Deloitte Touche Tohmatsu on Sovereign Wealth Funds

Deloitte Touche Tohmatsu has issued a new point of view (POV) on the Generally Accepted Principles and Practices (GAPP) for Sovereign Wealth Funds (SWFs), a set of voluntary principles agreed to by the International Working Group (IWG) of Sovereign Wealth Funds on 2 September 2008.

The 24 Principles, known informally as the "Santiago Principles" after the city in which the IWG drafted the final version of the GAPP, offer guidelines covering governance, accountability, transparency, and conduct of investments for SWFs. The 26 SWFs that make up the Principles include permanent observers from Oman, Saudi Arabia, Vietnam, the OECD, and the World Bank.

The Deloitte POV provides:
A brief history on the development of SWFs
A summary of the circumstances leading to the creation of the Principles
The text of the Principles
An initial assessment of their quality and potential impact.

The Santiago Principles mark a significant milestone in rationalizing the integration of SWFs into the global capital markets. A robust implementation of the GAPP should go far towards resolving questions about the transparency, accountability, and operations of SWFs. SWF adoption and implementation of the principles should also provide Deloitte member firms with significant opportunities to expand their relationships with existing or prospective clients in this sector.

Minding the GAPP (2720 KB) PDF download
Published 11 November 2008; 20 pages; A Financial Services guide.
http://www.deloitte.com/dtt/article/0,1002,cid%3D233332,00.html

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Sovereign Wealth Funds; Potential Strategic Tools for Regional Stability and Social Cohesion?

The opportunities for more cross-border GCC investments within the MENA region itself, as well as other emerging market regions, could be a good strategic response to the growing scrutiny over SWF investment in Western markets, says Alessandro Bruno.

The Case of the Middle East and the Growing Shiite-Sunni Rift

Investment Thesis:

True “sustainable” investment has at least three dimensions: economic, environmental, and social. With the conspicuous exception of Norway’s Government Pension Fund – Global, Sovereign Wealth Funds (SWFs) have paid relatively little attention to the latter two dimensions. We believe that the embrace of Sustainable Investment (SI) approaches by the SWFs, particularly those in the Persian Gulf region, could pay important economic, social, environmental and even political dividends.

More specifically, SWFs in the Persian Gulf region should consider making strategic, cross-border investments which are explicitly targeted at job-creation and economic and social development within the region. Historically, major SWF investments have tended to be either global or purely domestic. A third, mid-range category of SWF investments holds considerable promise: cross-border, intra-regional investments with a strong job-creation and social development focus.

Such investments could go a considerable distance towards mitigating the Sunni-Shiite conflict, thereby helping create a more stable and attractive investment climate in the region. This would not only benefit the overall investment programs of the SWFs themselves, but also those of Western investors. The latter impact would also have the collateral benefit of creating new reputation capital for the Gulf SWFs, and potentially mitigate some of the suspicion with which they are currently viewed by the West.

Background and Context:

Sovereign Wealth Funds have been one of the hottest topics in both financial and political circles since early 2007. While the definition of SWFs remains somewhat imprecise and even controversial, they are frequently defined as funds controlled by governments invested in international securities against which the government does not have any liabilities. This differentiates them from other government-controlled investment entities such as public pension funds.

Following the surge in the price of oil, most oil-rich countries, which are especially concentrated in the Middle East, have accrued significant amounts of foreign reserve surpluses. Consequently, the scale, risk appetite and impact of SWFs have all increased exponentially over the past few years. In the face of the credit crisis and the bail-out of several major western banks by SWFs, they have been praised especially by financial actors, as forces of financial stability and saviors for troubled banks. Among the Western financial institutions which received life-saving financial transfusions from SWFs in 2007 are: UBS, Citibank, Barclays, Merrill Lynch, and Morgan Stanley. Table 1 below summarizes the investable asset bases of four of the largest SWFs in the Gulf region:

At the same time, however, major multilateral institutions such as the OECD and the IMF, as well as the international investment community, have also shown increasing concern about the real or potential lack of independence of SWF operations from government policies, and the possibility of “politically motivated” investments by SWFs. The International Monetary Fund is currently drafting a code of conduct for SWFs (Generally Accepted Principles and Practices), which will primarily focus on the transparency and independence of their governance structures and behavior.

In this short Issue Brief for Innovest clients, we shall argue that, while “political” investments in the western capital markets might not be desired by the Western investment community and regulatory bodies, in other regions such as the Middle East, strategically-targeted, “political” cross-investments between countries can be a source of both political and economic stability in the region. This would actually benefit most of the stakeholders in those jurisdictions, as well as Western investors and corporates.

The Global Trend Towards Sustainable Investment

There is a powerful, worldwide trend among major institutional investors to incorporate “sustainability” or “ESG” (environmental, social, and governance) concerns – notably climate change – into their global investment strategies. Recent evidence indicates that, in addition to other less tangible benefits, risk-adjusted returns can also be improved by including sustainability factors.

By far the most far-reaching aspect of this trend has been its rapid recent growth beyond the narrow “socially responsible investment” niche into the mainstream investment world. Among the most recent examples of this “mainstreaming” phenomenon:

• Over 380 leading global financial institutions, with more than $55 trillion worth of managed assets, have formally expressed strong concern about climate change as an investment risk through the global Carbon Disclosure Project.

• Over 400 major institutional investors, with over $15 trillion in assets, have recently pledged formally to integrate sustainability considerations more directly into their investment strategies by publicly adopting the UN Principles for Responsible Investment.

• Over 20 institutions from seven countries, with over $2.4 trillion in combined assets, have already invested in investment research in this area through the Enhanced Analytics Initiative.

To date, however, with the conspicuous exception of Norway’s Government Pension Fund – Global, the world’s SWF’s have been conspicuous by their absence from participation in this global trend. This may be an ideal opportunity to change that.

The Potential Stabilizing Role of the GCC SWFs

The urgency of subduing the Shiite-Sunni quarrel at both regional and domestic levels is such that in Saudi Arabia, King Abdullah has risked his own legitimacy, challenging the dogmatic Wahabi clerics. The emerging sectarian struggle in an area holding most of the world’s known oil reserves is a grave geo-political and economic concern. However, as worthwhile as the interfaith dialogue recently launched by Saudi Arabia could be, it must also be buttressed by investment and economic growth.

Significant political and economic changes have recently swept across the Persian Gulf countries. The princes of the Gulf have taken small but symbolic steps to suggest that they are trying to earn greater legitimacy with their populations, including the election of women parliamentarians in Saudi Arabia and semi-democratic elections in Kuwait. The economic changes, particularly as far as capital markets are concerned, have been even more significant. Many Gulf countries and companies are now open to foreign investment. Saudi Arabia has embarked on a privatization process, and the smaller princedoms of the UAE and Bahrain have made attracting foreign investment one of their main priorities. Libya has also adopted market reforms easing foreign investment, opening up to trade and removing domestic barriers to resource allocation. This suggests that economic cross-connections driven by SWFs could be increasingly effective policy tools which could contribute to political stability and sustainable economic growth in such historically volatile regions.

Even at an oil price of “only” USD 70/barrel, the Gulf Cooperation Council states (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and UAE) can expect unprecedented revenue (into the trillions of dollars) over the next decade. This gives them extraordinary investment clout abroad. It also gives the GCC a powerful investment opportunity, which has a real chance to affect the very nature of the region’s economy and society, by promoting diversification away from oil, as well as social transformation through the employment and training of locals in a greater variety of industries. In other words, the GCC SWFs’ investment philosophy will have significant worldwide and regional repercussions.

While their domestic investment has focused largely on improving hard physical and industrial infrastructure, outbound foreign investment has concentrated on gaining a foothold in the world’s principal capital markets and targeted industries such as aerospace, real estate and high technology. The GCC sovereign funds have, however, paid less attention to emerging markets, particularly those that share their same language, customs, and culture in the Middle East and North Africa. One of the main problems afflicting the region, in spite of the various pockets of intense oil-derived wealth, is youth unemployment. Left unchecked, it remains the primary destabilizing element in the region, because of its vulnerability to ideological and potentially violent forms of social protest, which often take on religious hues in the MENA region. The tensions that linger from the Iraq war and the Lebanese political crisis, combined with the hegemonic challenge posed by Iran in the region, can only grow as destabilizing ingredients. Characteristically, governments remain the largest employers in the region. The GCC’s sovereign funds should not simply seek to replace the state in offering essential services; they should consider investing to help support emerging private sector companies, so as to reduce the employment burden on the state itself. Abu Dhabi is already using private capital to finance water and power projects, and the model could be exported and supported through SWF’s.

Sovereign funds may prove to be the ideal tool to catalyze a greater diversification of the region’s economy, based on private rather than public sector leadership, carrying with it the promise of an improvement of living standards for the entire population of the MENA region. The SWFs have at least five major advantages denied to virtually all other major institutional investors:

- Exponential growth rates

- An infinitely long investment horizon

- An extremely broad vested interest in the overall health of entire national economies and societies

- A lack of financial liabilities to offset their revenues

- A very short, efficient decision chain

These unique assets provide a unique set of capabilities which could and should, we believe, achieve much wider objectives and benefits than is currently the case.

Some Early Progress

One ambitious example of what we have in mind is Saudi Arabia’s planned USD 6 billion SWF to finance domestic projects designed to maximize employment and training in general, and youth employment in particular. This provides an excellent and recent example of a domestic initiative which could be replicated and scaled up on a regional basis. The opportunities for more cross-border GCC investments within the MENA region itself, as well as other emerging market regions, could be a good strategic response to the growing scrutiny over SWF investment in Western markets. The Western ambivalence and occasional antipathy towards sovereign funds in the GCC region militate in favor of more of this kind of “South-South” cooperation. Not surprisingly, Libya's USD 100 billion sovereign fund is primarily targeting investment in other emerging market areas such as Asia and South America. It should be encouraged to seek opportunities in the emerging markets of the Middle East as well.

Kuwait has already used its sovereign wealth fund to make a cross-border strategic investment in Syria. The Kuwait Investment Authority (KIA) has discussed launching a joint venture investment fund with the Syrian government to invest in Syria, which has continued to open its economy to foreign investment over the past decade despite the imposition of US sanctions. A Kuwaiti-Syrian holding already owns 10% of the Damascus Four Seasons hotel, which has been very profitable. In addition, in June 2008, it was also announced that Syria and Qatar set up a venture with share capital of $500 million to invest in property in Syria. The concrete prospects of peace with Israel are expected to boost market reforms in Syria even further.

Having historically been focused on either purely domestic or international investments, Gulf States now increasingly realize the investment opportunity to help develop the Muslim world, to overcome the sectarian rift, and to invest in the economic, social, and environmental infrastructure necessary for the region’s economic growth.

In the environmental sphere, Abu Dhabi’s USD 15 billion+ commitment to the ambitious MASDAR environmental technology initiative (including the creation of the world’s first carbon-neutral city) provides a compelling example of what can be accomplished with a “sustainability-enhanced” investment orientation. While MASDAR currently has a domestic focus, it could ultimately become an engine of technological development, employment, and forward-looking skills development for the entire region. On the social side of the sustainability ledger, in neighboring Dubai, investments improving the living standards of international workers could help minimize labor problems and bottlenecks which could otherwise threaten the emirate’s spectacular growth boom.

Conclusion

In the face of continued political crises in the Middle East, the GCC sovereign wealth funds and their oil revenues can play a significant political and economic stabilizing role in the region. We would advocate that the Gulf SWFs pursue three bottom lines (economic, environmental, and social) with their investment strategies, expanding their almost exclusive focus on only the first of the three. Such investments could decrease the overall investment risk profile of the region, and increase the scale and scope of the economic opportunities, for Gulf and Western investors alike.

Consequently, we believe that the attempts by western transnational institutions such as IMF and OECD to depoliticize the SWFs and to transform SWFs into pure economic players are not fully justified, and might deprive the investment community from the stabilizing roles that such funds could play in their own regions.

Any regulatory pressure on the SWFs by Western regulators and multilaterals, while attempting to depoliticize their investments in the international capital markets, should also permit or ideally encourage SWFs to make investments aimed at increased stability and long term economic, social and environmental progress in their home regions.

Alessandro Bruno is Research Analyst at Innovest Strategic Value Advisors.

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The 24 "Santiago Principles" - The International Working Group on Sovereign Wealth Funds

The International Working Group on Sovereign Wealth Funds has released its Generally Accepted Principles and Practices (GAPP), also known as the Santiago Principles.

At the Ministerial Meeting of the International Working Group of Sovereign Wealth Funds (IWG), held on October 11, 2008, Mr. Joaquín Almunia, European Commissioner for Economic and Monetary Affairs, made the following statement:

"Let me first congratulate the International Working Group of Sovereign Wealth Funds and the IMF for the major effort they have made to complete the Generally Agreed Principles and Practices (GAPP).

"When the IMFC and the G7 last April asked the IMF and the OECD respectively to prepare a set of best practices for SWFs and principles for recipient countries, it was difficult to imagine that so much would be accomplished in less than one year.

"The principles and practices of the GAPP amount to a global public good that can help foster trust and confidence between sovereign wealth funds, their originating countries, and the recipient countries. This is what we need in these turbulent times: a strong commitment to enhance mutual trust and maintain and preserve an open investment environment.

"The European Commission has pleaded from the very beginning for a cooperative and multilateral solution. In February 2008, the Commission issued a Communication on a common European approach to sovereign wealth funds. There we stated that: "Europe must remain committed to its tradition of openness to capital investments, as they are a vital source of strength for the European economies in a globalised world."

"There we made the case for engaging SWFs in a cooperative effort to enhance their governance standards and the quality of information they provide to markets in the mutual interest of both recipient and sponsor countries.

"I am very pleased to see that this approach is now generally accepted by both originating and recipient countries of the funds, and it is part of the cooperative philosophy that has produced the GAPP.

"I believe that reaching an agreement on a common European approach to sovereign wealth funds at an early stage was particularly important for the success of the process that produced the GAPP. In fact: (1) it pre-empted uncoordinated national actions by European countries with respect to sovereign wealth funds, and (2) it provided to originating countries the reassurance that they would continue to find in the EU a clear, predictable, and reliable legal environment for their investments, with the European Commission playing its full role in enforcing the European Treaty provisions on free movement of capital and openness.

"I think that the GAPP rewards all those of us who recognised from the beginning that sovereign wealth funds represent a major source of investment for recipient economies and that, as long-term investors, they will continue to bring benefits to global financial markets.

"Sovereign wealth funds, that today are a powerful class of investors in global finance, also needed to dispel concerns in recipient countries, through commitments towards higher transparency, better governance and greater accountability. All the more so given that the growth of SWFs is often the result of persistent imbalances in the global economy. Such imbalances need to be addressed with appropriate policy actions by originating countries of the sovereign wealth funds.

"I believe that by individually implementing the set of generally accepted principles and practices voluntarily agreed, and that are presented here today, SWFs will prove that they are responsible and reliable players in the global financial system.

"The European Union acknowledged from the start that the process of confidence building should not be one-sided and that recipient countries have also to take firm commitments. This is why we support the work of the OECD aimed at identifying best practice guidelines for recipient countries. Such work is in progress and we expect that it will provide greater predictability for sovereign fund investors and reassure that foreign investments are welcomed in our economies.

"With regard to the follow up, we strongly support the proposal contained in the GAPP to create a standing group of Sovereign Wealth Funds that would keep the GAPP under review, monitor its implementation, and continue the dialogue with recipient countries. I see the usefulness and importance of this group, in particular if it will continue to operate in a multilateral framework and provide a platform for a strengthened dialogue with recipient countries. The Commission remains committed to support the work of this standing group, and to facilitate the debate and continue to promote a common European approach."

In furtherance of the "Objective and Purpose", the IWG members either have implemented or intend to implement the following principles and practices, on a voluntary basis, each of which is subject to home country laws, regulations, requirements and obligations. This paragraph is an integral part of the GAPP.

• GAPP 1. Principle
  The legal framework for the SWF should be sound and support its effective operation and the achievement of its stated objective(s).
  • GAPP 1.1 Subprinciple The legal framework for the SWF should ensure the legal soundness of the SWF and its transactions.
  • GAPP 1.2 Subprinciple The key features of the SWF's legal basis and structure, as well as the legal relationship between the SWF and the other state bodies, should be publicly disclosed.
• GAPP 2. Principle
  The policy purpose of the SWF should be clearly defined and publicly disclosed.
• GAPP 3. Principle
  Where the SWF's activities have significant direct domestic macroeconomic implications, those activities should be closely coordinated with the domestic fiscal and monetary authorities, so as to ensure consistency with the overall macroeconomic policies.
• GAPP 4. Principle 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.
  • GAPP 4.1 Subprinciple The source of SWF funding should be publicly disclosed.
  • GAPP 4.2 Subprinciple The general approach to withdrawals from the SWF and spending on behalf of the government should be publicly disclosed.
• GAPP 5. Principle
  The relevant statistical data pertaining to the SWF should be reported on a timely basis to the owner, or as otherwise required, for inclusion where appropriate in macroeconomic data sets.
• GAPP 6. Principle
  The governance framework for the SWF should be sound and establish a clear and effective division of roles and responsibilities in order to facilitate accountability and operational independence in the management of the SWF to pursue its objectives.
• GAPP 7. Principle
  The owner should set the objectives of the SWF, appoint the members of its governing body(ies) in accordance with clearly defined procedures, and exercise oversight over the SWF's operations.
• GAPP 8. Principle
  The governing body(ies) should act in the best interests of the SWF, and have a clear mandate and adequate authority and competency to carry out its functions.
• GAPP 9. Principle
  The operational management of the SWF should implement the SWF’s strategies in an independent manner and in accordance with clearly defined responsibilities.
• GAPP 10. Principle
  The accountability framework for the SWF's operations should be clearly defined in the relevant legislation, charter, other constitutive documents, or management agreement.
• GAPP 11. Principle
  An annual report and accompanying financial statements on the SWF's operations and performance should be prepared in a timely fashion and in accordance with recognized international or national accounting standards in a consistent manner.
• GAPP 12. Principle
  The SWF's operations and financial statements should be audited annually in accordance with recognized international or national auditing standards in a consistent manner.
• GAPP 13. Principle
  Professional and ethical standards should be clearly defined and made known to the members of the SWF's governing body(ies), management, and staff.
• GAPP 14. Principle
  Dealing with third parties for the purpose of the SWF's operational management should be based on economic and financial grounds, and follow clear rules and procedures.
• GAPP 15. Principle
  SWF operations and activities in host countries should be conducted in compliance with all applicable regulatory and disclosure requirements of the countries in which they operate.
• GAPP 16. Principle
  The governance framework and objectives, as well as the manner in which the SWF's management is operationally independent from the owner, should be publicly disclosed.
• GAPP 17. Principle
  Relevant financial information regarding the SWF should be publicly disclosed to demonstrate its economic and financial orientation, so as to contribute to stability in international financial markets and enhance trust in recipient countries.
• GAPP 18. Principle
  The SWF's investment policy should be clear and consistent with its defined objectives, risk tolerance, and investment strategy, as set by the owner or the governing body(ies), and be based on sound portfolio management principles.
  • GAPP 18.1 Subprinciple The investment policy should guide the SWF's financial risk exposures and the possible use of leverage.
  • GAPP 18.2 Subprinciple The investment policy should address the extent to which internal and/or external investment managers are used, the range of their activities and authority, and the process by which they are selected and their performance monitored.
  • GAPP 18.3 Subprinciple A description of the investment policy of the SWF should be publicly disclosed.
• GAPP 19. Principle
  The SWF's investment decisions should aim to maximize risk-adjusted financial returns in a manner consistent with its investment policy, and based on economic and financial grounds.
  • GAPP 19.1 Subprinciple If investment decisions are subject to other than economic and financial considerations, these should be clearly set out in the investment policy and be publicly disclosed.
  • GAPP 19.2 Subprinciple The management of an SWF’s assets should be consistent with what is generally accepted as sound asset management principles.
• GAPP 20. Principle
  The SWF should not seek or take advantage of privileged information or inappropriate influence by the broader government in competing with private entities.
• GAPP 21. Principle
  SWFs view shareholder ownership rights as a fundamental element of their equity investments' value. If an SWF chooses to exercise its ownership rights, it should do so in a manner that is consistent with its investment policy and protects the financial value of its investments. The SWF should publicly disclose its general approach to voting securities of listed entities, including the key factors guiding its exercise of ownership rights.
• GAPP 22. Principle
  The SWF should have a framework that identifies, assesses, and manages the risks of its operations.
  • GAPP 22.1 Subprinciple The risk management framework should include reliable information and timely reporting systems, which should enable the adequate monitoring and management of relevant risks within acceptable parameters and levels, control and incentive mechanisms, codes of conduct, business continuity planning, and an independent audit function.
  • GAPP 22.2 Subprinciple The general approach to the SWF’s risk management framework should be publicly disclosed.
• GAPP 23. Principle
  The assets and investment performance (absolute and relative to benchmarks, if any) of the SWF should be measured and reported to the owner according to clearly defined principles or standards.
• GAPP 24. Principle
  A process of regular review of the implementation of the GAPP should be engaged in by or on behalf of the SWF.

October 12, 2008

http://www.iwg-swf.org/pr/swfpr0808.htm