UV1059

Oct. 15, 2008

THE CASE OF SOVEREIGN WEALTH FUNDS:

A NEW (OLD) FORCE IN THE CAPITAL MARKETS

On the morning of January 15, 2008, Merrill Lynch announced that it would assuage
more of its subprime woes with a $6.6 billion capital injection by the Kuwait Investment
Authority (KIA), the Korean Investment Corporation, and Mizuho Corporate Bank.1 Not entirely
new to the sovereign wealth fund (SWF) phenomenon, John Thain (Merrill Lynch’s CEO) had
announced a $5 billion capital boost from Singapore’s Temasek Holdings—one of Singapore’s
two sovereign wealth funds, just a few months before.2

Thain had been lured away from the New York Stock Exchange to shake things up at one
of Wall Street’s stalwart investment banks, and he was in the business of doing just that. Only a
few years earlier, no one had heard of SWFs, and now Wall Street was quickly turning abroad
for help in solving the American-initiated credit crunch. Along with Citigroup, Merrill Lynch
was leading the way in the search for significant wealth from beyond U.S. borders (Figure 1).

1
The Canadian Press, “3 Foreign Funds to Invest a Combined $6.6 Billion in Merrill Lynch,” January 15, 2008.
2
“3 Foreign Funds.”.

This case was prepared from public documents by Rachel Loeffler under the supervision of Professor Yiorgos
Allayannis. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of
an administrative situation. Copyright  2008 by the University of Virginia Darden School Foundation,
Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com.
No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in
any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission
of the Darden School Foundation.

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Figure 1. Recent investments in major financial services firms by sovereign wealth funds.

Investment
Company Investor %Stake Value (US$ Security Type
millions)
Citigroup Abu Dhabi Investment Authority 4.9 $7,500 New Convertible Units
Citigroup Government of Singapore Inv. Corp 3.7 $6,880 New Convertible Units
Citigroup Kuwait Investment Authority 1.6 $3,000 New Convertible Units
Merrill Lynch Kuwait Investment Authority 3 $2,000 New Convertible Units
Merrill Lynch Korean Investment Authority 3 $2,000 New Convertible Units
Merrill Lynch Temasek Holdings 9.4 $4,400 New Convertible Units
Morgan Stanley China Investment Corp. 9.9 $5,000 New Convertible Units
Barclays PLC Temasek Holdings 1.8 $2,005 Common Stock
Credit Suisse Qatar Investment Authority 1 $603 Common Stock
UBS Government of Singapore Investment Corp. 9.8 $9,750 New Convertible Units
UBS Saudi Arabian Monetary Agency 2 $1,800 New Convertible Units

Total Cash Infusions from SWFs $44,938

Source: Sovereign Wealth Fund Institute

The question for Thain on January 15, 2008, was whether the deal was a good one. On
the positive side, the over $12 billion total3 capital infusion would certainly make Merrill Lynch
stronger from a balance-sheet perspective. The Merrill Lynch brand, moreover, could capitalize
on its association with these high-profile foreign investors in its business endeavors abroad.
Asian and Middle Eastern investors would now be familiar with Merrill Lynch as it extended its
global reach. But Thain must have heard chatter around town about the possibility of overdoing
it when it came to raising capital through SWFs. Given that they were owned by foreign
governments, were these funds the right kind of investors, and did their interest dilute Merrill
Lynch’s ability to control its own future? In this deal, no mention was made about any request or
demand for board seats, and thus far in SWFs’ investments in U.S. financial institutions, none
had been granted. Ultimately, the market response would speak louder than any list of pros and
cons. As the mid-January day unfolded, Thain would slowly but surely realize the impact of this
decision.4

3
The figure varies according to different press statements. This includes $6.6 billion from Korean Investment
Corporation, KIA, and Mizuho Corporate Bank; $5 billion from Temasek Holdings; and $1.2 billion from Davis
Selected Advisers. Source: “3 Foreign Funds.”
4
A recent academic paper by Fotak, Bortolotti, and Megginson (2008) entitled “The Financial Impact of
Sovereign Wealth Fund Investments in Listed Companies,” (working paper, University of Oklahoma, June 19,
2008) examined the stock-market reaction upon announcement of 75 SWF acquisitions on equity stakes in publicly-
traded firms from around the world, and found a positive and significant mean abnormal return (of about 1% in size)
upon announcement of the investment. But after examining longer investment windows (from 30 days up to 2
years), the authors consistently found a negative mean abnormal-return (reaching a compound -41%, approximately,
for a two-year window), suggesting that the reverse is true when looking into longer horizons.

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Sovereign Wealth Funds: A New (Old) Force

SWFs had been a feature of global capital markets for decades, starting with the Kuwait
Investment Authority—originally the Kuwait Investment Board—in the mid 1950s.5 Since that
time, various SWFs emerged on the global scene from the Middle East, Asia, Africa, and Latin
America (Figures 2 and 3). According to Deutsche Bank research, SWFs were “financial
vehicles owned by states which hold, manage or administer public funds and invest them in a
wider range of assets of various kinds.”6 These sources of sovereign wealth came primarily from
the sale of oil, gas, or other natural resources. Most SWFs, in fact, were located in oil-producing
countries (e.g., Kuwait, Qatar, the United Arab Emirates, Saudi Arabia, Russia, and Venezuela).
Others were based on the sale of copper, diamonds, or minerals (e.g., Chile, Botswana, and
Kiribati).7 Still others, such as China, chose to dedicate central bank reserves (funded by large
export revenues) to sovereign wealth.8

Figure 2. Size of large SWFs.

Source: Lyons (2007)9

5
Steffen Kern, “Sovereign Wealth Funds—State Investments on the Rise,” Deutsche Bank Research,
September 10, 2007, http://www.dbresearch.de/PROD/DBR_INTERNET_DE-PROD/PROD0000000000215270
.pdf (accessed September 30, 2008).
6
Kern.
7
Kern.
8
Kern.
9
Gerald Lyons, “State Capitalism: The Rise of Sovereign Wealth Funds,” testimony before the Senate
Committee on Banking, Housing, and Urban Affairs, November 14, 2007.

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Figure 3. Launch dates of major SWFs.

Sovereign Fund Name Date of Launch

UAE-ADIA 1976
Norway 1990
Singapore-GIC 1981
Kuwait 1953
China-CIC 2007
Russia 2004
Singapore-Temasek 1974
Qatar 2005
Algeria 2000
US-Alaska 1976
Libya 2007
Brunei 1983
Malaysia 1993
Korea 2005
Source: Lyons (2007)

Not to be confused with state-owned enterprises (SOEs) or public pension funds, SWFs
were funded by export wealth or commodity (commonly oil) receipts, were entirely government-
owned and controlled, and had varying degrees of disclosure. State-owned enterprises, however,
were usually primarily government-owned or controlled and derived their funds from
government or corporate earnings. Public pension funds, by contrast, were owned by the pension
members themselves, derived funds from member contributions, and were transparent
investment vehicles (see Figure 4).10

Figure 4. Comparison of SWFs with other state firms/investment vehicles.

Sovereign Wealth Fund State-Owned Enterprise Public Pension Fund

Asset Ownership Government Primarily government Pension members
Primary Purpose Varied Varied Fund defined benefit
obligations
Funding Source Commodity/noncommodity Government/corporate Pension contributions
earnings
Government Control Total Significant Insignificant
Disclosure Varied Varied Transparent
Investor Class Growth High Steady Steady
Source: SWF Institute.

SWFs all shared the boon of excess wealth. But their commonalities essentially stopped
there. While they all stood atop abundant amounts of capital, the strategies with which they
allocated that capital and the kinds of people making investment decisions varied significantly
among these funds. Traditionally, SWFs had taken a long-term, passive approach to investing,
which is why, perhaps, they had not yet received widespread public attention. Recently,
10
Sovereign Wealth Fund Institute, http://www.swfinstitute.org/research/investmentvehicles.php (accessed 11
September 2008).

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however, SWFs had taken a more active investment approach by co-investing in M&A deals, as
illustrated by Barclays’ Temasek-China Development Bank bid for ABN AMRO.11 Furthermore,
some SWFs endeavored to maximize returns while others appeared attracted to investments in
brand names. SWF managers likewise could not be described in broad strokes—there were
varying degrees of sophistication in their investment styles.12

Like any deal-hungry investor, SWFs were increasingly concerned that they would be
excluded from potentially profitable deals. To diversify their holdings and gain access to the best
asset opportunities, they had begun to commit money to investment vehicles, such as private
equity. In June 2007, the China Investment Corporation (CIC) purchased a 10% stake in the U.S.
private-equity firm, Blackstone, for $3 billion.13 Some circles viewed this move as a different
way to invest in otherwise off-limits strategic assets (such as ports or other type of
infrastructure). This alternative, however, did not provide any meaningful control over the
aforementioned assets. Others debated this view and saw it as a sign of changing times.

The Issue of Transparency

While SWF capital had served to cushion the fall for many American banks during the
subprime-mortgage crisis, not all SWF investment was greeted so warmly. At issue with SWF
funds was primarily the question of transparency. While Norway’s and Singapore’s SWFs were
considered some of the most transparent SWFs in the world, not all of these funds stated their
objectives clearly, publicized information about returns, or revealed exactly who the people
behind their investment curtains were.

The lack of transparency raised serious concerns when it came to matters of so-called
strategic assets. In early 2006, Dubai Ports World (DP World), owned by Dubai, took over six
marine terminal concessions on the Atlantic and Gulf coasts of the United States as well as a
passenger-terminal facility in New York City when it acquired Britain’s Peninsular and Oriental
Steam Navigation Company. Although this transaction successfully passed a screening by the

11
On July 23, 2007, Barclays increased its offer for ABN AMRO to (euros) EUR67.5 billion after securing a
direct cash infusion from China Development Bank and Temasek Holdings of Singapore (Julia Werdigier, Joseph
Kahn, International Herald Tribune, “Barclays raises bid to €67.5 billion for ABN AMRO with Asian Help,” July
23, 2007). China Development Bank and Temasek agreed to buy a combined EUR3.6 billion or (U.S. dollars)
USD4.9 billion, worth of new Barclays shares and pledged to invest a further EUR9.8 billion if the bid by Barclays
for ABN AMRO succeeds. “Barclays said [Monday] that the deal with China Development Bank would give it
“unprecedented access” to the Chinese market and Chinese companies as they do business around the world.” China
Development Bank, which was created in 1994 to help finance Beijing’s top development priorities, has provided
backing for multi-billion infrastructure projects like the Three Gorges Dam, … and major ports and airports. The
bank may see benefits from allying with Barclays as it expands its lending in developing countries, especially
Africa, where Barclays has a major presence… Despite China Development Bank’s mission to carry out state
directives, on paper it is one of the country’s healthiest banks, according to Fitch Ratings…..”
12
SWFs seemed to acquire a large stake in the firms that they were investing in (about 13.9% on average in the
sample of Fotak, Bortolotti, and Megginson [2008]), but surprisingly, about one-third of SWF investments occurred
within their own country (and in total, investments were directed among 23 countries).
13
Asiamoney, “Investments—World grows more wary of sovereign wealth funds,” November 28, 2007.

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Committee on Foreign Investment in the United States—a governmental process specifically

designed to assess possible risks associated with foreign investments—it caused uproar in
Congress and ultimately caused the deal to fall through. Although DP World was not an SWF,
the process raised red flags about the prospect of strategic assets falling into the hands of
foreigners.

Since that time, the U.S. Department of the Treasury worked both to assure the world,
and especially the nations of large sovereign wealth, that its borders remained open to
investment. With that invitation, however, came the price of transparency. In March 2008, the
Treasury Department worked with the governments and SWFs of Abu Dhabi and Singapore to
draft principles of SWF investment. See Figures 5 and 6 for those principles.14

Figure 5: Policy principles for sovereign wealth funds (SWFs)

1. SWF investment decisions should be based solely on commercial grounds, rather than to advance, directly or
indirectly, the geopolitical goals of the controlling government. SWFs should make this statement formally as part
of their basic investment management policies.
2. Greater information disclosure by SWFs, in areas such as purpose, investment objectives, institutional
arrangements, and financial information—particularly asset allocation, benchmarks, and rates of return over
appropriate historical periods—can help reduce uncertainty in financial markets and build trust in recipient
countries.
3. SWFs should have in place strong governance structures, internal controls, and operational and risk management
systems.
4. SWFs and the private sector should compete fairly.
5. SWFs should respect host-country rules by complying with all applicable regulatory and disclosure requirements
of the countries in which they invest.

Figure 6. Policy principles for countries receiving SWF investment.

1. Countries receiving SWF investment should not erect protectionist barriers to portfolio or foreign direct
investment.
2. Recipient countries should ensure predictable investment frameworks. Inward investment rules should be
publicly available, clearly articulated, predictable, and supported by strong and consistent rule of law.
3. Recipient countries should not discriminate among investors. Inward investment policies should treat like-
situated investors equally.
4. Recipient countries should respect investor decisions by being as unintrusive as possible, rather than seeking to
direct SWF investment. Any restrictions imposed on investments for national security reasons should be
proportional to genuine national security risks raised by the transaction.

14
U.S. Department of the Treasury Press Release hp-881, “Treasury Reaches Agreement on Principles for
Sovereign Wealth Fund Investment with Singapore and Abu Dhabi,” March 20, 2008.

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The lack of transparency among the majority of SWFs was depicted by the Linaburg-
Maduel Transparency Index (Figure 7)15 Many SWFs lacked transparency on financials,
investment objectives, and guidelines on ethical standards, investment policies, etc.

Figure 7. Linaburg-Maduell Transparency Index (funds over $100 billion AUM).

SWF Country L-M Transparency Index

Norway 10
Hong Kong 7
Singapore-Temasek 7
Singapore-GIC 6
Kuwait 6
Russia-Oil Stabilization Fund 5
Saudi Arabia 4
UAE-ADIA 3
China-SAFE 2
China-GIC 2
Source: SWF Institute.

Figure 8. Linaburg-Maduell Transparency Index determination.

Point Principles of the Linaburg-Maduell Transparency Index

+1 Fund provides history including reason for creation, origins of wealth, and government ownership structure
+1 Fund provides up-to-date independently audited annual reports
+1 Fund provides ownership percentage of company holdings, and geographic locations of holdings
+1 Fund provides total portfolio market value, returns, and management compensation
+1 Fund provides guidelines in reference to ethical standards, investment policies, and enforcer of guidelines
+1 Fund provides clear strategies and objectives
+1 If applicable, the fund clearly indentifies subsidiaries and contact information
+1 If applicable, the fund identifies external managers
+1 Fund manages its own web site
+1 Fund provides main office location address and contact information such as telephone and fax
Source: SWF Institute.

The Deal

On January 15, 2008, Merrill Lynch issued $6.6 billion in mandatory convertible-
preferred stock in private placements, primarily to Mizuho Corporate Bank and Korean
Investment Corporation. They would be passive investors with no rights of control or any role in
governance. The convertible-preferred stock included a 9% dividend per year, a conversion
premium of 17%, a reference stock price of $52.40, maturity of 2.75 years, a one-year lock-up
15
“This index is based off ten essential principles that depict sovereign wealth fund transparency to the public.
The principles shown on Table 8 each add one point of transparency to the index rating. The index is an ongoing
project of the Sovereign Wealth Fund Institute. The minimum rating a fund can receive is a 1, however, the
Sovereign Wealth Fund Institute recommends a minimum rating of 8 in order to claim adequate transparency.”
(SWF Institute. http://www.swfinstitute.org/research/transparencyindex.php)

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and a 2-year standstill that included a prohibition on acquisitions of additional voting securities
that would give an investor more than 9.9% of Merrill Lynch’s outstanding shares.16 The terms
are laid out in detail in Figure 9.17

Figure 9. Terms of the deal.

Security Non Voting Mandatory Convertible Non-Cumulative

Preferred Stock, Series 1
Issuer Merrill Lynch &Co., Inc. or the “Company”
Dividend 9% per annum
Reference Stock Price $52.40 (equal to the 3-day average closing price per
share of the Company’s common stock ending on
Friday, January 11, 2008).
Conversion Premium 17%
Maturity 2.75 years
Liquidation Preference $100,000 per share

Mandatory Conversion at Maturity (Shares per Security) If the Company’s share price is below 100% of the
Reference Stock Price (the “Minimum Conversion Price,”) the Liquidation Preference divided by the Minimum
Conversion Price.
If the Company’s share price is above 117% of the Reference Stock Price (the “Maximum Conversion Price”), the
Liquidation Preference divided by the Maximum Conversion Price.
If the Company’s share price is between the Minimum Conversion Price and the Maximum Conversion Price, the
Liquidation Preference divided by the Company’s share price.
Lock-Up Investors are not permitted to sell, transfer or hedge, directly or indirectly, their preferred stock (or
underlying common stock) at any time during the one-year period following the closing.
Standstill Customary two-year standstill that includes, among other things, a prohibition on (i) acquisitions of
additional voting securities (or securities convertible into voting securities) that would cause an investor to own
more than 9.9% of the Company’s outstanding common stock (or securities convertible into common stock), (ii)
proposals to acquire the Company or (iii) otherwise seeking to influence or control the Company.
Price “Reset” Subject to certain conditions and exceptions, if the Company sells or agrees to sell more than $1
billion of any common stock (or equity securities convertible into common stock) within one year of closing at a
purchase, conversion or reference price per share less than $52.40, then the conversion ratio for the preferred stock
shall be adjusted to compensate the investor on a “full-ratchet” basis.
Preemptive Rights Subject to certain conditions and exceptions, if the Company offers to sell common stock (or
securities convertible into common stock) in a public or private offering, each investor shall have the right to acquire
from the Company, for the same price and on the same terms as such securities are offered, in the aggregate up to
the amount of such securities required to enable the investor to maintain its then-current ownership interest in the
Company’s common stock. The investors do not have these preemptive rights until the aggregate gross proceeds of
such offerings by the Company exceeds $1 billion.
Each investor’s preemptive rights terminate upon the earlier of: (i) the conversion of the investor’s preferred stock
into common stock, and (ii) such time as the investor no longer owns at least 75% of the preferred stock it
purchased, including as a result of hedging transactions.
Registration Customary registration rights.
Antidilution Customary antidilution protection.

16
AFX International Focus, “Merrill Lynch issues $6.6bn in convertible preferred stock to private investors,”
1/15/2008.
17
FT.COM “Statement in Full from Merrill Lynch,” 1/15/08.

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The Future

This was no doubt a very tumultuous period in the history of financial services firms. The
subprime-mortgage crisis and the resultant credit crunch led to severe losses and a major need
for commercial and investment banks alike to replenish their capital. SWFs were front and center
in this recapitalization, providing valuable capital in a time of need. Some argued that this was a
great time for SWFs to come in and provide capital given that it was almost certain one could get
a good deal. Others argued that the worst was not over and that there was some risk of additional
shareholder dilution and losses. There was still more to be learned from this crisis; people argued
that it had not unfolded completely and the housing and potential consumer-credit problems had
yet to play out in the markets. In such times, there were also commentators and regulators who
were not completely fond of money flowing in through SWFs. And the issue of transparency was
looming large. In this environment, Merrill Lynch’s John Thain was not in a very different
situation than some of his colleagues in other banks, but he still had to think of how to navigate
these turbulent waters and prepare the company for growth. SWFs were very important in this
process and very few on Wall Street could doubt that. Some were arguing that the 9% dividend
yield offered by Merrill in this deal was quite rich, especially when comparing it with an average
five-year dividend yield on common stock of about 1.4%. But was this a reasonable comparison?

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