Buy one, get one free… (Part 1)
The emergence of the euphemistically labeled ’sovereign wealth funds’ as (the) major players in global capital markets was one of the stories of 2007, brought home in the latter part of the year by some massive investments in major global banks (such as Citigroup and UBS) who were looking to quickly shore up their capital bases following their widely reported asset write-downs. A story which is continuing into 2008 with both Citigroup and Merrill Lynch (and almost certainly others) in the process of finalizing additional capital injections (mainly) from these investors:
(from The Economist) The risk of a big bank going under has receded as $27 billion (and counting) of capital has flowed into the sector from sovereign wealth funds. Recipients include Merrill Lynch, Citigroup, Morgan Stanley and Switzerland’s UBS (or, as wags now call it, Union Bank of Singapore). These injections may have upset existing shareholders, who have seen their stakes diluted, but they have ensured that although big lenders have wobbled, none has toppled.
(from Times Online, link above) [Merrill Lynch] is however in talks to raise up to $4 billion of fresh capital, with the KIA understood to be one of the big investors in the latest consortium. The Middle East sovereign wealth fund is reportedly also prepared to invest up to $3 billion of the $15 billion of new investment Citigroup wants to raise under Vikram Pandit, its newly installed chief executive.
Chinese state-backed investment funds or banks are expected to stump up collectively another $9 billion for Citigroup, which ousted Chuck Prince as its chief executive late last year after having to take multibillion-dollar writedowns on its balance sheet. The remainder is expected to come from public market investors.
Last month Merrill agreed deals to raise up to $5.2 billion from Temasek, the Singapore government-owned fund, and $1.2 billion from Davis Selected Advisors, the US asset manager. In November the Abu Dhabi Investment Authority, the investment arm of Abu Dhabi, injected $7.5 billion into Citigroup, in return for a 4.9 per cent stake. Last month China Investment Corproration, agreed to inject $5 billion into Morgan Stanley in return for a 9.9 per cent stake.
So just for argument’s sake, let’s say these investors are going to invest c. $50 billion (give or take a few…billion) of capital into these financial institutions. It obviously begs the question: why? A cursory analysis I believe throws up a few possibilities:
- Because they expect to earn a good risk-adjusted return on these investments over the medium term.
- Because they can: ie this is a rare opportunity to deploy substantial amount of capital without moving the market against you.
- Because there are additional ’strategic’ and /or ‘political’ benefits (over and above the expected financial returns.)
- Because they are major customers of these firms and they want to build even closer relationships and share in the upside of their own custom.
I figure that it is probably some combination of some or all of these factors. Let’s take them one at a time.
Because they expect to earn a good risk-adjusted return on these investments over the medium term.
This should - and probably is - the main reason. Classic distressed play: solid underlying business and franchise with one-off (solvable) problems creating a buying opportunity for investors with ‘patient capital’ - a medium to long term horizon (something that these funds ostensibly have.) I wouldn’t pretend to have done any sort of modeling (rigorous or otherwise) to have an opinion on the specific investments being made (and prices being paid) but wonder at a high level whether modern global (investment) banks are good long term investments (at any price.) I will come back to this point in a subsequent post. (Of course if these investors are looking to trade out of these positions over 12-36 months, my scepticism is much less relevant.)
Because they can: ie this is a rare opportunity to deploy substantial amount of capital without moving the market against you.
This may sound naive but is actually pretty important. Managing tens or hundreds of billions of funds may sound easy and fun (the world is your oyster) but as any good fund manager (hedge, sovereign or otherwise) knows, in many markets and instruments, size can be a curse on two counts: firstly, finding investments that are big enough to ‘move the needle’ - ie make a difference to the overall returns of the fund; and secondly, having identified such an opportunity, actually being able to execute without overwhelming the market and/or incurring such high transaction costs that the returns effectively disappear. In this sense, beggars can’t be chosers works both ways: you take what’s on offer (at least whatever seems at least somewhat reasonable.)
Because there are additional ’strategic’ and /or ‘political’ benefits (over and above the expected financial returns.)
Perhaps. I’m not really qualified to say, although I suspect that if the above two conditions are met, this is probably the icing on the cake (as opposed to the driving consideration.) As the sovereign wealth funds quickly grew in size, number and ambition (in particular straying out of bond markets into public and private equity) over the past few years, much of the political and business establishment in the developed world was growing increasingly anxious about what they saw as the potential of their economies and national corporate champions being unduly influenced by foreign governments. (Without I might add seeing the irony…) These funds as a result face(d) a real risk of being shut out of many potential (large) investment markets. Taking into account the challenges they already faced with respect to their size (see above) this would be disastrous. Bailing out key major financial institutions should in principle be a great way of keeping the door open and building political goodwill.
Because they are major customers of these firms and they want to build even closer relationships and share in the upside of their own custom.
The Victor Kiam gambit: “I liked it so much, I bought the company!” Maybe. Although the basis risk is huge and the potential for conflicts of interest enormous.
So if you had $50bn burning a hole in your pocket, would you do the same trade(s)? While based on my framework above, I can see what might be driving these investors, I’m not sure I’d do the same. Even if the goal is only to take a short term (1-3 year) “trading” view on valuations, there are probably better (ie more liquid, less risky) ways to express such a view even for the size. Some background on my view in Part 2.
