The ownership limit for the Government Pension Fund – Global
Norges Bank's letter to the Ministry of Finance 1 February 2008
We refer to the Ministry’s letter dated 19 November 2007 asking Norges Bank to make a reassessment of the issue of raising the limit on the permitted ownership interest in individual companies, cf previous letter from Norges Bank dated 11 March 2005.
Norges Bank considers it important that the limit on permitted ownership shall be raised, and recommends that it is set at 15 per cent of a company’s voting shares. The need for such an increase is warranted particularly by the fact that assets under management in the Government Pension Fund – Global have increased substantially, and the fact that the guidelines for the composition of the benchmark portfolio have been revised to include a 60 per cent allocation to equities and also now include small-cap companies. It should be stressed that this does not entail a proposal to change the principle of Norges Bank remaining a financial (rather than strategic) investor. Norges Bank does not intend to raise the equivalent limit of 5 per cent which applies to the investment portfolio in its foreign exchange reserves.
Reference is also made to Norges Bank’s recommendation in a separate letter that the regulatory framework for the Government Pension Fund – Global be amended to permit investments in pre-IPO companies.
Section 6 of the Regulation on the Management of the Government Pension Fund – Global contains a provision setting an upper limit on the ownership of shares issued by a single company:
“The investments may not be placed such that the Fund attains a holding of more than five per cent of the shares of a single company that confer voting rights.
[…] The overall goal of exercise of ownership is to safeguard the Fund’s financial interests.”
Originally, the ownership limit for the Fund was set at 1 per cent of both voting shares and the company’s share capital. It was then raised to 3 per cent in 2000. When Norges Bank wrote to the Ministry of Finance on 11 March 2005 recommending an increase in the limit from 3 to 10 per cent, the following points were stressed:
• Norges Bank (as the registered owner of shares in the Government Pension Fund – Global) is to remain a financial investor rather than a strategic investor.
• The ownership limit cannot be justified by the need to diversify investments. Diversification is assured through the choice of benchmark index and the limit for tracking error.
• The limit of 3 per cent was increasingly becoming an obstacle for both internal and external management in terms of taking the desired risk through individual positions.
• A small increase in the limit would not be enough to resolve these challenges in the longer term.
The Ministry of Finance considered this proposal in the National Budget for 2006 and revised the Regulation to raise the limit from 3 to 5 per cent. It was noted at the same time that continued growth in the Fund and changes in its strategy could affect the decision on maximum ownership interest, and that any subsequent reassessment could build on experience of the limit at 5 per cent.
In March 2006, Norges Bank proposed a change in the wording of Section 6 of the Regulation so that the ownership limit would apply only to voting shares and not also to share capital. It was stressed that this proposal would not change the principle that the Bank is to be a financial investor, and that this restriction was not needed as a means of assuring the diversification of the portfolio. It was also noted that the change would make it clearer which instruments (beyond shares with voting rights) would be taken into account when calculating ownership interests. The point of departure was that all instruments which can be used to attain an ownership position which allows the exercise of voting rights are to be included in these calculations. The Ministry of Finance responded to this proposal in the Revised National Budget for 2006, and the Regulation was amended to its current reading with effect from 1 June 2006.
The Government’s Report to the Storting No. 24 (2006-2007) On the Management of the Government Pension Fund in 2006 considered the expansion of the Fund’s benchmark portfolio to include shares in small-cap companies. This change has now been approved and is being phased in. The Ministry notes in its assessment: “If small-cap companies are to be included in the benchmark portfolio, the managers will probably wish to increase their holdings in order to keep the size of the active positions. The 5 pct. limit on ownership stakes may make this more difficult.”
The value of the Government Pension Fund – Global is undergoing strong and continuous growth. When Norges Bank submitted its proposal to increase the maximum permitted ownership interest in 2005, the Fund’s equity portfolio had a value of NOK 427 billion. In the National Budget for 2008, the Ministry of Finance is recommending an inflow of new capital into the Fund of NOK 265 billion in 2008. The Guidelines for the Management of the Government Pension Fund – Global have been amended to increase the allocation to equities in the benchmark portfolio to 60 per cent, and this change is currently being phased in. The Fund’s equity portfolio will soon be four times larger than when Norges Bank originally proposed raising the ownership limit to 10 per cent.
Another important development is that the benchmark portfolio now includes small-cap companies. This means that the number of companies in the benchmark portfolio has grown from around 2,400 to 6,900. This in itself necessitates larger ownership interests, because investments here will be more concentrated.
The need to raise the upper limit on ownership
On balance, Norges Bank believes that there is a strong need to increase the limit on permitted ownership for equity investments in the Government Pension Fund – Global, and that this would most appropriately be set at 15 per cent.
One important element of Norges Bank’s investment strategy for achieving excess returns has been to make a large number of independent and uncorrelated investment decisions. As part of this strategy, a large number of internal and external managers are used, where each manager is awarded an investment universe restricted geographically and/or to one or more sectors. To prevent breaches of the Regulation, the individual managers have to be awarded quotas, which must also contain a certain safety margin. Taken together, this entails considerable operational challenges and a reduction in the risk which can be allocated to each sub-portfolio.
When purchasing external management services, Norges Bank has to impose restrictions on holdings in individual companies which are not commonplace in the market. To be able to comply with these restrictions, external managers must often allocate a smaller share of Norges Bank’s portfolio to individual companies than they do for other clients. External managers are therefore forced to treat Norges Bank differently to other clients, which also makes the return difficult to compare in retrospect with that achieved for other clients. In addition, the portfolio currently has a smaller allocation to external mandates and lower overall risk exposure than it would with a higher limit on permitted ownership.
From time to time, Norges Bank may also wish to participate in relatively large capital expansions at individual companies wishing to recapitalise. With a low ownership limit, Norges Bank can put up only a limited amount at an early stage of such a recapitalisation process.
As stated in previous letters from Norges Bank, there is no need for a restriction on ownership as a means of assuring diversification in the Fund. The equity benchmark currently consists of around 6,900 equities now that small-cap companies are also included. The number of equities in the Fund is in excess of 7,400. From a diversification perspective, the level of ownership in the individual company is of little importance; the degree of diversification is determined by the choice of benchmark portfolio and the limit for tracking error (active risk) relative to this benchmark portfolio.
The largest funds in Europe with which it is natural to compare the Fund do not have any restrictions on ownership levels. Dutch funds ABP and PGGM and Britain’s Hermes have not set any upper limits on holdings in individual companies.
Through the external management of the Fund, Norges Bank is in contact with a large global network of portfolio managers. It is standard practice in the market for financial investors to use 15 or 20 per cent as an internally imposed limit on ownership.
Norges Bank does not see a need to make any changes in the principles for the calculation of ownership interests. In line with the Bank’s letter dated 9 March 2006 and the Ministry’s deliberations in Section 126.96.36.199 of the Revised National Budget for 2006, the limit applies to both holdings of shares with voting rights and holdings of other instruments (including ADRs, GDRs and derivatives) which can be used to attain an ownership position which allows the exercise of voting rights.
The role as financial investor
As can be seen from previous statements and assessments concerning the maximum permitted level of ownership in the Government Pension Fund – Global, the key consideration behind this limit has been to ensure that the Fund remains a financial investor and does not exercise strategic ownership. As mentioned in our letter of 11 March 2005, the Bank is of the opinion that it is not the percentage limit on ownership which is crucial to the difference between a strategic investor and a financial investor, but the investor’s objectives for his investments and how, through his actions, he uses the influence he has as a larger shareholder.
There has recently been an international debate about the role of sovereign wealth funds – see, for example, the proposal from US Secretary of the Treasury Henry Paulson in October 2007 concerning the need to establish a code of best practice for funds of this kind. In the debate about sovereign wealth funds, questions have been asked particularly about the lack of transparency about these funds’ investment strategy and exercise of ownership rights, and what it means to have these funds come in as owners. It has been claimed, for example, that a lack of transparency gives some sovereign wealth funds a corresponding lack of predictability. The level of ownership in individual companies has not in itself been highlighted as problematic. Opinions of the Government Pension Fund – Global seem to be largely positive.(1) Importance is attached to owner and manager providing a greater degree of insight into investment strategy and ownership than is usual among sovereign wealth funds.
As manager of the Government Pension Fund – Global, Norges Bank is to act as a financial investor. It is recommended that the final sentence of the second paragraph of Section 6 of the Regulation be retained, and no changes are proposed in the Ethical Guidelines which govern the Bank’s exercise of ownership rights for the Government Pension Fund – Global. As a financial investor still, Norges Bank would not permit the Bank’s employees or representatives to be elected onto companies’ governing bodies.
Norges Bank also manages the investment portfolio in its foreign exchange reserves, which had a value of NOK 214 billion at the end of 2007. The Bank’s corporate governance principles apply to both funds. If the limit on ownership in the Government Pension Fund – Global is raised to 15 per cent, Norges Bank’s combined ownership could be as high as 20 per cent. Given the significantly smaller size of the investment portfolio and the similar investment strategy, combined ownership on this scale is unlikely. Norges Bank does not intend to raise the limit on ownership which applies to the investment portfolio in its foreign exchange reserves.
It is proposed that the first sentence of Section 6 of the Regulation on the Management of the Government Pension Fund – Global be amended to read as follows:
“The investments may not be placed such that the Fund attains a holding of more than fifteen per cent of the shares of a single company that confer voting rights.”
1) A footnote to Appendix III to the US Treasury’s semi-annual Report to Congress on International Economic and Exchange Rate Policies in June 2007 states: “Norway’s Government Pension Fund – Global is broadly recognized as exemplifying best practices in transparency.”
Svein Gjedrem Yngve Slyngstad