Frontier markets: Investing around Asia’s edges

Asked to define a "frontier" private equity firm's investment rationale, Douglas Clayton, founder of Cambodia-based Leopard Capital, says: "Risks tend to be as overrated in many frontier markets, as they are underestimated in developed economies. This is because analysts in developed countries rate the risks, and are uneasy with anything unfamiliar."

Yet the appetite for assets in these unknown areas - chiefly Mongolia, Cambodia and Laos - is growing. Investment has gathered pace over the last five years, hitting a perhaps deceptively high peak of $1.3 billion in 2009 when China Investment Corp. (CIC) launched itself at Mongolia's mining sector.

Still, transactions have risen from zero to a steady trickle and fundraising efforts assumed a new vigor in 2011, with five single-country vehicles entering the market targeting $325 million between them. One explanation put forward for the renewed interest is that the difficulties in the developed world combined with a stutter among the BRIC economies has made investors more willing to take a punt where there is less competition.

These frontier markets share a common selling point: natural resources, including untapped mineral reserves, oil and gas, renewable energy potential and agricultural opportunities. There is also an enormous need for infrastructure in part to accommodate populations that are becoming more prosperous, albeit from a low base.

While risks remain, more experienced GPs in these countries have managed to gather momentum. Speaking on Cambodia, Maya Ballard-Downs of DFDL Mekong, says, "Although the market may not be totally transparent, the funds have generally established a presence with staff who bring local knowledge and connections with them."

A Mongolian story

The principal driver of the frontier markets' rising numbers is Mongolia. Investment reached $23.7 million in 2007, before shooting up to $300 million in 2008 and then $1.3 billion in 2009. Cambodia's surge came later as $10.1 million in 2009 and $5 million in 2010 became $50 million a year later. Laos is less developed, with $12 million in PE deals over four years.

Mongolia's bumper 2009 came as a result of three transactions in the space of two months. CIC committed $500 million to SouthGobi Energy Resources, $700 million to Iron Mining International and then another $100 million to SouthGobi alongside Temasek Holdings - two PIPE deals and one pre-IPO investment. This pace couldn't be sustained in 2010 and 2011 but early stage and growth capital deals in the mining sector continue such as Origo Partners' investments in Moly World and Kincora. Leopard has been similarly active in Cambodia.

Mongolia's population numbers just 2.7 million and 80% of them are engaged in herding. Yet the country is rich in copper, gold, coal and rare earths. Foreign direct investment was as high as $1.7 billion in 2010, up from $372.5 million in 2007, and year-on-year export growth is over 50%. As a result, GDP growth reached 6.1% in 2010 and 10% in 2011, according to the Asian Development Bank (ADB), making Mongolia the fastest growing economy in the region.

Origo, which is currently investing out of a $100 million fund raised in 2007, has backed four mining sector companies made four mining sector investments since mid 2010 and last year announced a joint venture with Trafigura. Chris Rynning, Origo's CEO, expects the partnership to augment his firm's financial and sector expertise as well as potentially opening the door to larger ticket deals.

"Our on-the-ground presence means we are in a strong position to create value by applying our exploration and engineering skills and equipment to all stages of project development," Rynning says.

He believes opportunities are being created by high interest rates, which have made it more difficult for domestic companies to raise funds. This also presents a challenge for Origo's portfolio companies and the private equity firm has responded by sticking to its core interests in the natural resources sphere, principally copper and coal.

By contrast, Mongolia Opportunities Partners, which has received commitments from the likes of the International Finance Corp. (IFC) and the European Bank for Reconstruction & Development for its latest fund, approaches the resources sector indirectly, targeting service providers and infrastructure. It told AVCJ last year that it had 30-40 targets in mind, including some in financial services. Sources close to the fund say a debut investment is now imminent.

"Our focus on non-mining opportunities here is not only because our development finance institution (DFI) investors don't want us doing mining deals," says Mandar Jayawant, the private equity firm's managing director. "We also think that these opportunities offer a better risk-reward profile, especially for a fund of our size."

Although Origo did list Kincora in Toronto last year and claims to have other IPOs in the pipeline, the reality for the Mongolia-focused funds is that trade sales are the most likely exit. The burgeoning number of regional strategic investors - whether from China, Japan or Korea - now flooding into the country, support this strategy.

Winning over LPs

Proximity to China is a key selling point for these PE firms - in Indochina as well as Mongolia - when making their case to LPs. Interest in frontier funds has grown but it remains difficult for a first-time GP in a far-flung location to secure commitments. According to AVCJ Research, of the 11 single-country frontier funds launched since 2007, only five have reached a final close.

Origo's Rynning doesn't see this as much of an obstacle, noting that "good companies can always raise capital, if the price is right."

Fundraising for Mongolia Opportunities Partners has taken a much more circuitous route, however. The founders have strong DFI backgrounds and this has influenced their approach to private equity. Jayawant worked at the ADB until about four years ago and Marvin Yeo was one of his colleagues. They paired up to launch Frontier Investment & Development Partners (FIDP fund) in 2008, with a view to targeting Southeast Asia and Mongolia.

"We'd seen the big gap between opportunities in those markets and the international investment community, and within the latter [between the purely commercial players and] the developmental finance community," Yeo recalls. "We set our business up to bridge these different groups."

A Cambodia-focused fund was to be anchored by a Swiss private bank, with a new Mongolia fund primed for launch as soon as the Cambodia vehicle achieved a first close. However, the onset of the global financial crisis saw the Swiss bank pull back. Deciding to re-roll the dice, Jayawant and Yeo accelerated their activity in Mongolia, and did the same with other assets in Laos. Then they bolted Laos on to Cambodia and re-branded it as a Cambodian-Laotian fund, while the businesses as a whole were repositioned as a China resources play.

FIDP got much more traction with the Mongolian fund because of its sizeable resource plays, and IFC agreed to come on board as an anchor investor in late 2009. The plan was to firm up interest from other DFIs in 2010 but then IFC and others decided they wanted the Mongolian fund spun out into a standalone entity, to avoid any potential conflicts of interest. This marked the birth of the Mongolia Opportunities Fund.

They also insisted that the fund size be reduced from $100 million to $50 million, and imposed stricter conditions that promoted investment in logistics, agribusiness, infrastructure and SMEs rather than mining.
Mongolia Opportunities Partners also set up a joint venture with Hong Kong-based asset manager Asia Pacific Capital (APC) and hired Batsaihan Jamichoi, formerly a senior manager at fast fashion chain Uniqlo, to work with APC and also leverage his Japanese connections to identify new partnerships. Yeo took a similar approach in Southeast Asia, teaming up with more experienced Vietnam-based Dragon Capital.

The Indochina Opportunities Fund, which is seeking $250 million and expects to reach a first close in the next 2-3 months, is intended to offer geographic diversification along with significantly lower asset valuations.

Investments in Cambodia will focus on agriculture and infrastructure while Laos expected to deliver more natural resources deals. Exposure to frontier markets is counterbalanced by capital allocations to Indonesia and Vietnam, which are economically more advanced and better established in terms of private equity.

Good governance

Wherever Jayawant and Yeo go, their DFI-dominated LP base - and Dragon Capital is also 10%-owned by IFC - is likely to remain an issue. This is particularly pertinent to socially responsible investment (SRI), which is inevitably a concern for LPs with exposure to frontier markets.

"We have to comply with all sorts of criteria, but we're comfortable with that. It doesn't mean we can't operate," says Yeo. "We just need to do things in an SRI way, meaning if we take away from something we have to put it back another way, and make sure our efforts ultimately benefit the local economy and local people, and are at least environmentally neutral.

On a general level, the countries' regulatory landscapes should become progressively easier to navigate, if for no other reason than the acute need for foreign direct investment.

At present, there is an unpredictability in the enforcement of regulations in Mongolia as well as bureaucratic blockages created by obscure official business documentation and some corruption. As a matter of record, back in November 2010 the government suddenly suspended more than 200 gold mining licenses for the alleged violation of a 2009 environmental protection law. The results of promised corrective measures have been mixed.

In Cambodia, WTO accession has led to many constructive changes to the country's legal framework, but DFDL Mekong notes that the system is still unreliable. "Consistencies between the black letter of the law and actual practice remain an issue, and anti-corruption practices are in their infancy," it says.

To Orgio's Rynning, the much bigger challenge is being able to hire and retain quality personnel, a situation exacerbated by there being so few Chinese investment professionals with the experience necessary to play a leadership role. Recruitment is a particular challenge because of Origo's specialist requirements. It employs controllers to work with portfolio companies, ensuring good financial and legal governance, and technical experts who offer geological and mining expertise.

Jayawant of Mongolia Opportunities Partners agrees that the HR situation is tough, which means extensive training is necessary for new recruits. "We use our established fund management expertise out of Hong Kong to train our staff and build up our local team," he says. "Analysts from Asia Pacific Capital spend a fair bit of time taking our junior analysts through the execution process."

Risk and return

Frontier markets wouldn't be defined as such if there wasn't an element of risk and hardship. It is up to the GPs to convince investors that returns will justify a jump into the relatively unknown.

Leopard's Clayton argues that the key to this approach is identifying defensive sectors driven by demographics and domestic development. The graduation from subsistence living to basic discretionary consumption requires electricity, telecom, financial services and food products regardless of what happens on Wall Street. With this in mind, Leopard employs a twin-prong investment strategy: backing businesses that provide necessary goods and services, and supporting high-quality local brands that are able to compete with imports.

It is not a commodities play, but still capitalizes on the economic growth that natural resources have delivered to these nations - one step further down the scale from Mongolia Opportunities Partners' thesis of targeting service providers to the resources sector. These investments tend to be start-ups or very early-stage growth capital, which means a heavier workload but potentially stronger returns.

"The paradox of frontier investments is that if you want to get in early, you usually have to back an inexperienced team, and this approach is anathema to the institutional investment world," says Clayton. "They usually wait and then enter in a big wave late in the cycle just when returns are falling and local macro risks are rising."

SIDEBAR: Myanmar - Asia's next frontier market?

To see a pariah state, isolated for half a century, transforming into a putative investment icon in a matter of months is nothing short of miraculous. But that's how a growing number of frontier investors now see Myanmar, the former Burma, once described back in the 1940s as the richest country east of Suez.

"Myanmar is one of the remaining jewels of the frontier space, with a potential 10x catch-up story once the reforms are anchored," says Douglas Clayton, CEO of Cambodia-based Leopard Capital.

Decades of iron-fisted military dictatorship and massive economic mismanagement left the country locked in a bizarre time warp as its neighbors achieved historic prosperity. But over the past year or so, President Thein Sein's regime appears to have eased its grip, releasing political prisoners, reaching out to the West, and talking of economic reforms. It is said that these moves are in part driven by concerns that growing Chinese influence could become pervasive.

The parallel market exchange rate of the kyat has appreciated by about 32% in nominal effective terms since the end of the 2010 fiscal year, primarily due to large foreign investment inflows. The IMF is projecting GDP growth of 5.5-6% in 2012, up from 3.6% in 2008. Inflation is expected to pick up as the recent decline in food prices phases out.

The progress has prospective international investors salivating. "George Soros has just been there. Bill Gates is about to go. And I can see Myanmar becoming the most exciting country in the region over the next five years," enthuses one. "Would-be investors are already flooding in. You can't get a hotel room in Yangon right now."
Maya Ballard-Downs of DFDL Mekong in Cambodia confirms that there is increasing interest among Indochina-focused offshore funds in Myanmar.

Their enthusiasm isn't hard to understand. Myanmar boasts a largely untapped treasure trove of natural resources, including oil and gas, minerals and timber, as well as equally impressive renewable energy, agricultural and fisheries potential. And while it is next door to tourist mecca Thailand, its beaches are almost deserted. In the long term, the 60 million population is seen as an emerging consumer market.

The downsides are a lack of foreign investment protection and incentives, plus an artificially overvalued currency. Economic sanctions may well be lifted, but there remains there is also a risk that the government will perform an about face.

It seems almost inevitable that the economic dynamism of Southeast Asia will in some way spill over Myanmar's borders. Clayton sees the first wave of investment focusing on hard assets like real estate, hotels and natural resource concessions.

"But as reforms take root, that will broaden to include financial services, telecommunications, electricity, local consumer products and labor-intensive export manufacturing," he tells AVCJ. "Most of the early opportunities will be for greenfield projects, however."

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• Topics
• Southeast Asia
• North Asia
• Expansion
• Industrials
• Cambodia
• Laos
• Mongolia
• Growth capital
• Commodities
• energy
• Leopard Capital
• Origo Partners