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WorldOctober 1 2013

Gulf SWFs look to move with the times

The Gulf’s sovereign wealth funds have grown in size and influence, adapting to market forces and taking advantage of the global financial crisis. But just how are they generating returns in the current economic climate?
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Gulf sovereign wealth funds (SWFs) have become a prominent feature of the international financial landscape. They have grown in size so considerably in the past decade that they are now recognised as key institutional investors across a multitude of asset classes and markets.

Today, assets accumulated by the Gulf’s 14 SWFs amount to more than $1800bn, or one-third of the $5400bn total assets accumulated by SWFs worldwide, according to a report published by the US-based Sovereign Wealth Fund Institute in May 2013.

Common themes

Given the disparities in size, structure and mandates of SWFs across the Gulf, as well as their varying degrees of transparency, it is virtually impossible to classify them into one homogenous group. However, there are some common themes that have emerged in their investment behaviour over the past few years, largely as a result of the global financial crisis.

“The question I am most frequently asked by SWFs today is ‘How do I generate returns in a low-yield world?,” says John Nugee, head of the official institutions groups at asset manager State Street Global Advisers, and an adviser to both central banks and SWFs. “What people often overlook is that while they are distinct from other investors, ultimately SWFs are part of the investment universe and the global financial crisis is colouring every market and investor’s outlook and strategy today.”   

Indeed, the search-for-yield phenomenon is prompting investors around the world to seek out new ways of investing their money that can provide better returns than traditional asset classes such as today’s low-yielding US treasuries and bonds. 

Private equity focus

The major Gulf SWFs now account for 35% of global SWF flows, and they are now raising their allocations to private equity at a faster rate than any other type of investment, according to a report published by US fund manager Invesco in May 2013.

The report states that the region’s development funds – those focused on investments that contribute to the progress of the local economy – on average allocated 33% of new assets to private equity in the past 12 months, more than a threefold increase on the 10% allocated in the previous 12 months. Meanwhile, investment SWFs – those that invest for future generations – on average allocated 13% of new assets to private equity, up from 9% in the preceding 12 months.

By comparison, the percentage rise in alternative investments such as real estate and infrastructure was only in single digits. The increased allocation to private equity reflects part of a broader trend to diversify away from public equities and achieve higher returns.

“Our analysis of total and new SWF asset placements in our study suggests that private equity is a key theme, not just for development SWFs, but also for investment SWFs,” notes the Invesco report. “Nearly all SWFs started out investing into funds but many have moved (or are considering a move) to co-investment or direct models.”

Bringing investment in house

This was certainly apparent in the 2012 annual review published by the Abu Dhabi Investment Authority (ADIA), which manages the surpluses that the Gulf emirate earns from oil exports and whose current assets are estimated to be between $400bn and $600bn. ADIA is now seeking to buy directly into companies rather than going through external private equity funds in a bid to maximise its returns, with the review noting that ADIA reduced its assets in externally managed funds from 80% to 75% during 2012, while also reducing its allocation to index-tracking strategies from 60% to 55%.

This more direct-oriented investment approach led ADIA to boost its staff from 1275 in 2011 to 1400 in 2012. It also made some high-profile appointments to its in-house private equity department – most notably by recruiting Colm Lanigan, a former partner at Caxton-Iseman Capital, the private equity affiliate of hedge fund Caxton Associates – to head up its dedicated principal investment portfolio.

“ADIA is very specifically deciding to follow a trend, started by others, which is to bring more of its investment capabilities in house,” says Rachel Ziemba, director of emerging markets at financial analysis firm Roubini Global Economics and an expert in SWFs. “It has realised that active management in indices can provide better returns.” 

The review also revealed that ADIA has cut its target exposure to developed market stocks to a range of 32% to 42% from 35% to 45% in 2011, while also cutting its minimum exposure to Europe across its asset portfolio to 20% from 25% in 2011. While ADIA has maintained its exposure to emerging market stocks in a 10% to 20% band, the review infers a shift in focus towards developing markets.

“Economic leadership is passing to emerging markets, not just as their weight in the global economy passes 50%, but as their share of likely future global growth moves far higher,” ADIA’s managing director, Sheikh Hamed bin Zayed al-Nahyan, is quoted as saying. “As a bloc, they continue to offer exciting and attractive opportunities to deploy capital.”

Chinese cravings

One of the highlights of ADIA’s activity in 2012 was the fund’s increased exposure limit on Chinese equities from $200m to $500m. Meanwhile, Qatar Holding, the investment arm of Qatar's SWF, was also granted a $1bn quota to invest in China's capital markets in December 2012.

As the world’s second largest economy, China is now firmly on the radar of long-term institutional investors and it hopes their investment will help it stabilise its volatile stock market. In addition to Qatar Holding, 10 other institutional investors, among them the Ontario Pension Board, Macquarie Bank and HSBC Holdings, were granted fresh or additional quotas for Chinese equities in 2012.

The Kuwait Investment Authority (KIA), the oldest of all the Gulf SWFs, having been established in 1953, currently has more than $250bn under management and is also showing a keener interest in China of late. It has already invested in the listed shares of Chinese financial companies, such as Agricultural Bank of China and Citic Securities. It is also an investor in private equity funds in China, where it has recently shifted its focus from the big international buyout groups to more local ones.

In March 2012, the KIA was granted a $300m quota to invest in China’s securities market. A few months earlier, it had opened a representative office in Beijing, making it one of the few SWFs in the world to have an office in China. Furthermore, Beijing is the KIA’s first overseas representative office since the Kuwaitis established one in London decades ago. There is no such office in the US.

Eurozone exposure

While Gulf funds have historically preferred to invest in Europe, the prevailing eurozone debt crisis and accompanying political uncertainty have led many to turn their gaze eastwards. It can also be viewed as part of a broader strategy given the flourishing trade between China and the Middle East and north Africa region. HSBC predicts trade between the two regions will reach between $350bn and $500bn by 2020.

However, Gulf SWFs have not totally turned their back on developed markets since the onset of the global financial crisis. In fact, many used the crisis to their advantage by buying up distressed assets at low valuations. 

The Qatar Investment Authority (QIA) was arguably the most daring in seizing upon the opportunities provided by the crisis. Through its subsidiary Qatar Holding, it invested $8.4bn in the UK's Barclays in 2008 to become the bank’s biggest shareholder with a 6.5% stake, thus helping Barclays narrowly avoid a government bailout. The QIA also acquired a 10% stake in Credit Suisse, as well as making investments in debt-laden Greece and Spain. Meanwhile, both ADIA and the KIA invested in Citigroup during the height of the crisis, and the KIA also acquired a stake in the New York-headquartered Merrill Lynch.

“SWFs have a tremendous advantage in that they are able to capitalise on dislocations in the market,” says Michael Maduell, president of the Sovereign Wealth Fund Institute. “This means they can ride out a cycle and watch their investments appreciate.” Indeed, when the KIA sold its stake in Citigroup, it walked away with more than $1bn profit. 

SWF opportunity

The financial crisis also spurred SWFs to increase their investment in developed markets’ real estate and infrastructure. “Much of the Western world has big infrastructure needs for which they are keen to find long-term equity investors,” says Mr Nugee.

“It is likely to become harder for traditional investors, such as insurance companies and pension funds, to invest long-term because of plans to apply capital requirements, such as those being introduced for the insurance industry under the Solvency II Directive, which could give greater opportunities for SWFs to step in.”

Furthermore, unlike insurance companies and pension funds, SWFs have no long-term debt or future payment obligations. And, as public investors, they are likely to have a better understanding of investment projects that depend on public policy, which gives them natural advantages over other institutional investors and means they are likely to play an increasing role in infrastructure finance.

In December 2011, ADIA acquired a 9.9% stake in Kemble Water Holdings, the parent of Thames Water, and the UK’s biggest water utility company. ADIA’s other recent infrastructure holdings include a 15% stake in UK’s Gatwick Airport and a minority holding in Australia’s Port of Brisbane. ADIA currently has a benchmark range of 1% to 5% of its assets invested in infrastructure.

Meanwhile, in April 2013, the KIA joined forces with real-estate developer Related Companies and real-estate investor Oxford Properties, to co-finance the first stage of the $15bn Hudson Yards redevelopment project in Manhattan, New York. “While [KIA is] still investing in bonds and stocks, the financial crisis has prompted a shift to hard assets, such as real estate,” says Mr Maduell. “It feels comfortable with real estate because it is very tangible – [KIA] can see it and touch it.” 

Traditionally, SWFs would invest in buildings for their rental yield, but with rental yields now averaging about 4% in the US, funds such as the KIA are preferring to assume development and construction risk on new buildings in their quest for higher returns – as high as 20% – on such investments. This underscores the growing trend among SWFs to invest directly. Typically in the past, they would buy into property through funds such as those managed by New York-headquartered Blackstone, the world’s fifth largest private equity firm.

Arable addition

In addition to real estate, another form of alternative asset that has become increasingly attractive to Gulf SWFs over the past few years is arable land. In light of their growing concerns over future food and water security, Gulf funds have started acquiring land and natural resources, and invested about $5.1bn in Brazil in 2011, according to the Gulf Latin America Leaders Council.

In 2011, for example, Al Gharrafa Investment, a subsidiary of Qatar Holding, acquired an 11% stake in Adecoagro – a farmland venture based in Argentina, Brazil and Uruguay. “SWFs are part of the relatively new South-South investment trend,” says Nick Tolchard, head of Middle East and global SWF coordination at Invesco. “They have a lot of experience, knowledge and contacts in those parts of the world that they are choosing to tap into.”

In today’s world of virtually zero interest rates and modest bond yields, SWFs are being forced to look at new avenues of investment, and in the case of the older funds, to abandon their tendency towards conservatism.

“Certainly, in the past 12 months, we’ve seen a move back towards a more risk-based approach – or what we call ‘re-risking’ – whereby SWFs are looking to go back into risky assets,” says Mr Tolchard. “And rather than buying into markets across the world, SWFs are becoming more choosy about particular stocks. We are also seeing a trend towards co-investment, particularly with other investment funds.” 

QIA's wide reach

In May 2013, the QIA, along with the SWFs of Norway and Azerbaijan, and China Construction Bank, acquired roughly 55% of the new shares on offer from Russia’s second largest bank, VTB, with each of the funds investing between $479m and $639m. In the same month, the Financial Times reported that the QIA also acquired a stake in Germany’s Deutsche Bank, with bankers claiming the investment amounted to more than $100m. 

These two latest investments bring the QIA’s portfolio of bank stakes to more than $10bn, which includes a list of household Western institutions, as well as stakes in banks in three of the four BRIC countries – Brazil, Russia and China. 

“Not all SWFs are investing for the long term,” says Ms Ziemba at Roubini Global Economics. “While ADIA, the KIA and the Norwegians tend to have a longer term approach, some, such as the QIA, are quite tactical and have been successful in acquiring strategic stakes. It was only established in 2005, which means it has been playing catch-up but it has not shied away from headline risk.”

Indeed, in less than a decade, the QIA has risen to prominence, helped largely by its acquisition of ‘trophy assets’ such as the UK’s luxury department store Harrods and a 10% stake in German sports car manufacturer Porsche. During this time, its assets have risen fourfold to roughly $100bn and are distributed across five continents.

Calls for transparency

Of course, as SWFs have grown in size and influence, so has the debate about whether they need to become more transparent. “SWFs have a difficult line to walk between satisfying calls to improve our transparency and not losing our edge as a strategic and competitive investor,” says an industry source at one of the key Gulf funds.

Over the past few years, however, there have been signs that some SWFs are choosing to increase their transparency. Two-thousand and ten marked the publication of ADIA’s first ever annual review, which helped to shed some light on its strategy.

In 2008, the International Monetary Fund oversaw the creation of the International Working Group on SWFs (IWG), which comprised roughly 20 SWFs, including ADIA and the KIA. The IWG was responsible for drawing up the Santiago Principles – a set of 24 voluntary guidelines that stipulate best practices for SWFs – with one of the main aims being to enhance transparency.

Since 2008, 25 countries have signed up to the principles, but while they mark an important first step toward managing SWFs’ legal framework, institutional and governance structure, as well as their investment and risk-management policies, the fact that they are voluntary means they have been applied unevenly, leading critics to claim that they are toothless.

In 2007, Edwin Truman, senior fellow at the US-based Peterson Institute for International Economics and former assistant secretary of the US Treasury, devised a SWF scoreboard that rates funds on structure, governance, behaviour, accountability and transparency. At the time, Middle Eastern SWFs sat at the bottom of the scoreboard with a mean score of 31 out of 100, significantly lower than Norway’s Government Pension Fund – Global, which carried the highest score of 84.

“When I first developed the scoreboard, ADIA was ranked at the bottom but it has since realised it is in its own interest to be more transparent,” says Mr Truman. “Because SWFs are acting on behalf of the citizens of their countries, they are subject to political scrutiny, which means they often tend towards increased conservatism. But there is a certain amount of both domestic and international pressure today, which is helping to drive increased transparency.”

Mr Truman will be publishing an updated scoreboard by the end of 2013 and says that he expects some of the Gulf SWFs will have improved their scores.

In light of the growing pressure being placed on Gulf SWFs to increase their transparency, they are gradually responding to calls for more openness, albeit tentatively. Furthermore, the criticism surrounding their opacity should not be allowed to eclipse an appreciation of the positive role they are having in aiding growth in both emerging and developed markets. 

Many of the Gulf SWFs are playing a key role today in reducing market volatility through financial intermediation, as well as in contributing to financing projects with long-term but positive rates of return. This arms them with a major trump card and, consequently, their relative size and influence in global markets will remain significant.

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