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 decade.
SWFs manage more than $3 trillion (Dh11 trillion). To put this figure into perspective, the hedge fund and private equity markets combined account for less than $2 trillion. Some estimates suggest that SWFs will manage more than $10 trillion by 2015.
SWFs have been in the headlines around the world for their potential global impact and investment strategies. They have become very prominent during the financial crisis because they have made huge investments — tens of billions of dollars — into western financial institutions like UBS, Merrill Lynch; and also in some other companies that people are not so much aware — like Madame Tussauds or MGM Casinos.
This debate, however, ignores a critical dimension of SWFs impact, their local development objectives.
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, and their typical position is not a controlling stake.
But as opposed to other funds, the underlying idea of all sovereign wealth funds is to leave a legacy for future generations.
This legacy concept is obviously linked to the long-term investment view that they have. As opposed to mutual funds, hedge funds or other kinds of funds, they don't have a short-term view of "How much money am I going to make this year or next year?" or "Am I going to beat the index or not?"
The valuation impact of SWFs is sizeable. Econ-omic analysis shows that in the year when an SWF invests in a company, the value of the company 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.
It is not just a market phenomenon. My study also investigated the actual performance of companies, profit margins, return on assets, return on equity, etc. Using these different measures of profitability and performance, the results clearly show that companies where sovereign wealth funds are investors performed better than other companies.
For the companies they invest in, there are basically three sources for the value-added of sovereign wealth funds.
Firstly is the cost of capital. Firms that have SWFs as investors have a lower cost of capital than other firms. That is traditional investment theory; when you have a lower cost of capital you will be able to take more investment projects; pursue more growth opportunities — and that is appreciated in the market.
The second is product market. A company that has an SWF as an investor will also get privileged access to the product market in the country or region where the sovereign wealth fund comes from.
The third is related to the takeover market and a little bit with corporate governance. SWFs can ward off hostile takeovers by corporate raiders. As opposed to most other funds and investors, SWFs are investing for the long run, with their legacy and development objectives in mind.
This long-term focus means that they are willing to block value-reducing acquisitions in the companies they invest in.
Nuno Fernandes is Professor of Finance at IMD, the global business school based in Lausanne, Switzerland (www.imd.ch). He directs IMD's Strategic Finance programme.