When Worlds Collide

U.S. Treasury Secretary Henry Paulson is meeting today with the world's largest sovereign wealth fund, the $900b Abu Dhabi Investment Authority, in a bid to get more oil riches from the Middle East invested in US companies socked hard by the housing and credit crisis as well as the US economic downturn.

But while Paulson vows that America will keep its doors ompen to investment from sovereign wealth funds, a growing chorus at the International Monetary Fund is demanding that SWFs need to be more transparent in their dealings.

The IMF is being pressured to draw up best-practice guidelines for SWFs, which have as much as $2.9t to invest, an amount that is estimated to be more than hedge funds or private equity funds. SWFs largely answer to no one, not market regulators, shareholders or voters. They don't have to disclose quarterly or even annually their investment stakes, much less their investment objectives or main holdings, and the push is on to get them to do so.

Paulson has reportedly said he wants the SWFs to voluntarily adopt codes of conduct for investing their proceeds from record oil prices. ``We're not picking on sovereign wealth funds,'' Paulson said. ``It's a good way to inoculate them against protectionist sentiment around the world.''

The IMF flap has irritated some governments in the Middle East, which say they are being asked to meet standards that don't apply to other investment vehicles, like hedge funds or private equity funds.

These SWFs are mindful, too, of the furor in the US when the China National Offshore Oil Corp. tried to buy Unocal, a California oil company, in June 2005 and when DP World, a Dubai-owned port operator tried to buy P&O's business in America, which included management of six of the largest ports in the US.

A public outcry ensued after both deals were announced, both were stymied due to US opposition, and after the DP World fiasco, Congress passed a law clamping down on security reviews of foreign investments. In a bit of intrigue, some are afraid the SWFs may secretly try to smother competition, spy on corporations, or undermine their companies' competitors overseas. To date, there are no examples of SWFs abusing their power in this manner.

A dose of circumspection on both sides of the aisle is needed.

SWFs have tossed a lifeline to crippled US financial firms, struggling under a massive $344b in estimated writedowns and credit losses at more than 100 banks. Companies in the West have raised $263b from sovereign wealth funds, their own governments and public investors to revivify their near-dead balance sheets brought low by Frankenstein securities backed by subprime mortgages, where many homeowners are bolting (dead loans walking).

SWFs in the Middle East and Asia have helped put out brushfires by investing money in beaten-up firms such as Merrill Lynch (MER), Citigroup (C), Morgan Stanley (MS) and UBS (UBS), which has taken so much money, it is now jokingly called not the Union Bank of Switzerland, but the Union Bank of Singapore.

Just this past January, the governments of Singapore, Kuwait and South Korea gave most of a $21b lifeline to Citigroup and Merrill Lynch.

US banks can't and won't ignore this source of liquidity. Something else to think about: If the SWFs are shooed away, or simply give up in frustration, sooner rather than later taxpayer money of some sort will be used to prop up the system. Think of the Fed's rescue of Bear Stearns.

Also, SWFs' investments are real, cold hard cash, they don't need and thus don't use leverage. SWFs "don't seek to take advantage of mispriced assets using high leverage" like hedge funds do, said Badar Al-Sa'ad, head of the Kuwait Investment Authority, which has invested in Citigroup and Merrill Lynch. Instead, the funds "are long-term in nature, they are not speculative," he has said.

And if the critics win at the IMF, the SWFs, just like any other private equity or hedge fund, can protect themselves from disclosure by turning to invest through other third parties like hedge funds. This is already happening.

China Investment Corporation, the Chinese sovereign wealth fund, was reportedly in talks with JC Flowers, the US private equity group, to put about $4bn into a new fund to invest in ailing financial institutions. China has been stung hard by its huge losses in Blackstone.

Other SWFs do not have a Midas touch or a great track record nailing the bottom of a bear market, as they have lost billions of dollars on their stakes in the financials since last August; they too can use intermediaries to do their investing for them, as China did. And already, Qatar's prime minister, who heads the country's $60b sovereign wealth fund, said he may lean toward investing in European rather than US banks since US bank shares have been pounded by subprime-mortgage writedowns.

SWFs are not a new phenomena, they have been around for decades, the first, the Kuwait Investment Office, was launched in 1953. It created a dustup in 1987 in Britain two decades ago when it bought more than a fifth of the recently privatized British Petroleum, raising hackles that a foreign oil company was becoming a large owner of a prized national company. Prior to that, Libya bought into auto maker Fiat and Kuwait purchased stakes in Daimler Benz in the ‘70s.

However, transparency is one thing. Corruption is quite another.

The real danger here is rogue traders, who already plague the seemingly transparent companies. Think Societe Generale and Barings Bank.

So who are these fund managers holding sway over trillions of dollars in capital at the SWFs? Do the SWFS in the Middle East and Asia already have internal codes of conduct, and what are they? What are the SWFs' safeguards to stop rogue traders?