Attention, sovereign wealth funds: You’re doing it all wrong. That’s the view of Don Putnam, who has played matchmaker for financial services companies for decades.

Three years ago, Mr. Putnam founded Grail Partners, a boutique merchant bank specializing in the financial industry. Earlier, he was co-founder and CEO of Putnam Lovell Securities. That bank, now part of Jefferies, was responsible for numerous high-profile transactions in the asset management business, such as the 1995 sale of Miller Anderson and Sherrerd to Morgan Stanley and the 2001 sale of Zurich Scudder, with assets under management of $278 billion, to Deutsche Bank.

Although Mr. Putnam says this is an excellent time to invest in the beleaguered financial services industry, he says he thinks the funds are going about it the wrong way. He visited with investors in the Middle East two weeks ago to share his views and to drum up interest in a fund that his firm is launching. His pitch for the fund focuses on the outsize returns that private equity players have historically earned in the financial sector during recovery periods — 30% in 2001 and 2002, for instance, compared with a not-too-shabby historical average of 18%. However, he says that by buying large slugs of common or preferred stock in companies such as Citigroup or Merrill Lynch, the SWFs give up their opportunity to take profits as the industry recovers. In effect, they are putting too many eggs in one basket.

Instead, he advises investing through experienced specialty private equity or asset management firms, or through hedge funds. Mr. Putnam’s partner, John Siciliano, says that “instead of looking to put a slug of money into Merrill Lynch or Citigroup, they should be investing with diversified managers like Pimco,” referring to a top-notch fixed-income firm. Another industry outsider views this advice as theoretical, as there are few organizations that can accommodate the SWFs’ need for large investments.

In a piece recently drafted for clients, Mr. Putnam argues that, though the SWFs have typically been able to buy equity positions in the banks at a discount to market, that is insufficient reward for having a very public and visible stake that can’t be sold.

To drive home the point, Mr. Putnam gives the example (without naming names) of the investment made by a Saudi prince, Alwaleed bin Talal, in Citicorp during its debt crisis in 1991. Imprudent investments overseas, overpriced real estate purchases, and other missteps led the giant bank to a need for capital. Prince Alwaleed came to the rescue, forking over $590 million for a convertible preferred stock with an 11% dividend. The prince made, as Mr. Putnam describes it, “a private yet very public investment” that comforted both regulators and markets. Does this sound familiar?

By 2000, Citigroup’s reins were transferred to Sandy Weill from John Reed, and the Saudi investor realized a 40% annualized return on his investment. Everything was going swimmingly, but because of the potential for embarrassment, the prince left his money on the table. Move the calendar forward once again, to 2008, and we all know what happens. What with management turmoil, bad investments (Old Lane comes to mind), and the subprime meltdown, the Saudi’s return is sliced to less than 20% for the 17 years that he has stuck with the company. Although he has arguably outperformed most alternative investments, he’s given back 10 years of this return, all because he couldn’t sell.

The price of being “locked up” could be particularly costly going forward, as Mr. Putnam thinks we are in for a period of “increasingly exaggerated swings of public pricing around long-term value.” This is not meant to dissuade investors from committing to financial services. Au contraire, Mr. Putnam says he thinks there are bargains aplenty in the sector, as banks and investment banks unload assets and seek out new financing to shore up their balance sheets.

Indeed, Mr. Putnam lauds the long-term favorable demographics and high barriers to entry of the sector, which arise in part from ever more complex regulations. (Wal-Mart’s effort to enter banking is a case in point.) Notwithstanding the drubbing taken in downturns, margins are typically high across the cycle. Also, he points out that the business is almost infinitely scalable, which leads to outsize earnings.

Mr. Putnam reminds us that the financial services sector is, even today, the largest component of the S&P 500, at 17% of total market capitalization, and that it accounts for fully 24% of America’s GDP (note to those who think the government should not be baling out banks). Moreover, American banks have been successful in exporting capital markets know-how across the globe, and they will continue to do so as more countries come of age. (We would question whether the welcome will be quite as warm going forward.)

Another appealing aspect for investors — and for banking firms such as Grail — is that, despite ongoing consolidation, the industry is still highly fragmented. He points out that between 1979 and 2002 the average quarterly merger and acquisition deal value in the sector was $102 billion, compared to $66 billion in high tech and $43 billion in populations/business services (whatever that means). Mr. Putnam says that, of 40,000 companies in the country, some 90% are profitable.

In short, Mr. Putnam advises clients to look over the valley and to invest with proven players in the sector. Who clears this hurdle? He lists several firms that specialize in banking, including J.C. Flowers & Co., CapGen Capital Advisors and Belvedere Capital, Hellman & Friedman, Crestview Partners, Reservoir Capital Group, TA Associates, Lovell Minnick, and, yes, Grail. They are given high marks for activity in the insurance, asset management, wealth management, and specialty finance sectors. Specialist hedge fund managers Tosca Asset Management and FrontPoint Partners (owned by Morgan Stanley) are described as top of the field.

Bottom line? Investing in the financial sector looks rewarding but risky; experience and diversification are essential. Secondly, maybe being an SWF isn’t so great after all.

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