The world’s new financial power brokersFour rising players will continue to grow in wealth and importance, even if interest rates rise and oil prices drop.

Diana Farrell and Susan Lund

d e c e m b e r 2 0 0 7

As a result of the growing importance of four rising capital markets players, the world’s financial structure is shifting. Asia’s central banks and the oil-rich countries have raised global liquidity, thereby lowering the cost of capital in many markets. Hedge funds and private-equity firms have made markets more efficient and influenced corporate governance, respectively. The roles of these new power brokers have created a sense of unease. But in our view, the benefits of greater liquidity, innovation, and diversification outweigh the dangers.

e c o n o m i c s t u d i e s

Article at a glance

Exhibit 1

The new power brokers

2

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 (Exhibit 1).1 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.

Assets under management

Total of $8.4 trillion to $8.7 trillion, excluding overlap

2006, $ trillion

Compound annual growth rate (CAGR), 2000–06, %

1Gulf Cooperation Council states (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, United Arab Emirates), Indonesia, Nigeria, Norway, Russia, Venezuela.

2Growth rate is based on International Monetary Fund (IMF) data, which is incomplete and does not include data from Qatar or United Arab Emirates.

Source: Hedge Fund Research; International Financial Services, London; IMF; PE Analyst; Thomson; McKinsey Global Institute analysis

Pension funds

Mutual funds

Insurance assets

Petrodollar assets1

Asian central banks

21.6

19.3

18.5

3.4–3.8

3.1

Hedge funds

Private equity

1.5

0.7

5

8

11

192

20

20

14

1This figure excludes overlap among the assets of the players (for instance, petrodollar investments in hedge funds).

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.

3

And over the next five years, the size and impact of the four new power brokers will continue to expand.2

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 (Exhibit 2). 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.

2 For a more detailed look at petrodollars, Asian central banks, hedge funds, and private equity, see The New Power Brokers: How Oil, Asia, Hedge Funds, and Private Equity Are Shaping Global Markets, McKinsey Global Institute, October 2007.

69

81

56

98133

20032

292

167

691

184

19992

125

60

412

218

1998

240

371

121

1996

132

62

301

1995

282

110

Net capital outflows from countries with current-account surpluses,1 $ billion

Rest of world

Western Europe

East Asia

Oil-exporting countries4

1Include only those countries, in any given year, with current-account surpluses and capital account de�cits.2Figures do not sum to total, because of rounding.3Estimated.4Algeria, Indonesia, Iran, Kuwait, Libya, Nigeria, Norway, Russia, Saudi Arabia, Syria, United Arab Emirates (UAE), Venezuela, and Yemen.

Source: Global Insight; International Monetary Fund; McKinsey Global Institute global capital �ows database

35

894

2001

91

127

417

169

2000

89

192

509

198

1997

151

351

156

49

20052

268

429

1,199

435

20063

446

308

484

1,319

2004

273

238

926

359

2002

224

108

503

1292

42

3030

42

3

7

Exhibit 2

Impressive growth

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.

4

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 (Exhibit 3). 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

Exhibit 3

The players Estimated assets of oil-exporting countries,1 2006, %

1Gulf Cooperation Council (GCC) states (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, United Arab Emirates or UAE), Indonesia, Nigeria, Norway, Russia, Venezuela.

2Includes sovereign wealth funds and central banks.3Assumes private–government split is the same as for GCC.4Includes Norway’s reserves and Government Pension Fund, Russia’s Bank of Russia reserves and Oil Stabilization Fund, Nigeria’s reserves, and Venezuela’s reserves.

Source: Expert interviews; McKinsey Global Institute analysis

Gulf Cooperation Council

67

$1.55 trillion–$1.98 trillion

33

Total

59

41

Other oil exporters4

48

$1.51 trillion

52

Other Middle East3

67

$0.33 trillion33

Private

Government2

$3.39 trillion–$3.82 trillion

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.

3 Determining the true size of the foreign assets of oil exporters is difficult because no comprehensive official figures exist. Only four of the six states that make up the Gulf Cooperation Council (GCC) publish any data with the International Monetary Fund’s International Financial Statistics (IFS), for instance, and these data are almost certainly underestimated. We have therefore constructed our own estimates of foreign investments bought with petrodollars. Our estimates are based on a variety of published data sources, McKinsey research, and interviews with banking experts in the region.

5

. . . 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 (Exhibit 4). 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.

Petrodollar foreign investment assets, $ trillion Compound annual growth rate (CAGR), 2006–12, %

Source: BP Statistical Review of World Energy 2006; Global Insight; McKinsey Global Institute (MGI) global capital �ows database; MGI analysis

Oil price $30

Oil price $70 13

Scenarios

Oil price $50 (base case) 10

6

2012

4.83

1.055.88

6.93

4.83

2011

4.68

0.81

2010

ForecastEstimated

4.54

0.57

2009

4.35

0.35

2008

4.09

0.18

2006

3.403.91

4.455.05

5.676.30

6.93

2007

3.77

0.07 0.350.180.07

0.560.81

1.05

Exhibit 4

Three scenarios of growth

4 For more on future oil price scenarios, see Curbing Global Energy Demand Growth: The Energy Productivity Opportunity, McKinsey Global Institute, May 2007. 5 Approximately equal to their current-account surpluses.

6

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 (Exhibit 5). 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

Exhibit 5

Opportunity costs for Asia

$ billionExcess foreign reserves,1 2006

Opportunity cost,2 2006

Share of GDP, %

1Determined using Greenspan–Guidotti Rule, which states that foreign-reserve assets should equal foreign short-term debt. Short-term external debt calculated as sum of external-bank claims and international debt securities; nonbank trade credits not included.

2Estimated returns of 5% more than US Treasury bills.3Figures do not sum to total, because of rounding.

Source: Global Insight; International Monetary Fund (IMF); Ministry of Economic Affairs, Taiwan; McKinsey Global Institute analysis

China

Japan

Taiwan

Korea

Singapore

981

475

218

116

27

Hong Kong

Malaysia

42

54

49

24

11

6

1

2

3

1.9

0.5

3.1

0.7

1.0

1.1

1.8

Total 1,9153 96 1.1

6 Excess reserves are determined using the Greenspan–Guidotti Rule, which states that foreign-reserve assets should equal foreign short-term debt. 7 This builds on an analysis by Harvard economics professor Lawrence H. Summers, “Reflections on global account imbalances and emerging markets reserve accumulation,” speech to the Reserve Bank of India, Mumbai, March 24, 2006.

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 (Exhibit 6).

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.

Exhibit 6

Even greater opportunity costs ahead

2005

843

826

774

2,727

2000355420

1,064

2006

875

1,066

3,126

854331

2007

945

1,317

3,543

951

330

20082

1,019

3,924

1,533

1,051

320

2009

1,105

4,238

1,687

1,148

2010

1,189

4,527

1,812

1,250

2011

1,271

4,788

1,921

1,354

2012

1,357

5,052

2,030

1,458

Asian holdings of foreign-reserve assets, $ billion % of nominal GDP

27618

2006 2012

50

41

20

6

53

32

21

298

207

Estimated3

284

242

168

121

1Bangladesh, Cambodia, India, Indonesia, Laos, Nepal, Pakistan, Philippines, Sri Lanka, Thailand, Vietnam.2Figures do not sum to total, because of rounding.3Assumes China’s current-account surplus declines dramatically over next 5 years and that Japan’s remains the same.

Source: Asian Development Bank's Asian Economic Monitor 2006; Global Insight; International Monetary Fund; Ministry of Economic Affairs, Taiwan; McKinsey Global Institute analysis

Other Asia1

Hong Kong, Korea, Malaysia, Singapore, TaiwanChina

Japan

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.

7

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 (Exhibit 7). 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.

Exhibit 7

Three scenarios

8 Hedge funds increase the amount of equity capital they get from investors by leveraging it with different forms of debt. The equity capital is known as “assets under management” or “net assets”; the amount of total assets invested in the market, “gross assets” or “gross market exposure.” Overall, we estimate, hedge funds have a total leverage of 250 to 350 percent of their net assets (including on-balance-sheet debt and off-balance-sheet derivatives), though individual hedge funds may have far higher or lower degrees of leverage.

2007

1,579

1,796

2008

1,682

322

2,189

2009

1,775

543339

2,657

2011

1,933

3,867

1,112

822

20121

2,001

4,642

3.466

2.001

1,465

1,177

2010

1,858

3,211

805

548

Hedge fund asets, $ billion

ForecastActual

2006

1,46514275 185

Continued growth Continued rapid growth at

15–20%, driven significantly by superior returns Returns are 12% Inflows grow at 15%

Plateau Slowing growth at 10–15% compound

annual growth rate (CAGR), driven by inflows slowing somewhat because of mediocre performance Returns are 8% Inflows grow at 5%

Correction Correction at 0–5% CAGR,

with dramatic fall in returns causing capital withdrawal Returns are 0 Inflows shrink at 10%

Continued growth

Plateau (slowing growth)

Correction

Unlikely scenarioVery likely scenario

1Figures do not sum to total, because of rounding.

Source: McKinsey Global Institute analysis

8

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 (Exhibit 8). 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.

Exhibit 8

A significant share Hedge funds’ estimated share of trading, %Securities trading turnover,3 2006, $ billion

1International Monetary Fund/Greenwich Associates estimates based on trading volumes reported by 1,281 US �xed-income investors, including 174 hedge funds.

2Press estimates.3Assumes that assets turn over 20 to 40 times a year and that leveraged assets turn over 5 to 10 times a year.

Source: British Bankers’ Association; Financial News; Gartmore; Greenwich Associates; International Monetary Fund (IMF); International Swaps and Derivatives Association (ISDA); LSE; NYSE; New York University’s Stern School of Business; Securities Industry and Financial Markets Association (SIFMA); McKinsey Global Institute analysis; McKinsey analysis

Cash equities on New York Stock Exchange (NYSE) and London Stock Exchange (LSE) 35–502 17,100 (NYSE)

6,700 (LSE)

US government bonds 302 136,745

High-yield bonds 251 335

Emerging-market bonds 451 271

Distressed debt 471 34

Leveraged loans 321 133

601

301937

Credit derivatives Plain vanilla Structured

9

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 (Exhibit 9). 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.

Exhibit 9

More options for financing

Strategy composition1 by assets under management, %

1As of Q3 2006.2Includes short-bias, market-timing, and Regulation-D investment strategies.3Funds that bet on market movements, eg, global macro funds.

Source: Hedge Fund Research; McKinsey Global Institute analysis

1

1996

21

62

9ArbitrageEvent driven

Equity based

Directional3

Other2

$257 billion

100% =

7

2006

15

26

21

$1,465 billion

37

1

Market-neutral strategies

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.

10

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 (Exhibit 10). This wave of buyouts has prompted CEOs and boards at some companies to find new ways of strengthening their performance.

Exhibit 10

Major players Share of leveraged-buyout funds (ie, private equity) in all M&A transactions, %

United States

Europe

Asia

Source: Dealogic; McKinsey Global Institute analysis

30

25

20

15

10

5

01995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

11

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 (Exhibit 11).

Exhibit 11

Limited impact

1LBO = leveraged buyout, ie, private equity.

Source: Dealogic; Private Equity Analyst Plus; VC Experts; McKinsey Global Institute analysis

For LBO-owned1 companies in Europe and United States, 2006, $ trillion

1.0

1.4

0.4

Estimated debt volume

Estimated enterprise value

1.4

2.0

0.6

Equity share (assets under management)

0.4

0.60.2

Europe

United States

Assumptions All funds raised in Europe and United States over last 5 years are fully invested Leveraged deals are financed with average debt-to-equity ratio of 70:30 Debt portion is financed solely through leveraged loans Speculative-grade default rate rises to 15%—ie, 50% over historic peak in United States in 2001 Recovery rate is 35%

Market impact Potential loss in case of sudden rise in speculative-grade defaults:

Europe ~$42 billion US ~$96 billion Compared with overall syndicated-lending market, this would equal:

Europe 3% of 2006 issuance volume US 7% of 2006 issuance volume

12

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 (Exhibit 12).

13

Exhibit 12

A fundamental shift

2007

864

962

2008

992

1,269

2009

1,069

237306

1,612

2011

889

2,245

523

833

2012

771

658

1,188

2010

1,027

1,927

370

530

Estimate of future assets under management in leveraged-buyout funds, $ billion

Source: McKinsey Global Institute analysis

ForecastActual

2006

709 4850

149

Continued growth Continued rapid growth of funds

raised (compound annual growth rate 2000–06), driven by low interest rates and high investor demand Funds raised in Europe grow by 20% a year Funds raised in United States grow by 14% a year Assets under management in Asia, rest of world grow by 20% a year

Plateau Slower growth of funds raised, to

roughly half of historical rates, driven by mediocre performance and rising interest rates Funds raised in Europe and in United States remain at 2006 levels Assets under management in Asia, rest of world grow by 10% a year

Correction Correction in funds raised, more

adverse regulatory environment, and defaults by some private-equity firms Funds raised in Europe shrink by 15% a year Funds raised in United States shrink by 15% a year Assets under management in Asia, rest of world remain at 2006 levels

128

2,617

1,429

4,642

Continued growth

Plateau

Correction

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. Q

14

Diana Farrell is director of the McKinsey Global Institute, where Susan Lund is a consultant.

The authors wish to acknowledge Eva Gerlemann and Peter Seeburger for their contributions to this research. We are also grateful for the insightful input we received from numerous McKinsey colleagues around the world.

9 Many governments in Asia and in oil-exporting countries are also creating private-equity-like funds, sometimes called government holding corporations. In contrast to the mostly passive, diversified investments of sovereign wealth funds, these entities (such as Dubai International Capital and Singapore’s Temasek) often centralize a government’s holdings in domestic state-owned enterprises and buy direct stakes in foreign companies as well.