Middle Eastern sovereign wealth funds reshape global M&A terms

Three years ago, a study from New York University, the London School of Economics and Bocconi University pronounced the end of the “golden era” for sovereign wealth funds. According to their research, the COVID-19 crisis marked a turning point for SWFs.

“This dramatic, unexpected shock accelerates the pre-existing negative trend of declining oil prices and slowing of global trade, the two main drivers of SWF growth,” it read.

Fast-forward three years and reports of sovereign wealth funds’ impending demise have proved incorrect – in fact wildly incorrect.

Russia’s invasion of Ukraine pushed oil prices to levels not seen since the global financial crisis, and while they have fallen during 2023, figures from the IMF suggest the revenues of Middle Eastern SWFs have grown by more than USD1.3 trillion since the start of the war.

With currencies in the region pegged to the dollar, GCC economies with lower fiscal expenditure were able to transfer large surpluses into their SWFs at year-end.

Where are Middle Eastern sovereign wealth funds investing?

Middle Eastern SWFs are now among the most active and sophisticated investors in the world. Last year they scaled new heights, more than doubling their investments in Western economies to USD51.6 billion.

Of the top 10 most active sovereign investors in 2022, five were from the GCC, while the region’s funds were responsible for almost half (43%) of the year’s 60 SWF mega deals (USD1.0 bn+).

A decade ago sovereign investors were generally cautious and often took passive minority stakes, but in recent years they have developed a higher tolerance for risk and now pursue a more diverse range of opportunities.

Today, Middle Eastern SWFs execute full buyouts, co-invest alongside other financial sponsors and are more active stewards of their portfolio companies, routinely insisting on broader governance rights and board oversight and representation, even where they don’t hold a significant position.

However, trying to identify consistent themes in their deployment of capital can be difficult because unlike many private investors, their unique strategies are diverse and focused on more than pure financial returns. Middle Eastern SWFs have domestic and geopolitical objectives and take a long-term view on where they put their money as they strive to diversify their national economies away from natural resources.

Why has the perception of sovereign money changed in Silicon Valley?

Their expansion into Silicon Valley is a good example of this shift. At the height of the tech boom, when venture capital funds were falling over themselves to back the next unicorn, sovereign funds were not seen by founders as the ideal growth partners due to their conservative reputation. The relatively light-touch approach of the VCs and their speed of execution made them highly competitive when assessing financing term sheets.

In the wake of recent high-profile tech failures and the retrenchment of traditional VC money, that view has changed. Having a Middle Eastern SWF in your cap table is now increasingly viewed as a hallmark of quality and maturity that can attract further investment, not least because of their preference for robust due diligence.

For tech companies themselves, SWFs’ emergence has coincided with a change in the way growth investments are structured – where founders used to dictate terms, we are now seeing more veto rights for investors and enhanced information rights. This is perhaps as much a sign of tech’s recent challenges as it is the demands of the SWFs themselves.

As far as the wider sponsor community is concerned, investing alongside an SWF has advantages beyond just their financial firepower.

Middle Eastern SWFs are increasingly able to negotiate preferential terms, and while they operate independently of the states they represent, their profile, reputation and contacts allow them access to opportunities not available to others.

How will the EU Foreign Subsidies Regulation affect SWF deals?

Looking ahead there are some recent regulatory developments that will add a degree of complexity to future sovereign wealth fund deals in Europe. The EU Foreign Subsidies Regulation – designed to allow the Commission to investigate government financing of businesses it believes could distort the functioning of the single market – introduces a new notification regime for certain transactions.

The rules apply where one or more of the merging parties, the target or the JV is established in the EU, generates sales of at least EUR500 million within the EU, and, together with all other parties to the transaction, has received combined “financial contributions” from a non-EU country of more than EUR50m in the previous three years.

The concept of “financial contribution” is drawn broadly and includes interest-free loans, capital injections, non-ordinary-course tax benefits or the purchase of goods and/or services by public authorities.

By being crafted in this way it captures financial investments by third countries into investment funds, and therefore applies to any acquisition by an SWF.

Private capital firms that have state-affiliated investors will also be in scope, and because the rules cover all parties to a deal, a filing is required where the target has received state benefits, even if the acquirer has not.

Filing a notification will start the clock on a 25 working day review, after which the Commission can launch an in-depth investigation lasting up to 90 working days. If it doesn’t like what it sees, it can block a deal or request the parties to submit remedies. Any failure to notify could result in a significant fine.

European regime will impose significant compliance burden on financial sponsors

The regulation will require sponsors to track (at fund level) the financial contributions they or their portfolio companies have received in the three years prior to any deal.

The look-back period applies from deal signing or announcement, meaning firms will need to monitor financial contributions across the relevant fund in real time, or at the very least on an event-driven basis, rather than relying on yearly updates (as is usual for merger control reporting).

The draft notification form reveals the Commission is looking for detailed, confidential data on the sources of finance used to fund transactions, as well as a comprehensive breakdown of how the target has been valued.