SWFs: Inward vs. Outward Investment Mandates Conditions for Success

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1 SWFs: Inward vs. Outward Investment Mandates Conditions for Success Eliot Kalter President of EM Strategies Co-Head, SovereigNET: Fletcher Network for Sovereign Wealth and Global Capital October 7, 2014

2 Presentation Overview Sovereign Wealth Funds as Global Investors Growing relevance among global investor SWFs are heterogeneous with wide range of purposes/mandates Sovereign Wealth Funds Purpose and Asset Allocation SWF mandates greatly influence asset allocation strategies Most SWFs are able to take advantage of the liquidity premium stemming from long liability structures SWF Direct Investments by Region and Sector Outward investments concentrated on real estate in developed economies Inward investment less than 30% of total direct investment; highly concentrated; greater focus on infrastructure investment Outward vs. Inward Investment Benefits of outward compared with benefits of inward investment Dangers of inward investment and policies needed to enable long-term success 2

3 Scale of SWF Among Global Institutional Investors AUM of Global Investors Proportion of Total ($120 trillion) 5% 3% 2% Pension funds Source of SWF Funding 27% 35% Insurance funds Mutual funds 28% Sovereign wealth funds Private equity Evolution of SWF SWF as Global I nvestors 1. SWFs proportionately small on global scale 2. Predominantly established since 1980, overwhelmingly emerging economies to sterilize large capital inflows 3. Rapid growth with over 60% of SWF established since Growing importance in global economy with long-term investment horizon allowing significant anti-cyclical investments

4 SWF Specification by Purpose Country Fund Purpose Kazakhstan Kaz Natl Fund Stabilization Algeria Rev Reg Fund Stabilization Iran Oil Stab Fund Stabilization Singapore Temasek Savings US-NM NM St Inv Council Savings Brazil Sov Fund Savings UAE ADIA Savings Kuwait KIA Savings Qatar QIA Savings UAE ICD Savings Libya LIA Savings UAE IPIC Savings US AK Per Fund Savings Brunei Brunei Inv Agency Savings US Texas Per School Savings Canada AB Heritage Fund Savings Oman Gen Res Fund Savings China SAFE Reserve Investment China CIC Reserve Investment China HKMA Reserve Investment Singapore GIC Reserve Investment Korea KIC Reserve Investment Saudi Arabia SAMA Reserve Investment China NSSF Pension Reserve Australia AFF Pension Reserve Ireland NPRF Pension Reserve New Zealand NZ Super Fund Pension Reserve Russia NWF Pension Reserve Norway GPG-G Stab/Savings/Pension Azerbaijan State Oil Fund Stab/Savings East Timor Tiimor-Leste Stab/Savings SWF Size and Scale as an I nvestor Class 1. SWFs have over $6T in asset under management 2. Asset concentration is high with the top 10 funds holding 79% of total SWF AUM and the top 20 funds 93% 3. Among the top 10 funds 7 are from China, Singapore, Saudi Arabia and the UAE funds have assets in excess of $50B 5. All SWFs (except stabilization) have long-term investment horizons M ajor Purposes of SWF 1. Stabilization - fiscal stabilization through the investment of excess budgetary reserves 2. Savings wealth preservation, expansion, and intergenerational transfer 3. Reserve Investment excess reserve management, beyond that required for stabilization or for direct monetary policy support 4. Pension Reserve national pension reserve management 5. Development strategic asset management, including privatization Chile Soc & Eco Stab Fund Stab/Pension Malaysia Khazanah Sov Dev Bahrain Mumtalakat Sov Dev UAE Mubadala Sov Dev France Strg Inv Fund National Strategic

5 Purpose of SWFs and Overall Asset Allocation Asset Allocation by SWF Type Asset Allocation affects Performance I mplications for I nvestment Strategy 1. Fund purpose reflects liability structure and informs investment horizon and asset allocation 2. Diversify of purposes implies dispersion of investment objectives and mandates 3. Asset allocation strategies conform to primary goals, but remain varied as a function of risk profile and mandate 4. SWF investment in alternatives ranges from 0% for stabilization funds to 34% for pension reserve funds, with savings funds also taking advantage of liquidity premium from long liability structure 5

6 SWF Direct Investments by Region and Sector in 2013 The Vast M ajority of D irect I nvestment is to D eveloped M arkets with a Focus on Real Estate Investment to Developing Countries is Concentrated in Infrastructure and Commodities 6

7 SWF Direct Investment by Domestic or Regional Distribution SWFs invest domestically At present domestic transactions are concentrated Distribution varies widely as does purpose Observations 1. Sample size of 895 deals; 178 domestic transactions; 39 discrete entities 2. Inward represent 20% of total sample reaching a high of 27% in Largest domestic investors remain development funds or their successors

8 Benefits of SWF Outbound Investment M ost SWFs have M andates that Require I nvestment Abroad SWF mandates: Stabilization, inter-generational wealth preservation, pension and reserve investment management Replace depleting natural resources with alternative sources of export proceeds Investment diversification of Sovereign reserves with higher risk-adjusted returns Investing abroad helps avoid Dutch Disease Capital inflows from resource sector can result in real appreciation of the country s exchange rate, reducing the cost of imports and reducing competitiveness of non-resource economy, such as manufacturing and agricultural Uneven or distorted sectoral development of local economy with loss of employment and sectoral diversification Capture and manage accumulation of assets to reintegrate them into the domestic economy based on absorptive capacity Advance domestic institution building Serving as a bridge between global markets their local markets, transferring international investment, capital market expertise and governance structure to build domestic capacity 8

9 The Benefits of I nward I nvestment External Investment M andates can be in Conflict with Countries Development Needs Sovereign development/investment funds: Complements direct domestic investments through the state budget allocation process with investment in strategic sectors of the domestic economy Oversee the management of state assets (including privatization) Inward investment has been concentrated in a handful of countries (China, UAE, Malaysia Singapore and South Africa), mainly through investment vehicle to oversee management of state resources Catalyze co-investment by foreign investors who might otherwise be concerned about issues of governance and political risk Promote the development of domestic capital markets by enhancing the governance of pre-ipo companies, thereby improving the overall investment climate Facilitate knowledge transfer, capacity building, enhanced project governance 9

10 D angers of I nward I nvestment D angers are Significant and can Outweigh Benefits if not Addressed Domestic investments driven by non-commercial, political agenda Domestic projects can conflict with budgetary investment agenda, bypass the budget process, and promote a higher likelihood of politicizing the investment process The majority of the SWFs started since 2000 (excluding the developed economies) have Transparency International scores of less than 5 out of 10 (54% of funds had TI scores of less than 3 and 79% had TI scores less than 5) Studies show that SWFs with greater involvement of political leaders in fund management have lower long-term investment returns Danger of pro-cyclical investment, which can contribute to domestic inflation and asset price appreciation Concentration of domestic investment can undermine fiscal and currency stabilization benefits of SWF structure Advance, rather than lessen likelihood of Dutch disease Leading to a misallocations of scarce investment capital Investment beyond the absorptive capacity of the economy 10

11 N ecessary Conditions for Successful I nward I nvestment Developing Economies need for Additional Investment is Clear but Conditions must be Set for Successful Implementation Institutional design of the governance to insulate it from political pressure, strengthen accountability, ensure oversight, and bring technical skills to bear on investment decisions; Create a clear separation between the government as promoter of investments and as owner of the SWF Ensure that domestic investments made by the SWF are considered in the context of the public investment plan and phased to ensure a sustainable flow of investment spending SWF domestic investment should be included in the budget for accountability and transparency Build capacity for the SWF to operate as a professional investor through, inter alia, investor partnerships, including private investors, to diversify risk and increase implementation capacity The investment policy needs to adopt an explicit risk tolerance level promote greater accountability for investment strategy Some of these elements are already included in good-practice principles for SWFs, in particular the Santiago Principles. 11

12 Conclusions Some Countries may be Able to M itigate the Risks of SWF I nward I nvestment For Countries with Weaker Governance, the Risks Outweigh the Potential Benefits Avoid inward investment unless SWF can: Draw clear lines of demarcation between sovereign assets as excess reserves vs budget revenues as primary funding for core social infrastructure Mitigate the obvious risks: Force domestic projects to compete on commercial terms for institutional capital Benchmark domestic projects using market-based financial measures of risk and return Maintain a counter-cyclical posture; avoid pro-cyclical behavior when prices and asset values are rising Enhance development investment process: Require strong project governance independent, arms length, transparent, audited Actively encourage and promote co-investment partnerships Use SWF assets as catalyst to leverage additional external institutional capital 12

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