The recent investment by a Chinese government fund in buyout giant The Blackstone Group – the vehicle invested $3 billion ($2.2 billion) for a minority stake in Blackstone's management company – has highlighted an issue that many in the private equity industry believe could become increasingly significant: the impact of huge sovereign wealth funds on the global M&A market.
At the time of the investment, Blackstone chief executive Stephen Schwarzman described the move as “a paradigm shift in global capital flows”. However, although the size of the commitment made it notable, the principle of sovereign wealth funds investing in private equity managers is not a new one.
Indeed, the Chinese fund is openly modelled on Singapore's Government Investment Corporation, a vehicle set up in 1981 to manage the country's foreign currency reserves. GIC's special investments division has since invested in more than 200 private equity groups, including funds managed by The Blackstone Group, TPG, KKR, Carlyle Group, Sequoia Capital and Affinity Equity Partners, among others.
In addition, the state-sponsored Abu Dhabi Investment Authority invested $600 million in Apollo Management's Euronext-listed fund, and is reportedly in talks about a $1.5 billion deal to take a 10 percent stake in Apollo's management company. Norway's Global Government Pension Fund, meanwhile, has also been a long-time investor in the asset class.
China is, however, a very different beast, according to Diana Choyleva, an economist at Lombard Street Research. “Norway and some of the oil-producing countries have followed an asset allocation model and been driven by profit maximisation for some time. But with China, because it's a command economy, it becomes more of a political issue,” she says.
Commentators have been wringing their hands about the prospect of these funds making politically motivated investments. But for the private equity industry, it is the sheer scale of these funds that presents a greater threat. The Chinese vehicle will ultimately control as much as $300 billion. Even this total pales in comparison with ADIA, believed to have as much as $600 billion under management, and is also less than Norway's fund, which has assets of about $333 billion. “These funds are already capitalised with more assets than the entire global hedge fund industry has at its disposal, and they are looking for investment opportunities,” says David Sable, chief executive of asset manager TriAlpha.
What's more, the current situation could represent merely the tip of the iceberg. Many resource-rich countries are continuing to build up huge foreign currency reserves. China, for instance, already has an estimated pot of $1.3 trillion, which is thought to be increasing by $1 billion every day. “Savings are on the increase,” says Choyleva. “China tried to restrain domestic demand, so now it has even more savings to offload.” According to a recent report by Morgan Stanley, sovereign wealth funds already control $2.5 trillion worldwide. The bank believes this figure will increase exponentially, rising to $5 trillion by 2010, and $12 trillion by 2015.
CHANGING THE GAME
With so much money to deploy, it is no wonder that these funds are starting to look beyond their customary bias toward lower-risk instruments like government bonds, and are casting envious glances at the higher returns on offer from alternative asset classes such as private equity. For the time being, they are generally doing this by investing through external managers – but will the time come when they decide to cut out the middle-man?
The Qatar Investment Authority provides an interesting case study. The fund came to prominence in Europe with a bid for UK water company Thames Water, although it was ultimately pipped at the post by Macquarie. Since then its affiliate Three Delta, run by UK national Paul Taylor, has bought nursing home group Four Seasons Healthcare for £1.4 billion, reportedly beating off the likes of 3i, Terra Firma and Borealis at auction, and is now plotting a £12 billion takeover of UK supermarket chain J Sainsbury, after accumulating a 25 percent stake.
The doomsday scenario for private equity is the prospect of consistently coming up against these huge funds at auction, with their deep pockets and cheaper cost of capital allowing them to pay more for assets. Three Delta's offer price of 610 pence per share was almost 5 percent higher than the offer price that four of the world's biggest buyout firms – CVC, Blackstone, KKR and TPG – were able to muster just a couple of months earlier. The result could be an escalation in pricing, potentially dragging down returns across the board.
High-profile bid targets like Sainsbury intensify debates about sovereign funds – and there is no shortage of opposition to them. Some critics cite dangers to national security or local jobs; others highlight the lack of reciprocity (many of these countries are hostile to foreign investment themselves) or even transparency (few publish any details of their investments).
Indeed, protectionism is bound to undermine the spread of this phenomenon, says Stephen Jen, an analyst at Morgan Stanley. “Foreign investors evolving from lenders to owners will likely trigger defensive reactions from the recipient countries, which may, in turn, undermine globalisation.” Very few countries will be happy to sell off their crown jewels to the highest bidder, he adds. The US has already blocked a Chinese bid for oil company Unocal, and prevented a Dubai fund from taking over P&O's US ports on security grounds.
The conundrum for private equity is that its standard performance measures – which are almost exclusively financial – may not apply when it comes to sovereign wealth funds. Their success may be judged against completely different objectives – political, strategic, even military. China is the classic example of this, Choyleva believes. “Ultimately China is going to take decisions based on the desire of the Communist party to keep its hold on power. So decisions might not be taken for economic reasons.”
STORM IN A TEACUP
But it may be too early to start hand-wringing, some say. “The impact of sovereign funds is over-estimated,” says one leading European investor. This is often because commentators fail to distinguish between sovereign funds and strategic buyers from Asia and the Middle East which have regularly been active in the M&A markets, he believes. “What we're seeing more is sovereign funds taking positions in funds – and there their impact is not material compared to pension funds.”
It is certainly true that the current contribution of sovereign funds to private equity is dwarfed by that of pension funds. Some of the largest US pension funds are bigger than the China and Norway government vehicles, and have long years of experience in the asset class. State funds still represent a very small part of the global wealth pool – for now. “When it comes to diversification of Chinese foreign exchange reserves, it's a bit of a storm in a teacup at the moment – the actual amounts involved are still very small,” says Choyleva.
Many economists believe there are more pressing concerns. The debt market turmoil has reduced borrowing demand, which means that it will no longer be as easy for these countries to offload their savings into foreign bonds. As their reserves grow, it will reduce their need to buy foreign currencies – allowing their own currencies to strengthen. “We may be on the verge of an adjustment where the enormous imbalances that have characterised the global macro-economic environment for the past several years begin to correct themselves,” says Sable.
It is certainly true that sovereign wealth funds, given their sheer scale and lower cost of capital, have the capacity to distort pricing in the buyout market, and thus drive down returns. But political forces may limit their long-term impact, and for now their involvement in private equity will more often be as a backer of funds, rather than a cut-throat competitor.