12/18/2013

Volcker Snags China Sovereign Wealth Fund

It looks like the Volcker Rule will force one of the world’s biggest investors in hedge funds, China Investment Corp., to exit many of its fund stakes.

The sovereign wealth fund, which ranks second on Hedge Fund Alert’s roster of the largest fund investors, is a U.S. bank holding company by virtue of controlling stakes in large Chinese banks with operations in the States. That means it is subject to Volcker Rule provisions barring banks from investing in hedge funds and private equity vehicles run by unaffiliated managers. Unless it restructures its bank holdings, or takes advantage of narrow exemptions in the final version of the rule regulators adopted last week, CIC would have to liquidate its stake in any fund managed by a U.S. firm, as well as vehicles run by non-U.S. managers with backers in the States.

That could have an outsized impact on the hedge fund industry, considering CIC’s fund investments total some $23 billion, according to the investor ranking. And at least one other sovereign wealth fund with a large hedge fund portfolio, Singapore’s Temasek Holdings, could be in a similar situation. Temasek recently increased its stake in DBS Bank, which has a branch in Los Angeles, to the extent that it would qualify as a bank holding company. Temasek is reviewing the impact of Volcker on its operations.

CIC owns stakes in four banks with operations in the U.S.: Bank of China, China Construction Bank, Industrial and Commercial Bank of China and Nanyang Commercial Bank of Hong Kong. Together, they control $43 billion of assets via offices in Chicago, Los Angeles, New York and San Francisco, according to the Federal Reserve.

As a hedge fund investor, meanwhile, CIC runs money through funds of funds operated by Blackstone and Morgan Stanley, as well as vehicles managed by Capula Investment and Oaktree Capital, among others, according to Preqin. It also has invested with private equity fund managers including Apax Partners, BC Partners, Carlyle Group and J.C. Flowers & Co. Under Volcker, covered institutions face a July 21, 2015, deadline to largely exit their positions in alternative-investment vehicles run by outside managers.

One industry lawyer noted that in 2008, the Fed granted CIC an exemption to Section 4 of the Bank Holding Act, which prohibits holding companies from engaging in non-banking activities. But a source familiar with the sovereign wealth fund said that exemption does nothing to mitigate the impact of the Volcker Rule, which provides for no such relief.

Indeed, CIC began preparing for Volcker well before the Fed and four other regulatory agencies adopted the Dodd-Frank Act mandate in its final form on Dec. 10. For instance, the fund has taken steps to make it easier to exit certain private equity positions should it have to, the source said.

“They considered themselves at risk under Volcker, depending on the final scope of Volcker, and the final scope has not changed in any relevant respect,” he said. “At some level, they are hoping they will get some exemption or executive order. It’s unclear where the Fed’s authority to do that lies, and it would probably have to be a political solution.”

Meanwhile, the final version of Volcker contains several provisions that could give CIC and Temasek some wiggle room. For example, banks can continue investing with outside managers via separate accounts, so long as the accounts don’t constitute proprietary trading. While the definition of prop trading is complex, it appears banks would be permitted to own such accounts as long as the investments are longer term — that is, they’re held for at least 60 days, and possibly longer. But any separate account would have to follow a different strategy than a manager’s main vehicle, and it can’t exist merely to evade the Volcker Rule.

The upshot: It will be difficult, at best, for CIC to restructure its relationships with many of the managers it works with.

Another option for CIC would be to take advantage of a provision that allows banks to invest in joint-venture vehicles they launch with up to 10 partners — so long as the vehicles support core banking functions. Thus a bank theoretically could invest in a direct-lending or loan-trading hedge fund that runs money for as many as 10 investors. However, the same provision prohibits investments in joint-venture vehicles that primarily trade securities — thereby excluding a large swath of the fund industry.

As for Temasek, it appears the impact of Volcker will be more muted — even if the Singapore fund is tagged as a U.S. bank holding company. That’s because the two Temasek units that deploy capital to hedge funds — Fullerton Fund Management and SeaTown Holdings — invest largely with managers in Asia. Still, some of those firms could be forced to choose between Temasek and U.S. investors, since Volcker bars banks from investing with non-U.S. managers that offer their vehicles in the States.

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