The world’s new financial power brokers

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One glance at the distribution of wealth around the world and the shift is obvious: financial power, so long
concentrated in the developed economies, is dispersing. Oil-rich countries and Asian central banks are now among
the world’s largest sources of capital. What’s more, the influx of liquidity these players have brought is enabling
hedge funds and private-equity firms to soar in the pecking order of financial intermediation.

New research from the McKinsey Global Institute shows that the assets of these four groups of investors—the new
power brokers—have nearly tripled since 2000, reaching roughly $8.5 trillion at the end of 2006. This sum is
equivalent to about 5 percent of total global financial assets ($167 trillion) at the end of 2006, an impressive number
for players that lay on the fringes of global financial markets just five years ago.

The impact and visibility of this quartet exceed its relative size, despite the discreet way its members operate.
Among other things, they have helped lower the cost of capital for borrowers around the world. In the United States,
we estimate, long-term interest rates are as much as 0.75 of a percentage point lower thanks to purchases of US
fixed-income securities by Asian central banks and petrodollar investors—$435 billion of net purchases in 2006
alone. Meanwhile, investors from the Middle East, pursuing returns they believe will exceed those generated by
fixed-income instruments or equities in developed economies, are fueling investment in Asia and other emerging
markets. Hedge funds have added to global liquidity through high trading turnovers and investments in credit
derivatives, which allow banks to shift credit risk off their balance sheets and to originate more loans. Private-equity
firms are having a disproportionate impact on corporate governance through leverage-fueled takeovers and
subsequent restructurings. And over the next five years, the size and impact of the four new power brokers will
continue to expand.

Oil rises to the top

In 2006 oil-exporting countries became the world’s largest source of global capital flows, surpassing Asia for the
first time since the 1970s. These investors—from Indonesia, the Middle East, Nigeria, Norway, Russia, and
Venezuela—include sovereign wealth funds, government-investment companies, state-owned enterprises, and
wealthy individuals.

This flood of petrodollars comes from the tripling of world oil prices since 2002 and the steady growth in exports of
crude oil, particularly to emerging markets. A large part of the higher prices paid by consumers ends up in the
investment funds and private portfolios of investors in oil-exporting countries. They then invest most of it in global
financial markets, adding liquidity that helps to explain what US Federal Reserve Board of Governors chairman Ben
Bernanke described as a "global savings glut" that has kept interest rates down over the past few years. In 2006
alone, we estimate at least $200 billion of petrodollars went to global equity markets, more than $100 billion to
global fixed-income markets, and perhaps $40 billion to global hedge funds, private-equity firms, and other
alternative investments. This capital is invested chiefly in Europe and the United States, but regions such as Asia, the
Middle East, and other emerging markets are also significant beneficiaries.

Although the added liquidity from petrodollars has helped buttress global financial markets, it may also be creating
inflationary pressure in illiquid markets, such as those for real estate and art. The unanswered question is whether
the world economy will continue to accommodate higher oil prices without a notable rise in inflation or an economic
slowdown.

Where the wealth is . . .

The Gulf Cooperation Council (GCC) states—Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab
Emirates (UAE)—are the largest oil exporters. Together, we estimate, they had foreign assets of $1.6 trillion to $2
trillion by the end of 2006. Other states in the region, including Algeria, Iran, Libya, Syria, and Yemen, held an
estimated $330 billion; the other oil exporters combined, about $1.5 billion. At the end of 2006, the oil exporters
collectively owned $3.4 trillion to $3.8 trillion in foreign financial assets.3

Much attention around the world has recently been devoted to the oil exporters’ sovereign wealth funds, which are
indeed large. By some estimates, the Abu Dhabi Investment Authority (ADIA) holds nearly $875 billion in foreign
assets, Norway’s Government Pension Fund $300 billion, Russia’s Oil Stabilization Fund $100 billion, and the
Kuwait Investment Authority $200 billion. But oil investors as a whole are a more diverse group, with hundreds of
individual players. We calculate that private individuals who actively invest in global financial markets hold at least
40 percent of the foreign wealth purchased with petrodollars. Also important are the oil-exporting states’ central
banks (such as the Saudi Arabian Monetary Agency) and private-equity-like funds, including Dubai International
Capital.

. . . and where it’s going

Compared with traditional players such as pension funds and mutual funds, the assets of petrodollar investors are
relatively modest. Still, they have been growing at an impressive rate of 19 percent a year since 2000 and will
continue to increase their impact on world financial markets because of escalating energy demand from China,
India, and other emerging markets. Even in a base case with oil prices reverting to $50 a barrel,4 the oil-exporting
countries would have net capital outflows5 of $387 billion a year through 2012—an infusion of more than $1 billion
a day of capital into global financial markets. Over the next five years, we estimate, this flow would generate
investments of $1.4 trillion in equities, $800 billion in fixed-income securities, and $300 billion for private-equity
firms, hedge funds, and real estate. The oil exporters’ total foreign assets would grow to at least $5.9 trillion in 2012.

If oil prices remained at $70 a barrel until 2012—and they neared $100 in November 2007 as this article went to
press—foreign assets purchased with petrodollars would grow to $6.9 trillion by then. This figure implies an inflow
of almost $2 billion a day into global financial markets. Even if oil prices declined to $30 a barrel, foreign assets
purchased with petrodollars would grow robustly. This enormous pool will continue to provide liquidity for capital
markets but may also cut investment returns and create inflationary pressures in areas such as real estate.

Reserves: Asia’s opportunity cost

Second in size to petrodollars are the reserves of Asia’s central banks—reserves that have grown rapidly as a result
of rising trade surpluses, foreign-investment inflows, and exchange rate policies. In 2006, Asia’s central banks held
$3.1 trillion in foreign-reserve assets, 64 percent of the global total and nearly three times the amount they held in
2000. Compared with petrodollars, these assets are concentrated in just a handful of institutions. China alone had
amassed around $1.4 trillion in reserves by mid-2007.

Unlike investors with petrodollars, Asia’s central banks have channeled their funds into conservative investments,
such as US treasury bills. We estimate that by the end of 2006, these institutions had $1.9 trillion more in foreign
reserves than they needed for exchange rate and monetary stability.6 Because they could have invested that sum in
higher-yielding opportunities, the forgone returns represent a significant opportunity cost. On the relatively
conservative assumption that alternative investments in a higher-yielding capital market portfolio might yield 5
percent more than US Treasury bills, that cost for Asia’s major economies, in 2006 alone, was almost $100 billion—
1.1 percent of their total GDP.7

What to do with growing reserves?

As trade surpluses accumulate, the opportunity cost of Asia’s reserves will become even greater. If recent growth
continues, they will reach $7.3 trillion in 2012. Even if China’s current-account surplus declined dramatically over
the next five years and Japan’s remained the same, Asia’s reserve assets would grow to $5.1 trillion by 2012 .

In a quest for higher returns, some Asian governments have begun to diversify their assets by channeling some of
their reserves to sovereign wealth funds similar to those of oil-exporting nations. The Government of Singapore
Investment Corporation (GIC), established in 1981, now has an estimated $150 billion to $200 billion in assets and
according to public statements has plans to increase them to $300 billion. Korea Investment Corporation (KIC) has
$20 billion in assets, the new China Investment Corporation (CIC) $200 billion. The assets of Asia’s sovereign
wealth funds could collectively reach $700 billion in the next few years, with the potential for even more growth.

Such a shift will benefit Asian nations through higher investment returns and spread the "Asian liquidity bonus"
beyond the US fixed-income market. Given the large and rapidly growing amounts of reserves used to purchase
assets, however, US interest rates won’t necessarily rise as a result. Over time, a greater share of the investments
made by the sovereign wealth funds may stay within Asia, spurring the development of its financial markets.

Beneficiaries of liquidity
Hedge funds and private-equity funds are among the beneficiaries of the added liquidity that Asian and oil-rich
countries bring to global markets. Assets under management in hedge funds totaled $1.7 trillion by the middle of
2007. But after taking into account leverage, we estimate that their gross investment assets could amount to as much
as $6 trillion, more than the foreign assets of investors from oil-producing countries or Asia’s central banks.8

Although the failure of several multibillion-dollar hedge funds in mid-2007 may slow the sector’s growth, investors
usually look to the long term; it would take several years of low returns before these vehicles lost their appeal.
What’s more, oil investors are big clients of hedge funds and private-equity funds, with around $350 billion
committed today, and high oil prices could more than double that sum over the next five years. Even if the growth of
the hedge funds’ assets were to slow significantly—say, to 5 percent a year—by 2012 they could still reach $3.5
trillion. Taking into account leverage, hedge funds would then have gross investments of $9 trillion to $12 trillion,
about a third of the assets that mutual funds around the world will have in that year.

Hedge funds as financial engines

Thanks to the size and active-trading styles of hedge funds, they play an increasingly significant role in global
financial markets: in 2006 they accounted for 30 to 60 percent of trading volumes in the US and UK equity and debt
markets, and in some higher-risk asset classes, such as derivatives and distressed debt, they are the largest type of
player. Although petrodollar investors and Asia’s central banks add liquidity by bringing in new capital, hedge funds
do so by trading actively and playing a large role in credit derivative markets. In this way, they increase the number
of financing options available to borrowers (including private-equity firms) that might have found it hard to attract
financing in the past, and their active trading improves the pricing efficiency of financial markets.

How risky?
Worries persist that the hedge funds’ growing size and heavy borrowing could destabilize financial markets. But our
research finds that over the past ten years several developments have reduced—though certainly not eliminated—the
risk of a broader crisis if one or more funds collapsed.

For one thing, their investment strategies are becoming more diverse. Ten years ago more than 60 percent of their
assets were invested in directional bets on macroeconomic indicators. That share has shrunk to just 15 percent today.
Arbitrage and other market-neutral strategies have become more common, thereby reducing herd behavior—one
reason most hedge funds withstood the US subprime turmoil in 2007. Several large quantitative-equity arbitrage
funds simultaneously suffered large losses, indicating that their trading models were more similar than previously
thought. But, overall, the sector emerged relatively unscathed.

In addition, banks now manage risk more capably; the largest appear to have enough equity and collateral to cover
losses from their hedge fund investments. Our analysis indicates that the top ten banks’ total exposure to credit and
derivatives risk from hedge funds is 2.4 times equity—a relatively high capital adequacy ratio of 42 percent.

Private equity: small but powerful

Private equity has gained prominence less because of its size than its impact on corporate governance. Although
assets under management rose 2.5 times, to $710 billion, from 2000 to 2006, the private-equity industry is roughly
half the size of the hedge funds, smaller than the largest petrodollar fund (the ADIA), and growing more slowly than
either.

Even so, thanks to typical investment horizons of four to five years, concentrated ownership positions, and seats on
the board of directors, private-equity funds can embark upon longer-term, and therefore potentially more effective,
corporate-restructuring efforts. Not all private-equity firms live up to that billing, however. Our research shows that
only the top-performing ones sustainably improve the operations of the companies in their portfolios and generate
high returns.

The growing size of individual firms—and "club deals" combining the muscle of several firms or investors—have
enabled them to buy ever-larger companies. Private-equity investors accounted for one-third of all US mergers and
acquisitions in 2006 and for nearly 20 percent in Europe. This wave of buyouts has prompted CEOs and boards at
some companies to find new ways of strengthening their performance.

Size limits risk

Private-equity firms may also amplify the risks in financial markets—particularly credit risk—because they like to
finance takeovers with leveraged loans and use their growing clout to extract looser lending covenants and better
terms from banks. The credit market correction of mid-2007, however, jeopardized the financing for many private-
equity deals.

Even if private-equity defaults rose sharply, they would not be likely to have broader implications for financial
markets. In 2006 private-equity firms accounted for just 11 percent of overall corporate borrowing in Europe and the
United States. If their default rates rose to 15 percent of all deals—the previous high was 10 percent—the implied
losses would equal only 3 and 7 percent, respectively, of 2006 syndicated-lending issuance in Europe and the United
States.

Growth signals a structural shift

Despite the difficult experience of some recent buyout deals, we believe that global private-equity assets under
management will double to $1.4 trillion by 2012. Our projection assumes that fund-raising remains at its 2006 level
in Europe and the United States and grows at half its previous rate in Asia and the rest of the world. If current
growth rates in fund-raising continued, private-equity assets would reach $2.6 trillion in 2012.

Either way, that kind of growth represents a fundamental shift in the development of financial markets. For the past
25 years, financial intermediation in mature economies has migrated steadily from bank lending to the public-equity
and debt markets. The rise of private equity and the private pools of capital in sovereign wealth funds herald the
resurgence of private forms of financing.

The road ahead

Regardless of whether interest rates rise or oil prices drop, the four new power brokers will continue to grow and
shape the future development of capital markets. To ease the transition to the coming financial order, the players can
take some useful steps.

Because capital markets function on the free flow of information, sovereign wealth funds and other types of
government-investment units9 in Asia and in oil-exporting nations should consider disclosing more information
about their investment strategies, target portfolio allocations, internal risk-management procedures, and governance
structures. (Norway’s Government Pension Fund is a model in this respect.) Funds can allay concerns that politics
will play a role in their decisions—and reduce the likelihood that regulators will act too aggressively—by publicly
stating their investment goals.

Policy makers in Europe and the United States should base any regulatory response to the activities of the new
power brokers on an objective appraisal of the facts. In particular, they ought to distinguish between direct foreign
acquisitions of companies and passive investments by diversified players in financial markets.

Banks must protect themselves against the risks posed by hedge funds and private-equity funds. In particular, they
need tools and incentives to measure and monitor their exposure accurately and to maintain enough capital and
collateral to cover these risks. Currently, it is difficult to assess the dangers stemming from illiquid collateralized
debt obligations (CDOs) and collateralized loan obligations (CLOs). Ratings agencies and investors alike must raise
their risk-assessment game.

With the growth of credit derivatives and collateralized debt obligations, banks have in many cases removed
themselves from the consequences of poorly underwritten lending. As institutions originate more and more loans
without putting their own capital at risk for the long-term performance of those loans, regulators should find ways to
check a decline in standards. Concerns about the rise of the four power brokers are rational. But we find cause for
qualified optimism that the benefits of liquidity, innovation, and diversification they bring will outweigh the risks.

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