Sovereign Investing and Corporate Governance: Evidence and Policy

IntroductionDiscussions of corporate governance often focus solely on the attractiveness of firms to investors, but it is also true that firms seek out preferred investors.1 What, then, are the characteristics of an attractive investor? With over $5 trillion in assets,2 sovereign wealth funds ("SWFs") are increasingly important players in equity markets in the United States and abroad, and possess characteristics that firms prize: deep pockets, long-term (and for some, theoretically infinite) investment horizons, and potential network benefits that many other shareholders cannot offer. Indeed, in a recent BNY Mellon survey of large corporations, SWFs were identified as particularly attractive investors.3 The survey report notes that "[w]hile in 2010 47% of corporates reported engaging with SWFs, in 2012 that had grown to 62%."4 But the report also notes an important concern for U.S. markets: of the companies reporting engagement with SWFs, companies based in Western Europe had the highest rate of engagement, with 79% of corporations reporting discussions with SWFs. On the other hand, at 49%, North American companies had the lowest rate of engagement with sovereign investors.5Despite their economic power, their reach, and their general desirability as investors, SWFs are almost entirely disengaged from corporate governance matters in U.S. firms. Indeed, with the exception of Norway's Government Pension Fund-Global,6 SWFs are notable primarily just for their passivity as shareholders. It is well documented that SWFs present unique challenges not only to the countries in which they invest, but also to their own domestic governments and citizenbeneficiaries, and it is these varied political challenges that provide the strongest explanation for SWFs' relative passivity in corporate governance.7 But complete passivity has a dark side, especially when combined with a long-term investment horizon. If, like consumers, shareholders' two primary means of affecting corporate behavior are voice and exit/ then passive SWFs are not simply a non-factor in corporate governance, but may also have a negative effect by holding large, inert share blocks that could be held by more engaged shareholders who would be more vigilant in containing managerial agency costs.Given the domestic and external political and regulatory factors that discourage SWF engagement in U.S. corporate governance, how can SWFs provide appropriate stewardship over their equity investments? This article answers that question by describing how SWFs and regulators can create the crucial "space" necessary for SWF engagement in corporate governance.The analysis proceeds in four substantive sections. Part I lays out a definition of SWFs and describes SWF investment patterns. Part II reviews empirical evidence on SWF investment behavior and the effects that the investment has on firm values, and then examines evidence on SWF activities in corporate governance. Part III discusses the key factors that limit SWF involvement in corporate governance activities. Part IV describes how, given these limitations, SWFs may engage in governance without triggering regulatory reprisals, and how regulators can encourage SWF investment and engagement.I. Defining Sovereign Wealth FundsDefining a role for SWFs in corporate governance requires us to first define the universe of funds to which the term "SWF" applies. There are several categories of funds owned and controlled by sovereign entities, including sovereign wealth funds, central reserve funds (often used as currency stabilization funds), and sovereign pension funds.9 The two that are most important for corporate governance are SWFs and sovereign pension funds. Sovereign pension funds face many of the same issues as SWFs in terms of investment decisions and governance, but have important differences from SWFs that become clear as one defines the term "sovereign wealth fund".Like hedge funds, SWFs resist definition. …