Moving beyond the strategic discussion, this article will provide some evidence on the impact of SWFs on firm valuation based on extensive research done at IMD using a large sample of SWF investments. Evidence will also be provided on SWF strategies and the kind of stocks they buy. The results are based on the study “Sovereign Wealth Funds: Investment Choices and Implications Around the World,” an IMD Working Paper, which uses a unique dataset of SWF investment. This study is the first to examine SWF equity holdings using a large-scale sample from 2002-2007. It covers more than 20,000 SWF holdings across 7,000 companies and encompasses funds’ stock holdings in 58 countries’ stock markets.
Understanding the role of SWFs is critical for hedge fund managers. These “new” players, SWFs, manage assets above $3 trillion. Some estimates suggest that SWFs will manage more than $10 trillion by 2015. Therefore, for the hedge fund world, it is important to understand their behavior as well as the criticisms behind them and the impact they have on companies. First, in terms of regulation, several multilateral institutions have been arguing the point for a need for additional scrutiny and regulation into SWFs. The lack of transparency of their investment strategies, and their potential destabilizing effect on markets, has frequently been compared to the impact of hedge funds. Also, the discussion on additional regulation of hedge funds, which will surely be raised during the G20 meeting in London, has similarities with the SWFs debate. Second, and probably more important, SWFs are large players, and have (as we show in this research) implications for all investors, in particular, for hedge fund managers. The potential implications for hedge funds’ strategies are huge.
The main results we find based on SWFs’ portfolio choices shows how SWFs have a stabilizing role on firms, and their ownership is positively valued by the market. There are several reasons why SWFs can be valuable strategic investors: they have a positive impact on a firm’s strength as an acquirer and value as a target; they allow firms to leverage political connections; they guarantee stable long-term finances; and as a cheap source of capital, they reduce firms’ cost of capital.
What are SWFs?
Although definitions vary, SWFs are essentially state-owned investment funds that invest in international financial markets. They have existed at least since the 1950s—the Kuwait Investment Office was set up in 1953—but their total size worldwide has increased substantially over the past 10 to 15 years. The biggest is the Abu Dhabi Investment Authority (ADIA) with assets under management of more than $850bn, making it a comparable player to Vanguard.
The first wave of SWFs was set up by oil producers after the price increases in the 1970s and 1980s. The underlying idea was to allow governments to spread the benefits of oil income across generations by investing in financial assets, since oil is a non-renewable resource. A second wave of SWFs followed the late 1990s crisis in East Asia. After the crisis, most emerging markets in the region experienced a shift from debtors to creditors. Savings have thus begun to accumulate in SWFs.
In principle, SWFs invest in equities with the purpose of maximizing the return on a country’s reserves. By taking sizeable stakes in corporations, they perform a desirable corporate governance role that should be welcomed by other shareholders. Unlike other controlling shareholders, SWFs pursue nothing but stock return maximization. Plus, they are typically long-term investors, well-governed themselves, so managers should feel the pressure to perform, even if SWFs have—until recently—been reluctant to sit on boards of directors. On the other hand, being powerful investors, there is no reason why we should not expect SWFs to expropriate minority shareholders.
With noteworthy exceptions (Norway Government Pension Fund), SWFs are opaque in their objectives and strategies. An argument has been made that they may hinder competition because the industries where they invest are not open to foreign investment in their own countries. Politicians’ response in general suggests a fear of hidden political agendas. For example, French President Nicolas Sarkozy stated in early 2008: “I believe…in globalisation but I don’t accept that certain sovereign wealth funds can buy anything here and our own capitalists can’t buy anything in their countries. I demand reciprocity before we open Europe’s barriers.”
Where do SWFs invest?
SWFs invest in virtually all countries in the developed world, and a few emerging market economies. As market players they are certainly a driving force, holding positions in virtually one out of every five firms worldwide. The typical position taken by an SWF is not a controlling stake. On average, an SWF takes 0.74% of the shares outstanding in a firm. In dollar terms the average position is $46.3m. Indeed, their level of control only reaches 50% in less than one per cent of their investments.
The average firm held by an SWF has total assets of $229m, annual sales growth of 15%, and a leverage ratio of 24%. In terms of visibility indicators, the average firm is tracked by 13 analystsand 32% of its sales are international. Compared to typical firms in the world market, firms held by SWFs are significantly larger, more liquid, and have proven records of profitable growth. Firms held by SWFs also tend to have significantly higher institutional ownership and analyst coverage than the rest.
SWFs are often opportunistic investors. They step into companies when their stock prices fall (the IMF has indeed praised them for their stabilizing role in financial markets). They are also more prone to investing in countries where legal protection of investors is stronger. In other words, they may bring in good governance, but only to the extent that the legal regime guarantees a minimum protection to their investment. As with other non-sovereign investment vehicles (CalPERS being a good example), corporate governance considerations are therefore important determinants of SWFs’ investment strategies.
Despite the previously noted preference for visible firms and demand for stocks with high analyst coverage, SWFs do not reveal any strong demand for firms that belong to the major stock indices such as the Morgan Stanley Composite Index. Index membership irrelevance is interesting, as SWFs, contrary to regular mutual funds or hedge funds, have no business concerns in terms of performance and flows. The money that flows into the fund is independent of its performance (or any benchmarking), and relies heavily on the health of the domestic economies of each of their countries. Belying one political argument traditionally raised, that SWFs try to invest in Western corporations as a means of corporate intelligence, SWFs do not have any particular preference for high-tech or R&D intensive firms among the universe of public firms.
The impact of SWFs on firm value
We know how politicians react to foreign investment by SWFs. The best way to judge SWFs is to ask how regular shareholders react. Financial markets are forward-looking, bring together thousands of different opinions, and can efficiently assess the economic impact of SWFs holdings. How do stock prices react when SWFs invest in a firm?
It is hard to write about firms’ fundamental value (the present value of the company’s future cash flows) after 2008’s events. Years of academic research have shown however that the identity of a firm’s investors determine market valuations. If we agree that, to some extent, market valuations approximate well the fundamental values, these results indicate that investors can affect firm performance either by performing a direct controlling role or by conditioning the firm’s financial policies, and ultimately its operating strategy. Indeed, the valuation impact of SWFs is sizeable. The econometric analysis shows that in the year when a SWF invests in a firm, the ratio of the market value of the firm to its book value increases by 15%. Put in simple terms, this finding suggests that other shareholders, including hedge funds that are long on these companies, benefit—a lot—from SWFs investing in their firms. Furthermore, the impact of SWFs goes beyond that of the typical institutional investor: the market pays on average a much higher premium for firms where SWFs have a stake than firms owned by general institutional investors. Everything else equal, the market prefers SWFs to any other institutional investor. Why?
Fig.1 presents evidence of the impact of SWF investment on different measures of firms’ operating performance. We use return on assets (ROA), return on equity (ROE) and operating profit margins (defined as EBITDA/sales and EBITDA/assets) as measures of operating profitability. The results show that after an SWF invests in a firm, overall, operational performance improves.
The benefits of SWF ownership
There are several potential benefits to SWF ownership which can make them more effective at enhancing firm value:
• SWFs can be more proactive in the takeover market and block value-reducing acquisitions by the companies they invest in. Because of their interest in stock returns, SWFs stay away from strategies that purely pursue value-destroying consolidation and scale.
• SWFs increase the takeover premiums in the companies where they invest. Norway’s Government Pension Fund opposed in late 2008 MidAmerican’s (a unit of Buffett’s Berkshire Hathaway Inc.) bid for Constellation, where the Fund had a 4.8% stake. MidAmerican Energy Company’s bid was interestingly backed by Constellation’s management itself. However Norway’s SWF considered the price insufficient and has brought MidAmerican to court. As this episode shows, powerful, non-controlling shareholders can exert external pressure.
• SWFs can be efficient internal corporate governance mechanisms, bridging any gap between shareholders and the top executive. As a substitute for the legal system, one expects the value effect of SWFs to be larger when they invest in companies coming from countries with a weaker legal system. However, our analysis of SWF holdings in the last five years shows that the SWF premium that we report above is the same no matter what the level of the country of origin’s investor protection.
• Unlike other types of institutional investors, SWFs provide guaranteed capital in case of future funding needs and therefore reduce the uncertainty regarding the firm’s future financing ability. There are two characteristics of SWFs which make them more desirable than regular institutional investors: they are larger and do not invest heavily in equities. As SWFs have access to massive funds, the market rewards the unlimited access to capital of the firms where they invest. Current estimates suggest that SWFs are still significantly underexposed to equities, as compared to a regular pension fund or other institutional investors. Hence the expectation is that SWFs will gradually increase their exposure to equities in the coming years (to about 40%).
• SWFs make companies more valuable because they reduce firms’ cost of capital, as a result of their commanding lower risk premiums. The opportunity cost of sovereign funds is to invest in risk-free instruments, like US bonds, as had been their common practice in the 1980s. Furthermore, relative to their size, a single SWF stake represents a small percent of their total assets anyway (the typical fund in the sample invests in more than 100 stocks), and the marginal investor of the firms where they invest becomes a more global, international, less risk-averse investor.
• SWFs provide valuable political connections. Brazil has recently established its own SWF, with the stated objective of buffering the country from the global financial crisis and helping Brazilian companies boost trade and expand overseas. It is likely that such international expansion is spurred by the Brazilian government’s appeal with multinationals and other regulators.
The results from this study have important messages for hedge fund managers. SWF ownership is positively valued by the market, with a premium of about 15% of company value. This suggests that the controversy surrounding SWFs and their future regulation is more political than financial. Contrary to claims that SWFs expropriate investors and pursue political agendas, they, in fact, contribute to long-term shareholder value. The evidence from this study suggests that the majority of SWF investments do not involve partial or complete control of firms. Even for investments that are large (and may involve control), there is no evidence that they harm companies or extract inside information or technology. The overall evidence is that firms perform better and are valued higher when SWFs invest in them.
Nuno Fernandes is a Professor of Finance at IMD, a global business school based in Lausanne, Switzerland. He has carried out extensive research on SWF portfolio choices in an IMD Working Paper, “Sovereign Wealth Funds: Investment Choices and Implications Around the World”. Fernandes is a Lamfalussy Fellow of the European Central Bank.