Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion

by Steven M. Davidoff

  The mad dash of 2007 and 2008 to send investment bankers and lawyers to these regions was thus an overreaction, but at least some of these funds will still be on the prowl, investing strategically in the United States and elsewhere. Their experiences of the last two years will mean that they will continue to look for investment expertise, either through investment or internal hiring. Evidencing such a trend in February 2009,Temasek replaced its own CEO, a Singapore national, with Charles “Chip” Goodyear, the U.S.-born ex-CEO of BHP Billiton, the global mining company.28 Sovereign wealth funds will also continue to serve an ancillary rather than primary role, making smaller investments and facilitating larger ones. In doing so, these funds will increasingly seek to guarantee a minimum return in order to assure that the failures during the financial crisis are not repeated. Given the difficulties with banks that private equity firms have had over the past year and a half, this may be a source that private equity firms cultivate. In fact, sovereign wealth funds may become locally vigorous competitors to private equity funds using their resources and local influence to dominate their markets.

  Sovereign wealth funds are often young, though, and controlled by their governments. This will make investors wary of taking capital when these funds are deemed too political. For example, in December 2008, Dow Chemical was badly burned when the government of Kuwait decided to terminate the $17.4 billion chemical joint venture between Dow and Kuwaiti-owned Petrochemicals Industries Company. The joint venture had been agreed to only the month before but was scuttled by the Kuwaiti government after political protests in Kuwait against the investment.29 This type of overt political decision making hurts sovereign wealth funds, but it also shows the parameters of their possible regulation and differentiation.

  The Sovereign Wealth Fund Problem

  The 2007-2008 wave of sovereign wealth fund investments stirred tremendous public controversy. Detractors highlighted the risk that these fund investments were not made for economic purposes. Rather, sovereign wealth funds would use their funds and investments to overtly or subtly act against Western interests. Alternatively, sovereign wealth funds would invest for very good economic purposes contrary to Western industry and business. Here, the anxiety was that sovereign wealth funds would use their ownership interests in U.S. and European companies to direct capital or valued technology to their own countries. In other words, they would steal our secrets. Despite these concerns, there was no concrete evidence that any of this conduct was occurring.The fears concerning sovereign wealth funds appeared to be simply, at this point, a fear, though possibly a well-founded one.

  Perhaps pointing toward an overreaction, the public response to the sudden increase in sovereign wealth fund investment was similar to other waves of high-profile foreign investment in the United States. In the 1980s, it had been Japan. The concern was that the Japanese, and their growing investment in the United States, were going to threaten the economic well-being of America. People like Steven Forbes, a future failed presidential candidate and publisher of Forbes, and Lester Thurow, at the time dean of the MIT Sloan School of Management, raised a public alarm.30 The result was a tightening of the national securities investment laws and a variety of forced restrictive trade pacts and quotas upon the Japanese. The worry turned out to be overinflated, as Japan’s economy suffered from its own economic crash in the 1990s. Nonetheless, it did produce one of the most lovable of Michael Keaton’s movies, Gung Ho, about a Japanese company taking control of a U.S. auto factory. In that movie, the Japanese were portrayed as friendly people seeking to understand American culture. But as the 1980s wore on, the public mood changed. The 1992 Michael Crichton book and movie Rising Sun portrayed the Japanese as sinister, bent on taking over the United States.

  The fear of sovereign wealth funds seemed to be affected by xenophobia, like the reaction against Japanese investment. This response was no doubt spurred by general fears about the rise of the Chinese economy and the growing power of Middle Eastern Islamic nations. In defense of sovereign wealth funds, though, their investment provided tangible benefits to Western countries. Capital investment is a good thing. The American railroads and the industrial economy in the Gilded Age were built in large part with British funds (i.e., foreign capital).31

  In the case of sovereign wealth funds, their U.S. investment has the virtue of recycling currency into our country. The United States continues to run the world’s largest trade deficit as it continues to purchase cheap, imported goods and commodities from other countries. So at a minimum, this investment recycles money back to the United States in the short term to hopefully bridge the gap toward our country closing this trade deficit. Furthermore, in these particularly troubled times, foreign capital is particularly necessary to restart our economy in a world of scarce credit. Sovereign wealth fund investment absent nefarious influence can provide a source of capital to further grow the economy.

  The trick is to balance the desire for this capital against the fears, real or imagined, surrounding sovereign wealth fund investment. It may be true that sovereign wealth funds have yet to cause any particular trouble, but the potential for mischief is there. The appropriate measure of caution will drive the need for sensible regulation and set the tension between attracting this capital and appropriately regulating it. As the Sultan Ahmed bin Sulayem, chairman of the United Arab Emirate’s sovereign wealth fund, stated to the BBC: “We are investors and we are free to go wherever we want. If you squeeze us, we will go elsewhere.”32 The irony in the sultan’s statement is that these countries, including his own, almost all regulate and restrict foreign investment in their own jurisdictions. Nonetheless, the point has validity; any regulation must not only be appropriate but also not drive capital inappropriately toward other less regulated jurisdictions.

  The sovereign wealth fund controversy and the drive to regulate such investments during 2008 focused on their governance. These funds are largely run by governments that are not known for their transparency. The funds historically have largely mirrored this practice, holding their investments and investment goals private. They are dark pools of capital. For example, the Sovereign Wealth Fund Institute publishes a transparency index rating each sovereign wealth fund on a scale of 1 to 10. Saudi Arabia’s sovereign wealth fund receives a 2, which is particularly troublesome when you look at the scoring system: A fund receives one point for publicly disclosing its main office location address and contact information, such as telephone and fax. Moreover, a score of 8 is needed to be considered adequately transparent. The only non-Western fund to receive a score this high is the Azerbaijani one.33

  At this point in time, this is perhaps the most legitimate source of concern about these entities. To address these governance issues, the United States and other Western countries have focused on erecting voluntary codes of conduct to ensure openness and professional investing by sovereign wealth funds. Nudged to adopt these codes, presumably these funds would be transformed into professional investing institutions immune from the political pressures of their controlling sovereign. This would have the secondary effect of ensuring that their investment was legitimate and economically based.

  In the fall of 2007, the European Community privately circulated a draft voluntary code, and the International Monetary Fund, at the request of the United States, Germany, Italy, Japan, Britain, France, and Canada, took the lead in leveraging this code into an international one.34 On September 2, 2008, the IMF through the International Working Group of Sovereign Wealth Funds announced that an agreement had been reached in Santiago, Chile, on a voluntary code with 26 countries, including China, Kuwait, Qatar, Russia, and the United Arab Emirates. The code was known as the Santiago Principles, and its 24 principles covered transparency, governance, and accountability. The code was modeled on the open practices of the Norwegian fund, requiring disclosure and reporting of investments and returns, transparency in investing intent, investment for only economic and not political purposes, and good governance.35

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sp; However, this voluntary code had a number of problems. One of the first problems was definitional. What is a sovereign wealth fund? People agree it includes a state-controlled pool of money designated for investment purposes, like Abu Dhabi’s $875 billion fund. The Santiago Principles similarly define sovereign wealth funds as “special purpose investment funds or arrangements, owned by the general government.”36

  But this definition excludes state-controlled companies like Chinalco. In a world where capital can easily be transferred and many of these sovereign wealth funds have massive state-owned industrial complexes, countries can merely reallocate this capital to these enterprises, thereby avoiding even the application of these principles. Moreover, many of the same issues of uneconomic or inappropriate strategic investment arise in the case of these state-controlled industrial companies.

  Another problem with a voluntary code is that it is voluntary. The governments agreeing to the Santiago Principles code already publicly state that they comply with many international norms and treaties they appear to blatantly ignore in practice. Does the West really expect these governments to follow the code of conduct they agree to or to otherwise keep investing if it is too rigorous? Here, one need only again peruse the Santiago Principles.The voluntary code uses the term should 37 times, including a requirement that “there should be clear and publicly disclosed policies, rules, procedures, or arrangements in relation to the SWF’s general approach to funding, withdrawal, and spending operations.” 37 This may sound fine on paper, but in practice, the Western nations risk giving up much—recognizing the unique problems of these funds and more direct regulation of legitimate concerns—and gaining very little. In fact, it may create an excessive amount of false comfort.

  All this begs the question, though. What is the real problem that any code or proposed solution is addressing? Presumably, it is to track this foreign investment, monitor it, and implement safeguards to ensure that there is no inappropriate activity. If that is the case, a code of conduct, voluntary or otherwise, may not be necessary, at least in the United States. In the United States, we have the basic elements of such a system already in place. The keystone is CFIUS approval. CFIUS is the Committee on Foreign Investment in the United States, an inter-agency committee chaired by the Secretary of Treasury. It is charged with administering the Exon-Florio Amendment. This law grants the president authority to block or suspend a merger, acquisition, or takeover by a foreign entity if there is “credible evidence” that a “foreign interest exercising control might take action that threatens to impair the national security” and existing provisions of law do not provide “adequate and appropriate authority for the President to protect the national security in the matter before the President.”38 The president has delegated this review process to CFIUS.

  The statute was enacted in 1988 in response to the 1987 attempt by Fujitsu Ltd., a Japanese electronics company, to acquire Fairchild Semiconductor Corporation. Again, that was back in the 1980s, when fears of Japan ruled the day. Congress struck back at this menace by passing the Exon-Florio Amendment.39 In July 2007, Congress passed the National Security Foreign Investment Reform and Strengthened Transparency Act, known as FISA.40 FISA further enhanced the CFIUS review process and adds to the factors for national security review critical infrastructure and foreign government-controlled transactions. In either instance, CFIUS can initiate a mandatory review. Like the 1988 bill, this amendment was a response to perceived foreign investment threats.This time it was the acquisition of Peninsular & Oriental Steam by Dubai Ports and the ensuing political brawl and heavy congressional protest, which led to Dubai Ports terminating the U.S. component of its acquisition.

  The problem is that sovereign wealth funds weren’t on Congress’s horizon back in July 2007. The 2007 amendments dealt largely with the problem of foreign-controlled entities acquiring controlling stakes in U.S. companies. But the Exon-Florio review process applies to acquisitions of only “controlling” interests. Control is not defined, but it has generally been considered under the securities laws to be a 10 percent or more voting stake.This is generally why the round of sovereign wealth fund investment in 2007 and 2008 was designed to be under this threshold; the parties were attempting to avoid CFIUS review. In response, CFIUS promulgated new regulations in November 2008 to specify that even 10 percent or lower interests could trigger CFIUS review, depending on the way soft and hard control were exercised.41

  The CFIUS process, together with other foreign investment reporting requirements set up by the Department of Commerce, provides a skein that imposes only incremental regulatory burdens on sovereign wealth funds and investments by companies controlled by foreign governments.42 It is a scheme that creates the clearance, monitoring, and tracking function that a voluntary code would largely produce while not unduly infringing on the operation of these funds. This is a scheme, a monitoring one, that appears likely to be more effective than a voluntary code of conduct.

  The trick is in setting the correct level of review under the CFIUS process and ensuring that it does track and monitor these investments.

  A status quo solution seems particularly appropriate in light of the fact that sovereign wealth funds have yet to show any significant harm. In fact, their 2007 and 2008 investments have thus far subsidized U.S. companies significantly, as these funds overpaid for their investments. In a remarkable turn, in October 2008, the Treasury Department Deputy Secretary Robert Kimmitt actually toured the Middle East seeking further sovereign wealth fund investment to assist capital-deprived U.S. corporations.43 Kimmitt’s tour reflected the desperate U.S. need for this capital during the financial crisis.

  Moreover, to the extent that sovereign wealth funds do act on an overtly political basis, as the government of Kuwait did with Dow Chemical, they risk alienating the companies who would otherwise solicit them for investment. This will provide a modest, though not complete, check on their behavior. There are still troubling aspects to sovereign wealth funds, their lack of transparency being the most prominent. These problems, though, can be addressed through the data collection features provided under the CFIUS process and through the Department of Commerce. A voluntary code is gravy in these circumstances—certainly to be paid heed to and pushed for, but otherwise to be backed by a real regulatory process. In fact, the primary role of a voluntary code of conduct may be in forestalling backlash.Western political leaders can show their political constituency that they have some gains and forestall harsher, perhaps uneconomic legislation.44

  There is still the problem of soft power exercised by these funds. And management may favor this investment because sovereign wealth funds are typically passive investors. Sovereign fund investment may therefore be more acceptable to management in that it strengthens their power. A monitoring program as I described does not address this type of power, yet this has been the typical investment made by sovereign wealth funds during the financial crisis. However, as discussed in Chapter 7, these soft power issues are present with normal institutional investing and even more overtly political state pension plan investments. Thus, this problem may be unavoidable, perhaps mitigated by other institutional shareholder pressures by hedge funds and at this point best met with a firm monitoring process. As time progresses, it can then be ascertained if more restrictions on sovereign wealth funds are necessary. In particular, this monitoring process should fluctuate, depending upon the country and fund. It is questionable whether Norway’s sovereign wealth fund needs the same monitoring as China’s. In fact, as the commodity boom fades and the financial crisis depletes and distracts many sovereign wealth funds, the sovereign wealth fund problem is likely to transform into a Chinese problem to the extent that China keeps accumulating assets at the expense of the United States.

  In the meantime, it is important to take perspective and view this is a learning process for both sides. As these funds grow, we will undoubtedly receive more information on their conduct, goals, and even investing skill. We should actively seek
to do so. More aggressive steps do not appear either justified or apt to produce more than is needed or provide a structure that incentivizes these funds to invest appropriately in the United States. Reciprocally, sovereign wealth funds’ need to show measured returns will also force them to naturally evolve structures and policies to guide their burgeoning wealth outside codes of conduct. A firm monitoring and disclosure process in the United States and Europe should push this process in the right direction. In the future, as sovereign wealth fund investment grows and becomes more professional, the sovereign wealth issue will probably be encapsulated increasingly around the appropriateness of foreign investment generally.

  CFIUS and Foreign Investment

  The sovereign wealth fund controversy is the latest one arising from five years of sustained foreign investment. In 2007, non-U.S. buyers made $365.6 billion in U.S. acquisitions, accounting for 23 percent of all U.S. takeovers. Even in the down year of 2008, non-U.S. buyers made $289.1 billion in acquisitions, accounting for 29 percent of U.S. takeovers. These figures are a marked increase from the $73 billion in non-U.S. acquisitions in 2002.45 The list of prominent foreign U.S. acquisitions during this time is long, including InBev’s 2008 $52 billion hostile offer for Anheuser-Busch, Saudi Basic Industries Corporation’s 2007 $11.6 billion acquisition of GE Plastics, and Vivendi’s 2007 $9.8 billion acquisition of Activision.