Frontier Markets: Cambodia and Mongolia – High risk for high returns

Investors prepared to place bold bets in the hope of outsized returns might find what they're looking for in the world's so-called frontier markets. Yvette Choo finds out why Cambodia and Mongolia merit serious consideration.

Rather like the gold prospectors who headed to California in the 1840s, private equity firms in so-called “frontier” (or preemerging) markets hope to make their fortunes by being first on the scene. Some do. Others, like those in the gold rush era, head home with little more than they started out with.

Some are skeptical of the ability of frontier markets to prove credible investment destinations in the long run. “I believe that you can make money in frontier markets but I question whether or not certain markets can support a long-term sustainable private equity industry. I'm not so sure,” says Veronica John, chief executive of funds of funds manager IDFC Capital in Singapore.

Nonetheless, some frontier markets appear to stand a better chance of attaining credibility – and perhaps one day graduating to “emerging” status – than others. Two of these are Cambodia and Mongolia. Below we explore the reasons why investors in these countries are optimistic, as well as the pitfalls that might conspire to send them home emptyhanded.

“Think of Thailand 30 years ago and Vietnam 10 years ago. That's Cambodia now,” declares Marvin Yeo, co-founder of Frontier Investment & Development Partners (FIDP), a private equity firm with offices in Singapore and Cambodia which focuses on frontier markets.

As the comparisons made by Yeo would suggest, Cambodia is at a very early stage of development but is enjoying a rapid rate of economic growth. From 2000 to 2007, the country's annual growth was an average of 9.3 percent, a close second to China's 9.6 percent and ahead of India andVietnamover the same period, according to a report from the International Monetary Fund's International Financial Statistics.

One feature to its advantage is that Cambodia has a remarkably investor-friendly business environment. A dollarised economy – in which the US dollar is used in parallel to the official local currency, the riel – reduces foreign exchange risk. In addition, there are no capital controls so money flows in and out of the country freely, and domestic companies can be 100 percent foreignowned. For these reasons and others, Cambodia ranked higher than China, India, Indonesia and Vietnam in the 2007 Economic Freedom Index produced by US political think-tank the Heritage Foundation and theWall Street Journal newspaper.

No surprise then that private equity firms are beginning to scour the country for opportunities. FIDP, which looks at markets such as Cambodia, Mongolia and Laos, is currently raising its Cambodia Investment & Development Fund with a target of $250 million. The fund already has a pipeline of possible deals and says it will make its first transaction soon after closing. The fund is targeting the agricultural, power, basic infrastructure and financial services sectors.

Nevertheless, in a small country which has a population of approximately 13 million, does a Cambodia-focused private equity fund make sense? Five years ago, fund sizes in China and India averaged between $50 million and $70 million, “yet you see some investors seeking to raise country-focused funds [in places like Cambodia] with target fund sizes in excess of $200 million,” says IDFC Capital's Veronica John. “Keep in mind that India and China are largermarkets as well. So the jury is still out on Cambodia,” she adds.

Marvin Yeo of FIDP counters: “What we are doing is very new in terms of strategy. Basic defensive sectors such as agriculture and power can be very interesting investments in these markets, so we are confident of generating high returns. While China and India are larger markets, there is also a lot of competition there. Here, we are in a position to cherry-pick and get the best deals because of our local relationships.”

Leopard Capital, a private equity firm with offices in Hong Kong and Cambodia, is raising its $100 million Leopard Cambodia Fund, which has received capital commitments of $13 million to date and expects a final close in March 2009. The fund recently committed $1.8 million to its first investment, a residential condominium development in Cambodian city Siem Reap, and has several deals in the pipeline in the banking, electricity, and agriculture-related sectors.

Douglas Clayton, managing partner of Leopard Capital, believes the country will see major developments soon. “Cambodia is full of untapped commodities such as oil & gas, minerals, rubber, rice and crops. When these industries really get underway in the next three to four years, it will have a big impact on the economy. It is also a small place, with an economy of just $8 billion. So even in a global credit crunch it doesn't require massive inflows to move this market – a little money goes a long way.”

On the downside, Cambodia is hampered by the absence of capital markets. The country does not currently have a stock exchange, although one is slated to be launched in the fourth quarter of 2009. “The capital markets infrastructure in many of these economies does not exist to support a robust private equity industry,” says John. “Exits in these markets are quite limited.”

In addition, says John: “Investors that consider investing in these markets must have a very long-term view and must be willing to support unprovenmanagers, many of whom lack direct private equity experience.”

In FDIP's case, experience is on its side. Jim Rogers, who co-founded the Quantum hedge funds group with George Soros in the 1970s, sits on the firm's board. So too does Marc Faber, the famed Swiss investment analyst labeled “Dr Doom” for his frequently bearish predictions. In addition, Robert Ash, former chief executive of AIG Asset Management Services, is chairman of the firm's investment committee.

But perhaps even more significantly, Frontier's fund principals are native Chinese and Teochew speakers. This is an invaluable asset in the Cambodian business landscape, which is dominated by theTeochew Chinese community, according to Yeo. Business in Cambodia is very relationship-driven and knowing who to talk to is vital in order to get access to the best deals.

Other idiosyncrasies in Cambodia that investors should not overlook are an evolving legal system, inconsistent accounting standards and corruption. However, recent moves into the country by global financial services specialists such as PricewaterhouseCoopers, KPMG and Ernst and Young should help to clamp down on irregular practices.

Also worthy of consideration is that investors in Cambodia may need to adopt a very hands-on strategic approach. “Some of the best opportunities are to bring missing industries into the economy,” says Clayton. “This means you have to work out the entire supply chain, and train all the human resource. It also means investors have to become more involved with their investments, working closely with the management team to execute the business plan.”

Market participants believe the extra effort can bring rewards: “The Cambodia marketplace is not yet efficient so you can end up being the sole player in your segment for longer than normal and make abnormal profits,” Clayton asserts. “Several locally started businesses have already grown into multi-national corporations, with overseas expansion funded by their Cambodian profits.”

With the global credit crisis battering developed and even some emerging markets, private equity investors looking further afield may observe the Cambodian growth story with increasing interest.

Population: 13.4m

Capital: Phnom Penh

Size in area: 181,040 km sq

Internet users: 30,000

Cell phone users: 380,000

0-14 year-olds: 38.3%

15-64 year-olds: 58.6% 65+: 3.1%

Labour force: 7m (54%)


Since the early 1990s when it began to develop a market economy, Mongolia has embraced foreign direct investment. This has been well rewarded since neighbouring China's rapid growth has led to strong demand for Mongolia's mineral deposits. In addition, China's proximity has offered Mongolia easy access to one of the world's largest markets.

Such positive traits have attracted private equity funds. In April 2008, Chinese private equity firm Hopu Investment Management invested $300 million together with Singaporean sovereign wealth fund Temasek Holdings in Hong Kong Lung Ming, the owner of aMongolian ore mine.

Furthermore, Singapore- and Cambodia-based private equity firm Frontier Investment & Development Partners (FIDP) intends to launch the $250millionMongolia Investment & Development Fund early next year and is aiming for a first close on $100 million in June 2009. The fund will invest in mining and mining support industries such as logistics and transport and is anticipating achieving an IRR of between 30 percent and 40 percent.

On a smaller scale, Mongolia-based investment firm Asia Pacific Investment Partners (APIP) is investing a fund that closed on $25 million in April this year. In June 2008, the firm invested in Mongolian cement factory Central Asian Cement, which is currently applying for an IPO on the country's stock exchange.

But how confident are the likes of FIDP and others that investors will over the coming years be attracted to a frontier market like Mongolia when many longestablished private equity firms around the world are facing the prospect ofmissing fund targets in the tough current climate?

“We expect a delay of threemonths to a year to our initially expected close. But we still expect to do our first close by June 2009,” says Mandar Jayawant, who is spearheading FIDP's efforts in Mongolia. “This is because we are offering opportunities based on very real and simple investments such as commodities and agribusiness. The way risk is assessed by global investors has changed dramatically and will continue to change dramatically. While potential returns in the public markets are very attractive, people do not trust financial markets as much any more because of the volatility – so they will take more kindly to ‘real’ assets, ‘real’ investments.”

However, while Mongolia's assets may be attractive, investors are wary of political instability in the country. Violent riots after the recent elections in June left five dead and many more injured.

“There is a perceived political risk when it comes to investing in Mongolia,” says Jayawant. However, APIP managing partner Lee Cashell points out that there has been democracy in Mongolia since 1990 and the government is very stable. Furthermore, corruption seems to have decreased in recent times.

In a sign that economic development is becoming a key concern to Mongolians, rival parties based their election campaigns on fiscal issues such as soaring inflation and how tomanage the tapping of recently discovered mineral deposits. A government action plan regarding these issues has been submitted and is pending approval.

But while this may be encouraging, private equity firms are presented with a tough operating environment in Mongolia overall. For example, says Jayawant: “Mongolia has a judiciary system in place but since it is very young, some legal issues, which we may face over the course of investing, will have no legal precedent and may take longer to resolve.”

To make up for the lack of experienced lawyers and accountants, Cashell says his firm outsources such services to firms in Hong Kong while Jayawant relies on his own firm's personnel based in Singapore and Phnom Penh.

But despite weaknesses such as these, Mongolia has its attractions. Perhaps most notable is its extremely friendly foreign investment regime, according to private equity fund managers. For example: income tax is low, there is no withholding tax and also no tax on the repatriation of profits.

Few would dispute that the country is doing what it can to roll out the welcome mat to investors. For the time being though, Mongolia is still a country for adventurous GPs (and LPs) only. Such is the nature of a frontier market.

Population: 2.8m

Capital: Ulan Bator

Size in area: 1,564,116 km sq

Internet users: 50,000

Cell phone users: 216,000

0-14 year-olds: 29.7%

15-64 year-olds: 66.7%

65+: 3.6%

Labour force: 1.4m (50%)