When three officials of Lehman Brothers (LEH) parachuted into Seoul in early June seeking a cash injection from South Korea's $22 billion sovereign wealth fund, they were quickly shown the door. After buying 5% of Merrill Lynch (MER) for $2 billion in January, Korea Investment Corp. had a pretty good idea what was happening on Wall Street. So just a few hours after a quick tea with the Lehman team, the fund's managers said no without even taking the time to look through the bank's books. "Lehman's profile is similar to that of Merrill, and we concluded it would be better for us to avoid concentrating our exposure to Wall Street banks," says Kim Ryoung, a KIC director.
It was another moment in the cooling romance between the world's giant sovereign funds and financial firms. Last year big sovereign funds—which invest government money in private companies—plowed tens of billions of dollars into the likes of Citigroup (C), UBS (UBS), and Merrill. Today, though, the funds are no longer riding to the rescue. "Everybody is adopting a wait-and-see attitude," says Tarek Abdel-Meguid, a partner at New York investment firm Perella Weinberg who works closely with sovereign funds.
One big reason is that their investments in banks and brokerages haven't turned out to be such a great deal. Such funds invested nearly $60 billion in the financial industry over the past 18 months. By June, the market value of their shares had declined by $14 billion, McKinsey & Co. estimates. Since then, those stocks have continued to slide (though some of the funds have deals that protect them against falling prices). "It is a bit of a shocking situation," says a top executive at a Persian Gulf sovereign fund. Another turnoff: a wave of criticism, both at home and in the U.S., of their growing involvement in Western banks. "The way most of the funds have been treated has created a very negative attitude about getting involved," says Rachid M. Rachid, Egypt's Minister of Trade & Industry. "They are happy not to be part of this."
With Wall Street in flux, the sovereign funds are also faced with the likelihood of owning big chunks of companies they didn't plan to invest in. Korea's sovereign fund, Singapore's Temasek Holdings, and the Kuwait Investment Authority, for instance, all own stakes in Merrill. Now, the three must convert those shares into stakes in Bank of America.
When sovereign funds swarmed over Wall Street last year, many thought they were making investments close to the bottom of the cycle. Now "there is no light at the end of the tunnel," says a Middle Eastern sovereign fund manager. Lehman's bankruptcy and Merrill Lynch's shotgun marriage with Bank of America (BAC) signal more downside. "In today's turmoil, making multibillion-dollar investments is beyond risky," says Arif M. Naqvi, chief executive officer of Dubai-based Abraaj Capital, a private equity firm. "It is almost like rolling the dice."