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State capitalism

Sovereign wealth funds are becoming major forces in the global investment market thanks to surging oil revenues and swollen currency reserves. These national funds are set to have a big impact on private equity real estate. By Dave Keating

As bidding battles go, the fight for UK supermarket giant J. Sainsbury's has been one of the more interesting spectator sports in finance this year.

First the publicly traded company rejected a bid of £5.82 per share from a CVC Capital Partners-led group of private equity investors in April. But when Blackstone, Kohlberg Kravis Roberts and TPG pulled out of the consortium, CVC abandoned its bid. A rush of share-swapping ensued, and soon a relatively unknown firm emerged from the shadows to accumulate a 25 percent stake in the company, and this summer it made a £6.10 per share offer, valuing the company at a whopping £12 billion.

That bidder was Three Delta, an affiliate of the Qatar Investment Authority, a sovereign wealth fund run by the government of Qatar and established just two years ago. Three Delta, led by UK national Paul Taylor, was able to muster up an offer five percent higher than that of four of the world's biggest private equity firms – no small feat. The acquisition of the UK grocer, would hand over an £8.6 billion real estate portfolio to Qatar. The deal is just one of the latest high-profile real estate–backed acquisitions by a state-controlled wealth fund, and it has brought new attention to the growing power of these vehicles.

“Many large pools of capital are less interested in investing into a fund and more interested in doing direct investments. [Some will] put a token amount into a fund, in order to be able to invest side by side in deals and cherry pick. A GP has to be careful and sensitive to that.”

Certainly, direct and indirect investments in real estate by state-sponsored funds is nothing new. But the size and scope of the most recent activity of these funds in alternative investments, including real estate, has raised their profiles in these asset classes. A newly launched $200 billion Chinese government fund recently paid $3 billion for a minority stake in Blackstone's management company, raising more than a few eyebrows throughout the industry. In September, The Carlyle Group agreed to sell a 7.5 percent stake of itself to Mubadala Development Company, an Abu Dhabi government investment arm, for $1.3 billion, with Abu Dhabi contributing an additional $500 million to Carlyle's private equity funds. Apollo Management is now reportedly in talks with the Abu Dhabi Investment Authority to sell a 10 percent stake of the firm's management company for $1.5 billion. All these firms have significant private equity real estate platforms, and these are expected to grow further as sovereign wealth is put to work.

Sovereign partners
According to a recent report by Morgan Stanley, sovereign wealth funds today control as much as $2.9 trillion, which is a trillion more than the global hedge fund industry. The report estimates that this number could grow to $12 trillion by 2015, making these funds the largest pool of global investment capital. This growth has been accompanied by a marked increase in investment. Sovereign wealth funds are estimated to have invested $26 billion in financials in the past six months alone.

“These funds were originally set up as buffer for economies in surplus, and as surplus has built up over time they are keen to invest the excess surplus,” says Morgan Stanley analyst Hubert Lam. “Now they're diversifying their assets out of traditional liquid US treasuries and looking more toward private equity, real estate and equities.”

This increase in large-scale investment activity hasn't come just from the most established sovereign funds such as the Government of Singapore Investment Corporation (GIC), the Abu Dhabi Investment Authority (ADIA), the Kuwait Investment Authority and Norway's Global Government Pension Fund. There has also been an increasing number of new entrants with vast amounts of cash to invest.

“There's been an awful lot of money available to managers like me,” Jonathan Short, executive chairman of London-based Internos Investors, and former chief executive of Pramerica Real Estate Investors, recently said on a panel in Munich. “In the Middle East, at $80 a barrel, there is money coming out of Bahrain, Qatar, places that weren't on the map when you originally went to the Middle East in 2000 or 2002, when you saw three or four institutions.”

Given that real estate is considered a relatively safe investment, it is no wonder that these sophisticated and cautious investors have looked to enter real estate funds. “Sovereign funds are major indirect investors in real estate funds, as indirect funding presents easy and more diversified exit options,” says Ernst & Young analyst Mohammed Dahmash. “They diversify their portfolio in emerging as well as mature real estate markets globally.”

Overall there are today about 20 countries that take an active approach to investing their foreign reserves, including funds controlled by Russia ($128 billion), Brunei ($30 billion), Korea ($20 billion), Venezuela ($18 billion) and Kazakhstan ($14.9 billion). But the biggest funds are the oil-producing countries and the East Asian trading economies. Placement agent Mounir Guen of MVision says that the appeal of these established sovereign funds comes not just from their vast amounts of capital, but also from their expertise in their home regions.

“Usually these sovereign wealth funds come out of markets that are emerging,” Guen says. “As GPs are growing, they're becoming more global and growing their businesses, and they'll find additional value in having investors that have knowledge of their country and region. Singapore is a classic example. GIC is a fantastic value-add for GPs, allowing insight into the Asian marketplace and links with their partners.”

This relationship works the other way around as well. By taking minority stakes in private equity funds, these countries can gain insight into the industry, which will better prepare them for the direct investments they are increasingly making on their own. “Part of the reason why they invest in these [funds] is that they gain knowledge transfer and insight,” says Morgan Stanley's Lam.

“Many large pools of capital are less interested in investing into a fund and more interested in doing direct investments,” agrees placement agent Paul Denning of Denning & Company. “[Some will] put a token amount into a fund, in order to be able to invest side by side in deals and cherry pick. A GP has to be careful and sensitive to that.”

Getting direct
Besides taking minority stakes in private equity funds investing in real estate, sovereign wealth funds are increasingly becoming direct buyers of real estate-rich assets themselves. Such recent deals have included Dubai-owned private equity firm Istithmar purchasing high-end New York retailer Barneys for $942 million in August; Qatar-owned Three Delta purchasing UK healthcare group Four Seasons Healthcare for £1.4 billion last September; to GIC Real Estate's purchase of Munich's tallest office building in a €300 million deal last year. These funds are also starting to do development deals. Bahrain-owned Arcapita, formerly known as First Islamic Investment Bank, formed a vehicle in September to construct 1,500 mid-income apartments in Poland for $407 million.

The appetite for foreign real estate acquisitions by sovereign wealth funds is only growing. The Norwegian Government Pension Fund, which previously had not invested directly in foreign property, has proposed adding a ten percent real estate allocation to the fund's remit as well as a five percent allocation to private equity. The Norwegian parliament will vote on that change next month. And as these funds raise their real estate allocations, the global credit crunch can only help them as they compete with private equity funds for the best deals.

“Sovereign wealth funds are less prone to the credit crunch because they don't have to borrow money from banks, unlike private equity companies,” says Lam. “They have a competitive advantage over private equity, given that credit markets are tighter.”

In addition, sovereign funds don't have standard shareholders or LPs to report back to like private equity funds do, meaning they can take an even more long-term approach and be less affected by price concerns.

One area that is receiving increasing speculation as a potential target for these funds is the US commercial property market. The concurrent devaluing of US real estate and the rise of sovereign funds may create the perfect storm for such acquisitions, according to analysts. Thus far, the US real estate bubble has discouraged such investment, but with domestic dealmaking drying up, a weak dollar and property prices forecast to drop by 10 percent to 15 percent in the next year, these cash-rich funds could swoop in and acquire US property assets using little or no leverage.

“Sovereign funds view real estate as a medium- to long-term investment that offers good hedge against currency depreciation with potential for upside when markets recover.”

“Due to excess liquidity, it's believed sovereign funds will capitalize on the opportunity and will make significant [real estate] acquisitions,” says Dahmash. “Sovereign funds view real estate as a medium- to long-term investment that offers good hedge against currency depreciation with potential for upside when markets recover.”

Ports vs. real estate
The increase in sovereign fund activity has not been without controversy. Western critics have cited dangers to national security as a result of foreign government-tied funds taking stakes in sensitive industries. The general lack of transparency across sovereign wealth funds has not helped in this regard, nor has the lack of reciprocity, perceived or real, in trade relations, as these countries themselves place restrictions on foreign investment. Last month the US government called for new guidelines demanding better disclosure by sovereign wealth funds and giving governments greater ability to scrutinize their activities. A report issued last month by Standard Chartered had dire predictions for the political hurdles that await these funds, noting a “serious likelihood of Western governments and sovereign wealth funds clashing over what they can buy and where.”

A preview of these predicted clashes was seen last year when US authorities blocked an attempt to acquire a company managing US ports by DP World, a United Arab Emirates-linked company.

But would real estate acquisitions raise the same political concerns as ports of entry to the US? While the argument could be made that infrastructure assets, defense firms or technology companies falling into foreign hands might pose such a risk, property doesn't seem to be nearly as dangerous. “You're not going to find as much political sensitivity with real estate,” says Guen. “There will always be some governmental views around infrastructure or technology, but if you're buying a shopping mall in Miami, it would be hard to say that will pose a national security risk.”

Still, many have made the comparison between the likely upcoming sovereign fund property buys and the Japanese binge in US property in the 1980s. At that time, foreign real estate acquisitions by Japan were greeted with distrust and hostility from some locals. But Guen says that was a different time, and the reaction to pure real estate plays would likely be different today. “At that period, the markets in and of themselves were quite insular, so it was new,” he says. “Today, we've got a much more open flow of capital, and economies realize the benefit of being open.”

Of note, the Japanese ended up taking a bath on many of their 1980s investments. “I sometimes jokingly say, when I got into this business the fear was the Japanese were coming,” observes placement agent Remy Kawkabani of Credit Suisse. “Within five years, the fear was that the Japanese were leaving. It'll be a similar type of thing here. Right now the Middle East is flush with cash. It's new cash, and it needs a home. But it's long-term stable capital.”

Launch Year:1976Fund Size :$875 billion (as of March 2007)Allocation to private real estate:N/A (65% direct, 30% private funds, 5% public funds)Select private RE fund commitments:Global Innovation partners Fund, GI PartnersLaunch Year:1981Fund Size :$120 billion (as of December 2006)Allocation to private real estate:$12 billion, 10% (35% direct, 59% private funds, 6% public funds)Select private RE fund commitments:Lone Star Funds I & II, Prologis European Properties,ProLogis Japan Properties I&IILaunch Year:1953Fund Size :$213 billionGrowth Rate:30% (2006)Allocation to private real estate:N/A (0% direct, 100% private & public funds)