This time last year protectionists were slating opaque sovereign wealth funds' designs on ‘strategic' infrastructure. Now the question is whether they can still woo these super-liquid investors into pricey property markets. Shayla Walmsley reports

When the chairman of China's sovereign wealth fund (SWF), Gao Xiqing, suggested earlier this year that it would invest in markets that were "happy with us", he presaged what was to become obvious months later when credit all but dried up.

The balance of power between SWF investors and recipient markets has fundamentally changed. The liquidity shift isn't the only change in sovereign wealth funds' investment in global real estate markets. Another is that the shareholdings are getting bigger. Up to now the unwritten rule has been that these funds' investments should be passive and below the radar.

The Qatari Investment Authority (QIA) has breached that rule with its acquisition in September of 20% of Chelsfield, a UK property group. QIA's recent acquisitions in the UK capital include a £600m (€750m) stake in the decommissioned Chelsea Barracks and a 20% interest in the Shard of Glass trophy building.

"Trophy assets don't fall much in value and they're often in prime locations," says Penny Hacking, a partner with property consultants King Sturge, citing the acquisition of the Wallis Building by St Martins, a London subsidiary of the Kuwaiti Investment Authority (KIA). "They've moved a bit - say, 50 basis points down in Europe - but there is a limited supply. Trophies are one-off opportunities."

QIA sees the investment in Chelsfield as a means to acquire assets. This points to another change in the way SWFs invest in real estate: a shift from direct acquisition to indirect investment - in this case via property equities but increasingly via funds. "The question is whether it will go into direct or indirect, and that will depend on the fund's investment strategy. Direct is still hard - there's a lack of product - so you'll see an increase in indirect," says Thomas Beyerle, research and strategy director at German fund manager DEGI.

China Investment Corporation, for example, is to invest at least half of the US$70bn (€55bn) it has earmarked for overseas investment through international fund management companies. Likewise, the US$380bn (€240bn) Norwegian Government Pension Fund - Global will invest its planned 5% property allocation via funds and property equities.

 "They'll look at funds of particular types - most likely unlisted funds, and they'll want to be significant but not majority shareholders in them, with around 20-40%," says Michael Haddock, director of investment research for EMEA at CBRE. He predicts that (relatively) larger funds will invest directly in the largest core world real estate markets, then fill the geographical and sector gaps with property funds. "They might buy office and retail in the UK, France and Germany, for example, then invest in a Nordic retail fund to fill a gap," he says. "The more mature the sovereign wealth fund, the more likely it is to behave like an institutional investor."

In contrast, smaller SWFs will look for more exposure worldwide, for example via a pan-European office fund.The obvious advantage of investing via funds is that it enables SWFs to spread the risk but without putting people on the ground. But the QIA-Chelsfield deal earlier this year overturned another rule - that SWFs' investments should be purely financial. In this case, QIA will gain two seats on the board, but the trend change isn't simply that SWFs are exchanging cash for clout.

Rather, they're using their investments in infrastructure and real estate to build capacity within their own economies. Drosten Fisher, a principal at the Monitor Group, a US-based research organisation, identifies recent diversification - albeit small in dollar amounts to date - into telecoms and aerospace.

Is it substantially different from pension schemes such as ABP using their investments in infrastructure funds to learn how it's done alongside the fund managers? Perhaps not - but that doesn't make it less of a change, and in this case it has a political component.
Another shift in SWFs' real estate investment approach is that they increasingly know their own strength, and it lies in multiples. In some cases, SWFs are working in aggregate - for instance via the US$2bn (€1.3bn) investment fund set up by the Abu Dhabi and Qatari SWFs. One of the explicit benefits of Abu Dhabi's Mubadala SWF's recent agreement to provide US$4bn in infrastructure finance for GE projects was energy technology transfer.

The GE deal follows an earlier one with the same firm aimed at developing regional infrastructure. But it's a partnership model exercised with outside partners able to aid their capacity-building efforts (or ease entry into new markets). This emphasis on joint ventures as a model for investment is designed to avoid political protectionism.

If some SWFs are investing more boldly, it's difficult to see that trend extending to public pension funds such as the €18.7bn Irish National Pension Reserve Fund or the Norwegian pension fund. Critics of the distinction between SWFs and public pension funds, such as the IMF's Juan Yermo, have been dismissive of pension funds' attempts to distance themselves from the label. Yet there may be a difference in investment approach, to judge by the Norwegian fund.

Despite earlier this year announcing that it would divert 5% of its equities portfolio into real estate, after years of wrangling the fund has still not received a mandate for diversification from the ministry of finance (such is the arm's length management that distinguishes public pension funds from SWFs, it seems) .

"Investment in real estate has been several years in the planning but when we'll get a mandate is hard to say," says fund spokesman Vidar Korsberg Dalsbø. "It'll be in the near future - perhaps even before the new year." Despite the planning, the fund has yet to form a team under Paul Golding, recruited last year to head the real estate initiative. It seems the fund wanted to get its strategy straight before appointing managers to implement it.

Relative caution isn't the only distinction emerging. "Sovereign wealth funds have different investment strategies. Some, like [Singapore SWF] GIC, behave like university pension endowments. Others, like QIA, behave like private equity funds," says Fisher.
Beyerle concurs, adding that it makes no sense to group together the investment styles and behaviour of GIC (which does not disclose its assets under management) with the [US$28bn] Alaska permanent fund.

If there has been a shift, it's attributable to the impact of the current financial crisis on large SWFs, such as GIC, which took a hit when their much-publicised equity stakes in banks began to look less judicious. "They've been set up to guarantee revenue streams," says Fisher. "It's a conservative function. They're not just looking to make as much money as they can."They've been keen for gold-standard investments - financial services and real estate - because these represented good value. But the perception of where good value comes from has changed, from financial services to real estate."

The shift isn't simply in favour of real estate away from perilous equities. It also suggests geographical diversification in search of lower volatility. The Monitor Group report suggests a shift away from opportunistic investment in the US and Europe in favour of emerging markets. Its Q2 analysis found these made up 68% of deals by value. BRIC and non-OECD transactions were worth US$15bn, and half of these were in real estate.
 
"If you look at deal volumes, [the increase in emerging market investment] shouldn't come as a surprise. The deals were smaller because deals in those markets tend to be," says Fisher. "Philosophically, you're better off looking at sovereign wealth funds at fund level. But, as a class, they tell you a lot about market sentiment."

Dubai International Capital (DIC) has already announced that it will invest US$5bn in India, China and Japan over a three-year period. QIA reportedly plans to increase its Asian investments to 40% of its overall portfolio. Building expertise within Asian markets will take time and effort - and probably partnerships or at least joint ventures. Ask pension funds - not least because, in many respects, SWFs appear to be emulating them. After all, they're both core buyers.

One difference in the investment trajectory of SWFs and pension funds is that with pension funds infrastructure tended to come after real estate, even as a subset of it. "In infrastructure you've seen increased construction costs and returns reduced," says Hacking. "With the recession, there isn't so much money going into infrastructure. There has been a change in pricing risk. The impetus for infrastructure investment was that property was quite expensive and investors wanted a higher return."

In other words, the trend is as much about timing as it is about markets throwing up the barricades. The fact that infrastructure is the political asset class par excellence may act as a significant deterrent but there are good reasons to think protectionism is only a minor factor in driving SWFs towards real estate and emerging markets. Omar Shaikh, executive board member of the UK's Islamic Finance Council, acknowledges that US protectionism - notably the 2006 blocking of DP World's planned US port acquisition - "went down very badly in the Gulf".

But he claims the issue of SWFs' transparency, cited either as a reason or an excuse for objections to the investment, "is last year's issue. Institutions seeking finance have got over it. Now it's ‘show me the money'," he says.Does the fact that SWFs have addressed the transparency issue mean that governments with a protectionist bent will take the money and keep their suspicions to themselves? In any case, says Fisher, protectionism has always been a specific affair - country investing and the country being invested in. "When the Singaporeans [GIC and Temasek] invest in OECD markets, they faced no criticism.

When they invested in Thai telecoms, they did. In the same way, Gulf funds will face criticism in the US but not in India or China," he says. Although alternate protectionist and free-market statements from the French and German governments might make SWFs hesitate, Haddock claims European markets are already highly international and largely outside state control. Even in Australia, investors still have to ask regulators for permission for foreign ownership but it's only a formality. "The internationalisation of ownership is already well developed," he says.

None of this has stopped global institutions encouraging SWFs to adopt credible disclosure practices and good governance. In return for designating SWFs "reliable, long-term, commercially-driven investors and a force for global financial stability" in its guidance for recipient countries, the IMF's international SWF working group in October agreed the 24 Santiago Principles aimed at greater transparency.

Kathryn Gordon, a senior economist in the OECD's investment division, implies that the real achievement was to have struck any agreement at all. "The group included China, Qatar and Botswana. They come from very different positions to, for example, the US or the UK. There are policy environments on both sides [SWFs and recipient countries], and the agreement will make it possible for both sides to work towards a common understanding."

Despite the involvement of SWFs as different as those from Abu Dhabi and Equatorial Guinea, there are no penalties for non-signatories - "although the principles also include the concept of regular public accountability", points out IMF spokesman William Murray.
Gordon acknowledges that the principles won't be enough to eradicate protectionism. "With the financial crisis, the temptation to be protectionist may well be reduced.

The political demand for protectionist measures is strong but the crisis will have an impact. OECD recipient countries would be making a mistake to start sounding protectionist now. Protectionism may be keeping a low profile right now, but in future it will raise its ugly head." Yet there's nothing quite like a shortage of cash to endear liquid, opaque investors to their former critics, and to encourage quasi-protectionist governments to fling open their strategic assets and invite in all comers.

"Sovereign wealth funds are not Jesus Christ coming to rescue the world, though it could be the case that they rescue some investors," says Beyerle. "They're here and they make the market happy. For us, they're competitors. There's always a reflection in what the market price will be, and it will be a
stabilising impact."