WEEKEND READ: Sovereign fund heat shield

Sovereign wealth funds are attracting political heat. China's solution is to create additional, smaller branches in its fund and run them like normal hedge funds alongside international investment partners.

The China Investment Corp (CIC), China’s sovereign wealth fund, is considering expanding by creating additional branches and is seeking international private equity and hedge fund investment houses as potential partners for the fund.

Together, these announcements suggest that the new CIC branches will be established as joint venture investment funds with foreign firms, with each fund specialized in a certain type of financial instrument type (such as private equity or bonds) as opposed to a specific industry (such as minerals, gas, or automobiles). It remains unclear whether such CIC branches would be located inside or outside China, but they represent a push by Beijing to take some of the political controversy out of its foreign investment strategy.

Beijing wants to put political distance between itself and CIC’s investments. While no significant foreign acquisition bid by the fund has yet been rejected by foreign governments on the basis of national security or political considerations, protectionist cries are being raised against the way in which Middle Eastern and Asian sovereign wealth funds have been snapping up energy and banking stakes in Western companies. CIC already is starting to become an explicit political target for anti-China factions in Washington and elsewhere.

The only way China can fly under the radar is to run its branches the same way the United Arab Emirates does: as hedge funds and not as sovereign wealth funds. That means buying shares piecemeal and actively managing the money like a "normal” private fund, without any overarching commodity or industry theme. CIC would still be there in Beijing to handle the politically heftier items, such as major domestic deals or energy acquisitions requiring significant diplomatic leverage.

Setting up these hedge-fund-like joint ventures with the likes of Goldman Sachs or Morgan Stanley would help keep CIC’s investments under the radar politically. The move would institutionalize the CIC’s existing investment strategy – not making strategic purchases, not seeking board seats, and not trying to buy influence – and replicate it into multiple, relatively smaller, CIC-dedicated funds.

The overseas investment officers overseeing each potential joint venture would in essence be fund managers, buying specific numbers of shares here and there, instead of percentage stakes in any one specific company. The location of each CIC mini-fund would likely be determined by operational priorities; to manage a fund actively, one needs to be trading in the same time zone.

A raft of CIC-dedicated funds, led by outside foreign investment managers, could well give CIC’s investment projects the geographic and industry breadth it desires, but with a notably lower profile and less risk of foreign political controversy. With CIC’s capital diversified across multiple international joint ventures, grouped according to the type of financial instrument and not a specific type of commodity, anti-China factions in other countries will find it harder to link each CIC deal to a defined national security threat.

Foreign investment banks will doubtless welcome such a lucrative opportunity for a slice of the at least $US65 billion that CIC has to spend abroad, and for better access to China’s developing domestic capital markets.

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