and sellers can find one another.   Although there is not currently such a platform serving the infrastructure space, an up-and-coming technology platform may soon fill the void.   Several of my former students are behind this project, along with a team of world-renowned industry veterans and Silicon Valley entrepreneurs.  Known as Zanbato, more than 50 market-participants are signed up for the service already, which is now in a limited invitation-only Beta test period.  When the time is right, we will post more information on this blog — so do stay tuned!

Dr. Ryan Orr is Executive Director of the CRGP at Stanford University.


This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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