Lack of confidence in financial markets has driven investors and funds away from corporations. As balance sheets deteriorate, companies are in need of more and more capital, which investors are not willing to provide. In this setting, sovereign wealth funds (SWFs) have emerged as the funding source of the next few years. According to the Sovereign Wealth Fund Institute, SWFs manage $3,000bn. To put this figure into perspective, the hedge fund and private equity markets combined account for less than $2,000bn. Some estimates suggest that SWFs will manage more than $10,000bn by 2015.

However, SWFs’ investment strategies and potential political agendas remain controversial. In this article, we move beyond the strategic discussion and provide evidence on the impact of SWFs on company valuation, based on research done at IMD that covers more than 20,000 SWF holdings across 7,000 companies and covers funds’ stock holding in 58 countries’ stock markets. Our analysis of their portfolio choices shows how SWFs have a stabilising influence on companies, and that their ownership is positively valued by the market. We point to several reasons why SWFs can be valuable strategic investors: they have a positive impact on a company’s strength as an acquirer and value as a target; they allow companies to leverage political connections; they guarantee stable long-term finances; and as a cheap source of capital, they reduce companies’ cost of capital.

How do SWFs operate?

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 during the past 10 to 15 years. The biggest is the Abu Dhabi Investment Authority (Adia), which has assets under management of more than $850bn, making it a comparable player to Vanguard, the US mutual fund group.

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 being debtors to creditors. Savings have thus begun to accumulate in SWFs.

In principle, SWFs invest in equities with the purpose of maximising 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 share return maximisation. Plus, they are usually long-term and well-governed investors, 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. Studies by academics Alexander Dyck and Luigi Zingales and a more recent one by Craig Doidge, Andrew Karolyi, Karl Lins, Darius Miller and René Stulz suggests that concentrated ownership may be associated with the extraction of private benefits of control, and therefore should be value decreasing .

With noteworthy exceptions (for example, the Norway Government Pension Fund) SWFs are opaque in their objectives and strategies. It has been argued that they hinder competition because the industries in which 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, Nicolas Sarkozy, French president, said 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 almost one-fifth of companies worldwide. The typical position taken by an SWF is not a controlling stake. On average, an SWF takes 0.74 per cent of the shares outstanding in a company. In dollar terms, the average position is $46.3m. Indeed, their level of control only reaches 50 per cent in less than 1 per cent of their investments.

The average company held by an SWF has total assets of $229m, annual sales growth of 15 per cent, and a leverage ratio of 24 per cent. In terms of visibility indicators, the average company is tracked by 13 analysts and 32 per cent of its sales are international. Compared with typical companies in the global market, companies held by SWFs are significantly larger, more liquid and have proven records of profitable growth. Companies held by SWFs also tend to have significantly higher institutional ownership and analyst coverage than the rest.

SWFs are often opportunistic. They step into companies when their stock prices fall. They are also more inclined to invest 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, the California state pension fund, for example), corporate governance considerations are, therefore, important determinants of SWFs investment strategies.

Despite their preference for visible companies and demand for shares with high analyst coverage, SWFs do not reveal any strong demand for companies that belong to the major share indices such as the Morgan Stanley Composite Index. Unlike regular mutual funds, SWFs 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. It is often argued that SWFs invest in western companies as a means of gaining corporate intelligence, but SWFs do not display any preference for high-tech or research and development-intensive companies.

Impact on company value

We know how politicians react to foreign investment by SWFs. We think 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 company?

It is hard to write about a company’s fundamental value (the present value of the company’s future cash flows) after the 2008 events. Years of research have shown, however, that the identity of the investors in a business determine its market valuations. If we agree that, to some extent, market valuations approximate well the fundamental value of a company, these results indicate that investors can affect performance either by performing a direct controlling role or by conditioning the company’s financial policies, and ultimately its operating strategy.

As the business scholars Miguel Ferreira and Pedro Matos have shown, institutional ownership (particularly foreign) in general is associated with higher company valuations. SWFs are both large and foreign, so in principle they should encompass higher market valuations.

Indeed, the valuation impact of SWFs is sizeable. Economic analysis shows that in the year when a SWF invests in a company, the ratio of the market value of the company to its book value increases by 15 per cent. Put in simple terms, this finding suggests that general shareholders benefit – a lot – from SWFs investing in their companies. Furthermore, the impact of SWFs goes beyond that of the typical institutional investor: the market pays on average a much higher premium for businesses where SWFs have a stake than in organisations which are owned by general institutional investors. Everything else being equal, the market prefers SWFs to any other institutional investor.

Benefits of SWF ownership

■ 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 share returns, SWFs avoid strategies that purely pursue value-destroying consolidation and scale.

■ SWFs increase the takeover premiums in the companies in which they invest. In late 2008, Norway’s Government Pension Fund opposed a bid by MidAmerican Energy Company (a unit of Warren Buffett’s Berkshire Hathaway) for Constellation, in which the pension fund had a 4.8 per cent stake. MidAmerican’s bid was backed by Constellation’s management itself. However, Norway’s SWF considered the price insufficient and has since brought MidAmerican to court. As this episode shows, powerful, non-controlling shareholders can exert external pressure.

■ SWFs can act as 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 from countries with a weaker legal system. However, our analysis of the past five years shows that the SWF premium that we report above is the same regardless of the level of investor protection in the country of origin.

■ Unlike other types of institutional investors, SWFs provide guaranteed capital in case of future funding needs and, therefore, reduce the uncertainty regarding the company’s future financing ability. There are two characteristics of SWFs that make them more desirable than regular institutional investors: they are larger and they do not invest heavily in equities. As SWFs have access to massive funds, the market rewards the unlimited access to capital of the companies in which they invest. Current estimates suggest that SWFs are still significantly underexposed to equities, compared with regular pension funds or other institutional investors. The expectation is, therefore, that SWFs will gradually increase their exposure to equities in the coming years (to about 40 per cent).

■ SWFs make companies more valuable because they reduce companies’ 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 such as US bonds, as was their common practice in the 1980s. Furthermore, relative to their size, a single SWF stake represents a small percentage of their total assets anyway (the typical fund in the sample invests in more than 100 stocks), and the marginal investor of the companies in which 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 to 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 controversy surrounding SWFs is more political than financial. SWF ownership is usually positively valued by the market, with a premium amounting to about 15 per cent of company value. This suggests that, contrary to claims that SWFs expropriate investors and pursue political agendas, they, in fact, contribute to long-term shareholder value creation and bring about larger value increases than other institutional investors.

Nuno Fernandes is professor of finance at IMD and a Lamfalussy research fellow of the European Central Bank. He has done extensive research on SWF portfolio choices in an IMD working paper, “Sovereign Wealth Funds: Investment Choices and Implications Around the World”
nuno.fernandes@imd.ch

Arturo Bris is professor of finance at IMD, a research fellow at the Yale International Center for Finance, and a research associate at the European Corporate Governance Institute
arturo.bris@imd.ch