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«International Finance Discussion Papers Number 940 August 2008 Friends or Foes? The Stock Price Impact of Sovereign Wealth Fund Investments and the ...»

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Board of Governors of the Federal Reserve System

International Finance Discussion Papers

Number 940

August 2008

Friends or Foes? The Stock Price Impact of Sovereign

Wealth Fund Investments and the Price of Keeping Secrets

Jason Kotter

Ugur Lel

NOTE: International Finance Discussion Papers are preliminary materials circulated to

stimulate discussion and critical comment. References in publications to International

Finance Discussion Papers (other than an acknowledgement that the writer has had access to unpublished material) should be cleared with the author or authors. Recent IFDPs are available on the Web at www.federalreserve.gov/pubs/ifdp/. This paper can be downloaded without charge from Social Science Research Network electronic library at http://www.ssrn.com/.

Friends or Foes? The Stock Price Impact of Sovereign Wealth Fund Investments and the Price of Keeping Secrets Jason Kotter and Ugur Lel* Abstract This paper examines the stock price impact of 163 announcements of Sovereign Wealth Fund (SWF) investments. We document an average positive risk-adjusted return of 2.1 percent for target firms during two days surrounding SWF acquisition announcements.

The announcement effect is both statistically and economically significant. A multivariate analysis shows that the degree of transparency of SWF activities is an important determinant of the market reaction, and both the SWF and the existing shareholders of the target firm benefit from improved SWF disclosure. In addition, target firms’ profitability, growth, and governance do not change significantly in the three-year period following the SWF investment relative to a control sample. These results are robust to a battery of tests. Overall, our findings suggest that SWF investments convey a positive signal to market participants about the target firm, increased SWF transparency is enjoyed by both the SWF and existing shareholders, and SWFs are passive investors.

JEL Classification: G14, G15, G34, G38 Keywords: International Finance, Sovereign Wealth Fund, Cross-border Investment, Market Efficiency, Transparency.

* Research assistant and economist, respectively, in the Division of International Finance of the Board of Governors of the Federal Reserve System. We would like to thank Carol Bertaut, Mark Carey, Sally Davies, Darius Miller, and Edwin Truman for their comments. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or any other person associated with the Federal Reserve System.

1 Friends or Foes? The Stock Price Impact of Sovereign Weal

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The size of assets under the control of Sovereign Wealth Funds (SWFs) has grown from $500 billion in 1995 to about $3.3 trillion in 2007, and is expected to quadruple by 2015.

To put this number in perspective, much publicized hedge funds and private equity funds, both of which are highly leveraged and include some SWF investments, have assets in the order of about $1.9 trillion and $0.8 trillion, respectively.1 Further, fueled by rising oil revenues and trade account surpluses, several countries have recently initiated a SWF while several others are contemplating establishing one.2 The size and rapid growth of SWFs suggest that they are an important class of investors and will likely become more important in the future.

The fact that SWFs are foreign government-owned has led to a recent debate on cross-border investments. On one hand, SWFs are viewed as perilous investors with strategic and potentially politically driven plans that may destabilize financial markets.3 Target firms technically become partially state-owned, and as such, a major concern is that their investments can lead to inefficient outcomes as a large body of literature suggests for state-owned enterprises (e.g., Dewenter and Malatesta, 2000). Further, foreign governments that own SWFs may tunnel the target firm’s assets or transfer its sensitive know-how out of country using their positions as large shareholders of the firm.4 The opaqueness surrounding SWFs’ activities only intensifies these concerns.5 In fact, the lack of transparency of SWFs has prompted several recipient countries including the United States to debate whether and to what degree to regulate SWF cross-border

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principles aimed at improved SWF transparency.6 On the other hand, SWFs are regarded as long-term, passive investors who play an important role in deepening financial globalization. Some observers argue that despite being government-owned, SWFs behave like institutional investors such as Berkshire Hathaway with the objective of profit maximization. They also provide sizable crossborder liquidity into the global financial system, which is particularly important for countries with current account deficits such as the United States. In addition, largely devoid of highly leveraged positions and stringent capital requirements, they can help stabilize financial markets in times of elevated uncertainty.7 Despite their importance, very little is known empirically about the valuation impact of SWF investments. In this paper, we provide detailed empirical evidence on the wealth effects of SWF investments on shareholders of target firms. Specifically, we examine a) the stock market reaction to announcements of SWF investments in firms, b) the impact of the degree of transparency of SWFs’ activities on this market reaction, and

c) how the operational performance and corporate governance environment of target firms change following the SWF investment.

Examining the initial stock price impact of 163 announcements of SWF investments in 28 countries, we document a risk-adjusted positive abnormal return of 2.1 percent on two days surrounding the announcement date. The announcement effect is economically and statistically significant. Moreover, the effect is not short-lived, as target firms continue to experience a positive cumulative abnormal return (CAR) on average in the 20-day period following the announcement date. The magnitude of the average CAR

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investors like CalPERS on stock returns for a comparable event window (e.g., Brav et al, 2008; Del Guercio and Hawkins, 1999), indicating that SWF investments convey a positive signal to market participants about future risk-adjusted returns of target firms.

The multivariate analysis from cross-sectional regressions shows that the transparency of SWFs plays a major role in determining investors’ reaction to the acquisition announcement. Using the SWF scoreboard developed by Truman (2008), we document that firms experience higher CARs if the investing SWF is more transparent.

For example, controlling for various SWF, firm, and country characteristics, we document that the average CAR is more than 3.5 percent higher in absolute terms for firms targeted by SWFs that are subject to independent audits or make annual reports publicly available. This finding suggests that investors use voluntary SWF disclosure as a signal of the quality of screening and monitoring by SWFs. We also analyze who benefits from increased SWF transparency and find that both the SWFs and existing shareholders of the target gain from voluntarily improved SWF transparency. The benefits that accrue to SWFs from higher disclosure are one third of that enjoyed by shareholders.

Next, we analyze the reasons underlying the positive market reaction to SWF investments. Specifically, we test if the market reaction is due to SWF-related shareholder activism, liquidity effects generated by block purchases of SWFs, a potential transfer of wealth from target firms’ creditors to shareholders, or information effects of the stock picking abilities of SWFs. Our results reveal that target firms do not experience any robust and statistically significant change in their profitability, growth, investment, and corporate governance environment in the three year period following the SWF

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industry, and profitability of target firms in the year prior to the SWF investment. These results show that SWFs do not improve firm value in long run, suggesting that shareholder activism is not common among SWFs, which is consistent with the empirical evidence documented for U.S. institutional investors.8 These results also imply that SWF investments do not deteriorate firm value.

We also do not find any indication that the positive market reaction is driven by a temporary liquidity effect produced by block purchases by SWFs or that it comes at the expense of target firms’ creditors. Other alternative explanations such as the expectation that SWFs may recapitalize the target firm in case of future financial difficulties are not supported by the data. Therefore, by process of elimination, our findings suggest that SWFs are passive shareholders who invest in under-priced securities.

Our results are robust to the inclusion of firm-specific financial and ownership control variables such as firm size, growth opportunities, and the presence of institutional investors; deal characteristics such as the size and type of investment in the target firm;

country-specific variables such as investor protection laws, and stock market capitalization of the countries of SWFs and target firms; SWF characteristics such as the type of funding, age, and estimated size; and industry and year controls. We also conduct a series of robustness checks to gauge the sensitivity of our results to alternative benchmarks, estimation procedures, and sub-samples. In all instances we find that our results continue to hold.

Our results contribute to the extensive literature that studies the impact of crossborder M&A transactions and share purchases by institutional shareholders on target

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Cabolis, 2008; Brav et al, 2008; Del Guercio and Hawkins, 1999). We provide detailed empirical evidence on the valuation impact of an important class of institutional investors, namely SWFs, which are foreign government-owned, larger than hedge funds and private equity funds, and generally operate in a very opaque environment. Our evidence suggests that SWF investments have a strong positive effect on stock prices around the announcement date and no substantial effect on operational performance and corporate governance outcomes, consistent with the empirical evidence on share purchases of institutional shareholders (e.g., Karpoff, 2001). Our paper is also relevant for the literature on state-owned enterprises, as our findings suggest that limited government ownership of publicly traded firms does not necessarily lead to a deterioration of performance when the target firm is publicly traded and the government is a passive shareholder.9 Our paper also helps academics and regulators alike to better understand SWFs’ motives by examining how investors perceive SWF investments. Our findings show that market participants react favorably to SWF investments, suggesting that they view SWFs as profit-oriented investors. At the same time, a positive and statistically significant relation between the market reaction and the degree of SWF transparency implies that market participants use voluntary disclosure by SWFs as a signal of SWF type. This evidence is supportive of policies recently initiated by SWFs to voluntarily increase their disclosure standards.10 The remainder of the paper proceeds as follows. Section 1 provides the background information on SWFs. Section 2 describes the data. Section 3 presents event

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robustness tests. Section 5 investigates possible explanations for the positive market reaction. Section 6 concludes.

1. Background on Sovereign Wealth Funds There is no universally accepted definition of SWFs, although many definitions have been proposed. This paper defines SWFs as government-owned investment vehicles with no explicit liabilities, significant exposure to high risk foreign assets, and a longterm investment horizon.11 The main stated objectives of SWFs are to provide intertemporal stabilization, diversification, and risk-return optimization for nations (Kern, 2007). While SWFs invest in a variety of assets, including equity and debt securities, commodities, and property in order to achieve these goals, there is a belief that they are shifting from bonds to equities (Johnson, 2007). The asset allocation of SWFs is estimated to be 35 to 40 percent in fixed income securities, 50 to 55 percent in equity securities of public firms, and 8 to 10 percent in alternative investment products such as private equity securities, hedge funds, and commodities (Fernandez and Eschweiler, 2008).

Table 1 provides some information about the largest SWFs.12 Abu Dhabi Investment Authority is the largest SWF, with assets estimated to range from $250 billion to $875 billion. The next largest SWFs are the Norwegian Government Pension Fund and the Government of Singapore Investment Corporation, controlling about $375 billion and $150-330 billion, respectively. The primary sources of funding for these largest SWFs are

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Vitanza, 2007).

Table 1 also shows that the Kuwait Investment Authority is the oldest SWF, established in 1953. Since then, there have been two major waves in SWF establishment—during the 1970s and from 2000 to present. There are now around 40 active or announced SWFs worldwide. The recent increase in the number of countries with SWFs is impressive; about 35 percent of SWFs currently operating were launched in the last five years. Figure 1 displays further evidence of SWF asset growth from their activities in the United States. It shows that holdings of U.S. corporate equity and debt by foreign official institutions, which can be considered as a proxy for SWF investments, has increased substantially since the beginning of 2000 [from $89 billion and $13 billion in 2000 to $266 billion and $98 billion as of June 2007 in equity and debt securities, respectively], confirming this trend (Bertaut and Tryon, 2007).13 Funding for this rapid growth has been made possible by growing current-account surpluses from increased prices for non-renewable resources (primarily oil, but also copper, diamonds, and phosphate) and accumulation of foreign currency reserves through interventions in FX markets.

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