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Sovereign Wealth Funds Embrace Hedge Funds

Sovereign wealth funds are beginning to see compelling new opportunities in hedge funds.

Singapore’s Temasek Holdings — like a lot of sovereign wealth funds — has struggled to cope with the volatility of financial markets since the crisis erupted two years ago. The fund bought chunky stakes in Bank of America–Merrill Lynch and Barclays, only to sell both positions at a loss of an estimated $5.5 billion earlier this year. Temasek also suffered an embarrassing failure when it sought to overhaul its management by recruiting a high-profile foreign CEO, Charles (Chip) Goodyear, only to see the former BHP Billiton chief executive bolt in July over strategic differences before taking the job.

Those setbacks, however, haven’t stopped Temasek from diversifying its investment strategy. In March, at a time when hedge funds were reeling from billions of dollars in outflows, the subsidiary that oversees the sovereign wealth fund’s hedge fund investments announced a major new commitment to the beleaguered sector. It was particularly keen to allocate to managed futures, equity strategies and compelling new opportunities arising from the dislocation in global credit markets. Soon thereafter, in July, Ho said that Temasek might begin inviting “sophisticated” investors to co-invest with the fund. And in August, Temasek revised its charter, affirming its intent to invest on commercial principles. The sovereign wealth fund also dropped language describing itself as a company that manages the government’s investments for the long-term benefit of Singapore and disclosed that it would be prepared to list some of its largest domestic holdings if they failed to provide solid growth opportunities.

On the hedge fund front, Singapore’s gigantic neighbor to the north is making similar shifts. In June, Felix Chee, an adviser to China Investment Corp., which manages $200 billion of that country’s vast foreign exchange reserves, told conference attendees in Monaco that the fund aims to tap into its war chest to invest in hedge fund strategies. In late July, CIC made good on its promise by allocating $500 million to the fund-of-hedge-funds business at Blackstone Group, despite suffering substantial losses — and attracting unwelcome criticism at home — after its $3 billion investment in the alternative asset manager, completed in 2007, plummeted in value. It’s just one of many hedge fund investments that CIC is likely to make in the coming years as it deploys its massive holdings — a huge chunk of which is still held in cash or cash-equivalent products — into higher-risk, higher-return assets.

These are hardly isolated moves. Preqin, an investment research firm based in London, recently surveyed 55 sovereign wealth funds and found that 38 percent invest, or are considering investing, in hedge funds. More than one quarter of these funds — including CIC and Korea Investment Corp., which oversees $27 billion — made their first foray into the space as recently as two years ago. And more are expected to follow suit. Among the roughly 20 funds surveyed by Preqin that currently invest in hedge funds, the average allocation was 6.8 percent of the overall portfolio, representing about $25.3 billion in capital. Over the next couple of years, Preqin expects the average sovereign wealth fund allocation to rise to 8.1 percent, generating billions of dollars in mandates for hedge fund managers.

“During times of distress in the equity markets, with beta hit badly, sovereign wealth funds look for portfolio insurance,” says Aref Karim, founder, CEO and CIO of London-based Quality Capital Management, which specializes in managed futures and counts such funds among its investors. “Interest in hedge funds is definitely growing.”

Karim is himself an early pioneer. In January 1988, while working as a senior investment manager at the Abu Dhabi Investment Authority, he was part of a team that led the fund’s initial foray into hedge funds — a move given added urgency by the 1987 U.S. stock market crash just three months earlier.

The quest for noncorrelated returns is a key factor behind sovereign wealth funds’ growing embrace of hedge funds. But other, more subtle and complex motivations also exist. Stung by high-profile losses on big bets that they placed on the wounded financial services sector at the height of the credit crisis, leading sovereign funds have reawakened to the political benefits of flying below the radar.

“The fact that hedge funds invest with less visibility is an attraction,” notes Martin Kaplan, CEO of Mesirow Advanced Strategies, a Chicago-based fund-of-funds firm with $10.5 billion in assets, about 10 percent of which comes from sovereign wealth funds.

A thirst for market intelligence is also driving interest in hedge funds. As sovereign wealth funds seek to build more-sophisticated portfolios, they are finding that hedge funds — hungry for capital — are more than willing to provide a window into their holdings and share their perspectives on the forces shaping capital markets. Sovereign funds typically achieve this level of access and transparency by investing in hedge funds using a managed-account structure.

“Even if the funds allocate only small portions of their reserves to hedge funds, they can make this access one of the conditions of investing,” says Andrew Rozanov, head of sovereign advisory at State Street Global Markets in London, who is credited with coining the term “sovereign wealth fund” in a 2005 Central Banking Journal article titled “Who Holds the Wealth of Nations?”

Temasek’s game plan has relied on that type of access. In 2003 its group overseeing alternative investments, Singapore-based Fullerton Fund Management Co., began making direct investments in Asia-Pacific hedge funds. But for allocations farther afield, Fullerton went to funds of funds “that could help us learn about the markets,” says Shirin Ismail, who heads up absolute-return strategies at the wholly owned investment subsidiary. Now, she says, Fullerton has built up enough expertise and contacts that it is ready to begin making direct investments in more complex strategies — and hedge funds have taken notice. “Everyone comes to us,” Ismail notes. “We’re now a stopover for hedge fund managers when they are in Asia.”

The financial crisis has been deeply felt by the world’s sovereign wealth funds, whose rapid growth, massive capital base and potential for political influence have raised hackles among Western politicians, regulators and the public alike. This wariness grew as funds like ADIA, CIC and Temasek made huge, high-profile bets on key pillars of a global banking establishment desperate to refill its coffers. Among the recipients: Barclays, Citigroup, Merrill Lynch & Co. and Morgan Stanley.

To say that these investments proved to be ill-timed is an understatement. ADIA’s $7.5 billion stake in Citigroup has lost more than 80 percent of its value, based on Citigroup’s recent price of $4.70 a share, down from roughly $30 when ADIA took the plunge in November 2007. Temasek, for its part, is said to have lost $4.6 billion alone on the 14 percent stake it took in Merrill Lynch and converted into Bank of America Corp. stock before selling it off earlier this year.

All told, from the end of 2007 to the end of the first quarter of 2009, sovereign wealth fund assets fell by 18 percent, or roughly $600 billion, to a little more than $3 trillion, according to a recent report by Deutsche Bank, fostering criticism from their home governments and contributing to a near-halt in cross-border investment activity, as many funds came under pressure to restrict their purchases to ultrasafe U.S. Treasuries or to reserve their capital for bailouts at home. The Deutsche report recorded only $10 billion in first-quarter investment transactions by sovereign funds, compared with $58 billion for all of 2008 — more than a 30 percent drop in activity on an annualized basis.

Western governments and the International Monetary Fund have already been pushing for — and have won promises of — greater transparency from sovereign wealth funds, many of which are now producing annual reports and disclosing their policy purposes and relationships with state bodies (see article, "Sovereign Wealth Funds Come Out of the Shadows"). But chastened by their very public investment losses, sovereign funds have learned a key tenet about secrecy that hedge funds have long abided by. As State Street’s Rozanov puts it, “The more allocations you have to illiquid investments, the less you want the marketplace to know.”

Allocating to hedge funds — and to funds of hedge funds in particular — is helping sovereign wealth funds avoid the spotlight while they learn about markets and risk management. Temasek’s evolution is a case in point. Fullerton’s Ismail says her group has received many key introductions to managers from funds of funds in the past few years. Now that her team is more educated, she is ready to plunge into more-complex strategies through direct hedge fund investing. For example, Ismail explains, Fullerton is “excited about debt now” after having avoided credit strategies up until this year, and it is already investing in distressed-debt hedge funds. She says she never would have made this move without those years of gathering intelligence and getting to know the best managers.

“We have selected a very small handful of funds we want to work with in this area,” says Ismail. “It was not so easy to figure out who can sustain debt investments over a long period of time.”

Judith Posnikoff, who oversees equity-market-neutral and merger-arbitrage strategies for Pacific Alternative Asset Management Co., a fund of funds in Irvine, California, sees a similar trend. “Sovereign wealth funds have become interested in taking advantage of market dislocations and learning more about these strategies from hedge fund managers,” she notes.

Adds Paamco CEO Jane Buchan, “A lot of sovereign wealth funds seem to be looking for new ideas for their direct investments.”

In an environment where hedge funds are eager for capital, sovereign funds can, and often do, call the shots on fees, terms and the disclosure of underlying positions by investing through a separately managed account. “Some sovereign wealth funds want a lot of customization in their portfolios,” notes Mesirow’s Kaplan. “Also, they may want control over how their portfolio is handled.”

Ismail, for one, says that Temasek expects to pay management fees of 1.5 percent to 2 percent and an incentive fee of no more than 15 percent. “There are fund managers willing to adjust their fee structure, and we think that shows a certain flexibility that is important,” she contends.

State Street’s Rozanov figures that the trend toward customization will continue as long as sovereign wealth funds can provide the kind of capital that has proved so hard to come by in the current environment. He predicts that sovereign funds will even begin wrapping their hedge fund investments in principal protected notes and other derivative products to preserve capital better and mitigate downside risk. “The losses of the past year have posed a serious reputational risk in sovereign wealth funds’ home countries,” he says. “A capital protected note is one way to mitigate the concerns.”

Although sovereign wealth funds are exhibiting a growing interest in going it alone, many fund-of-funds managers believe they will continue to have a primary role in allocating capital. One advantage that funds of funds provide is proximity to local managers. “You need a network and staff, and if you’re based thousands of miles away, it’s more difficult to visit and local knowledge is more difficult to come by,” says Kaplan.

For Paamco’s Buchan, it all comes back to the benefits for sovereign fund clients of staying at arm’s length from potential investment opportunities. “If you run a sovereign wealth fund and you send staff on a big trip to perform due diligence on certain hedge funds,” she says, “the managers know they’ve almost won just by the fact that you’re there.”

That may be true. But as sovereign wealth funds increasingly get up to speed on hedge fund investing, nothing, it seems, beats going straight to the source.

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