Volcker’s strangle on sovereign wealth funds

A few days ago some lawyers talking with PE Manager pointed out something not many people had focused on in the Dodd-Frank act's Section 619 (better known as the “Volcker Rule”): it appears sovereign wealth funds, like their institutional investor banking cousins, may also be restricted in making private equity investments and commitments. 

Some sovereign wealth funds, such as China Investment Corporation (CIC), could fall under the definition of a “bank holding company” in the US because they own more than a 5 percent stake in a bank with a US presence. They may be able to push back on that definition by avoiding various regulatory “control” thresholds, but a 25 percent ownership stake in a bank with a US branch guarantees the definition sticks.

And as GPs are aware, bank holding companies will be prohibited from supplying more than 3 percent of the capital in any private equity or hedge fund. 

Nothing is for certain until US regulators release the rule’s final language – which may or may not come before the election depending on who you ask – but unless tweaks are made US-based GPs face yet another rule handicapping their ability to fundraise.

Just how much is at stake? Sovereign wealth funds collectively manage some $5 trillion in assets, according to the Sovereign Wealth Fund Institute. Assuming a 5 percent private equity allocation in your average sovereign’s portfolio that translates to $250 billion in commitments that could be cut down in size as a result of the rule (though it’s impossible of course to know by just how much considering the private nature of sovereign wealth funds).  

China’s preeminent sovereign wealth fund, CIC, is a prime example of the rule’s potential impact on fundraising. CIC, which made its first private equity investment in 2008 to JC Flowers & Co., holds stakes in China's biggest banks which in turn have US branches. Last week the group published figures revealing its alternative investments had grown in value to $40.4 billion in 2011 from $29.3 billion in 2010.

Considering sovereign wealth funds' rising interest in the private equity asset class it's perhaps surprising they have not done more to address the issue, according to sources, who believe they have simply been unaware of the rule’s potential reach. That needs to change, for both the industry's benefit and theirs.