On rocky ground: PE’s Mongolia risk factor

Despite having just stepped off a plane in Hong Kong to attend a mining conference, Alisher Ali, founder and managing partner of frontier investors Silk Road Management, is able to overcome his jetlag to speak enthusiastically about Mongolia's prospects.

"By 2030, Mongolia will become one of the three richest countries in Asia by GDP per capita after Singapore and Japan," explains Ali, whose firm raised $30 million for its maiden fund, the Mongolian Human Capital Fund, in 2011, $5 million above target.

There is good reason to be upbeat about Mongolia. Back in 2002, the country's GDP per capita was just $500; now it stands at $4,500 and is expected to reach $30,000 by 2030. Citigroup Global Markets projects Mongolia will be the fastest growing economy in the world between 2010 and 2030, expanding at an annual average rate of 9.7%. It is safe to say these positive vibes derive from the nation's mineral wealth, which accounts for nearly one third of GDP.

Yet the private equity industry remains in its nascent stages. Silk Road is one of just a handful of PE firms focused on the country and its mining-fueled growth. Others remain wary, pointing to the volatility of commodities market s and Mongolia's near non-existent track record for investment.

While commentators are keen to frame the country as an Asian El Dorado, the road to wealth has been far from even. The mining sector has an all-too-evident and controversial track record on the environment and local politicians have recently come under pressure to reassess the country's relationship with foreign investors. A presidential election will take place in June, which only heightens the climate of uncertainty.

The opportunity is still there, but whether private equity can thrive in the country very much depends whether it can stomach the risk.

History lessons

Deal flow so far has been characterized by a handful or large-ticket mining investments. According to AVCJ Research, the last five years have seen just over $2 billion of private equity investment across 13 deals. The lions' share of this came in 2009 when China Investment Corp (CIC) put $500 million in SouthGobi Energy Resources, $700 million in Iron Mining International and then another $100 million in SouthGobi alongside Temasek Holdings. Two PIPE deals and one pre-IPO investment - and very much a sovereign wealth fund story.

This was the same year President Nambaryn Enkhbaya of the Mongolian People's Revolutionary Party (MPRP) lost an election to Tsakhiagiin Elbegdorj, who became the country's first ever Democratic Party leader. What followed was a period of renewed openness to foreign investment.

The most significant deal came when Ivanhoe Mines, now owned by Rio Tinto, finalized an investment agreement with the government to develop the Oyu Tolgoi project in South Gobi, one of the world's largest untapped copper-gold deposits. Around $6.5 billion has been invested so far to bring the mine into production, which is expected to happen later this year. In financial terms, it is the largest mining project Mongolia has ever seen.

Taking advantage of the positive sentiment, smaller GPs started making their first forays into the country. With a population of just 2.7 million and few significant opportunities outside of mining, the obvious investment thesis was backing companies that benefited by proxy from the commodities boom, typically mining services, infrastructure and exports.

"Because of these early indications that growth in the mining sector was set to accelerate, our aim was to try and support companies in the non-mining sector," says Mandar Jayawant, managing director and founder of the Mongolia Opportunities Partners (MOP). The firm, which was set up in 2009, launched the Mongolian Opportunities Fund the following year, with a target of $75 million. It reached a first close of $25 million in 2011.

"We look at drilling, drill blasting, geo-physical surveying, mining contracting, mine services and pretty much the whole spectrum in brining the commodities to market," says Jayawant. Companies directly involved commodities trading are off limits so as not to expose the GP to price cycles.

Silk Road has a similar approach, targeting businesses in the knowledge-based industries and services sector in order to minimize mining risk. "We believe that, on a risk adjusted basis you can actually create significant value in Mongolia without taking too much risk on the geo-political implications," explains Ali, " It may not be like other frontier markets like Myanmar where you very diversified sector, never the less there is enough deal flow."

One particular area that has been targeted by private equity is the logistics space. With 90% of all Mongolia's exports going to China, investors are looking to capitalize on the cross-border movement of resources.

In November 2011, Origo Partners became one of the first GPs to tap into this theme, forming a 50-50 joint venture (JV) with leading global commodity trader Trafigura to develop iron ore and coking coal projects in Mongolia. The purpose of the JV was to export several million tons of coal and ore to China by truck and rail each year. Origo and Trafigura also agreed to expand the scope of the project to other countries in the region, such as Kazakhstan and Russia, and to other commodities.

"We know there are resources available in Mongolia but it is another thing entirely to bring them to market," says Chris Rynning, CEO of Origo. "The JV with Trafigura was a combination of addressing those challenges. Origo has access to capital and expertise investing in frontier markets, but we don't necessarily have sales, marketing or logistics skills to bring resources to the market whereas Trafigura does. It was a natural partnership."

Banking matters

As these peripheral industries develop and GDP grows, then so has demand for financial services in the country. With Mongolians will having more income to deposits, investors are also looking at banks. So far the only significant deal in this space has been Goldman Sachs' purchase of a 4.78% stake in Trade & Development Bank of Mongolia in February last year. The stated intention was to act as a passive investor hoping to reap the returns generated by Mongolia's rapid growth.

Others, however, see a sector ripe for consolidation. "With around 15 banks for a population of around three million, the country is vastly over banked. There are four major banks right now, offering a similar services which mostly involve retail banking," says MOP's Jayawan.

He sees two potential inroads: there is room in the market for a lender that can serve companies in the mining supply chain; and there is space at the underserved bottom end of the market, where there is scope for microfinance companies to be developed. "It is very high-return business in other places, because your risk is diversified and there is a lot of demand for smaller loans," Jayawan says of the latter opportunity.

Jan Hansen, senior country economist with Asia Development Bank (ADB), agrees a deficit in Mongolia's finance sector, populated by a large number of relatively small institutions, has created a capital gap in the country; one which could be serviced by private equity.

"Mongolian banks are quite sophisticated given the overall development of the country but they are quite small so they do not serve the mining sector, where the funding comes totally from abroad," he says. "So right now we have a funding gap of $30-100 million that is not served by the market."

Large capital investments - typically those of $100 million or more - come almost entirely from abroad, usually in the form of investments from development finance institutions (DFI). Unlike many investors, these institutions' mandate means they have a much greater appetite for risk, so they have provided much of the muscle when it comes to funding Mongolian growth. Broadly speaking, their role is twofold.

First, DFIs are among the major investors in mining projects. As recently as last month, the boards of the International Finance Corporation (IFC) and the European Bank for Reconstruction and Development (EBRD) agreed to provide part of the $4 billion project financing for the Oyu Tolgoi mine. Second, DFIs have been significant investors in the early Mongolian-focused private equity funds. This is done with a view to encouraging growth outside of mining the mining sector.

"There is a lot of talk about the diversification of the country in order to make it less vulnerable to external shocks and create employment," explains ADB's Hansen.

The Mongolia Opportunities Fund counts IFC and EBRD among its cornerstone investors along with Germany's DEG. "When MOP first knocked on our door we thought this would be a good opportunity to extend our reach further into the market because obviously we have limited capacity on the ground," says Philip ter Woort, head of EDRB's Mongolia office. "So to extend our capabilities through a PE fund with the same standards as us would make sense."

Their capital comes with one major condition attached: DFIs will only invest in private equity funds that are not engaged directly in mining. Ter Woort explains that the policy and strategic rationale behind this position. In addition to wanting to promote economic diversification away from the mining sector, the DFIs also prefer to invest in mining without going through an intermediary.

Despite these restrictions, the consensus among GPs, including those who do not count DFIs among their LPs, is that this kind of blue-chip institutional support emboldens other LPs who might not otherwise invest.

"I think the role of DFIs is very important and a catalyst for risk taking and growth," says Origo's Rynning. "I have huge respect for the work of IFC and the way they combine world class investment practice with sustainable, responsible investing. IFC is a perfect example of an investor that can handle social, political and developmental risk while looking to create long term investors returns."

This is not to suggest there are few willing LPs beyond DFIs. For example, Korean and Japanese institutions have generally been keener on investing in Mongolia than their western counterparts for example. In February, Japan's Orix Corporation committed an undisclosed sum to Mongolia Opportunities Fund with the aim using the fund to make its own first foray into the country. The same fund also received backing from Mitsubishi Corporation.

"There is a lot of interest coming out of Japan because the countries have historical ties and also because of the geo-political and strategic interests that Japanese companies have in securing natural resources in the region," says MOP's Jayawant.

Unclear rules

Yet, with the current political climate, the likelihood of others wanting to put risk capital into the country has lessened. This has been exacerbated by the government's recent alterations to investment laws. "Mongolia has become a politically unpredictable environment having gone from being everyone's darling to a place investors shy away from," says Origo's Rynning. "Investors want consistency and predictability, and Mongolian politics have provided little of that in the last year."

It was in May 2012 that the government, fearing increased foreign investment and potential loss of control of the country's resources, decided to introduce the "Law on Regulation of Foreign Investment in Business Entities Operating in Sectors of Strategic Importance (SSI)."

In practice, it introduces a government and parliamentary approval requirement for foreign investment in certain sectors, including most importantly the mining sector. This applies to any foreign investor acquiring more than a 49% share of an SSI entity, worth more than MNT100 billion ($76 million). For many, this has meant not only greater government oversight but has also additional delay in effecting foreign investments.

"There has been something of a change in the environment," explains Michael Aldrich, a partner with Hogan Lovells in Ulan Bator, who describes the movement as resource nationalism. "Looking at the first three years you had a fairly open environment. Investing was far less time consuming and document-intensive compared to mainland China."

A further problem cited by industry participants has been a lack of clarity concerning the law, which is by no means precise in its terms. For example, there is no indication as to whether the 49% and the MNT100 billion thresholds refer to the market value of the SSI entity, the book value of the company's assets or the value of the foreign investment transaction. Investors will only know where they stand once the government issues implementation regulations, but these have yet to be forthcoming.

How this development pans out depends on the election in June, but there is concern that a resolution on whether the law will be clarified or repealed won't come before October, leaving the country's stance towards foreign investors in limbo. President Elbegdorj's announcement last month that the nation should have more control of Oyu Tolgoi, of which it currently owns 37%, hasn't helped matters.

"The country is at a very interesting cross-road," says Aldrich. "Either it will continue to take this anti-foreign sentiment and entrench it further, in which case the economy will have a down turn or by the time we get to October we will have some clarity."

Opinion is divided as to the direction in which events will pan out. The EBRD's ter Woort, for example, is not so pessimistic. He believes the government realizes it has gone too far and has begun to make investors nervous. "Now there is concerted effort to win back the hearts and minds of foreign investors and the government is trying in earnest," he says.

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• Topics
• North Asia
• Industrials
• Regulation
• Expansion
• Mongolia
• Origo Partners
• China
• Commodities
• energy
• Growth capital
• Fundraising
• Silk Road Management