7. The Profits and Perils of Reputation

Both reputable capital and political access can create advantages for investors at the deal level, but they are somewhat intangible. And similar to intangible assets at the company level (brand value, goodwill, etc.), they can produce a very high return on equity. Two or three people with laptops, business cards, and connections can structure very lucrative deals—an “asset-light” type of deal-making.

However, this same “intangibility” also makes reputable capital and political access the most vulnerable in difficult environments. If you can compete for deals with no real concrete assets, so can your competitors. Just as brands and intellectual property can be copied much easier than a factory or building, so can deals done with these sorts of intangible advantages. As value keys, reputable capital and political access are both the most compelling and the most perilous.

Building advantages at the deal level is a topic Graham did not discuss at length in his writings. But for those of us value investing globally, access is almost always question #1. Getting preferential access to private investments or private investments in public equities has a large impact on deal flow and pricing. In Buffett’s writing, deal advantages are also not discussed much, but clearly he enjoys a significant advantage in this area. That he can sit in his office and wait for the phone to ring, as opposed to actively bidding for deals, is a sign of a uniquely powerful reputation.

This chapter details various value strategies that rely on these types of intangible deal advantages. They are responsible for some of the most spectacular successes and failures of the last five years.

Institutional Investors on the Frontier

Reputable capital and political access are key assets for famous investment firms going global

Real estate investors and private equity firms are going east in search of growth. And although they sometimes use other capabilities, they are most often deal-makers using expertise, reputation, and capital. In this, they offer good test cases for reputable capital and political access strategies. Private equity firms in particular are good cases because, outside the West, they have shrunk their standard “leveraged buyout through distressed turnarounds” playbook to primarily growth equity. And most often they limit themselves to minority stakes in pre-IPO companies. In practice, this type of private equity looks a lot like traditional value investing with an overwhelming emphasis on discounting projected growth back to current intrinsic value. And also like global value investing, they face the same challenges with deal access, current uncertainty, long-term uncertainty, weakened claim to the enterprise, and foreigner disadvantages.

Looking at the successes and failures of these firms’ global initiatives is illuminating.

Morgan Stanley Properties Rises and Falls in Shanghai

Morgan Stanley Properties opened its Shanghai office in 2006 with grand ambitions. The firm announced it would invest across all property types—publicly traded and privately held real estate companies, direct real estate assets, and direct developments. Having made its first investment there in 2003, a full Shanghai office and team were more of an acceleration than a new initiative. And by all accounts, the firm had some very successful initial years. It acquired multiple properties in Shanghai, including prominent commercial developments and redevelopments near Huaihai Road. And it comfortably pulled ahead of the local operations of Citi Property and Carlyle Group real estate.

But significant developments quickly buffeted, if not derailed, Morgan Stanley’s ambitions. The first was that China discovered it no longer needed foreign capital for real estate; in fact, too much local capital was going into the sector. Second, Morgan Stanley encountered a surge in local competition. Local private equity firms, large real estate companies, private investors, various state-owned enterprises, and just about every other type of Chinese company started getting into real estate.

Morgan Stanley found itself less and less competitive at the deal level, particularly in sectors such as residential housing. Even in commercial development and redevelopment, where the firm’s reputation and expertise gave it a bigger edge, it still faced serious challengers. After all, how do you compete for deals as a foreigner if the competition is mainly about reputation, capital, and political access? Within only four years, Morgan Stanley Properties Shanghai found itself in the situation you never want to be in in China—a foreign company with no clear advantage in an intensely competitive industry.

With state capitalist rules tilted against them, no real strong advantage to help win deals, and intensifying local competition, it was only a matter of time before a serious blow arrived. This appears to have now happened with the emergence of renminbi-denominated (RMB) funds. Companies using RMB funds have significant advantages, such as faster transaction approvals and an easier ability to access local debt. Not only has Morgan Stanley lost its main advantages in the face of intensifying competition, but its access to international funds is now almost a disadvantage.

This situation is not unique to Morgan Stanley Properties. Real estate investing in developing economies is mostly a competition for deals fought with reputation, capital, expertise, and political access. Most foreign real estate companies in hypercompetitive China now lack any significant advantage.

You’ll recall how different Prince Waleed’s approach was to Chinese real estate. Instead of trying to compete within the mainland market, he leveraged his reputation into a cross-border situation where it was more effective. He also focused on completing one or two very large deals where political access could be deployed more powerfully at a single point in time. This is in stark contrast to trying to play across the field and in every deal type long-term.

Currently, many foreign private equity firms are ramping up their operations in the Chinese mainland. Kohlberg Kravis & Roberts (KKR), Bain, and many others are migrating from Hong Kong into Beijing and Shanghai. But they will likely face the same key questions as the real estate investors. Reputation and capital currently are strong advantages at the deal level in private equity, but will they last? They are certainly much larger than any of the local private equity companies, and the major Chinese companies have not yet entered this space. But is there any reason to think they won’t? At this point, reputable capital plus political access in the hypercompetitive Chinese market appears to be a necessary but not sufficient strategy—particularly for foreigners.

The Carlyle Group’s Entry into the Middle East Leads to Gradual Success

The Carlyle Group entered the Middle East in 2006 with a similar splash. It opened a large office in the Dubai International Financial Centre, hosted a regional conference, and flew in British Prime Minister Tony Blair to speak. It was an impressive event, and most of the major families and investors from the region attended. But as the partners gave an overview of the company’s history, there was really not much the attendees did not already know. Most had been targets of Carlyle fund-raising for decades.

In the midst of this event, a senior Saudi family head, who shall remain unnamed, stood and asked a pointed question along the lines of, “Why do you think you can succeed here? What do you do that we cannot?” It was a somewhat ornery but also fairly penetrating question. After all, the Middle East was not a new market, and the local companies and families had well-established systems for local deals. Plus, everybody had money. What exactly was Carlyle doing that they could not?

Middle Eastern players have been doing large deals, both locally and internationally, for a long time. They are quite comfortable buying real estate assets and doing private equity-type acquisitions in Europe and the United States. Cities such as London, Paris, and Marbella have extensive Middle East-owned real estate. And locally, the many family offices and conglomerates have been buying and selling assets easily, if not quickly, through well-established and mostly closed networks for decades. I’ve watched well-connected local investors sell tens of millions of dollars’ worth of apartments in one late-night meeting over tea. Local cement factories and other industrial assets can sell in a day or two. If all Carlyle was bringing were capital and reputation, those were two things local companies already had in abundance.

The Carlyle Group’s Middle East effort was not only competing with well-established family-type offices, such as the Olayans and the Rajhis, but it was also facing a host of newly formed local private equity firms, such as Abraaj Capital and Amwal Al Khaleej. The fight for private equity deals quickly became a fight between deal access—mostly political access—and specialized abilities and expertise. But everybody had a good reputation and lots of capital, and an active deal-maker could easily visit all the region’s major cities in about four days.

Carlyle and the other international private equity firms quickly gravitated to deals where they could use their superior technical ability and international partnerships. Local firms quickly focused on political and family connections. And some, such as Amwal Al Khaleej, paired a private equity management structure with a network of politically connected owners.

The saving grace for Carlyle has turned out to be that most Middle Eastern investments are joint ventures between local companies and Western capabilities, such as brands, products, technologies, and management. It is a region with extensive overseas customers (oil, natural gas) and fairly limited local capabilities. Many, if not most, deals are cross-border, and that gives international firms such as Carlyle an advantage. In effect, Carlyle’s reputation enabled it to be a recognized player from the minute it opened its Dubai office. But to remain competitive, the firm had to draw on other strengths and quickly recognize the need to do so.

I earlier presented a simplistic worldview in which I argued that most of the Middle East is godfather capitalism that is neither self-sufficient nor really that competitive. In such an environment, a strategy of political access plus reputable capital is likely enough to compete long-term. Drawing on foreign partnerships and capabilities helps as well. With this type of “asset-light” strategy, Carlyle can likely do well in Middle Eastern limited-competition godfather capitalism in a way it likely could not in hypercompetitive Chinese state capitalism.

Kingdom Zephyr Thrives on the Large, Developing African Continent

Kingdom Zephyr Africa Management, run by Tom Barry and Kofi Buckner, is a pan-African private equity firm based in South Africa. It was originally created through a unique joint venture between Middle Eastern investors and Western private equity professionals, both of whom were interested in broadly targeting Africa. Prince Waleed, who had been investing in Africa since 1996, represented the Middle Eastern investors, and Zephyr Management, L.P., which had been investing in Africa since 1995, constituted the private equity management. The resulting company, Kingdom Zephyr, has focused on growth equity, and its portfolio companies now cover the continent, including everything from turnkey power developers and small-scale consumer lenders to insurers and banks. It is an example of a foreign private equity firm using primarily reputable capital to thrive in a developing economy.

Unlike the Middle East and China, Africa has a significant lack of capital, an absence of particularly strong domestic competitors, and persistent cross-border inefficiencies. Adding to these challenges, investor bias toward Africa is very high. If German firms are somewhat hesitant to invest in Saudi Arabia or India, they are really hesitant to invest in Uganda. But the region is growing, prices are cheap, and really only 10% or so of countries have significant political problems.

In this sort of large geography, Kingdom Zephyr is in a likely sustainable advantaged position. It has a reputation that enables it to access both international and Middle Eastern capital. It can access deals anywhere on the continent. And it now has a strong deal history across industries, with no obvious impediments to industries going forward. As a strategy, it is leveraging reputation and capital in the short term while building scale and expertise in the long term.

All these situations boil down to the basic challenges for global value investors described in previous chapters. How do you get access? How do you deal with current and long-term uncertainties and instabilities? How do you deal with weakened claims against the enterprise? How do you overcome the foreigner disadvantages? In certain environments, these problems are larger than others. In most of these cases, it was deal access that was the primary challenge.

Reputation was a critical advantage—at least initially—in every case. However, investors who failed to realize that reputational and capital advantages can be lost over time encountered far greater difficulties.

Hong Kong, Dubai, and the Path of Least Resistance

A strong reputation can also create capital bridges

Reputation is more than a key for accessing deals in developing economies. It can also enable capital to move between disconnected geographies and investment groups. For example, Prince Waleed is seen not just as a reputable partner, but also as a bridge to Middle Eastern capital. Although he gets a warm reception almost everywhere, he gets a particularly enthusiastic welcome in places such as Kazakhstan, Kenya, and Mongolia. In these places, Middle Eastern capital can make a tremendous difference, and he is seen equally as a businessman, a prince, and a potential doorway to Middle Eastern petrodollars.

The importance of reputation in cross-border deals is an interesting quirk of global investing. We have become used to the idea that globalization makes money move fairly easily around the planet. Public markets, derivatives, commodity exchanges, and multinational banks have created a deeply interconnected financial system. Certainly, we are getting used to the increasingly frequent financial shocks that this interconnected system seems to deliver. But private deals are still done person-to-person and face-to-face on the ground. For large direct investments to happen between the U.S. and China or between the Middle East and Africa, there must be trust between partners. Going from domestic to global investing, trading seems to become more high-tech, but direct investing seems to become more hands-on and personal.

Asia Alternatives Management LLC, a fund of funds, offers an interesting example. It was founded in 2006 by Melissa Ma, Laure Wang, and Rebecca Xu and is based equally in California, Hong Kong, and Beijing. Asia Alternatives positioned itself as a solution to American institutional investors struggling to invest in alternative assets in the developing Asian economies (China, Vietnam, India, and so on). They positioned themselves as a trusted and reputable intermediary and a solution to this cross-border capital flow problem. The group quickly raised two funds and is now managing $1.65 billion.

In a sense, Hong Kong itself serves as a reputable capital bridge between Mainland China and the world. As recently as ten years ago, economists, public officials, and investors worried that Hong Kong would decrease in significance following its 1997 reentry into China. However, with Hong Kong sitting at a collision point between state capitalism and international capitalism, mainland companies found raising international capital much easier through private or publicly traded Hong Kong subsidiaries. For example, when China Resources Land, a $3 billion mainland Chinese conglomerate, wanted to raise foreign capital for mainland real estate development and acquisition, it launched a new Hong Kong subsidiary, Harvest Capital, for this purpose. Founded in 2006, Harvest, run by Rong Ren, launched both a $346 million international fund through Citigroup and a $500 million Shariah compliant fund for the Middle East through DTZ. Being based in Hong Kong and having reputable management and partners enabled them to become a capital bridge to the mainland. They rapidly raised an additional $1.2 billion in funds since.

In the Middle East, Dubai has played a similar bridge role to Europe and the U.S. As recently as 2003, it was uncommon to hear of significant European or American capital entering the Middle East. There were no headlines about The Royal Bank of Scotland Group (RBS) buying large amounts of Dubai’s debt or GE making major private investments in Abu Dhabi. Local capital had similar difficulties moving freely within the region. Qatar investors were somewhat hesitant to invest in Dammam. Saudi investors were hesitant to invest in Lebanon. Money would move, but it was slow and inefficient.

Dubai changed this by establishing itself as a financial hub and by bringing investment professionals, bankers, and lawyers into the region. Dubai firms provided not only a trusted capital bridge to move money but also the brainpower to do it. With Dubai’s rise, money began to move more freely (perhaps too freely) both within the region and between the Middle East and the West.

On an unrelated note, Dubai’s rise as both a capital bridge and a service center for professional talent has had some interesting effects on the Middle East economies. The region is severely unbalanced, with the oil wealth in the Gulf Cooperation Council (GCC) contrasted with the poorer but more educated populations of Lebanon, Jordan, and Syria. As talent and money began to move increasingly freely throughout the region, countries such as Jordan and Lebanon increasingly found themselves losing their professionals to the GCC.

This situation came up in an exchange I had at the palace of the King of Jordan. King Abdullah and Queen Rania held a meeting at their home to discuss the state of Jordan’s healthcare sector and to brainstorm possible initiatives. Improving healthcare, particularly private-sector healthcare, in a developing economy typically requires a sufficient and rising gross domestic product (GDP) per capita, a critical mass of healthcare professionals, and an effective regulatory framework. Jordan can put the right regulations in place, but the average GDP per capita is likely too low to support a full private healthcare sector at the current time. Compounding this problem is the fact that their professionals, who are particularly well educated, keep getting stolen by hospitals and insurance companies in the GCC.

Queen Rania asked whether Jordan could train more hospital managers and other professionals thereby leveraging Jordan’s greatest asset—its educated population. This idea got the most support. In a bad turn of phrasing, I countered by claiming that if Jordan trained more staff, “someone like me” would simply fly into Jordan and hire them away. It would basically be a subsidy for Saudi healthcare. I believe the queen’s exact reply as she wagged her finger at me was, “See, it’s you. You are the problem!” I’m still hoping she was joking.

These sorts of cross-border bridges, whether at the company or geographic level, are all ultimately about reputation. The critical mass of reputable investors and institutions in places such as Hong Kong and Dubai is enabling capital to move in a way it has not previously. And in the process, we global investors have perhaps inadvertently answered an oft-discussed politico-cultural question: How do you reconcile deep but incompatible cultural traditions in a global world?

Many nonbusiness books have argued that the Middle East cannot really reconcile its deep cultural and religious traditions with the modern world. There is not a lot of common ground between the traditional Saudi-Wahhabi views of a desirable society and those found in Hollywood movies (or in much of Los Angeles in general). Similarly, it is questioned how Chinese state capitalism can reconcile itself with the requirements of international capitalism, such as free press and transparency. These sorts of questions contain an implied assumption that such differing politico-cultural viewpoints must increasingly interact and reconcile.

Both Hong Kong and Dubai demonstrate that such differing systems do not actually have to interact directly, let alone reconcile. The path of least resistance is to build parallel systems with cross-border bridges. Leaving on a plane from Riyadh to London, the women immediately uncover their hair, and the men all start drinking Johnny Walker Black. (It is rumored that on a per-capita basis, Saudi Arabia is the world’s largest market for Johnny Walker Black.) Chinese business leaders work in one style in Beijing and then put on different suits and attend meetings with Western and Japanese bankers in Hong Kong. In all these cases, it turns out that walking between different worlds and ways of living has proven to be fairly easy and comfortable.

“Danger: Alligators. No Swimming. Survivors Will Be Prosecuted.”

Never overestimate the life span of a reputational edge

This warning, sent to me by a friend, is reportedly from a sign next to a Florida river. It pretty accurately captures the feeling many foreigners have when doing business in China, Russia, and similar places. The competition is brutal. The rules are against you. And if you do manage to succeed, you will be punished (or, more likely, the rules will be changed on you).

Ten years after China joined the World Trade Organization (WTO), foreign life insurers have less than 6% of the market. Foreign property and casualty insurers have less than 1%. Citigroup and the other foreign banks constitute less than 2% of the Chinese banking market by assets and less than 5% by most other measures. In contrast, Goldman Sachs is arguably the most successful foreign financial firm in China. And it has recently come under significant media criticism for precisely that—for being too successful during difficult times. Survivors will be prosecuted.

These types of difficult environments are good test cases for reputation-based investment strategies. If a deal strategy based mostly on a reputational edge can work in China and Russia, it can work anywhere.

Chinese domestic management capability is improving and competition can emerge rapidly. In terms of competition, certain industries can be truly ruthless environments. You don’t go to Kenya to compete in long-distance running, and you don’t go to China to compete in industries such as restaurants and real estate. The combination of hypercompetition and a tilted playing field can be particularly brutal on foreign entrants.

However, per the central thesis of this book, this is not a criticism of the Chinese or Russian economic environments, but of strategies that fail to account for fundamentally different systems. Remember that the overriding concern of many such systems is economic growth, development, and advancing the living standards of their people. This is not necessarily the same thing as providing an equal playing field or being terribly concerned with private investment returns. How and when a reputable capital strategy is likely to succeed has a lot to do with understanding the environment.

Russia is generally less discussed but offers similar stories of the profits and perils of a reputable capital strategy. Additionally, we can see significant investor bias against Russia at the current time. But such bias can be an opportunity if you have the right strategy (i.e., you can eliminate the uncertainties and strengthen your claim). Russia’s current focus on growth and modernization creates some fairly attractive opportunities for cross-border deals by reputable investors. The uncertainties can be eliminated through deal structuring against these objectives, and the impractical claims problem can be dealt with through tactics such as equity swaps.

The next two cases detail examples of both the profits and perils of relying mostly on reputation and capital advantages in such difficult environments. I detail the experiences of two very capable companies, Coca-Cola and Danone Group, which both entered China as foreign deal-makers using primarily this approach.

Both companies operate in consumer products—Coca-Cola in beverages and Danone in bottled water and dairy products. And entering China’s growing market was a straightforward strategic decision for both companies. China is a “must-win” market for any beverage company with worldwide ambitions. Additionally, China’s consumer-products market is largely free of the political forces that are woven into many of its other industries. Joint ventures are not required for market entry. Both acquisitions and joint ventures can be done with foreign majority control. Technology transfer is not much of an issue. At first glance, the Chinese consumer market appears free of many of the issues that Western companies often struggle with in state capitalist systems.

The beverage industry also has few specialized capabilities. True, Coke has its secret formula, but certainly other companies can make cola. Most successful brands are somewhat replicable, and there are few technology breakthroughs. The competitive advantages lie primarily in creating local economies of scales in the fixed assets (distribution, bottling) and captive customers (frequently used brands and products). But for all the surface similarities between the two companies, Coke and Danone had very different experiences in China.

Reputation and Capital Were Not Enough to Save Danone’s China Venture

Groupe Danone gets wiped out in Hangzhou

French Danone entered the Chinese market in 1996 through a joint venture with the Hangzhou Wahaha Group, at that time a struggling beverage producer that had evolved out of a public school. Wahaha was emblematic of many domestic companies in the 1990s’ nascent consumer market of Mainland China. It was quasi-government. It had launched a series of unsuccessful projects. It was struggling to find successful products while being severely limited in both capital and management ability.

Enter Danone, which had lots of capital and the right capabilities. Investing $70 million with another foreign partner, Danone (and foreign partner) secured 51% ownership of five joint ventures with Wahaha. Danone provided both needed capital and internationally successful products, and Wahaha provided needed local distribution and sales. Forbes characterized it as a “showcase joint venture” (see Figure 7.1).

Figure 7.1. Danone Group in China

The deal effectively targeted Wahaha’s need for products, management, and capital. But it took Danone’s reputation to enter the Chinese market at that time and secure a joint venture with Wahaha, which turned out to be the ideal partner in many ways. Although there are large numbers of beverage companies with similar capabilities, it is unlikely that many other groups could have gotten such a deal at that time. I argue that it had as much or more to do with reputable capital than with the companies’ products.

In fact, the Wahaha-Danone partnership would fulfill all expectations and grow into the largest beverage producer in China, ultimately containing 39 joint ventures.

Unfortunately, Danone’s reputation, capital, and management prowess were not enough to keep the deal together. Within ten years, the joint venture fractured. Danone publicly accused Wahaha of creating copied products in separately owned companies under the Wahaha brand. Wahaha accused Danone of hampering its ability to succeed in the hypercompetitive China market. Lawsuits were filed starting in 2007, and Danone exited entirely in 2009. Before discussing the reasons for this, let me first summarize Coke’s different outcome.

Coca-Cola Rides Its Reputation to 1.3 Billion New Customers

Coca-Cola wins in the future’s biggest market

Some accomplishments in business really are impressive. The iPhone is truly a fun device. Being able to pay my New York Internet bill from my laptop in New Delhi really impresses me. I’m still not sure how Starbucks has convinced me to pay $4 per day for coffee. And Coca-Cola’s successful targeting and capture of 1.3 billion new Chinese customers is one of those business stories that is more impressive the more you know about it. You cannot find a village anywhere in China that doesn’t have Coca-Cola. Even the small makeshift roadside stands and random individuals selling from the backs of their bicycles usually have Coke. You also have to give Coca-Cola special praise for arguably the cleverest name of any Western product in China. Not only is “Kou ke ke le” pronounced just like “Coca-Cola,” but it also translates to “can drink and make you happy” (approximately).

Coca-Cola entered the Chinese market in 1978 through an agreement with China National Cereals, Oils, and Foodstuffs Corporation (COFCO), at that time the largest state-owned enterprise in the food industry. In the initial agreement, Coca-Cola was given permission to introduce its products into select cities and tourist areas, which was a fairly big step in 1978 China. It also built a sales force, provided bottling equipment, and constructed bottling factories, with the first factory completed in 1980 in Beijing. Over time, Coca-Cola built a wholly owned company for its products in China and partnered with multiple bottling groups (Swire Coca-Cola, COFCO Coca-Cola, and Coca-Cola China Industries Limited [CCCI]) for distribution. Coke’s standard separation of its concentrate/marketing activities from its bottling/distribution activities proved critical for navigating the Chinese market over the long term. The bottling joint ventures involve a complicated and evolving mix of government agencies and Hong Kong-based partners. But the concentrate business remains firmly under Coke’s control at its Shanghai headquarters. This type of hybrid structure is discussed extensively in later chapters.

At the time of the deal, the approach was primarily based on political access and reputation. In 1978, every Chinese industry had government involvement, so partnering with COFCO was necessary to gain market access. Coke also provided management and products, but companies all over the world had similar capabilities. Even more than Danone, I argue that it was Coke’s political access and reputation that enabled it to be the first foreign company to open the door to China.

And over the longer term, Coke did several things that Danone did not. First, it kept effective control over its management and operations, primarily through the separation between concentrate/marketing and bottling/distribution activities. Second, Coke rapidly built brand awareness and captured a large customer base. In Buffett’s language, it captured a piece of Chinese “consumer minds.” This is in contrast to the Danone-Wahaha enterprise, in which Wahaha sold products under its own name.

The lessons for global deal-making from Coca-Cola and Danone are that reputation and capital can be very effective at gaining access to deals even in the most difficult of markets, and that is sometimes enough. Both Coca-Cola and Danone entered deals using reputation and capital in a way that was an effective but short-lived advantage for both. That left them only two possible strategies:

• They could have planned for an early exit. Recognizing that they were in a weakening position, both could have arranged an IPO for their China operations. This is the strategy many private equity firms use in certain industries in China and Russia.

• They could attempt to rapidly build an entrenched position, such as strongly branded products, a large captive customer base, or local economies of scale. This is basically a race against the clock. You have to build a more sustainable and defendable competitive position before your current advantage declines. And this is somewhat difficult in basic product categories such as beverages. It is much easier to do in technology or cross-border situations.

Note that both of these cases depended heavily on three factors:

• The type of landscape. State capitalism is very different from godfather capitalism or international capitalism. Additionally, whether that environment has low or high management capability and competition can have a large impact. Danone’s approach would have likely been successful in Abu Dhabi or India.

• The type of enterprise. Operating or “light” assets are harder to defend but have a higher return on equity. Fixed or “heavy” assets such as real estate are easier to defend but, absent an exit transaction, they have more difficult economics over time.

• Timing. Entering the market or asset at the right moment and understanding your likely timeframe for survival (short-term versus long-term) is critical.

You have probably noticed that I have blurred the lines between direct value investing and more strategic cross-border deal-making. Clearly, Coca-Cola and Danone were focused on a strategic objective and not a value strategy. But in practice, many of the issues in negotiated deal-making are the same whether done with a strategic or value approach. Coca-Cola and Danone were both primarily struggling with how to access an opportunity and then how to deal with a weakening claim to the enterprise.

This blurring of the lines between traditional value investing and more value-added deal structuring is central to value point. In the basic framework, this is reflected in Question 3: Is the margin of safety capturable and sustainable? Getting a yes answer to this question in the short-term and long-term (and thereby eliminating the long-term downside uncertainty) often requires deal structures and strategies similar to those seen in the Coca-Cola case.

Emerging-Market Shenanigans

Political access and reputable capital deals are prone to shenanigans

Many emerging-market businesses and entrepreneurs long ago realized that foreign and multinational investment dollars are often much larger than the profits they can make with their actual businesses. As a result, over the past 20 years, a very sophisticated and complicated set of structures has evolved for fleecing foreign investors out of their capital. The complexity and creativity of the fleecing techniques is actually quite impressive.

All this falls under the fairly entertaining topic of emerging-market shenanigans. If disreputable Western companies such as Enron fleece investors with accounting gimmicks (accounting shenanigans), disreputable developing-market companies do so through clever deal structures with foreigners. And foreign investors who are overly reliant on reputation and capital are particularly vulnerable to this problem.

A common assumption throughout this book is that in many economic systems, investments that directly or indirectly rely on the rule of law and contracts, let alone minority shareholder rights, have additional uncertainties—and therefore unknown risks. Contracts can be broken. Political winds can shift. I know of one Middle Eastern company that, after partnering with an overseas group, simply stopped answering the phone when they called. And investments relying on “intangible advantages” such as political access and reputation are the most susceptible to the various emerging-market shenanigans. As discussed in the next chapter, the more tangible advantages (technologies, customers) are much less susceptible to these problems.

The topic of emerging-market shenanigans could likely be a book in its own right. And the list of investors who have fallen prey to some of these shenanigans is long and prestigious. The following sections present two of the more common ones.

Shenanigan #1: The Long-Term Squeeze-Out

I have presented a few examples of situations in which foreigners invest and then are slowly pushed out of the venture. This results from a changing power relationship between the parties over time, although it usually appears on the surface as a dispute about something else. A fight of some sort is provoked. A regulation is changed. Or a party is simply pushed aside and ignored, gets frustrated, and lashes out (creating a rationale for responding) or leaves on their own.

These sorts of squeeze-outs are described at length in Tim Clissold’s book Mr. China, which chronicles the adventures of Jack Perkowski and his $500 million China fund. In deal after deal, he ran into trouble post-investment, finding himself in a weak position and struggling to keep control and ownership of his investment. In most cases, he was squeezed out, pushed aside, or ignored by the local partners.

Mr. China is actually a good Rorschach test for global investing. Western investors and deal-makers reading the book always comment on how badly the local partners behaved. However, developing-market investors always comment on how naïve the foreign investors were. I tend to side with the developing-market opinion in this. If you leave your front door wide open every day, eventually someone will enter your house and take something. If you make passive minority investments in China or Russia using the strength of your reputation, but with no real legal protection, there is a good chance you will get ripped off or squeezed out.

The long-term squeeze-out follows from the weak or impractical claims against the enterprise and a weakening advantage over time. The Danone case, and the Shanghai GM case in the following chapter, are both examples of this approach. I find it rare to talk at a conference in the West without someone bringing up a Chinese or Russian “horror story” of this type.

For value investors, dealing with a weakening claim to the enterprise over time is a central question. Adding sustainable value is an effective solution, and my preferred approach, but is not always possible. Using equity swaps, public shares, and other more liquid structures can also be effective. If neither of these methods is available, one needs to make an honest assessment of the investment landscape and how likely such an event is. Reputable capital is usually enough in the short term or long term in environments such as Africa and the Middle East. It’s usually not enough in Russia or China.

Shenanigan #2: The Profit Shell Game

Moving profits among associated companies, usually with different partners and equity-debt structures, is not a new shenanigan. Many of the original American industrialists were very skilled at shifting profits between their railroads, steel factories, supplier companies, and so forth. Typically, the idea was to use certain vehicles to raise capital for projects and then push the actual profits to different wholly owned companies. It’s basically a shell game, in which you constantly move around the profits, and the outside investor or partner never chooses the right one.

A multipolar world is particularly prone to this type of shenanigan. The legal structures are vague, governance is weak, and reporting is haphazard. Many of the corporate structures are naturally interconnected and complicated: state-owned entities, publicly listed projects, family conglomerates, trading companies, and overseas holdings. And in global investing, partners are often geographically distant from each other and the projects. This last factor can give rise to the feeling that “Heaven is high and the emperor is far away.”

When raising money or launching projects, disreputable businesspeople gravitate with surprising speed toward the idea of starting a second associated company at the same time. What if we start a supply company and give ourselves the contract? What if we just take the subsidiary public? What if we sell that one asset from our company A to our company B? And so on. The profit shell game has many permutations.

The recent arrival of public markets and IPOs in many developing regions has fueled the use of this type of shenanigan. Russia, Kuwait, Shenzhen, Dubai, Saudi Arabia, and many other places now have public markets that make this sort of profit shifting easier. These markets often have fairly weak regulatory oversight. There are often few institutional investors relative to the retail market. And many companies view the public market as something to be taken advantage of. On one side, you see companies going public in unusual ways such as floating a minority of shares, floating specific subprojects, or floating funding vehicles. But to be fair, on the other side, you have investors taking similar advantage of the situation by rampant insider trading and frequent manipulation of stock prices.

In a typical IPO profit shell game, a minority share of a company or a newly created project company (sometimes little more than a business plan) is taken public, and capital is raised. But the majority owners (those who control the project) then push the profits from that entity to their other companies, and the public vehicle sees few to no profits. The public entity eventually declines in value, and the majority owners buy it back from the public at a discount.

A debt-variation on this abuse-the-minority-shareholders strategy is to raise equity for a subsidiary or other controlled entity and then subsequently load it with debt (which you can do with controlling interest). Not surprisingly, the company cannot bear the debt burden, so it defaults and must re-raise equity in a distressed situation one to two years later. Usually this is brought on by a market downturn, which is not uncommon in developing economies. But the public and minority shareholders often can’t afford to reinvest or choose to walk away, so the majority owners buy it back cheap. In the clever cases, the majority shareholders act as both buyer and seller. In the really clever cases, the majority shareholders also own the bank that provided the debt.

* * *

These are two of the more common emerging-market shenanigans. Note that they mostly, but not always, require majority ownership or control, so foreign investors who buy in with large dollars for minority stakes are a common target. As a general rule, it’s always wise to talk to someone’s previous minority partners. You figure out pretty quickly who you’re dealing with.

Public shareholders are usually the second most common targets. A third group are corporate debt holders. This is a newer phenomenon, because many developing economies have just started creating bond markets. Similar to the opening of the public equity markets, people are finding ways to take advantage of the immaturity of these markets and their participants. In 2010, Western investment banks, such as RBS, that owned Dubai World’s corporate debt were surprised to learn that most of the projects were not viable under any capital structure and that they didn’t really have a sovereign guarantee. This was not a planned shenanigan, but it worked out about the same.

* * *

Reputation can be a very powerful and profitable deal advantage. And the more uncertain and unstable an environment becomes, the more effective it can become. But similar to political access, it is fairly intangible, thereby both enabling a higher return on equity (ROE) on one’s time and assets but also being more susceptible to problems over time. It’s profitable but somewhat perilous.