The Spectator: CIC changes tack

Spectator Business, December 2009

Andrew Ross Sorkin’s Too Big To Fail, the behind-the-scenes account of Wall Street’s brush with oblivion, contains an interesting detail that tells us a lot about the power of Chinese money. In that lurching week in September 2008 after Lehman collapsed, Morgan Stanley – by now looking perilously close to the edge – invited Gao Xiqing, the president of the China Investment Corporation sovereign wealth fund, to New York to talk about increasing the 9.9% stake it already held in the American bank to as much as 49%. In those uncertain days, it looked like a deal that could save the whole bank.

Gao, lying flat on his back on a couch in a Morgan Stanley conference room to ease his bad back, offered the ultimate lowball offer for the increased stake: up to $5 billion and a credit line. Even in those dark days the American firm was considered to be worth $40 billion, and it was a sufficiently hardcore negotiating stance to shock even the archetypal Wall Street ballbuster, Morgan Stanley chief John Mack. Sorkin says Mack was “stunned”, and anyone who’s ever met the man knows that takes some doing.

It didn’t come to that in the end – the Japanese came to Morgan Stanley’s rescue instead and Gao took CIC’s money home again. But the incident speaks volumes about how China’s newly minted sovereign fund, established only in September 2007, has grown up and, after initial mistakes, is nobody’s fool now.

The subtext to that stand-off with Mack is one of CIC’s first ever investments: a $5.6 billion stake in Morgan Stanley on December 19 2007 which, by the time of that apocalyptic week nine months later, had halved in value. CIC had been similarly bruised by another investment, a $3 billion stake in private equity group Blackstone. CIC was far from being the only sovereign wealth fund to be battered by taking stakes in western banks – others included Singapore’s Temasek and GIC, and funds in Kuwait, Qatar and Korea – but many of those had wisely insisted on provisions that enabled them to reset their purchase prices if the firm subsequently raised equity at a lower level. CIC, new to these investments at the time, had not done so with Morgan Stanley; Gao’s tough offer to Mack was an attempt to implement such a reset after the fact.

Consequently, one banker who deals closely with CIC says that today, if he comes to them with a deal, “The very first question I get asked is ‘will it have downside protection?’”

“With Blackstone and Morgan Stanley they didn’t, but they now consider a comfortable level of protection to be a key component of any new deal,” says the banker. “They didn’t have the sophistication back then and got taken for a ride. That’s never going to happen again.”

CIC was not irredeemably put off American banks – indeed, in June this year it bought another $1.1 billion of Morgan Stanley stock, and after the rally of the last six months, is in the money on its investments in the US bank. But there’s no question CIC has changed its stance since, in terms of the type of assets it buys, the locations in which it buys them and the approach it takes to buying them.

Almost every recent deal CIC has taken on has been in the energy and resources area, and the bulk of them have come in frontier markets. An example came in October when CIC bought $500 million of convertible debentures from South Gobi Energy Resources, a Mongolian coal mining and exploration company listed on Toronto’s TSX Venture Exchange. The debentures can convert into SouthGobi common stock if the company goes ahead with an expected Hong Kong listing.

The same week came a potential $700 million investment in another Mongolian mining group, Iron Mining International, this time through a convertible loan. Then there’s the $300 million, 45% stake in Nobel Oil Group in Russia. Or the 11% of Kazakh energy company JSC KazMunai Gas Exploration Production’s global depositary receipts, bought for $939 million in June. CIC has put $1.9 billion into the Indonesian mining group PT Bumi Resources, and $858 million into the Singapore-listed agriculture and energy supply chain leader Noble. In the developed world, CIC paid $1.512 billion for a stake in Canada’s Teck Resources, and most recently paid $1.58 billion for 15% of Virginia-based power company AES, plus $571 million for a 35% stake in AES’s wind development business.

Somewhat surprisingly, CIC publishes an annual report – its first one ever came out in August – and from this, we know that by global standards it has done pretty well so far. In 2008 it made a 2.1% loss in its global portfolio (relatively speaking, a standout among sovereign funds) and if we include CIC’s Central Huijin subsidiary, which invests in domestic banks on behalf of the state to improve governance, the overall group generated a return on registered capital of 6.8%. But in truth CIC hasn’t really demonstrated investment nouse yet: it put only $4.8 billion into overseas assets in 2008 and by far the biggest driver of returns was that by the end of the year 87.4% of the global portfolio was in cash.

CIC declined to answer Business Spectator’s detailed written questions, but its chairman, Lou Jiwei, occasionally speaks out at conferences to give the world a sense of where the fund might go next. In October, for example, he told a Beijing audience that CIC had invested about half its $110 billion in available funds for offshore investment, mainly in publicly traded assets. He went on to call returns “not bad” and warned of a bubble in global asset prices, saying that the fund’s focus on investments in commodities and real estate – it is a major investor in the UK’s Songbird Estates, for example – is partly as a hedge against inflation and currency depreciation.

The point about the currency is key. CIC’s existence stems from a sense that China’s vast foreign exchange reserves ­– $2.273 billion as of September, according to China’s State Administration of Foreign Exchange – could be earning better returns, and it was given a $200 billion chunk to form the foundation of its registered capital at launch in 2007. China’s state agencies, CIC among them, are concerned about falls in the value of the US dollar, with a knock-on effect on the real value of China’s reserves and the exchange rate.

But investing in energy is not just about currency hedging. Various arms of the Chinese state, from its behemoth listed oil groups (Petrochina, Sinopec and CNOOC), to unlisted state entities (such as Petrochina’s parent, China National Petroleum Corporation) have been buying up companies and oil fields from Sudan to Kurdistan Iraq in a bid to improve China’s energy security. Expect to see CIC buy into African energy assets before long.

This brings up a favourite subject among CIC-watchers: the degree to which it represents the state in its investment decisions. Lou knows it: he said in October, “the outside world is very suspicious of us, saying we have a national agenda. But our strategy is just one of long-term risk-adjusted returns. It is to make money.” Others say that, of all sovereign funds, CIC fits most closely with broader national objectives in reflecting the interests of the sovereign. “It’s a part of the jigsaw,” says a senior banker who deals closely with them.

While this is hardly surprising, and entirely within China’s rights, it does create a political sensitivity when CIC invests. It’s a big issue, for example, for a Chinese state agency to go into Mongolia, where local people are adamant that they won’t see their natural resources swallowed up by Chinese or Russian interests. It’s perhaps because of this sensitivity that CIC had to get its South Gobi exposure by buying into a business listed in Toronto, and even then with a business structure that gives it a maximum 22% stake if the company went ahead with a Hong Kong listing.

Nevertheless, emerging markets represent fewer complications for a state Chinese entity to buy into than developed nations, where attitudes towards CNOOC’s tilt at Unocal and Chinalco’s at Rio Tinto demonstrate clearly the unease western politicians feel at Chinese ownership of their mines and oil rigs. With no need to explain the rationale of their decisions (or their ethics) to a democratic public, CIC’s future investments will take it to some unloved parts of the world – and a long way from Wall Street.

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