China's $3 Billion Bet on Blackstone

The Chinese government is wagering $3 billion on a stake in U.S. private equity shop Blackstone in FX diversification strategy

Ever since China announced in March it would start looking for ways to invest its monster hoard of foreign reserves beyond primarily U.S. Treasuries, speculation on who would get the first deal has been rife. Most observers expected the newly formed State Foreign Exchange Investment Company would sink some of its cash in oil, coal, or other energy assets needed to feed the country's ravenous economy.

So the May 20 announcement that the agency will pay $3 billion to buy a stake in private equity shop Blackstone Group ahead of Blackstone's $7.75 billion initial public offering later in the year, comes as a something of a surprise. "We are very pleased to be able to make the State Investment Company's very first investment in such a well-respected firm as Blackstone," said Lou Jiwei, head of working group managing the launch of the agency that is expected to manage $200 billion of China's roughly $1.2 trillion in foreign currency reserves.

Possible Backlash

Because of high anxiety in the U.S. about China's gargantuan trade surpluses and the hunger for foreign acquisitions, the deal was structured to defuse fears. China agreed to buy nonvoting shares and will keep its stake under 10% in the New York private equity firm run by Chief Executive and co-founder Stephen A. Schwarzman.

Beijing is still smarting from the failed attempt by state-controlled oil company CNOOC (CEO) to purchase Unocal (UCL) in 2005, and realizes it faces a possible backlash every time a Chinese company takes out its wallet for a foreign shopping spree. There are also worries that China will use its massive foreign exchange reserve stockpile to subsidize purchases by state-owned companies or provide preferential loans from government-controlled banks.

"If China uses these funds in an economically aggressive way against the interest of other countries they would react, and it will be game over," Nobel Laureate economist Robert Mundell said in a May 2 interview with BusinessWeek (see, 5/7/07, "A Nobel Winner's Rx for China").

Diversifying Management Overseas

This could be the start of a fruitful relationship between Blackstone and the Chinese government. Its new state-run investment agency is going to need fund management expertise, and Blackstone will probably now have an edge over rival firms such as Kohlberg Kravis Roberts, the Texas Pacific Group, and Apollo. "I think it's very sensible. Sooner or later they have to diversify to overseas managers, because they can't do it themselves," says Carl Walter, Beijing managing director of JP Morgan (JPM).

At the same time there is a risk that Blackstone's China investment calls will be second-guessed. "Now every time they invest, people will say here is the Chinese state investing in this company, Blackstone is going to be under a lot of scrutiny," says Fraser Howie, co-author of the book Privatizing China.

The Blackstone announcement comes just days before Chinese Vice-Premier Wu Yi travels to Washington to meet with U.S. Treasury Secretary Henry Paulson on May 22 and 23. The strategic dialogue is expected to tackle issues such as China's ballooning trade surplus and rampant problems of counterfeiting and copyright piracy in China.

Modeled After Singapore's Temasek

Details of the new fund still remain unclear. Though former Vice-Finance Minister Lou Jiwei is expected to lead the new agency, he is merely referred to as the head of the working group of the State Investment Company, according to the Blackstone press release. China has also not officially disclosed how much the agency will be responsible for investing, and how much additional money it will receive if China continues to accumulate reserves at its current rate of more than $20 billion per month.

It's expected to be modeled after Temasek Holdings, the investment arm of the Singaporean government. Over the years, Temasek has made strategic investments in large Singaporean-listed companies as well as foreign companies engaged in telecommunications, property, financial services, and pharmaceuticals. (It is actually a huge investor in mainland Chinese banks.)

China's investment arm will definitely aim to get a rich return, but its decisions will also be guided by political and strategic considerations. China is likely to focus on large equity stakes in oil and gas concerns, minerals such as gold, and possibly shipping assets.

Jing L. Ulrich, Managing Director and Chairman of China Equities at JP Morgan, reckons that whatever form the new agency ultimately takes, it will become the new 600-pound gorilla in global finance. "It will be one of the largest state investment corporations in the world, and it will have a major impact on global asset prices," she says. She expects to see investments not just in energy and resources, but other areas where China lags, such as technology and consumer-product companies with strong international brands and Western companies with deep management expertise.

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