Why Saudi Arabia is riding into private equity

Rather than relying solely on income from oil production, Saudi Arabia is planning a 5% IPO of state-owned oil company Aramco that will dramatically increase the size of the kingdom’s sovereign wealth fund, allowing investments to become another major source of government revenue. But amid today’s low-growth environment and fully-valued public financial markets, will Saudi Arabia be able to generate an acceptable return to justify its ambitious 15-year project? The kingdom already holds $116.8 billion in U.S. treasury debt and around $52 billion worth of U.S. stocks, with both markets appearing to offer scant upside from their current levels. The lackluster expected returns of traditional safe-haven assets have prompted U.S. pension funds to pile on risk in search of yield. In like mind, the Saudis have decided to dig deeper down the spectrum for potential windfalls, loudly introducing themselves this week to the U.S. private equity market via a $3.5 billion investment in Uber.

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Aramco is estimated to be worth $2 trillion, so a 5% IPO would immediately add $100 billion to the sovereign wealth fund’s coffers (Deputy Crown Prince Mohammed bin Salman wants to eventually grow the Public Investment Fund (PIF) to $2 trillion). This week, the kingdom found a sensational partner to absorb a healthy chunk of that capital burning a hole in its pocket. Saudi Arabia’s massive investment into the ride-hailing company is the largest-ever venture capital (VC) investment, the amount equivalent to 6% of all VC inflows in 2015. Along with an approximately 5% stake in Uber, the PIF’s managing director, Yasir Al Rumayyan, will join the company’s board. J.P. Morgan advised on the deal, putting it in prime position to advise on the lucrative Aramco IPO.
 
The deal is controversial because Saudi Arabia, although a long-time ally of the United States, does not exactly have a spotless human rights record. The kingdom operates under Sharia law, exacting corporal punishment for the crime of homosexuality and beheading dozens of prisoners each year. In addition, the Saudi government has remained steadfast in its ban on female drivers. As a result, Saudi women have been avid users of ride-hailing startups, accounting for 80% of Uber’s ridership in the kingdom. Deputy Crown Prince Bin Salman has hinted at the possibility of relaxing those rules as part of a sweeping social and economic reform, but now both the Saudi government and Uber have incentive to keep the status quo intact. The deal has prompted protests and boycotts by Saudi women, but Uber CEO Travis Kalanick is famous for his indifference to optics.

The news is also likely to quiet, or at least delay, speculation about an Uber IPO. The $3.5 billion infusion takes Uber’s war chest to $11 billion, begging the question of whether — at least for true Silicon Valley bellwethers –IPOs now simply represent the moment private investors decide to cash out. For perspective, Facebook raised only $2 billion in private capital before its IPO, less than 60% of just one check collected by Uber this week. Kalanick has made noises about never having to go public.
 
What company would choose to subject itself to the prying eyes and short-termism of public markets when it could raise eleven figures in private markets with fewer strings attached? Well, eventually the narrative might change because of how quickly the company burns through cash. Uber sees ride-sharing as a winner-takes-all war and subsequently is willing to offer below-market prices in a bid to crowd out the competition. Uber’s cost of revenue is growing quickly and the current $62.5 billion valuation makes a lot of generous assumptions about the company’s ability to overcome regulatory hurdles in international markets where it is often cast as the unwelcome foreign invader. Its acceptance of Saudi Arabia’s dollars represents a tacit acknowledgement of the importance of creative political maneuvering if the company is to more deeply penetrate certain coveted markets.

Besides the potential for higher investment yields, why else might Saudi Arabia be attracted to Uber? For a government fully dependent on oil revenue, investing in a ride-sharing company with ambitions to put self-driving electric cars on the road also represents a hedge of sorts. If global transportation does eventually move beyond dependence on gasoline, the kingdom now has a significant stake in one of the companies best-positioned to benefit from that paradigm shift.
 
Uber’s seemingly endless ability to raise money also belies the recent contraction in the availability of capital for “unicorns,” or private companies worth in excess of $1 billion. To most observers, the “Uber-corn” now stands in a category of its own with little bearing on the health of private markets as a whole. Ultimately the investment is a microcosm of today’s world. There is an abundance of cheap capital available, with Europe and Japan offering to pay banks to make corporate loans, but in the absence of public-sector investment and private-sector trust of political regimes, there just isn’t the demand required to put that capital to productive use. Will global governments awaken to the need for investment and pro-growth structural reform, or will the rise in nationalism cause the pie to shrink for all multinational corporations? The answer will determine the outcome of Saudi Arabia’s bold foray into private equity.
 
Worst jobs report in six years
 
The U.S. labor market extended its streak to 75 consecutive months of job growth this week, but just barely with only 36,000 jobs added in May (versus consensus expectations for 160,000). The paltry non-farm payrolls number, the lowest in almost six years, dramatically reframed expectations for Fed policy this summer and caused a reset of recent currency dynamics (even though a portion of the shortcoming was due in part to the recent Verizon work stoppage). Perhaps even more disheartening was the unexpected decline in labor force participation, which fell 0.2% to its lowest level of the year (causing the official unemployment rate to fall from 5.0% to 4.7%). Part of the decline was attributed to structural forces, including an acceleration in the retirement of baby boomers.

While expectations had been building for a summer rate hike, the market now sees the door for a tightening barely ajar. The Fed Funds Futures market now indicates only a 2% likelihood of a June hike (down from more than 30% prior to the jobs report) and only a 30% chance of a hike by July (down from nearly 60% early last week). In fact, odds now favor the Fed standing pat until its December meeting, which would mark an unusual 12 months between rate hikes. The downbeat news came only days after the Fed’s Beige Book indicated a rise in inflation and a tighter labor market. The employment situation report wasn’t the only piece of bad news this week either, as U.S. auto sales also plummeted in May.
 
The dismal jobs numbers revived concerns the U.S. economy could turn toward recession rather than continue on its slow, methodical growth course. Stocks and the dollar fell sharply Friday while U.S. treasuries spiked on the news. The Chinese yuan also had its largest one-day rally in five years, just after trading to its weakest level against the dollar in the same time frame. The dramatic move reinforced the fact Janet Yellen has more control over the yuan than the PBoC. With gyrating Fed policy expectations having a significant impact on the renminbi, Chinese policy officials have urged the U.S. central bank to more openly communicate about its interest rate decisions. On Monday and Tuesday, the U.S.-China Strategic and Economic Dialogue will be held in Beijing, and a few of these topics might come up. 
 
OPEC looks to mend fences
 
A bold leap into private equity wasn’t the only item of business taking place in Saudi Arabia this week. With the U.S. shale revolution quelled and oil prices back on higher ground, the Saudis entered this week’s OPEC meeting looking to restore unity among member nations. But while the Saudis are the unstoppable force with the ability to unilaterally manipulate oil prices, its geopolitical nemesis Iran remains the immovable object preventing coordination over new production caps as no deal was reached. Despite a fourth straight month of rising oil prices, divisions within OPEC have never been deeper. While the wealthy Gulf Cooperation Council (GCC) members (Saudi Arabia, Qatar, Kuwait and the U.A.E.) have been able to weather the storm of lower oil prices, the “Fragile Five” (Algeria, Iraq, Libya, Nigeria and Venezuela) have plunged into varying degrees of chaos and are now staring into the abyss.

Part of the reason Gulf states have been able to get through oil’s rough patch relatively unscathed is healthy investor demand for their sovereign debt. After surprising interest at a recent Qatari debt auction, which swelled unexpectedly to $9 billion after a record $23 billion in orders, Saudi Arabia is now weighing a $15 billion bond sale. With oil prices plummeting in late 2015 and early 2016, Gulf states have taken the unusual step of issuing sovereign bonds to ease budgetary concerns. If Saudi Arabia goes through with the auction, it would be the kingdom’s first foray into global credit markets.
 
Also read — The Untold Story Behind Saudi Arabia’s 41-Year U.S. Debt Secret: How a legendary bond trader from Salomon Brothers brokered a do-or-die deal that reshaped U.S.-Saudi relations for generations.
 
China condemns yuan speculation
 
After suggestions last week that People’s Bank of China (PBoC) officials want the renminbi to gradually depreciate, the central bank moved swiftly to condemn foreign media reports about the currency. However, signs continue to point to deteriorating conditions in China’s bloated credit markets. 
 
Because the credibility of China’s officially-reported economic statistics is widely dismissed, investors often look to its trading partners for a more accurate picture of the country’s economic health. The ripples of faltering growth are starting to spread more noticeably throughout Asia, with economies in Hong Kong, Macau and Taiwan all contracting in the first quarter to their slowest pace in 25 years. South Korea, long considered the global economy’s “canary in a coal mine,” also saw its exports contract much more quickly than expected.

As we discussed last week, while China’s economic growth is slowing, investment in shadow-banking products is growing. Wealth Management Products (WMPs), which traditionally funnel money from Chinese individuals into various securities, are now increasingly investing in each other. With worsening fundamentals in underlying assets, the increasing layers of securitization have heightened the risk of chain reaction defaults in the $3.6 trillion market.
 
While Chinese corporations have completed a record number of cross-border acquisitions this year, the number of broken deals (often under mysterious circumstances) is also starting to reach never-before-seen heights.
 
As further evidence of investors’ desire to diversify out of the yuan, Chinese demand for crypto-currencies helped Bitcoin add $1 billion to its market cap this week.
 
In a rebuttal to fears about China’s rising debt, one writer made the case this week that there is no need to worry about a Chinese banking crisis.
 
Financial regulation’s unintended consequences
 
Milton Friedman said “one of the great mistakes is to judge policies and programs by their intentions rather than their results.” In the post-crisis regulatory era, new capital and lending rules may have decreased the likelihood of another systemic crisis, but they’ve also had the unintended consequence of reducing access to capital for prospective lower-income homeowners. Banks today are willing to take fewer risks, leading to a preference for jumbo mortgages and decrease in loans for minorities.
 
The post-crisis push for tighter financial regulation is causing big banks to retreat from global ambitions and creating strange day-to-day struggles between bankers and regulators. Meet the man leading the regulatory charge, Fed governor Daniel Tarullo, who wields major behind-the-scenes influence over everything from corporate strategy to capital rules.
 
Billionaire Blackstone founder Steve Schwarzman slammed the Dodd-Frank Act for its adverse impact on liquidity, but Josh Brown thinks banks should pray for more regulation because it raises barriers to entry.

Fed governors are signaling that more stringent bank capital requirements are looming, but don’t expect big banks to go extinct any time soon. Big changes are on the way for investment banks, with Goldman Sachs reportedly set to cut dozens of i-banking jobs.
 
UBS is ready to solve Wall Street’s work-life balance riddle by giving its bankers two whole hours of personal time per week.
 
The predictable failure of negative interest rates
 
Surprise, surprise, negative interest rates have failed to spur corporate investment in Europe. It’s time to stop pretending negative rates have any redeemable value — besides the ability to stimulate the market for physical safes.
 
After the conclusion of the European Central Bank’s (ECB) Governing Council meeting Thursday, President Mario Draghi defended the ECB’s bold March policy intervention, which he credits for staving off continent-wide deflation. The ECB’s corporate bond-buying program is set to kick off this week, with the central bank relaxing previous guidelines that would have prevented it from holding onto bonds that saw their credit ratings downgraded to junk. He also emphasized the need for fiscal policy measures to deliver sustained economic growth.

Greek parliament approved reforms necessary for the release of bailout funds, while J.P. Morgan CEO Jamie Dimon warned his firm may have to cut U.K.-based jobs if the kingdom backs the “terrible” Brexit deal.
 
Auto-loan market breaking down
 
Speaking of Dimon, he also believes the auto-loan market is stressed and could bring pain on banks. With Uber’s auto-lease machine, almost anyone can get a car, but, due to aggressive terms, good luck getting out of it.
 
Alibaba getting re-sold
 
Japanese private equity giant SoftBank is selling $10 billion of its Alibaba Stake, with around $1 billion of those shares going to two Singaporean firms, which continue to increase bullish China bets. With his company enduring a difficult period, Jack Ma laments that it’s just hard for U.S. to understand Alibaba.
 
Brazil’s canary
 
Brazil’s recession deepens after a fifth straight quarter of contraction. However, the movement to root out corruption looks to be gaining steam, with Brazilian billionaire Martin Odebrecht ready to “sing like a canary” about the Petrobras scandal as part of a plea deal. Former Petrobras CEO Pedro Parente, who stepped down in 2003, is returning to the helm in an effort to restore the company to former glory.
 
Broken unicorn dreams
 
The meteoric rise of blood-testing unicorn Theranos vaulted its founder Elizabeth Holmes to the top of Forbes’ rich list of self-made women, but after recent questions about the efficacy of the company’s technology, Forbes has now written down Holmes’ estimated wealth from $4.5 billion To $0. Nada. Zilch. Ouch.
 
In other news…
 
Direct-sold 529 college savings plans grew faster than advisor-sold plans in 2015, perhaps one reason Wealthfront decided it was time for roboadvisors to get into the 529 game.
 
The Dallas Fed says businesses are complaining about a lack of productivity from millennial employees due to high social media usage. 
 
Bill Gross, in his latest colorful investment outlook, said the last 40 years of investing history are a “black swan” that won’t be repeated.
 
Influential technology analyst Mary Meeker says internet boom times are over.
 
Defined-benefit pensions are a foolish dream.
 
Diversification, hindsight bias and leaving the past behind.

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