Sovereign investors look abroad for returns

26 April 2017

With little capacity to invest productively at home, sovereign wealth funds have focused their attention on developed overseas markets

Not long after the oil-rich Gulf states began generating income from their hydrocarbons reserves, they were confronted with a dilemma: with domestic economies still undeveloped, there was little scope for them to place their revenues into investable, wealth-creating opportunities at home.

Domestic equity markets were undeveloped. Only Beirut (pictured above), which in the 1950s emerged as a credible regional financial centre, was able to service the Gulf states’ expanding oil incomes.

From the outset, the region’s economic development template was characterised by an outward-focused strategy. Kuwait was the first to think strategically. In 1953, it set up Kuwait Investment Authority (KIA), the region’s first sovereign wealth fund (SWF). Before long, it had opened the first overseas office in London – the Kuwait Investment Office – to manage investments in foreign real estate, infrastructure and financial services.

Lebanon’s 1950-60s’ heyday as the repository of Gulf capital was short-lived. Mindful of the need to build up foreign exchange reserves, Middle East oil producers chose to bank their earnings overseas. In the 1970s, petrodollars were largely deposited in Western banks.

US depositary

While the 1973 quadrupling of oil prices shifted the power of the market away from the West’s ‘Seven Sisters’ giant oil firms, the US was strongly positioned as a depositary for Gulf sovereign dollars.

In 1973-74, US President Richard Nixon’s administration struck a deal with Saudi Arabia, under which the kingdom would only use US dollars as payment for oil, and invest any surplus in US Treasury bonds, notes and bills. In return, Riyadh could avail itself of US defence kit and – crucially – a guarantee from America to defend the kingdom in the event of an attack. That relationship has lasted more than four decades. In March 2016, the US Treasury Department estimated Saudi Arabia’s holdings of US debt at $116.8bn – a sizeable sum, although well below China’s $1.25 trillion holdings.

Over time, the theme has moved on from seeking safe places to park Gulf petrodollars. The impetus is now to deliver strategic leverage through overseas investments, whether direct or portfolio, and build up a more diversified economic endowment. The creation of SWFs such as Abu Dhabi Investment Authority (Adia), formed in 1976, has played a role in reframing how Middle East states view their overseas investments. With little capacity to invest productively at home, their focus – inevitably – turned to developed overseas markets.

Inorganic growth

Meanwhile, large state-owned diversified entities, such as Saudi Basic Industries Corporation (Sabic), began to see the value of inorganic growth opportunities in overseas markets. Over time, the likes of Sabic have become major buyers of foreign assets – witness the $11.6bn Sabic spent in 2007 to buy US-based GE Plastics, or the $700m it spent on UK’s Huntsman Petrochemicals in 2006.

 Gulf's biggest sovereign funds

Gulf’s biggest sovereign funds

Private equity is another area where Gulf players have sought to make inroads. In 2007, Abu Dhabi’s state investment vehicle Mubadala Development Company bought stakes in the US private equity firm The Carlyle Group. Financial investments have also emerged; one example is Adia’s 2008 spending of $7.5bn for a stake in US banking giant Citigroup.

The strategic sovereign investments outside the Gulf region have over time migrated from the mature Western markets to developed countries, including in the Middle East and North Africa region, tying in with a view that emerging markets offer higher yields. That still leaves a sizeable proportion of their holdings located in the West. According to a Boston Consulting Group study from 2012, about 68 per cent of GCC SWFs’ direct investments were in developed economies, with Qatar Holding’s as high as 92 per cent.

Exposure to traditional ‘bricks and mortar’ investments continues to dominate overseas portfolios. Adia, the region’s largest SWF, invests up to 10 per cent of its portfolio in real estate, while Qatar Investment Authority (QIA) has also accrued a sizeable real estate portfolio, including trophy assets such as Harrods and The Shard in the UK.

More recently, QIA has shown a more diverse interest, buying into Russian oil company Rosneft and a poultry producer in Turkey. Of any sovereign investor, QIA is most attuned to financial services, with Boston Consulting noting that it has almost 50 per cent allocated to this sector.

Redirecting focus

The Middle East’s overseas sovereign investment theme is not set in stone. Approaches invariably reflect economic circumstances. The Arab Spring, and the weakening of oil prices, have left an imprint, giving more of a push to domestic or regional investments. Many have redirected investment into infrastructure developments in Egypt, Jordan, Tunisia and Morocco – countries most affected by the wave of regional turbulence.

QIA has invested $600m in a real estate and tourism complex in Morocco, as well as in similar schemes in Tunisia and Egypt via its Qatari Diar subsidiary. The UAE’s Aabar Investment joined with KIA to set up a $3bn fund with Morocco’s Fund for the Development of Tourism. Adia has been active in Egypt, as has Saudi Arabia’s Public Investment Fund (PIF) more recently. The latter has committed to invest up to $8bn in Egypt’s energy, tourism and housing sectors. These are isolated examples, however. There are limits to their appetite for within-region investments. Given the requirement of the SWFs for an internal return rate of 15 per cent, infrastructure projects in countries like these may not be suitable matches for investment mandates.

There seems to be no slackening of appetite for investing overseas

Most wealth funds prefer European equities, although QIA’s forays into Russia underline a renewed boldness in seeking to invest in countries where economic conditions have weakened and asset prices are potentially more amenable. In November 2016, Mubadala also announced new investments in Russia, buying into a vegetable oil producer and a rice manufacturer.

Looking ahead, there seems to be no slackening of appetite for investing overseas. PIF has signalled its intention to build up overseas investment holdings. The fund has been earmarked to play a key role in realising Riyadh’s National Transformation Programme, and plans to increase the proportion of its foreign investments to 50 per cent by 2020, from 5 per cent now.

Technology investments

PIF has shown a strong interest in high-tech sectors, another theme likely to dominate overseas investments. In October 2016, PIF announced a partnership with Japan’s SoftBank to invest in a new fund to buy as much as $100bn in the global technology industry in the next five years. Other tech investments include a $3.5bn stake in US ride sharing group Uber.

The late 2000s trend for GCC states to buy up farmland appears to have tapered in recent years, although Saudi Arabia and the UAE remain significant holders of arable land in Africa.  

Asia is likely to be a prominent location for sovereign investments in future. Saudi Aramco announced in March 2017 it would invest $7bn in Malaysia’s Petronas Refinery & Petrochemical Integrated Development project. Other investments in Asia are being made in real estate, financial services and telecoms.

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