Michael Madden

Chairman, Teneo Capital & Teneo Restructuring

Frontier States: High Risk, High Reward

To find golden opportunities look to frontier states that have internet connectivity, instant worldwide communication, ubiquitous mobile technology and a young, educated work force.

Rich world countries will not remain rich forever and poor countries will not remain poor. As global economic trends and resource control shifts, so does the smart investor’s capital.

As explorers once sailed into the unknown, searching for new land and wealth, today’s adventurers take the form of frontier markets investors, seeking countries and opportunities where capital and expertise can yield the greatest returns. Unlike Columbus or Marco Polo, today’s capital explorers often arrive to internet connectivity, instant worldwide communication and ubiquitous mobile technology. The world has changed, but the golden opportunities remain abound; the question is how to find them.

Frontier markets are markets that have in some way been inaccessible to investors in developed countries until very recently. Frontier markers are best defined as countries that are on the cusp of ‘emerging market’ status. These countries were previously blocked off from the rest of the world by Western sanctions, until a recent series of political and economic reforms re-opened the borders to international investment.

After the collapse of the Soviet Union, new nations became ‘frontier’ states, attracting a host of once-prohibited companies and investors to help build the economies that thrive today. In recent years, the frontier states are those that have re-engaged the international business community that is now open to foreign investment after decades of isolation (such as Mongolia, Iran, Cuba, and Myanmar).

These markets offer high returns for those willing and able to approach them. With little established competition and huge potential to grow an enterprise on fresh and fertile soil, frontier market investments can bring internal rate of returns (IRRs) of 30-35 percent when executed successfully. But the challenges and risks to operating in frontier states are significant investors can only succeed through extensive and diligent on-the-ground contextual research.

Untapped Resources

The natural resource boom in Mongolia illuminates the potential rewards available when investing in new markets. Once the established government signed an $8 billion mining deal with the mining giant Rio Tinto in 2010, the country swiftly became the fastest growing market in the world with 17 percent GDP growth in 2011. The deal was sparked the country’s boom, with extraordinary knock-on effects for the economy that supported the mining sector. A USD investor in Mongolia in 2011 could be guaranteed nine percent on USD deposits at major banks, and up to 15 percent within the Mongolian financial services.

But metals and mining are not the only untapped resources that frontier states have to offer. Mongolia is a landmass endowed with great mineral wealth and a small population. With only 2.8 million people, Mongolia is the most sparsely populated country on earth – an ideal target for mining projects where fewer communities may be affected by the landscaping alterations.

Myanmar, by contrast, contains 53 million people in a country the size of France, around the world average in terms of population density. After a series of democratic political reforms in 2011, investors began to flock into this once economically-isolated land in the heart of booming Asia. The next few years brought huge developments in telecoms, construction, tourism, and financial services.

Construction boomed in Myanmar’s largest city, Yangon, with familiar hotel names and conglomerates itching to get in on the new market. Shangri-La committed to the development of a huge corporate hotel in the centre of downtown, as well as a newly built serviced apartment block and a soon-to-come serviced office complex. As with many emerging market cities, a visitor cannot turn a corner without seeing a half-built high-rise surrounded by cranes.

The most exciting developments in Myanmar over the past few years are in the telecoms space. Up until 2013, only six percent of the population had access to a mobile phone. When the government began an auction for mobile network operator licenses in 2013, the world’s largest names rushed to tap into Asia’s last telecoms market, spending billions on marketing and the construction of network towers. Again, the knock-on effects were felt throughout the country’s other nascent sectors and today Myanmar rests on the cusp of a complete technological overhaul. In just under three years 20 million Burmese people have gone from relying on off-grid, isolated pockets of information to having almost immediate access to the world’s store of knowledge.

Organic Growth

Frontier market economies have only one direction to go: up. For investors that can navigate hurdles and challenges, the macroeconomic tide will lift a lucrative opportunity even higher. International development funding, legacy debt write-offs, discounted new debt lines, new bond markets and giant multinational corporate deals often come thick and fast for a newly opened frontier market. Strategic political interests lie at the heart of some funding sources as nations compete for the new nation’s favor, thus kick-starting the wider economic progress.

Myanmar, for example, bordering both China and India, has received vast amounts of funding from Japanese Corporations, OPIC and Chinese national conglomerates. Mongolia had a similar balancing act to perform in its boom period. Its third neighbour’ policy looked to bring in Western nations to offset the political and economic dominance of its two large, bordering powers: Russia and China.

As the rich world workforce grows older and looks to retirement, the young emerging world is itching to take their place. Many Frontier economies possess a young, well-educated and technology-driven population. Myanmar has an estimated median age of 27 while in Mongolia it is 27 - the majority of the population takes great pride in being early adaptors of technology and desire to feel part of their country’s development. Myanmar and Mongolia both have an estimated median age of 27, with two international mobile network operators granted licences in 2014, the smart phone uptake has been exponential. It is anticipated that 90 percent of the country will have mobile coverage by 2018. For the youth of Myanmar, having a smart phone and being connected to the world has become a number one priority.

The lack of international competition coupled with a blank canvas to operate provides the opportunity for an investor to establish early and grow quickly.

As technology advancements accelerate and take an ever-more important role in global commerce, a young, fresh-minded workforce is essential to the long-term success of a business. Many tech-focused businesses have already outsourced their workload to yesterday’s frontier markets. India and China, followed by Vietnam and Taiwan, have some of the most efficient tech labour pools in the world. Tomorrow’s tech hubs are today’s frontier markets.

Those that take the risk to approach a frontier market first often reap the largest rewards. The lack of international competition coupled with a blank canvas to operate provides the opportunity for an investor to establish early and grow quickly. The question remains: do international investors acquire or build when entering Frontier markets? Often the only answer is to build given the low levels of development and lack of infrastructure. While this provides an opportunity to build economies of scale, it also presents a myriad of additional challenges to navigate through with often nascent legal, banking, investor, regulative and trading environments.

Economic contagion

The impact of China’s economic slowdown rippled across the globe, proving particularly challenging for a number of low-income and lower-middle-income economies, including Mongolia, that have depended on exports to China. China is Mongolia’s biggest trading partner, with 90 percent of Mongolian exports going to China in 2013. However, consisting almost entirely of coal, copper, iron ore, and crude oil, Mongolian exports have been hit incredibly hard by the drop in Chinese industrial demand.

The fall in commodity prices has put pressure on Mongolia’s currency, the Tugrik. Compared to the U.S. dollar, it reached a record lows in September 2015. Comparing the Tugrik to the Chinese Yuan shows an even more alarming trend: the Tugrik has depreciated by 40 percent since 2011 relative to the currency of China, its biggest trading partner. Since Mongolia imports many consumer goods, including textiles, the exchange rate has directly impacted Mongolians’ purchasing power.

Frontier markets only gain the ‘frontier’ title on the back of a major political or economic shift in their recent history – meaning their previous state of affairs was extremely unfavourable. Iran, Cuba and Myanmar were once known as ‘enemies’ of the West, and are only recently emerging from a stifling blanket of economic sanctions that prohibited many forms of trade and commerce. Although these countries are now reforming towards a more open democratic system of governance, many investors fear a stall in reforms and their governments re-imposing the sanctions that would legally mandate them to exit.

Russia, although no longer a ‘frontier’ market, has stalled in recent years as the government’s political rhetoric shifted. Western statecraft now threatens to have dire consequences on the country’s long-term economic trajectory, reacting to the conflict in Ukraine and a shift towards state-directed model of development rather than market-based.

A direct consequence of the imposition of these sanctions is the impact on Russia’s foreign direct investment (FDI), which dropped 46 percent in the last twelve months to $2,806 million. Furthermore, Russia’s economic performance has been weakening for several years, with GDP growth being in its fifth year of contraction and the International Monetary Fund currently forecasting negative growth of almost -4 percent for 2015. In addition to its economic and foreign investment woes, Russia’s currency has consequently paid the price also, losing over 50 percent of its U.S. dollar value since January 2013.

Another example of a stall as a result of government meddling is Mongolia’s foreign direct investment collapse. At its peak in 2011, Mongolia achieved $4.6 billion in foreign direct investment. By 2014 this had evaporated to the paltry levels of $300 million. The driving factor was a disagreement between the Mongolian government, which owned 34 percent, and Rio Tinto, which owned the majority stake in Oyu Tolgoi (OT), the vast new copper mine in the Gobi Desert. When it is fully up and running, the copper mine could account for one-third of GDP. The $6 billion spent to date account for most of the recent foreign direct investment.

Legal Grey Areas

The instability of frontier markets governance often casts a shadow over the rule of law. With little precedent for international business practises and few litigation cases to learn from, the correct path to market can seem unclear. This lack of clarity is not debilitating, but heightens the risk that a law may be changed or other players in the market do not abide. Many frontier markets will need reform governing bodies and legislative process that may have not been addressed or are outdated.

For example, with the recent opening of the financial sector to foreign entrants and severe lack of banking services in Myanmar, the Central Bank and Ministry of Finance are scrambling to draft and implement the necessary laws and regulations to governing modern day banking. The entire system is leapfrogging from an old paper-based, cash-driven ecosystem to a modern internet and mobile friendly platform. However, policy makers are struggling to keep pace with laws (such as the Microfinance Law in 2011 and Mobile Banking Law in 2013) being swiftly implemented. Moreover, the country awaits the impending Financial Institutions Law and Dedicated E-money Directive to give better clarity to this rapidly evolving sector.

These legal gray areas can create a long, painful process when establishing a business and operating in a frontier market. The bureaucratic systems in place take time to dissolve, and investors are often faced with unexpected hurdles in the early stages. Some sectors are deliberately “off limits” to foreign investment, but others are beneath a pile of paperwork, partnerships, and convoluted structuring.

Single Sector Growth & Brain Drain

Frontier markets led by a single sector, are looking to hire the best-educated native workers. The pool of educated, English-speaking employees is often small: the country has not engaged internationally for generations and salaries are swiftly blown out of proportion. Even in a diverse economy, the pool of educated skilled workers can quickly be drained by new, competing international businesses.

Extractive industries have the power to create huge investment inflows, but reliance on natural resource exports often creates a huge risk for the country that can lead to a bust. The average price for Urals crude oil hovered around $110 per barrel from 2011 to June 2014. Since then, prices have plummeted to under $50 per barrel in 2015, thus exacerbating the pressure on the economy further. Mongolia faced a similar trend off the back of its mining industry in 2010, attracting huge inflows of capital before political infighting turned the tap of capital off and many investors exited as quickly as they’d entered.

Liquidity Issues

A wary investor will be keeping an eye on their exit. As a frontier market is new and fewer international players are present, finding a timely exit can be a challenge. The typical frontier private equity exit is four to six years, well over the average for developed market deals.

Stock exchanges, if they exist, also have the same liquidity issues. Mongolia’s local stock exchange faced low volumes for trade even when the London Stock Exchange group installed the most modern platform to trade. Within the 300 companies listed, only 10-20 gave any real movements even during the boom period, and an investor who wanted to capitalize on the paper returns would have to wait weeks to place large amounts of capital, let alone exit.

Further, frontier markets will often experience economic cyclical challenges. A boom period may often be followed by a settlement lag (or even a dip) after high performance. These swings can alter the envisaged path of an equity investment by either presenting early or delayed exit opportunities. However, exits are always bound by the illiquid private process. Taking the Mongolian economic example earlier, while the first phase expansion of the OT mining project catapulted the growth up to its peak in 2011, due to a combination of negative factors, the economy has been stunted ever since, with 2015 GDP estimated to only surpass 4%. Internal policy and unattractive reforms to foreign investment law lead to stalls in OT phase two expansion and new foreign direct investment. This damaged investor confidence weakened the currency and halted the Mongolian ‘Wolf’ economy. For many early investors this also shifted expectation of exit opportunities and liquidity events.

An attitude of humility and adaption to host nation practises is essential for the long-term success of a placement and solidifying the relationships necessary to secure partnerships.

Lessons Learned

There are many lessons to be learned from the emergence of previous frontier markets. The fall of the Soviet Union allowed Russia and some of its surrounding nations to experience the investor boom and subsequent busts. Mongolia attracted a swath of capital before falling into political infighting that put much at risk. Myanmar, now at the height of its boom, still attracts the world’s awe in its development. Cuba and Iran are next and North Korea will follow.

To approach these markets successfully, an investor must adapt to a few principles. Many investors have been burned quickly by assuming developed market practises will automatically work in a “less” developed nation, or assuming that their assets, capital and expertise will be accepted and embraced by those looking to develop economically. An attitude of humility and adaption to host nation practises is essential for the long-term success of a placement and solidifying the relationships necessary to secure partnerships.

With little access to certified, reliable information on sector research, government figures, or corporate profiles, a frontier markets analyst will have to widen the margin for error, taking all data with a pinch of salt. What little data can be gathered through conventional sources will need extensive back up from surveys, on-the-ground knowledge, local participation and rumour-driven word of mouth.

Establishing an office early, with one to two years lead time on a major investment, will greatly alleviate some of the issues above. An arrogant and hasty investor will hit unnecessary pitfalls in frontier markets that can be identified through local engagement, a strong network, and reliable sources of information that may take months to establish.

Incentives to do business in emerging markets may differ from developed nations, and pride may be more likely to win out over profit in major deals. Keeping strong relationships with business partners and offsetting political risk through established business networks is key to maintaining stability.

Frontier markets entice many investors, but a steady approach is essential to maximise the chance of success and alleviate some risks. With fresh opportunities to implement successful first-world models on fertile ground, frontier markets offer huge growth potential for smart capital willing to commit for the long-term and rise with the tide.