Power Brokers

The rise of four new financial power brokers is causing a good deal of unease around the world. Increasingly influential, but traditionally secretive, these players—investors from oil-exporting nations, Asian central banks, hedge funds and private-equity firms—are stirring fears of the wealthy outsider everywhere they turn.

With oil prices running high, investors from petrol powers have become a major target of protectionist countermeasures. Asian central banks now hold so much American debt, rumors of a shift in China's appetite for U.S. Treasuries send tremors through U.S. credit markets. The top hedgefund executives, who manage money for wealthy clients, have become so

spectacularly well paid that the movement to restrain their power (and tax their billions) now spans the Atlantic and the Pacific. And private equity firms, which buy and sell whole companies, have been attacked as "vultures" and worse, particularly in Europe.

Much of the unease arises from the public's lack of knowledge about who these players are, and even how much money they really control. In a new report, the McKinsey Global Institute (MGI) lays out the facts about these new "power brokers," and their growing clout and ability to shape global financial markets. And it is indeed impressive: the combined assets of the four key players have tripled since 2000 to around $8.5 trillion at the end of 2006. That is equivalent to 40 percent of the wealth held by global pension funds—striking for players that were on the fringes of financial markets just five years ago.

However, even if you assume big is bad (and we don't), the concerns are not always well targeted. Private-equity funds, perhaps the most scrutinized of the four, are also by far the smallest. Engineers of what are called leveraged buyouts—or LBOs, in the 1980s—private-equity funds have tripled in size since 2000 and have $710 billion in investors' capital (as of the end of 2006). But hedge funds are at least twice as large, holding assets of $1.5 trillion. If you count leverage—borrowed money hedge funds often use to boost returns—they may control as much as $6 trillion invested in financial markets. That, surprisingly, would make hedge funds the biggest power brokers, bigger even than the oil states.

In terms of dollars in hand, the tripling of world oil prices since 2002 has made petro-investors the largest of the four new power brokers. MGI estimates that oil investors have between $3.4 trillion and $3.8 trillion in foreign financial assets. Close behind are the Asian central banks, with foreign-reserve assets of $3.1 trillion—the results of soaring trade surpluses, significant foreign investment in the region and exchange-rate policies.

No matter how the current financial-market turmoil develops, the four new players are unlikely to diminish in size or market strength. One reason is that their growth has become mutually reinforcing in ways that are still not fully recognized. For example, low interest rates—resulting in part from all the money pouring into credit markets from Asia and oil exporters—have helped spur the rise of hedge funds. Hedge funds have helped fuel growth of private equity through their huge role in the credit derivatives market.

Far from being a temporary phenomenon, the new power brokers will be a prominent feature of the global landscape for years to come. If their current growth rates continue, the four power brokers would see their assets climb to $20.7 trillion by 2012—making them two thirds the size of global pension funds. But they will also grow even if oil prices fall, Asian trade surpluses decline and investor inflows into hedge funds and private equity slow. In this case, MGI projects that their assets will double over the next five years, to $15.2 trillion.

Given the sheer size of these new powers, the concerns about them are hardly surprising. Increasingly large investments by quasi-governmental investors from the Middle East and Asia are stirring nervousness about "national security" in the United States and Europe. The rush of cash emanating from these players could be fueling asset-price bubbles. Private equity and hedge funds could create new sources of financial-market instability, including higher credit risk and a greater change of "systemic risk" in which one or more large hedge-fund failures start a dangerous ripple effect across global capital markets—as occurred in 1998 with the near collapse of Long-Term Capital Management. Because all these players are lightly regulated, they can move huge amounts of money beyond the scrutiny of financial-market authorities.

Yet the new power brokers have also strengthened financial markets in many ways. Together, oil investors and Asian central banks are major contributors to the "global savings glut" that has lowered interest rates worldwide and enabled new forms of lending to many borrowers. Now, amid a global credit crunch, these financial players may also provide much-needed liquidity. They can afford to think long term, countering the quarter-to-quarter ethos so prevalent in other parts of the market where institutions are accountable to armies of shareholders. And with their strong focus on investments in Asia, the Middle East and other emerging markets, these two power brokers will spearhead faster financial-market development outside the traditional power centers.

As for hedge funds and private-equity firms, many are entering the mainstream, going public and adopting better reporting standards. The bottom line, in our view, is that each of the new powers is evolving in ways that will do more to foster than to disrupt steady growth in the global economy. Here's our forecast:

Last year, with oil at about $60 a barrel, petroleum-exporting countries became the world's largest capital exporters, surpassing Asia for the first time since the 1970s. These nations will be among the most important players in world financial markets over the next five years, thanks to the escalating energy demands of developing economies. Six of the 10 largest companies in the world by market capitalization are now oil companies in the Middle East and Asia, if we estimate what private companies would be worth if they listed publicly. In this scenario, Saudi Arabia's state oil company Saudi Aramco is believed to be valued at twice as much as General Electric—the largest public company in the world.

Because the domestic economies and financial markets of oil exporters are small, the majority of oil revenues end up invested in global financial markets. MGI estimates that if oil prices stay at about $70 a barrel (and prices just passed $85 a barrel), some $628 billion a year in petrodollars will flow into global markets by 2012, doubling oil exporters' foreign assets to nearly $7 trillion in the next five years.

The oil investors are a diverse group, including hundreds of wealthy individuals, sovereign wealth funds, and central banks in the Persian Gulf, Norway, Russia, Nigeria, Venezuela and Indonesia. Dubai International Capital is one example, a private-equity-like investment fund that bought Tussauds theme-park empire and the Travelodge hotel chain. Norway's Government Pension Fund, with some $300 billion in assets, employs ethics criteria for choosing investments and is the only oil fund that publicly discloses its investments. Saudi Arabia's Prince Alwaleed Bin Talal Alsaud has tens of billions of dollars invested in companies all over the world.

Because of their long-term investment horizons and higher preference for risk, oil investors have spurred the growth of hedge funds and private equity. Their penchant for developing economies will hasten financial-market development in the Middle East, North Africa, and Asia. They also will fuel growth in the currently small market for Islamic financial products.

Asian central banks have been the cautious giants in global capital markets, investing their burgeoning reserves chiefly in U.S. dollar-denominated assets, particularly Treasury securities. But they are starting to be more adventurous; China, South Korea and Singapore have announced plans to shift as much as $480 billion into state-owned, diversified sovereign wealth funds. The first investment by the new China Investment Corp. was a $3 billion stake in the U.S. private-equity firm Blackstone Group.

The potential impact on capital markets of this new strategy is significant, given the staggering amount of capital concentrated in the hands of just a half-dozen Asian governments. China's central bank, the People's Bank of China, had accumulated $1.1 trillion in foreign-reserve assets by the end of 2006, making it arguably the single wealthiest investor in international financial markets. A year ago Asian central banks held nearly two thirds of the world's foreign reserves. MGI finds that even if Asia's current-account surplus growth slows, its reserve assets will grow to $5.1 trillion by 2012.

Thus far, the Asian central banks' conservative investment strategy may have lowered long-term U.S. interest rates by 0.55 of a percentage point. But the relatively low returns from these investments also cost Asian economies as much as $100 billion a year, equivalent to about 1 percent of GDP. The shift of some of these assets into sovereign wealth funds should improve returns, while spreading funds to other asset classes. Some worry that this process will raise U.S. interest rates, but MGI concludes it may not, since the central banks' rapidly growing reserves will allow them to continue buying large amounts of U.S. securities even while slowly diversifying.

The hedge-fund universe is expanding rapidly, with more than 7,300 funds managing some $1.7 trillion in assets by mid-2007. The three largest hedge funds each manages at least $30 billion in investors' assets, and have estimated investment positions in financial markets of up to $100 billion. MGI projects that the value of hedge-fund assets under management will more than double over the next five years to $3.5 trillion.

Hedge funds have benefited capital markets by increasing liquidity and spurring financial innovations. Yet worries persist that their growing size and heavy use of borrowing could destabilize financial markets. When Long Term Capital Management ran into trouble in 1998, the fund's catastrophic losses prompted the Federal Reserve to coordinate a $3.6 billion rescue by a group of large banks.

More recently, several multibillion-dollar hedge funds suffered big losses in mid-2007 as rising defaults on subprime mortgages caused turmoil in the debt and equity markets. Some smaller and midsize funds shut down. So the question arises again: could a hedge-fund meltdown trigger a broader financial-market crisis?

MGI's research suggests that several developments over the last decade may have reduced—but certainly not eliminated—the risks. Hedge funds have adopted more-diverse trading strategies, reducing the likelihood that many would fail simultaneously. The banks that lend to hedge funds have improved their assessment and monitoring of risk, and have reasonable financial cushions—collateral and equity—to protect them in case one or more of their hedge-fund clients were to fail (as we saw last summer). The largest hedge funds have begun to raise permanent capital in public stock and bond markets, while imposing more restrictions on investor withdrawals—changes that should improve their ability to weather market downturns. Once financial-market mavericks, hedge funds are joining the mainstream.

Private equity is a relatively small industry, but one that has had a disproportionately large impact on the corporate world. The value of private-equity-owned companies is only 5 percent of the value of companies listed in the U.S. stock markets (and just 3 percent in Europe). However, private-equity firms now account for nearly one in three mergers or acquisitions. These firms have grabbed public attention with a series of huge deals, including the buyouts of energy giant TXU Corp. for $45 billion and health-care company HCA, Inc., for $33 billion.

Private-equity firms are ushering in a new model of corporate governance, and the best funds improve the performance of many of the companies they buy. For instance, one study of 60 leveraged-buyout deals found that two thirds of them improved company performance and posted risk-adjusted returns of twice the industry average. Seeing superior returns in companies taken private, shareholders of publicly listed companies are inclined to scrutinize the performance of their respective managements more closely and demand improvements.

Although private-equity funds are sometimes accused of seeking short-term profits, most private-equity funds invest on a three- to five-year horizon, giving them leeway to engage in root-and-branch corporate restructuring. By adding debt to an acquired company's balance sheet, they force managers to hit tough financial targets. As the pace of buyouts quickened earlier in 2007, private-equity firms caused many public companies to rethink their attitudes toward debt and equity—in the United States, for instance, companies have increasingly been choosing to buy back shares, often purchasing them partly by raising levels of debt.

The recent tightening of credit markets has complicated the financing of some recent buyout deals and may dampen the flow of investor money into private-equity firms. But even if growth slows in the short term, MGI projects that the industry's assets will increase to $1.4 trillion by 2012. As the industry expands, private-equity firms will mature, consolidate and diversify their investments, amplifying their influence on the broader corporate and financial landscape.

These new power brokers are here to stay and they are increasingly venturing into each other's territory. Hedge funds are buying up companies. Asian central banks are starting to replicate the sovereign wealth funds of oil exporters. Oil exporters are creating more-sophisticated investment vehicles such as private-equity funds.

The concerns about the new power brokers are genuine—and may well be justified. But we should make judgments based on the facts—not out of an emotional response to power's passing to a new set of actors on the financial stage. There is cause for qualified optimism that the benefits of liquidity, innovation and diversification brought by the new players will outweigh the risks.

Power Brokers | News