NO EASY DEAL: China's sovereign wealth fund half year of operation hasn't been rewarding so far due to huge paper loss in investing in Blackstone Group IPO

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The April deal between the China Investment Corp. (CIC) and the U.S. company J.C. Flowers & Co. LLC. to set up a $4 billion joint private equity fund cast the two in the spotlight. It is the first private equity firm CIC entered, while J.C. Flowers, a scarcely heard of Wall Street institution, has made itself well known on the mainland through the deal.

Beijing-based CIC is the nation's sovereign wealth fund, independent of the Chinese Government and pursuing commercial operation. It will become a limited partner of the new private equity fund, contributing about 80 percent of the total capital. The New York-based private equity firm J.C. Flowers will offer about 10 percent of the money. Several other general partners will be involved and cover the rest of the capital.

In spite of putting the lion's share in the new fund, CIC refrained from taking a management role, just as it did with its previous deals. The new private equity fund will be run by J.C. Flowers, which will brief CIC on some significant investments in advance, according to Reuters. The two companies could not be reached for comment.

Learning to grow

It is still early to judge when the new firm will generate profits. However, domestic experts turned from criticizing to commenting positively after observing CIC's recent deals, whereby CIC is growing from a fledgling investor to a more proficient player in the international financial market.

China has invested more than two thirds of its foreign reserves in U.S. dollar-denominated assets, mostly U.S. Treasury bonds and Agency bonds. However, the dollar depreciation on world currency markets provides poor returns, forcing China to think of other ways to generate profits from its huge foreign exchange reserves. CIC was created to take the opportunity.

Even before the inauguration of the company on September 29, 2007, CIC rushed to buy $3 billion worth of stocks in the U.S. private equity Blackstone Group at approximately $30 per share. However, on April 21, Blackstone's stock price dropped to $18.7, leading to about a 40-percent paper loss in the CIC account. The $3 billion is locked for a four-year period, during which CIC will remain a passive investor with no voting rights.

Critics had little mercy for CIC's Blackstone deal, complaining of its hasty timing and immature investment skills without a calculated analysis of the global financial market risks. They said the loss from investing in Blackstone could be regarded as a tuition fee for engaging in the global financial arena.

In defense of CIC's huge paper loss from its Blackstone investment, Wang Jianxi, Deputy General Manager of CIC, said in March that CIC looked for long-term investment returns.

The Blackstone defeat shocked CIC managers, who turned to more conservative investments. Last December, CIC announced to purchase $5 billion worth of convertible securities in Morgan Stanley to inject capital into the cash-hungry Wall Street giant. The $5 billion could give CIC a stake of up to 9.9 percent for a per-share price between $48.07 and $57.68. Though Morgan Stanley's share price once plummeted to about $30, it has recovered to around $50 after a rally in the U.S. markets. CIC is expected to produce profit through this deal, as the convertible securities could last for 31 months.

"Compared with the previous deal, this one is much better," said Li Yongsen, finance professor at Beijing-based Renmin University of China. Li said major U.S. financial institutions were short of capital after being hit hard by the subprime mortgage crisis, thus they offered a more favorable price for investors. "Plus, it is less risky to buy convertible securities," Li added.

At present, CIC peers have been investing heavily in subprime-hit companies in a bid to lower investment costs. For instance, Singapore's Temasek Holdings bought $4.4 billion worth of stocks in Merrill Lynch, the Singapore Investment Corp. poured $9.72 billion in the United Bank of Switzerland, and the Abu Dhabi Investment Authority invested $7.5 billion in Citigroup.

Analysts praised CIC's J.C. Flowers deal, saying CIC was maturing. Guo Tianyong, professor at Central University of Finance and Economics, said it was a perfect time to invest in overseas markets. Excessive liquidity is now a headache in the Chinese economy, whereas the Western countries are suffering liquidity shortages. The new private equity fund will inject $4 billion into the liquidity-hungry U.S. markets. When the U.S. markets recover, CIC should make a significant profit in spite of paper losses for the time being.

Problems still exist

Wang said CIC was under enormous pressure at home and abroad. On the one hand, the $200-billion capital was raised through the selling of 1.55 trillion yuan worth of special treasury bonds. Hence, CIC must be responsible for paying interest to individual or institutional buyers. The yearly interest rate is 5 percent, equivalent to 77.5 billion yuan ($11.1 billion), which means CIC must make at least 300 million yuan ($43 million) in profit a day to pay the interest.

On the other hand, the stumbling overseas financial markets have posed a negative external investment environment for CIC. The subprime mortgage crisis has triggered signs of economic recession in the United States and spread to the European continent. The U.S. Federal Reserve slashed its interest rates, which gave rise to more volatility in financial markets.

Moreover, CIC has a strong penchant for investing in initial public offerings (IPOs). Blackstone was the first one. Then it was followed by the purchase of $100 million worth of stocks in China Railway Co. Ltd.'s IPO in Hong Kong in February, and another $100 million in Visa Inc.'s IPO in March on the New York Stock Exchange. Though CIC had made paper profits from participating in the last two IPOs, 22 percent and 40 percent respectively, the insignificant amounts were negligible compared with the tremendous paper loss in the Blackstone deal.

At the 11th Asia Investment Forum held in Hong Kong on April 2, Wang talked about CIC's special zeal for IPOs, saying "Unfortunately, my colleagues are traditional Chinese, and they believe it is totally safe to buy IPO stocks." Wang acknowledged risks in buying IPO stocks in foreign markets, because when market conditions are bad, it's very likely that stock price will fall below the IPO prices.

Wang pointed out that the CIC was challenged by "too much money and too little experience. It will be difficult to attract talents as CIC has not come up with a competitive salary package yet." According to Nanfang Daily's report on the day when CIC was founded, its original seven founding managers' income was "a little higher than civil servants." Compared with the multi-million-yuan salary package that managers earn at securities companies and fund management companies, CIC's staff could justifiably have reason to complain. Currently, CIC is trying to recruit fund managers to invest in global bonds and fixed-asset investments in emerging markets.

Wang also listed urgent tasks for CIC-establishing sound company management, risk control management and human resource management systems.

CIC is now conservative about its target of investment returns, and Wang believes a "5 to 6 percent profit" would be most possible.

Regarding developed countries' concerns over sovereign wealth fund, Wang said CIC would strive to be as transparent as the Norwegian sovereign wealth fund.

According to CIC's inaugural statement, one third of its registered capital will be used to purchase Central Huijin Investment Co. (which holds controlling stakes in China's four biggest commercial banks), one third will be used to support and provide a fund for the shareholding reform of state-owned banks, and the rest of the capital, about $70 billion, will be invested overseas.

Up to now, deducting the already invested sum, CIC has about $60 billion of disposable capital. CIC's new managers would decide how to make the biggest profit from it.