Assessment of the Petroleum Fund's ownership limits

In the Revised National Budget for 1997, it was emphasised that the Petroleum Fund shall be a financial investor and not a tool for strategic ownership. Norges Bank finds that this is important for several reasons. First, this approach will ensure a sound diversification of the Fund's investments, which will secure the government's capital in the Fund and promote the objective of maximising the return on the Fund at a given risk. Second, the Fund's investments will be liquid and thus easy to realise if there is a need to draw on the Fund's capital. Third, it will be easier to evaluate the management of the Petroleum Fund as the return on the Fund can be compared with returns on recognised benchmark portfolios and with the investment performance of other financial investors. Moreover, strategic ownership requires different expertise and follow-up compared with portfolio investment. The risk of attempts to exert active external influence in corporate decisions is greater in the case of strategic ownership. As a financial investor, the Petroleum Fund is invested at present in around 2000 companies in 21 different countries and has very small ownership interests in each company.

In Norges Bank's submission of 22 August 1997 to the Ministry of Finance, the Bank recommended that the Petroleum Fund's maximum allowed ownership interests in an individual company be set at 3 per cent. The Bank argued that such a limit would promote effective management of the Fund and the limit would also be consistent with the requirement that the Fund shall not engage in strategic investments in the equity market. In the National Budget for 1998, the Ministry commented on the Bank's recommendation as follows:

"The Ministry wishes to underline that the Fund's ownership interests in individual companies shall be small. According to the Ministry's assessment, at this stage a limit of 1 per cent on ownership interests in individual companies is adequate. When the Fund increases in size it may be appropriate to increase the limit. The question of whether the limit shall apply to the individual manager's ownership interests, and not to the Fund's overall investments as is the case at present, may be considered at a later stage, cf that investment decisions within the framework of the general guidelines will be taken by the individual manager."

Since October 1997, when the existing ownership limit was adopted, the Fund's size has increased substantially, and the Fund is expected to continue to increase in the years ahead. Equity investment started in the beginning of 1998, and at the end of 1998 and 1999 the Fund's equity portfolio stood at NOK 70 and 94 billion, respectively. On the basis of the estimates in the National Budget for 2000, this is expected to increase to NOK 120 billion at the end of 2000, and to NOK 260 billion at the end of 2003. Furthermore, Norges Bank has appointed a number of external equity portfolio managers, which requires that the ownership limit must be set at a low level for each manager so that the sum does not exceed the limit that applies to the Fund as a whole. Against this background, it seems natural to reassess the ownership limit for the Petroleum Fund. In this submission, Norges Bank will recommend an appropriate limit for the Fund in the years ahead.

2. Implications of ownership limits for operational management

The existing limit on ownership interests for the Government Petroleum Fund restricts the leeway of active managers. These managers are often responsible for constructing an equity portfolio which they believe will outperform the benchmark portfolio. This means that if a manager is particularly confident that a company will perform well, the manager will want to invest a relatively large amount in that company. The amount the manager may invest in the company depends, however, on the ownership limit applying to the manager. Since Norges Bank uses several external managers, the Bank has had to set this limit at a low level for each manager. The reason for this is that we receive information about the managers' positions two days after their purchase orders have been effected. From an operational viewpoint, each external manager must therefore be subject to a limit on ownership interests as managers may simultaneously have the same expectations as to the most profitable companies to buy into. As a result, each of the active external managers in Europe has been allotted an ownership limit of 0.3 per cent. In this way, the Petroleum Fund as a whole will not exceed an ownership share of 1 per cent. However, it is very seldom the case that the external managers used by Norges Bank choose to invest in the same companies. At the end of 1999, the three managers that engage in active management in European equity markets did not have any of the same companies as their top ten (compared with the benchmark portfolio). The same applies to the two active managers in the Japanese equity market. This means that the Petroleum Fund's ownership interests will normally be considerably smaller than 1 per cent, cf Table 1, which shows that the Fund's ten highest ownership interests at the end of 1999.

Table 1: The ten largest ownership interests at the end of 1999

A closer look at the companies where the ownership limit is currently restricting managers' leeway shows that this is primarily the case for the smallest companies. This is illustrated in Table 2, which shows the relationship between ownership interests and the average market capitalisation of the companies. The table shows that the companies where managers have ownership interests exceeding 0.25 per cent (the limit for managers is 0.3 per cent) are considerably smaller than the companies where ownership interests are less than 0.1 per cent. An increase in the ownership limit will therefore primarily result in larger ownership interests in the small companies. As the small companies account for a limited share of the Fund's equity portfolio, a higher ownership limit will only result in a marginal increase in the Fund's risk exposure.

Table 2: Average market value and managers' ownership interests

When the Petroleum Fund's external managers undertake transactions in the equity market, it is important that the Fund is provided with the same treatment as the managers' other customers. However, as the ownership limit applying to the Fund is often more restrictive than the limitations stipulated by other customers, it may be difficult in practice to achieve equal treatment. Table 3 shows that we are now approaching the ownership limit for several of the companies in the equity portfolio for which Norges Bank has selected external managers. It is therefore reasonable to assume that these companies will have a lower share in our externally managed portfolios than in other customers' portfolios. This may make it difficult for the external equity managers to achieve an excess return on the Petroleum Fund's portfolio compared with other customers' portfolios.

Table 3: Comparison of number of companies and manager's ownership interests

3. What should the ownership limit be?

The ownership limit for the Petroleum Fund should be set so that the Fund does not become a strategic investor. In addition, risk considerations imply that exposure to a single company should be limited. The Fund should therefore be invested in a large number of companies with a small ownership share in each company. However, it is also important that the management of the Fund is not subject to unnecessary constraints with regard to outperforming the benchmark portfolio.

There is no clear dividing line between strategic ownership and financial investment. One possible approach could be to look at the criteria applied by other countries to determine the level of ownership interests which is assumed to be of interest to other investors. Table 4 shows that this threshold ranges between 5 and 10 per cent in most countries. Only Italy (2 per cent) and the UK (3 per cent) have limits that are lower than this. In Norges Bank's view, a maximum limit for the Petroleum Fund which is lower than the threshold which normally requires disclosure of ownership interests should be consistent with the Fund's role as a financial investor.

Table 4: Thresholds for disclosure of ownership interests in different countries

For countries with * the limit applies to shares with voting rights (Source: Chase Manhattan Plc)

We have demonstrated above that an ownership limit of 1 per cent already represents a problem for the active management of the Petroleum Fund. Furthermore, the Petroleum Fund is expected to expand sharply over the next few years, which may entail a larger number of active managers in each market and an increase in the amount under management. Against this background, Norges Bank recommends that the ownership limit should be increased to 3 per cent. This would promote an effective management of the Fund and would be consistent with the Fund's role as a financial investor. An ownership limit of 3 per cent will also safeguard risk considerations as in practice it would apply in particular to smaller companies in which investments will account for a small share of the Fund's total investments. The proposed limit is the same limit recommended by Norges Bank in August 1997 (see submission of 22 August 1997). Since the ownership limit of 3 per cent must be broken down on various managers, it is reasonable to assume that the ownership interests in most companies in the Fund's equity portfolio will be substantially lower than this limit.

The question of whether the ownership limit should apply to the Fund as a whole or each manger has been discussed. From an operational viewpoint, a limit must be set for each manager since they are the ones making the investment decisions. It can also be argued that when investment decision-making is delegated, the limit that applies to each manager is the limit that restricts the manager's scope for strategic ownership. On the other hand, the overall ownership interests determine the potential influence of Norges Bank in a company, and which therefore would be of relevance with regard to the question of strategic ownership. Against this background, Norges Bank would recommend that the Ministry of Finance continue to apply an ownership limit for the Fund as a whole and that it should be left to Norges Bank to decide how this limit is allocated to each manager.

In many limited companies there are several classes of shares (eg A and B shares, preference shares and non-preference shares, etc.). Share classes and their characteristics are stipulated in financial legislation in various countries. An important distinction is whether the shares have voting rights or not. A natural question is therefore whether a maximum limit of 3 per cent should apply to all classes of shares or as a portion of total share capital in the company. Norges Bank recommends that the limit apply to total share capital (as is the case today), but that in addition a maximum limit of 3 per cent is introduced for the portion the Fund could invest in shares with voting rights. While the limit for total share capital limits the Fund's exposure to a single company, the limit for shares with voting rights limits the potential for strategic ownership. A separate limit for shares with voting rights is consistent with the rules that apply in many countries for this type of shares (see Table 4).

4. Summary

Norges Bank proposes that § 10 of the Regulation on the Petroleum Fund be amended to read as follows:

"The combined investments of the environmental portfolio and the regular portfolio may not exceed 3 per cent of the total share capital in any one company. Furthermore, a 3 per cent limit on shares with voting rights in the environmental portfolio and the regular portfolio combined shall apply. Norges Bank shall not exercise its ownership rights linked to shares unless this is necessary to secure the financial interests of the Fund".

Svein Gjedrem

Harald Bøhn