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A Guide to Speed-Dating with Sovereign Funds

Citigroup and Merrill Lynch on Tuesday announced a collective $19.1 billion worth of new investments, with a significant chunk of this money coming from sovereign wealth funds.

Once again these funds, the investment arms of foreign governments, appear to have saved the day for American financial institutions. They seem ubiquitous these days, and according to a recent speech at the University of Pennsylvania Law School by Brian G. Cartwright, the general counsel of the Securities and Exchange Commission, it is estimated that by 2015, sovereign wealth funds will have approximately $12 trillion in investable assets.

For those companies contemplating tapping this seemingly endless source of wealth, here are a number of questions you might want to ask as you make the rounds for investment. A dating guide, so to speak:

Just who are you anyway?

Investments by non-United States entities are on Congress’s radar screen. Only this July, Congress passed The National Security Foreign Investment Reform and Strengthened Transparency Act. The bill further enhanced the national security review process under the Exon-Florio Act for non-U.S. acquisitions, and added critical infrastructure and foreign government-controlled transactions to the factors for review.

Congress passed this bill in the wake of the acquisition of Peninsular & Oriental Steam by Dubai Ports and the ensuing political brawl and heavy congressional protest, which led Dubai Ports to terminate the U.S. component of its acquisition.

The current national review process is not set up to review the typical sovereign wealth investment, usually a stake of 10 percent or less in the company, which is often a nonvoting interest. Technically, since these investments are often noncontrolling and nonvoting, the applicability of the Exon-Florio Act is uncertain. Moreover, review under the Exon-Florio Act is voluntary — but failure to do so may mean that the federal government can later unwind the investment.

Nonetheless, it pays to know your investor. Exon-Florio may not apply, either because of the type of investment or simply because you are in an industry that does not implicate national security. Even so, Congress has a history of acting against foreign investment if it appears too controversial. In fact, the initial apparatus for national security review was passed in 1988 in response to fears of Japanese investment and particularly the 1987 attempt by Fujitsu, a Japanese electronics company, to acquire the Fairchild Semiconductor.

Picking the wrong investor if you are in a sensitive industry may spark a political backlash even if the national security implications are few. It remains to be seen what Congress’s response will be to the current wave of sovereign wealth investments in the finance industry.

What do you want with me?

Ask what services to your country or business the fund will want you to provide in connection with this investment. Sovereign wealth funds may often be investing for political or other reasons or simply to direct business or investing opportunities to their funds or countries. Given their investment inexperience, the attraction of investment in private equity and hedge funds is also likely the ability to access the investing skill of these funds. For example, the newly public hedge fund adviser Och-Ziff Capital Management has a very loose agreement with its sovereign wealth fund investor, Dubai Capital Investment, which gives the fund the opportunity to co-invest with Och-Ziff in transactions.

Moreover, sovereign wealth funds are learning from this process. The China Investment Company, the investing arm of the Chinese government, initially invested in the Blackstone Group and received a slight discount on the units it purchased. When China Investment later invested in Morgan Stanley, it received securities convertible into common stock — but with a 9 percent yield, providing it a bit of a hedge against declines in Morgan Stanley’s stock price, something it did not negotiate with Blackstone.

How will you treat me?

Ask whether the stake is going to be voting or nonvoting, and whether the fund desires a designated board seat or seats and a say in management. Regulatory legislation in the United States, such as the Bank Holding Act, have put an effective limit on the amount and nature of these funds’ investments in financial institutions. However, as sovereign wealth funds move beyond investment in financial institutions and gain more experience, expect them to require more control over their money.

Even if there is no formal voting arrangement, remember that, informally, these funds can assert control. For example, Saudi Arabian Prince Alwaleed bin Talal is said to play a significant role in advising Citi even though he does not sit on its board of directors.

Will you ever leave me?

Sovereign wealth funds will inevitably want to profit on their investment and sell all or part of their holdings. Companies should negotiate provisions that provide for an orderly exit of the fund and do not create a significant overhang of stock for sale all at once. Think about a long lock-up period for the fund’s shares and negotiate a registration rights agreement that provides for sales in appropriate periods and sizes. In addition, remember that a sale by the fund can result in a sale of the entire company.

Below, a timeline of some American firms’ sovereign wealth dating success stories this past fall. Pictures not included.

Dec. 24, 2007: Temasek Holdings, a fund owned by the Singapore government, invests $4.4 billion to purchase a 9.4 percent interest in Merrill Lynch .

Dec. 19, 2007: China Investment Corporation, the investment arm of the Chinese government, agrees to buy securities worth $5.579 billion convertible into a 9.9 percent stake in Morgan Stanley.

Nov. 26, 2007: Abu Dhabi Investment Authority, the sovereign wealth fund of the Abu Dhabi government, invests $7.5 billion to purchase a 4.9 percent stake in Citigroup .

Nov. 16, 2007: Mubadala Development Company, the investment arm of the Abu Dhabi government, spends $622 million to acquire an 8 percent stake in Advanced Micro Devices, the chip maker.

Oct. 29: Dubai International Capital agrees to buy a $1.26 billion stake in Och-Ziff Capital Management Group, the hedge-fund firm run by Daniel Och, ahead of its initial public offering.

Oct. 22: Citic Securities, a top state-controlled investment bank in China, announces a deal to invest $1 billion in Bear Stearns and form a joint venture with the firm in Asia.

Sept. 20: Mubadala Development Company, the investment arm of the Abu Dhabi government, announces a deal to buy a 7.5 percent stake in a buyout giant, the Carlyle Group, for $1.35 billion.

Sept. 19: Borse Dubai, the government-controlled exchange, agrees to take a 19.9 percent stake in the Nasdaq and to buy Nasdaq’s 28 percent stake in the London Stock Exchange.

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