China Sovereign Wealth Fund’s Shifting Strategy

China Investment Corporation (CIC), the country’s main sovereign wealth fund, posted a 10.65% return on its overseas investment in 2012, registering an above 5% cumulative annualized return since its establishment in 2007. This is a significant improvement compared with the 4.3% loss last year, the fund’s worst performance in 5 years. As a young member of the sovereign-wealth fund club, CIC has been constantly adjusting its strategies to respond to the changing international environment and to better serve its mandate of achieving higher returns on China’s rapidly growing foreign exchange reserves. At its inception, CIC initially focused on investing in the US financial sector. In the aftermath of the financial crisis, CIC recalibrated its strategy to direct investments into real sectors in energy, natural resources, and real estate in both developed and developing countries. Now amidst the ongoing Eurozone debt crisis and the sluggish global economic recovery, CIC continues to increase its allocation in long-term assets, pivots to Europe and emerging markets for investment opportunities and ramps up its practices of co-investing to boost returns.

Overweighting long-term assets

One of the major institutional improvements of CIC was to extend investment horizons from 5 years to 10 years in January 2011. In line with this new investment horizon, CIC not only has created a long-term asset portfolio, but also has gradually built up positions in nonpublic market assets, particularly direct investments, private equity, real estate and hedge funds. CIC significantly reduced its holdings of public securities from 48% of the global portfolio at the end of 2010 to 25% at the end of 2011. Long-term assets, on the other hand, increased from 21% of the global portfolio to 43% in the same period (Table 1). According to Wang Jianxi, the fund’s chief risk officer, long-term assets now account for more than half of the fund’s global portfolio. The increasing distribution of investments to long-term assets may serve three purposes. First, it helps establish and cement fund’s credibility to become a long-term investor. Second, investments on oil, gas, mining, infrastructure and real estate projects could throw off steady cash flows and provide solid returns. Third, long-term investments could shield the fund from short-term market volatilities created by political uncertainties.

Table 1 Global Investment Portfolio Distribution

(Alternative investments include direct investments into nonpublic companies, private equity, hedge funds, real estate and infrastructure)
Source: CIC, annual reports, 2008,2009, 2010,2011

Pivoting towards Europe and emerging markets

At its inception, CIC initially made several big investments in the US financial sector, such as Blackstone and Morgan Stanley. However, the rising protectionism in U.S., reinforced by substantial stakes CIC’s subsidiary, Central Huijin, has in large state-owned banks, has made it very difficult for CIC to acquire even minority stakes in strategic sectors such as energy and telecommunications. Several senior executives of the fund have openly lamented “the fear” of Chinese investments across U.S. As a result, the fund’s long-term investments in U.S. have been far and few between in the past two years. On the other hand, the financial woes in Europe have caused the attitudes of European governments towards sovereign-wealth funds to undergo a reversal. Instead of being perceived as a threat to national security, CIC is now seen as a savior of distressed firms and a catalyst for economic recovery in Europe. Lou Jiwei, the former chief executive of CIC, said that U.K is the most welcoming of Chinese investment among all countries and other European countries have also effortlessly courted Chinese investment. The ameliorating investment environment in Europe, accompanied with undervalued assets there, has induced a surge of long-term investments in Europe in the past two years.

Thus far, CIC’s investments in the region have concentrated on infrastructure and industrial projects. In January 2012, CIC bought an 8.68% stake in UK-based utility Thames Water from a consortium of investors. Later in October, CIC agreed to buy a 10 percent stake in Heathrow Airport. Assuming that CIC would receive new capital from the government in the near future, I expect CIC to devote most of its new firepower to refurbishing the obsolete infrastructure in Europe, especially the UK. In addition, CIC investments in the region have also created a win-win situation. For CIC, it could capitalize on the cheap valuation in Europe to enhance returns by continuing to make direct investments in the property market and industrial projects. For the core countries of the euro zone such as U.K and France, overseas investments in infrastructure would be conducive to accelerating the economic recovery and to growing out of the recession. For European companies, CIC stakes may also help them build closer ties with the Chinese government and enter into the Chinese market with less resistance.

While CIC’s investments in Europe are mainly driven by superior returns, its investments in emerging markets are motivated by both commercial and strategic interests. Although CIC has insisted that it only acts as a financial investor, its proclamation that it invests solely on the commercial basis is not set in stone. CIC first made its foray into Africa on 28 December 2011 when it acquired a 25.8% shareholding in South Africa’s Shanduka Group, a prominent investment holding company with interests in coal mining and other industries. Later in 2011, Russian Direct Investment Fund, a state-sponsored private equity fund, and CIC launched the joint Russia-China Investment Fund to invest $1 billion in Russian private equity deals. More recently, CIC also signed a memorandum with Russia to invest in infrastructure and natural resources projects in Russia, and invested in the pre-IPO of the Moscow Exchange. This deluge of investments in Africa and Russia echoes with President Xi’s first state visits to Russia and African countries after he took the helm of the world’s second largest economy. Although Lou Jiwei, the former CEO of CIC, reiterated the financial nature of these investments, the strategic motivations of these investments are evident. The Chinese government, the shareholder of CIC, is likely to leverage these investments to secure energy and natural resources to power its economy. In addition, by supporting neighboring countries to develop industries that are complementary to China’s growth, China would increase the dependence of neighboring countries on China and hence strengthen the bonds with political allies. We have yet to see how these investments in emerging markets will pan out. At any rate, they would help the fund achieve meaningful diversification of its global portfolio and advance its shareholder’s interest, if not purely in the form of financial returns.

Investing through third-party managers vs direct investments

Within long-term investments, CIC has recently adopted a more active investment approach of co-investing with–rather than investing through—third-party fund managers. For instance, CIC has recently sought to co-invest with Brookfield, a private-equity fund specializing in timber assets, in forestry assets in the Pacific Northwest. This is a marked deviation from its early days’ investment model that heavily relied on external managers to make overseas investments. The adoption of more proactive investment approach has been aided by two structural changes within CIC. First, on 28 September 2011, CIC created a subsidiary called CIC International to solely focus on overseas investment. CIC international is a separate entity from Central Huijin, another subsidiary of CIC that has large stakes in state-owned Chinese banks. Since the holding of Central Huijin used to present regulatory obstacles for the fund when investing abroad, this reorganization of CIC has addressed the issue of conflict of interests caused by Huijin and has helped remove unnecessary regulatory hurdles for overseas investments. Second, due to the rapid growth of its overseas portfolio, CIC has been hiring aggressively to replenish its personnel reservoir in natural resources, real estate and private equity. Consequently, CIC’s total number of employees increased from 67 in May 2008 to 405 as of June 2012, 165 of whom have overseas work experience and 44 of whom are foreign citizens (Table 2). This expansion of talent pool, loaded with international experience and investment expertise, has made it possible for the fund to make viable overseas investment decisions on its own.

Table 2 Profile of Investment Management Team

Source: CIC, annual reports, 2008,2009,2010,2011

Although co-investing with external fund managers could give CIC greater financial returns down the road than investing through third-party managers, the traditional approach still has a number of advantages. First, investing indirectly through external managers could reduce risk exposure associated with direct stakes in companies. Second, indirect investments could help reduce regulatory hurdles in host countries. Therefore, compared with the steady increase of the weight of long-term investments in global portfolio, the shift from investing through external managers to direct investments has been more judicious and gradual. As of 31 December 2011, 43% of global portfolio was managed internally, up from 41% in December 2010 (Table 3).

Table 3 Internally Managed Assets Versus Externally Managed Assets
Source: CIC, annual reports, 2009, 2010, 2011