Managing Partner and Co-Founder of Scale up VCa venture capital firm, and West Coast Equity Partners, a private equity firm.
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Sovereign wealth in venture capital is nothing new. Elizabeth I invested in Francis Drake, and he made a return of an estimated 4,600%, which incidentally formed the inspiration for the establishment of the East India Company. This is demonstrable the first unicorn in history. (If you get your Series A funding from a monarch, the sovereign actually gets sovereign wealth.)
Sovereign wealth also makes a lot of sense. Individuals invest for a variety of reasons: saving for a rainy day, raising their standard of living, and generating a cycle of reinvestment of profits toward sustainable passive income. Countries invest in the same way for the same reasons. Perhaps that is why sovereign assets under management almost tripled from about $3 trillion in 2007 to about $8 trillion in 2020. Each of those numbers doubles again if you include public pension funds.
Still, sharing a cap table with sovereign wealth can be risky, and the risks are usually political. If the country behind the money annoys much of the world, it could make the next round of funding inconvenient, when their money is no longer accessible or accessible but poisonous. That’s clear, especially now.
What is less obvious is that such risks apply differently to different sources of sovereign wealth, and there is a large pool of so-called pseudo-sovereign wealth that falls outside conventional definitions but is subject to similar risks. Let’s take a look at what lies within and beyond the vague confines of sovereign wealth.
What is Sovereign Wealth?
All definitions of sovereign wealth that matter, be it the Santiago Principles of the International Forum of Sovereign Wealth Funds or the Organization for Economic Co-operation and Development, share a common criterion: state ownership. Semantically, that criterion makes sense. Sovereign means having supreme political power, meaning it applies to states.
But semantics is not the only factor to consider when defining terms in finance. Other criteria, such as return, regulations, organizational structure or participants can play an important, even decisive role. For this analysis, the decisive criterion is risk versus benefit. Money that enjoys the same benefits and is subject to the same risks as real sovereign wealth can also be considered sovereign wealth in all respects.
A major advantage of sovereign wealth is political cover. It wouldn’t surprise anyone if a certain industry or company with sufficient clout pressured the political machine for favorable regulation or less regulation. That’s a big idea behind the theory of public choice. It is essentially lobbying. What if the government itself, as an investor, were the beneficiary of the growth of an industry or company? Could a government agency use a lighter test for a company in their sovereign wealth fund’s portfolio?
Even bureaucrats have a survival instinct. A department manager is likely to make an informal phone call before imposing a fine. A cynic might even suggest that some companies are dealing with regulatory pressure sovereign wealth at court investments for exactly such reasons.
Another important advantage is access. Sovereign wealth funds are usually large and may be able to convince a minister or undersecretary to call and arrange a meeting. Even the best general partnerships of the largest funds would find that useful every now and then.
As a result, sovereign wealth is also subject to political contamination. Sovereign wealth funds are often and understandably lumped together with their regimes. Investors complaining about SEC regulations should try UN sanctions, which pose a risk to sovereign wealth funds.
Such risks, of course, depend on how powerful and globally integrated the countries involved are. Weak countries cannot or cannot credibly penalize the sovereign wealth of powerful countries. Another important question is transparency. Risks shrink with the chance of getting caught, and sovereign wealth funds vary widely in the field of transparency.
Pseudo Sovereign Wealth
There is a large but unquantifiable amount of money in world markets that is not owned by governments, but that benefits from the same kind of political access and cover as official sovereign wealth.
For example, a prime minister can be a member of a family conglomerate for construction, telecom, media and banking. Or, to avoid a conflict of interest, a leader may relinquish ownership and control of his shipping company by: give it to his sons. But pseudo-sovereign wealth goes beyond family ties. It can also include money held by those who can help an important person in a difficult place, for example by: buy votes for their reelection.
Fascinatingly, political access and coverage can even become obligations in such cases. If, as often happens, the story comes out about how a deal came about, who opened which doors, and who covered which mistakes, a banal example of austerity can make an entire deal or fund poisonous.
Don’t worry, check
The point is that sovereign wealth goes beyond formal definitions and official sovereign wealth funds. Sovereign wealth comes with benefits and risks, and they apply to quite a bit of investment capital. Because sovereign wealth goes beyond state money, any investment that can benefit or suffer from government ties, even weak, informal ones, counts. All of us venture capitalists probably share at least one cap-table with pseudo-sovereign wealth.
The best way to deal with this, as so often, is to do your homework. Not all sovereign wealth will be as obvious and hassle-free as, say, Norges, Temasek, or the Alberta Investment Management Corporation. Find out who else is involved in a deal and who is in their network. One way is to ask about the benefits: What connections do they bring? What doors can they open? What problems can they solve? And then, privately, reverse the equation. Every asset is a liability somewhere else. Any casual favor is a risk of having a bad day. You can’t overdo due diligence, especially when it comes to sovereign wealth.
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