Asiamoney: Getting to the Bottom of CIC’s Central Huijin Anomaly

Asiamoney, October 2014

In early September, Li Jiange, the vice-chairman of Central Huijin Investment, was speaking at a banking conference in Germany, and said something puzzling.  “When we invest in China, efficiency and investment return has gone down,” he said, through a translator. “If we can then expand abroad, then we are highly interested in looking into European banks.”

It doesn’t sound much, but it’s a significant thing to say. That’s because Central Huijin is a unit of China’s $653 billion sovereign wealth fund, the China Investment Corporation, and the comment muddies the waters still further at a powerful institution whose inner workings are becoming steadily more difficult to fathom. International asset managers, who are already finding themselves being asked to do more work for lower fees and are being rotated in and out of mandates with renewed vigour, are now finding it increasingly difficult to work out where Central Huijin fits in following a change in CIC’s top management.

First, the background. Having started out in September 2007 with a registered capital of $200 billion, by the end of 2013 CIC’s overall funds stood at $652.7 billion, bolstered by a series of asset injections along the way. But from the outset, these impressive-sounding numbers were misleading. CIC has two wholly-owned subsidiaries. CIC International is the one that all international fund managers care about; that’s the one mandated to diversify China’s foreign exchange holdings and to invest exclusively outside of China, in an asset allocation model similar to other sovereign funds around the world, combining debt, equities and various alternatives. The other is Central Huijin, which holds controlling stakes in most of the biggest state-owned financial institutions in China, including Bank of China, ICBC and China Commercial Bank.

From day one, fund managers have wondered why on earth the two are put together. They are, as CIC’s most recent annual report states, “two distinct entities, with a strict operational firewall separating the business activities of the two entities.” When CIC’s returns are announced each year, it’s really just CIC International’s results: Central Huijin is considered completely separate, and the two arms account in different currencies, the dollar and renminbi respectively. In fact, the only place where they seem to be lumped together is when people talk about CIC’s total assets. But that’s where things become misleading. $653 billion represents one of the biggest sovereign wealth funds in the world, probably behind only Norway and the Abu Dhabi Investment Authority (ADIA doesn’t disclose its own asset number). But in truth, it may be that as little as $200 billion of that figure is invested offshore, because Central Huijin is now believed to account for the majority of the assets. And it’s always been this way: when first reported in 2008, only $56.06 billion of the $227.22 billion in assets was actually used for international investment.

Generally, this has been an oddity rather than a problem. “For our purposes, Central Huijin just isn’t relevant,” says one manager who has run mandates for CIC. “We have nothing to do with it. When we talk about working for CIC, we’re talking about the international part, and it would be the same for all of our peers.” But Jiange’s comment changes things, because it suggests that Central Huijin is going to start investing actively outside China too. “That is puzzling, and not what we expected,” says another fund manager. “It does raise the question of how the two are going to fit together. It’s a little like the Abu Dhabi situation, except here the two are part of not just the same sovereign apparatus but technically the same institution.”

The “Abu Dhabi situation” he is referring to is the multiplicity of sovereign vehicles in that emirate and the sometimes unclear separation of mandates between them, most obviously ADIA – the Gulf’s biggest sovereign wealth fund – and The Council, or the Abu Dhabi Investment Council to give it its full title, which was initially set up with a different mandate to ADIA (ADIA for international investment, ADIC for local) but has increasingly had blurred lines of separation as its investments have tended to overlap. It doesn’t yet sound like CIC International and Central Huijin will overlap in quite that way – Central Huijin might just make direct investments in international banks, rather than appointing external asset managers – but it does create a level of confusion.

Michael McCormack, executive director of the Shanghai-based research group Z-Ben, believes the remarks were an attempt to bring Central Huijin’s role and future into a more public realm. He describes it as a “trial balloon: let’s see if anyone sacks me if I say this out loud.”

“There’s never been a particularly clear plan agreed by all the relevant parties about what would become of Central Huijin’s surplus wealth once it started spinning off assets to the public market,” he says. “I think this is Central Huijin’s leadership trying to frame the conversation, or to have a more public voice in the conversation at a time when CIC has undergone a leadership transition.” Strategically, buying stakes elsewhere in the world make a certain amount of sense; it’s just that that’s what CIC was supposed to be doing (and, indeed, has: 22.9% of CIC’s international exposures are in financial services).

There are two ways through which CIC’s control of Central Huijin would make sense. The first, McCormick says, came at the outset, “that by setting up CIC to be a government-independent investor it might gain preferential access to markets, or preferential status with various global regulators that SAFE could never achieve; and that dovetailing in in the key ownership stakeholdings of the largest Chinese banks might mean they could sneak in under CIC’s broader cloak.” But if that was the plan, McCormick says, it was clear within six months of CIC’s foundation that it wasn’t work.

The other was if Central Huijin was intended to be the future source of funds for CIC’s investments. Central Huijin has been growing domestically as China has begun to take its brokerages public. Where once it was thought of as simply a repository for shares in the big four banks plus China Development Bank, it now has stakes in 18 separate enterprises, including insurers, asset managers and securities houses, and as these are gradually listed, Central Huijin is finding itself with a lot of cash. “It is theoretically possible those bank shares that comprise 91% of Central Huijin’s dowry could be passed up to CIC and potentially disposed of,” says McCormick.

It’s just that Central Huijin doesn’t appear to be making those transfers. In fact CIC’s international arm doesn’t seem to be getting any more funding, either from the state or from Huijin. From 2009 to 2012 there was additional state funding of between US$20 billion and US$50 billion a year, but that has stopped, and those close to the fund say they don’t expect any more to come.

There’s also the fact that China now has several state institutions offering external mandates, and some of them appear to overlap with CIC. One, the National Council for Social Security Fund, is easily distinguished: it’s a state pension enterprise, and over the years has given a number of big mandates for international investment, to names including JP Morgan, Schroder Investment Management, AMP Capital and Lombard Odier, among others. But then there’s the State Administration for Foreign Exchange, and its Safe Investment Company arm in Hong Kong, responsible for foreign investments.  “As a proportion of overall assets, SAFE outsources very little, and far less than CIC,” says one fund manager. “But they’re there, giving mandates.” They are more conservative than CIC, managers say, but there’s clearly an overlap.

For fund managers, there are other reasons for confusion. On one hand, CIC is a wonderful opportunity for them. At the end of 2013, 67.2% of CIC’s international assets were outsourced to external managers, a figure that has been steadily increasing over the years (59% in 2009, 63.8% in 2012). Also, after some difficult early years when investments in groups like Blackstone and Morgan Stanley turned sour (though the latter of those did eventually turn profitable), CIC appeared to have a very good year in 2013. Its overseas portfolio posted a net return of 9.33%, bringing net cumulative annualized return since inception to 5.7% – not bad, considering that period includes the global financial crisis. And it has a healthy-looking asset allocation, with 40.4% of the fund in public equities, 17% in fixed income, 11.8% in absolute return, 28.2% in what it calls ‘long-term investments’ (direct investment, private equity, resources, commodities, real estate and infrastructure) and 2.6% in cash.

Yet on the other hand, this year CIC found itself under an extraordinarily blunt attack from China’s National Audit Office, which accused the fund of  – these are the NAO’s own words – “dereliction of duty, inadequate due diligence, a lack of post-investment management and other problems.” It referred to 12 overseas investments between 2008 and 2013 which made losses, and spoke of irregularities in the hiring of external managers.

So what should we read into that? Not sweeping changes in management, because they’ve already happened. Ding Xuedong, former Deputy Secretary General of the State Council and a long-term Ministry of Finance man, became chairman and CEO in July 2013, followed by Li Keping, who had worked with Ding on the National Council for the Social Security Fund before joining CIC and being named president and chief investment officer in December. The attack by the National Audit Office refers pretty much entirely to events prior to either man’s appointment so won’t affect them, although it will presumably lead to increased due diligence and monitoring of external managers in future.

But the change of leadership raises its own questions about how CIC might develop. “Are PE [private equity] and alts [alternatives] still considered to be the core part of the portfolio?” asks McCormick. “I don’t mean a mathematical majority, but at least the key component.”

At first glance it would appear so. In 2012 – when Li Keping was CIO but before he was named president – CIC completed a review of institutional investors over the previous five years and decided to base its allocation on the endowment model made popular by Yale and Harvard. It set a three-layered asset allocation framework combining strategic and tactical asset allocation styles with a policy portfolio (which apparently means allocations based on mid-term economic projections). That appeared to suggest an increasing importance for private equity and infrastructure, for a start, which has been apparent since several direct investments that year, such as Thames Water and Heathrow Airport Holdings. One can see the same approach at work in CIC’s bid, still open at the time of writing, to buy Dublin-based aircraft leasing firm Avolon, and its purchase of a stake in Irish technology start-up FieldAware. Ding himself wrote an editorial for the Financial Times this year about the benefits of farmland investment, saying: “Difficult as this sector is, for long-term and patient investors it can offer bounteous returns… we believe the agriculture sector offers stability, a way of hedging against inflation and a device for spreading risk. We are keen to invest more across the entire value chain.”

CIC is increasingly well set up for this kind of investment. It has two departments that handle these areas – the Department of Private Equity and the Department of Special Investments – with the second of those said to focus on investments in energy, mining, infrastructure and agriculture.

But McCormick also notes that the increase in the percentage of the total portfolio that is being offered to third party mandates suggests the reverse, because private equity, alternatives and direct investments are the sort of thing that CIC should be trying to do in-house. “CIC has frequently expressed a desire to be a co-lead or GP,” or general partner, in private equity-style investments, he says. “But we have insufficient evidence to judge whether the portfolio trend [of PE and alternatives] still has a similar degree of sway over the minds of decision-makers at CIC, or another course is being charted for the margins.”

Then there’s the question of what’s happening with external manager mandates. Yes, more and more money is being managed externally, but that appears to be only part of the story. Fund managers report razor-thin fees (which is hardly unusual for a sovereign wealth fund) in all areas bar alternatives. Z-Ben Advisors believe it is possible to work out just how tight those fees are. The latest annual report discloses CIC’s total expenses for the year at US$1.2 billion. Z-Ben crunches that to what it calls an “astonishingly low” figure of 61 basis points for CIC’s total expenses, including, but not limited to, fees paid to external managers. “In truth, CIC may be paying even less than that for many of its mandates.” There’s another line in the report – “investment expense” – which was US$444 million in 2013, and if that’s the fees total, then average annual fees come out at just 32 basis points, Z-Ben calculates.

The only way that can be feasible is if a lot of the outsourced money is going to passive managers – and Asiamoney is aware of passive managers handling large mandates for CIC – but even so, it suggests eye-wateringly low fees. Z-Ben refers to mandates as “an area of intense competition, with slight performance edges and blood-letting fee cuts dictating success”, and adds: “In our view, CIC is going to become even more picky and even more stingy when reviewing current and future partners. It gets worse: funding and cash levels detailed in [the latest annual report] suggest that CIC is planning to rotate through asset classes and managers more flexibly and frequently than ever before.”

Z-Ben also notes that the lively changes in asset allocation last year (public equity holdings went from 32% of the portfolio to 40.4%) suggest that CIC is rotating swiftly to reduce returns and ditching managers along the way. “It is widely understood within the industry that CIC terminated or largely defunded a number of underperforming mandates in 2013,” Z-Ben says. “Expect that behaviour to continue in 2014 and beyond as CIC seeks to squeeze its global portfolio for every last drop of juice.”

Is Z-Ben right? Fund managers spoken to by Asiamoney paint a mixed picture. “CIC has never been the toughest sovereign wealth fund on fees,” says one. “I remember several years ago going in and being authorised to offer a discount of up to 20%. But they never even asked for one. Those days are gone,” he adds, “but I have not found them any harder than other sovereign funds. They’re all tight on fees.”

Another says that, while passive mandates pay a tiny margin, for alternative asset classes fees are not extremely tight and are in any case often performance-related rather than flat.

Managers also say that the types of mandates on offer vary dramatically, and fees do too. Yes, there are big passive mandates, but some are quite specialist. For example, 26.8% of CIC’s fixed income portfolio at the end of December was in sovereign bonds of emerging economies, an area that needs specialist advice; similarly 17.1% of public equities are in emerging markets.

Still another says that Z-Ben’s 32 basis point theory may well be right, but is not particularly unusual.

“It works like this,” he explains. “For an actively managed fund, I might have a retail class charging 150 basis points, and an institutional class at 90. For a mandate over $50 million, perhaps I go to 80, and over $100 million, to 70. And at a certain point I get to what we call relationship pricing, which will be lower still.

“You will have a big spread of managers. Ones who have capacity constraints won’t give their last remaining space to CIC for 60 basis points, so they will probably be quite well paid. And others who just want funds and the fact that it looks great to represent CIC will agree to much lower fees.

“The figure you raise is perfectly feasible if a lot of the mandates are passive, because these days it’s not unusual for the big guys to accept as low as eight basis points, or even five, for a big mandate, because that is truly a commoditized game.”

McCormick counters that CIC has only really started exploring passive allocations in the last 15 to 18 months, “and prior to that, their theory really was: long and lumpy,” that is, big commitments to active managers. “The 32 basis points figure is an exaggerated low because it would include certain internally managed parts of the portfolio, but it’s been largely applied to an active universe. And that is consistent with every anecdote you’ll hear about how much fun it is to strike a bargain with CIC.”

For fund managers, whatever the opacity of direction, CIC is a vital institution they must continue to court no matter how tight the fees become. But in several areas – future funding sources, direction of management, and just what Central Huijin is really for – some clarity would be more than welcome.