Sovereign funds face sobering test of strategy

By Natsuko Waki

LONDON (Reuters) - Sovereign wealth funds are looking less keen to live up to their recent reputation as investors of last resort given huge investments they made in failed Western banks are turning sour one year into the credit crunch.

State-owned wealth funds, which manage almost $3 trillion (1.5 trillion pounds) in assets, have grabbed global financial markets' attention since last year, when they replaced hedge funds and private equity as the main driver of corporate takeover activity.

Since 2007, these sovereign funds -- mainly from emerging economies with excess reserves -- have spent nearly $80 billion to buy stakes in major banks desperately needing cash to repair balance sheets damaged by losses on U.S. subprime mortgages.

It was a match made in heaven -- except that the arrival of the sovereign funds does not seem to have been enough to stop the rot. Banking stocks have continued to tumble and some shares have become diluted as a result of rights issues.

Most sovereign wealth funds (SWFs) do not have to report mark-to-market losses in public and some argue they can ride out temporary losses and cycle downturns to seek long-term returns.

But while they are unlikely to unwind investments they have already made, their appetite for jumping into risky deals again may be dulled.

"The opportunity of making large scale investments in Western investment banks doesn't come along very often. They have made these investments because it was a rare opportunity and one they could not turn down," said Ben Faulks, associate director at Standard & Poor's.

"(But) wealth funds have a mandate to make money, not to plough money into ventures destined for collapse. They are not charities. They won't make investments unless they think they can make money."

In a sign that SWFs might be worried about their loss-making investments, South Korea's state-owned fund said it had posted about $800 million in valuation losses before it converted preferred shares of Merrill Lynch MER.N into common stocks last week, more than two years ahead of schedule.

Under the original agreement, Korean Investment Corporation was to swap the shares into common stocks in mid-October 2010, but the fund had faced heavy criticism after Merrill's share price tumbled more than 50 percent this year.

"We learned a lot of good lessons from the investment in Merrill Lynch," said Chin Youngwook, KIC's chief executive."

"I think we may have to approach cautiously."

Another official at KIC said a share purchase in other U.S. financial firms could skew its portfolios and the fund was not seriously considering raising exposure to them at the moment.

Also facing huge paper losses on its Merrill investment, Singapore's wealth fund Temasek negotiated a rebate of $2.5 billion on its original $4.4 billion stock purchase after the U.S. investment bank raised fresh funds in July.

"SWFs have emerged as significant global investors," said Gay Huey Evans, who as vice chairman of investment banking and investment management at Barclays is responsible for coordinating the financial group's sovereign wealth business.