Herd Mentality

With a sound financial system and a bountiful resource-based economy, Canada’s pastures should be some of the greenest around for large investment vehicles like sovereign wealth funds (SWFs). However, a combination of recent losses and amendments to Canadian foreign investment laws has sent many SWFs elsewhere in search of returns—which may make it difficult for institutional investors looking for capital partners.

While there is no standard definition, a defining characteristic of SWFs is that they make investments on behalf of a state or sovereign jurisdiction. SWFs differ from other investment vehicles such as pension funds in that the capital originates from surplus foreign exchange reserves or the proceeds from commodities sales, notably oil. High-profile examples of SWFs include the Government Pension Fund of Norway and the Abu Dhabi Investment Council.

Trillions in Transactions
The volume of capital controlled by SWFs is estimated at roughly US$3 trillion—double that of the hedge fund industry, but dwarfed by the $15 trillion managed by pension funds—and is expected to reach $10 trillion by 2012.

Although SWFs have been around since the 1950s, until recently, they have flown under the radar of most regulators. However, SWFs have become a subject of increased scrutiny in the past few years due to issues of opacity and strategic intent. The most well-known cases involve SWFs from China and the United Arab Emirates. Both funds were forced to withdraw their bids for a U.S. oil company and a series of U.S. ports, respectively, when controversy erupted over the wisdom of selling strategic assets to foreign, non-democratic governments.

In a 2008 report by the Institute for the Analysis of Global Security, based in Washington, D.C., executive director Dr. Gal Luft explains that, at their current growth rate of 24% a year, SWFs are presenting tough competition to other institutional investors over access to investment opportunities in the U.S. “As SWFs gain strength and volume, they could sideline other players vying for investments,” he says. “Unlike pension funds and other institutional investors who are slow in their decision-making processes, following strict timelines set by their investment committees, SWFs are agile. They have the in-house structure and the resources to make investment decisions quickly.”

Curtis Cusinato, a partner with Stikeman Elliott LLP in Toronto, says that’s not the case in Canada. According to Cusinato, it’s rare for SWFs to bid for outright ownership of a Canadian asset. Instead, most choose to find a local institutional investor familiar with the asset class and the regulatory environment. “I would characterize it more as co-operation,” he says. “Typically, you would see large pools of capital reach out to a domestic partner on the equity side.”
Flaws in the Laws?

A series of proposed transactions that involve SWFs seeking large stakes in Canadian energy companies has prompted the Canadian government to amend the Investment Canada Act to ensure that all such transactions are of “net benefit to Canada.”

According to Sandra Walker, a lawyer with Stikeman Elliott, these changes allow the government to scrutinize any deal that sets off alarm bells at Industry Canada (whose mandate is to foster a growing, competitive knowledge-based Canadian economy). “There’s a new national security review process in place retroactive to Feb. 6, 2009, when the legislation was introduced to Parliament,” she says. “Under this act, the government can look at foreign investment—what sector it’s in, who’s behind the investment, who has a minority stake—and can prohibit such investment if it is deemed to be injurious to national security.”

But the new laws may have a flaw. “An interesting point is that there’s no definition of national security and no guidance from the minister of industry, which creates a lot of uncertainty as to how these rules will be applied,” Walker explains.

In addition to possible regulatory hurdles, investments by SWFs in North American markets have trailed off since the beginning of the financial crisis in August 2008, according to Josh Lerner, a professor of investment banking at Harvard Business School. Lerner says that many SWFs, after getting their fingers burned in asset classes they didn’t fully understand, are going back to basics and looking for investments in their own backyards.

“Institutional investments, mostly in the financial sector, have been disappointing for many SWFs,” he explains. “There is a process of reassessment underway among these and other institutional investors, particularly with regard to illiquid assets.” He says that SWFs are likely to ask more questions regarding North American investments or to simply stick to the industries they’re already comfortable with.

Cusinato confirms Lerner’s observation, explaining that he’s seen a drop in the number of transactions in Canada and abroad. He adds that, of the investments he’s seen lately in Canada, most have been minority stakes. Due to the current lack of liquidity, many larger organizations are reaching out to SWFs for capital—namely, natural resource companies. However, with the new Canadian investment laws and a diminished appetite for risk, many funds are holding back for now. “SWFs are very sophisticated investors with significant pools of capital, and it is unclear how they will react to these new rules,” says Cusinato.

A Matter of Principles
As a result of increasing global scrutiny of SWF investment activity, a set of shared principles and practices (known as the Santiago Principles) was adopted in October 2008. Set in motion by the International Working Group of Sovereign Wealth Funds, the principles consist of 24 voluntary ideals focused on transparency, enhanced government practices and sound portfolio management.

With the onset of a worldwide recession, the focus on the Santiago Principles has been reduced, according to Lerner. “The spotlight is off SWFs right now,” he says. “There is less pressure than when the Santiago Principles were being discussed.” He explains that a combination of government regulation and self-regulation is on the horizon but, for the meantime, many funds are just trying to stem the losses.

Cusinato believes that, given time, initiatives such as the Santiago Principles will foster investment in Canada and around the globe. “We have yet to see the true results of these principles put to work.”
To date, there is no clear evidence that the new investment laws have negatively affected SWF activity in Canada. Indeed, recent transactions have included Cirque de Soleil, Prime West Energy Trust and Nova Chemicals Corp., presenting opportunities for Canadian pension funds to participate as capital partners. The real test, however, will be when the markets turn around and confidence—and credit—is restored.

Whether changes to the Investment Canada Act have loosened the country’s golden straitjacket or the SWF members of the electronic herd are simply sticking to more familiar pastures, Cusinato sees great prospects ahead. “I think the Canadian pension funds are very well situated to reap the benefits of greater co-operation and collaboration with SWFs.”

Jody White is associate editor of benefitscanada.com.
jody.white@rci.rogers.com

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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the May 2009 edition of BENEFITS CANADA magazine.