9. Capability Deals in Practice
When you walk along Century Avenue in Liujiazui, Shanghai’s Wall Street, it is hard not to be impressed by the level of activity. The buildings and parks are flooded with newly minted bankers, financiers, and lawyers (also “my people”). There are cranes on almost every block, and new companies are opening and closing almost every week. The chaos is thrilling.
Located halfway along Century Avenue is the newly completed 692-foot Hines building, now named the 21st Century Tower. It contains a 187-room Four Seasons Hotel, 430,556 square feet of Grade-A office space, and 65 Four Seasons private apartments. In 2009, a minority owner of the project wanted to sell his stake, and I was investigating to see if it was a possible Kingdom Holding investment. Prince Waleed is already an owner of the project through the Four Seasons. Buying the minority stake and acquiring the naming rights seemed like a possibly clever way to acquire a Kingdom Tower on the next Wall Street.
Located just down the street from the Hines building is the Bank of China tower. Waleed and several Saudi associates own several hundred million USD of the Bank of China through an initial public offering (IPO) allocation in 2006. Along the river in the other direction is the Citigroup skyscraper, another Waleed holding. Looking across the river on the Bund you can see the newly renovated and reopened Peace Hotel, which is now managed by Fairmont, another Waleed holding. In the notoriously difficult Chinese investment landscape, you can pass four Waleed properties in a 10-minute walk.
This raises one of the initial questions in this book, which is, how is he doing this? How is it that so many investors struggle to go worldwide, while Waleed, from his small office in Riyadh, seems to walk so effortlessly across geographies and industries? Even into difficult environments like China?
A big part of the answer is his “deep bench” of Western capabilities. Drawing on his Western portfolio and relationships, he can leverage capabilities into private deals. In China, he was able to launch a fairly powerful three-pronged investment approach made up of his Western holdings expanding into the mainland, his ownership of an emerging-markets hotel vehicle, and his ownership of both Bank of China and Citigroup.
Waleed also started out as an emerging-markets investor and understood investing in places such as the Middle East and China 20 years before it became an important investment question. In the late 1970s, he began his career by opening a small prefabricated office on a Riyadh side street and doing local deals with little capital and no assets. He started off as an investor in an environment with no public companies, little rule of law, fuzzy regulations, no market information, and little reliable management. He toiled away for 10 years, gradually going from a fairly unknown prince to one of the Middle East’s leading investors. He was profiled in Forbes for the first time at age 33.
Only in the late 1980s did Waleed begin to seriously enter the developed economies. Only then did he really start to develop deeper expertise in areas such as public markets, multinationals, global strategy, formal governance relationships, reporting relationships, and rule-of-law environments. His first major Western investment was his 1991 distressed acquisition of Citigroup, still his most famous. Following this with a string of high-profile Western investments—the Four Seasons, News Corp., Euro Disney, Apple, Canary Wharf, Saks Fifth Avenue, the Fairmont, the Plaza, Motorola, and on and on—he quickly became the largest foreign investor in the United States. But people tend to forget that Western investing was really the second act of his career and that he was also actively investing in the Middle East and Africa all during this period.
The third act began in the late 1990s, when Waleed seriously returned his sights to the emerging markets: Africa, the Middle East, and Asia. Ironically, it was his then-extensive Western holdings that gave him his biggest advantage in many of these markets.
At the beginning of a global investing age, Waleed was in the enviable position of being very comfortable in both developed and emerging markets—and having a deep bench of Western capabilities and relationships to draw on. Unsurprisingly, he has been a flurry of activity, continually traveling to everywhere from Mongolia and Kazakhstan to Africa and South America. He perhaps better than any other private investor understands the power of reputation in many cross-border situations, the value of political connections in some systems, and the impact of the right strategic partners—say, GE or News Corp.—on deals. Forbes aptly nicknamed him the “Prince of Deals.”
This chapter is about capability deals in practice. It’s about how to use capabilities to access and construct deals with a significant and stable margin of safety. If the overall presented strategy is a combination of Graham’s value thinking and the deal history of various global investors, this is the crossing-over point from the former to the latter.
On a side note, Waleed recently announced two such capability deals that are worth pointing out:
• In April 2010, Qatari Diar, a wholly owned unit of the Qatar Investment Authority, purchased a 40% stake in Fairmont Raffles “for a combination of cash and other considerations.” The deal was reported to be $847 million, made up of $467 million for the 40% Raffles stake, $105 million for the hotel contracts, and $275 million for an unnamed hotel property. The transaction was announced by Prince Waleed, who, prior to the acquisition, was the majority shareholder of Fairmont Raffles with 58%. It’s basically a capability deal straight out of the Prince Waleed playbook. Qatari Diar’s subsidiary QD Hotel & Property Investment can now steer Qatari hotel management contracts to its new partner, Fairmont Raffles. In one move, Fairmont got access to Qatar’s tightly controlled real estate and hotel market and reshuffled some of its assets. It was a cross-border deal based on valuable capabilities.
• In February 2010, Rupert Murdoch’s News Corp. purchased part of Prince Waleed’s Rotana Group, the leading Arabic media and entertainment group. This was another capability deal. Prior to the transaction, Waleed was the second-largest owner of News Corp. and the largest owner of Rotana. News Corp.’s extensive capabilities can add real economic value to Rotana’s regional media and entertainment business. Immediately after the deal was made public, Waleed also announced plans for a Rotana IPO within 2 years, saying, “We need to brand the company very well before going into an IPO.” This was using reputation and capabilities to add economic value and then an IPO to further monetize it. In a January 2010 interview on Fox News, Waleed also described his investment in News Corp. as an “alliance,” as a “core investment that may never be sold,” and as a “strategic investment.” Per my framework, News Corp. is one of Waleed’s best capability keys.
Waleed remains one of the greatest business stories never told. He created one of history’s largest fortunes but has never undergone much external, independent analysis. In part, this is due to the lack of an independent press in the Middle East (there’s no such thing as Saudi investigative journalism). It’s also due to the fact that he has had only about 10 investment staff in 30 years, so firsthand accounts are limited. And because I’m a loyal guy, you won’t read the “Waleed story” here. You’ll note that all the information on Prince Waleed and Kingdom Holding in this book is limited to already-public information.
Winning Long-Term in Difficult Environments
Capability keys crack the China problem
I focus a lot on China, both in this book and in life. In terms of global investing, it is the largest developing economy by far—now the world’s second-largest economy—and in terms of strategy, it’s just a fascinating question. If you can crack the China problem and succeed as a foreign investor there, you can succeed anywhere. Per Takashi Miike’s fantastically violent film of the same name, hypercompetitive state-capitalist systems are the Battle Royale of global investing.
Chapter 7, “The Profits and Perils of Reputation,” recounted the experiences of Coca-Cola and Danone in Mainland China. Both had primarily reputation and political strategies that I have argued are usually short-term deal advantages in such an environment. Danone died fairly quickly, whereas Coca-Cola beat the clock and managed to build economies of scale in time. But this was also in beverages, which is an industry that changes very little when moving from international to state capitalism. Industries such as banking or oil and gas change much more dramatically.
A famous Warren Buffett quote is, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact.” The same could be said about good investors meeting a difficult investment environment. Good management and excellent execution won’t save you. In difficult investment environments, you need an overwhelming advantage from day one. Or it’s better to steer clear.
The only strategy I know for consistent successful long-term private investing in China is to use capability keys. Purchasing public equities through the exchanges or by private negotiation can be done with traditional value investing techniques, but private, illiquid, long-term investments require capability keys. By assembling the right combination of capability keys, you can create an overwhelming value-add that enables you to access investments and overcome the uncertainty and control problems. However, you will also encounter many situations when even that is not enough, and you may need to exit early or steer clear.
The following sections detail three capability key deals in the Chinese mainland. All are within the automotive industry, and they cover a wide spectrum, from great success to great failure. They are not direct value investments but illustrate the dynamics of structuring value-added deals in such environments.
Case #1: GM’s Precarious Success in Chinese Automotive
General Motors (GM) entered China in the mid-1990s. Per government mandate, it entered through a joint venture with a state-owned company, Shanghai Automotive Industry Corporation (SAIC). Over the following 15 years, the joint venture (Shanghai GM) achieved an impressive level of commercial success, but GM now finds itself in a precarious state of existence. As will be detailed, Shanghai GM is a case of good management executing effectively against a likely nonwinnable strategy.
In contrast to beverages, the Chinese automotive industry is an example of a fairly “state-capitalist” industry. The development of a domestic auto industry and domestic auto companies is a priority for the country and the state actors that have such a prominent role in the economy. In practice, the strategy is to import Western and Japanese automotive capabilities while simultaneously developing local expertise and operations. And because this is China, the competition can be fierce.
The political factors operate at three levels—national, local, and company. At the national level, the country has created a three-tier system for auto company operations. Wholly owned Chinese companies (such as Cherry and Geely) are given top priority, joint ventures with foreign automakers (GM-SAIC, VW-SAIC) are second, and wholly owned foreign companies are third. At the local and company levels, political factors generally impact the terms of contracts, staffing, and trade agreements.
At each level, the objective is to develop the industry and protect nascent domestic enterprises from much larger foreign competitors. This can lead to awkward situations in which local companies partner with foreign companies to access technological and management expertise. But they also want to limit their size and influence so that they are not pushed out of their own market.
Within this system, GM entered China through a 50:50 joint venture (foreign companies are limited to 50% ownership) with SAIC. The deal was a good example of using capability keys to add value rapidly. GM had a strong position due to its deep automotive expertise, products, and management—all of which SAIC lacked at that time. Plus, its Buick and Chevrolet brands had complete product series, with both small-volume cars and luxury middle-class vehicles. SAIC was an attractive partner given its capital, human resources, and access to a deep local auto supply chain. It also had government support in Shanghai and nationally.
The Shanghai GM venture was well managed, with no major conflicts or management changes. Over time the local partner (SAIC) gradually assumed more governing power, with greater localization of expertise. Three production centers and one tech center were established on the mainland. The consortium was also very effective at targeting changing Chinese consumer tastes, frequently replacing their cars with newer generations. As of 2009, Shanghai GM was the number two automaker in China, with more than 720,000 cars sold per year. By all accounts, the joint venture is a commercial success.
However, GM is still locked into a difficult investment environment, and this is slowly playing out over time. As a large state-owned industry group, SAIC can set up multiple auto joint ventures and has many subsidiaries and affiliates: auto component companies, testing and verification centers, logistics companies. This domestic strength is one of the reasons Shanghai GM has been successful. It also enabled Shanghai GM to be included on government procurement lists and enjoy other supportive policies. But this is also the problem. Year by year, GM’s value-add is diminishing, and SAIC’s is strengthening. And this is the big red flag for illiquid foreign investing in difficult environments.
In 2006, SAIC launched its own 100%-owned car business, SAIC Passenger Cars. Unsurprisingly, significant management and other levels of Shanghai GM transferred from Shanghai GM to SAIC Passenger Cars. This places GM in a precarious position. Will SAIC give preference to SAIC Passenger Cars? Will market share start to shift? What if they now ask to renegotiate the terms of the joint venture agreement?
Altogether, SAIC now has three competing passenger car companies: Shanghai GM, Shanghai VW, and SAIC Passenger Cars. But two are foreign joint ventures, and one is domestically owned. From the perspective of Chinese officials, this is very logical and pretty smart. It is an excellent strategy for developing a domestic auto industry and auto companies. But absent some new value-add by GM, it places GM in an increasingly precarious position. I suspect it is only a matter of time before car sales begin to shift to the domestic companies, or GM is forced into a more passive minority position, or both.
Note that I am again mixing direct investing and business development considerations. Clearly GM is not entering China as a direct investment, but rather as a multinational with a strategic objective. But compare this type of deal with a classic long-term value investment in an illiquid asset. You typically want to buy a “great” company at a good price, with a sufficient margin of safety. But in many developing economies, very few “great” private companies can be bought, so your best approach is often to very surgically build a “great company.” You add value at the company level, like GM did, to create a great Chinese car company of which you then have ownership. But to get access, eliminate uncertainties, and strengthen control, you also need advantages at the deal level—and how sustainable these are is an important question.
GM in China exemplifies the struggle in executing even a strong capability key strategy long-term in an investment environment that is likely just too difficult. The precarious state of GM’s position goes hand-in-hand with the success of the enterprise thus far. The early value-add at the enterprise level that created a “great company” is now slowly being overshadowed by both a threatened competitive position (domestic auto companies have a better government-given competitive advantage) and weakening advantages at the deal level. All this occurs despite outstanding management and execution. Note that in 2010, SAIC quietly purchased an additional 1% of Shanghai GM, giving it 51% ownership and control of the joint venture.
Case #2: Fiat Dies Quickly in Chinese Automotive
If GM is dying slowly in China, Fiat died almost immediately. It entered in 1999 through a similar joint venture with a state-owned entity, Nanjing Automotive. But in contrast to the GM joint venture, this partnership had problems from the start. The joint enterprise ended up offering only four types of passenger cars (Palio, Siena, Weekend, and Perla) and between 2003 and 2006, the yearly number of cars sold varied between 26,000 and 36,000, less than 2% market share. The joint venture ended in 2007 with Fiat recalling its management and selling its stake to its partner.
Although Fiat’s capability key strategy was similar to GM’s, poor partner selection and ineffective execution doomed the enterprise. For one thing, Fiat’s partner, Nanjing Automotive Group, largely carries commercial vehicles, which are a poor fit with Fiat’s passenger car lines. Its expertise and assets in commercial vehicles could offer little support to passenger cars. The Nanjing government is also considerably less influential than Shanghai.
Management was the other problem. Per the terms of the deal, Fiat oversaw manufacturing, and Nanjing oversaw sales, but this strategy never proved very effective. The four compact cars that management introduced were at odds with the Chinese focus on big size and luxury style. Even within the four models, few innovations were introduced. The additional fact that the company CEO changed four times in 7 years probably didn’t help.
If the key takeaway from GM is that even a very strong capability strategy with effective execution is sometimes just not enough in a difficult environment, Fiat’s takeaway is that it is better to walk away early when your only option is clearly a losing strategy (such as joint venturing with an inappropriate partner in a difficult environment). Sometimes ineffective management is a blessing, as dying quickly and getting on with other things is better than dying slowly and losing a decade of work.
Case #3: Bosch Succeeds in the World’s Largest Automotive Market
In contrast to both GM and Fiat is Germany’s Bosch, which enjoys a leading, stable, and well-protected 40% market share on the Chinese mainland today. It’s a long-term direct and illiquid investment that is doing exceptionally well in the same industry.
Bosch entered the Chinese market in 1995 through a 50:50 joint venture—in this case with Zhonglian Automotive Electronics, a subsidiary of SAIC. The joint venture, named United Automotive Electronic Systems (UAES), produces not automobiles but the advanced engine management systems (EMSs), which are sold to local automakers such as Shanghai GM. This was a capability deal based on Bosch’s technological leadership in the EMS field. By all accounts, the joint venture has been very successful, and UAES is now the Chinese market leader. In 2009, UAES annual sales reached 7.15 billion RMB. And far from weakening over time and in exact reversal of the Shanghai GM situation, Zhonglian Automotive sold an additional 1% to Bosch in 2008, giving it 51%.
The key differences with Fiat and GM are the strength of the capability strategy and the targeted industry position. Bosch’s leveraged capability was a fairly unique advanced technology that it kept control of. In terms of the discussed framework, it is a sustainable capability key (it did not decrease or become localized over time). Additionally, UAES uses Bosch logos in its sales, and the Bosch brand has become well recognized among Chinese consumers and within the Chinese auto industry. Bosch is slowly translating a strong and sustainable capability key into brand awareness, customer loyalty, and other business strengths that will make it very difficult to dislodge from the market. This is a case of a winning capability key strategy and effective management thriving long-term in a difficult environment.
Bosch’s positioning in an automotive subsector was also critical. By entering a highly technical subsector that the major automakers depend on, it effectively turned the political forces from challenges into advantages, a state capitalism judo throw. The primary interest of the government is the development of domestic automakers that can make globally competitive cars. The government focus, which is a mixed blessing for GM, actually strengthens Bosch’s position. China cannot make globally competitive cars without advanced engine systems.
Compare these cases with the Coca-Cola and Danone examples from Chapter 7. GM and Bosch are primarily using capability keys but also are targeting much more difficult environments. Coca-Cola used primarily reputable capital and targeted beverages, a fairly open industry sector. It is still unclear whether a foreign majority-owned automaker probably can succeed long-term in China. The competition is intense and the politics difficult. But this is not necessarily a bad thing if you understand the situation. A foreign investor in the automotive sector can still focus on illiquid investments but depending on the subsector may have to go short-term (sell after 3 to 5 years), accept an eventual likely minority position (not bad if it’s public), or attempt to turn the political priority to an advantage by investing in an indispensable success factor for the domestic automakers (a critical supplier or distributor).
The language I am using is different, but these questions should be familiar to value investors. Graham wrote extensively about an investor’s obligations at both the time of the investment and going forward as an owner. That a value strategy depends equally on the time of the investment and going forward. I have translated this into uncertainty language by arguing that the primarily challenge is eliminating downside uncertainty at the time of the investment and in long-term. But I have found that a clever investor can often achieve this with structured deal-making, even in the most difficult of markets. And the more value keys you have in your tool kit, particularly capability keys, the easier accomplishing this becomes.
Winning Short-Term in Really Difficult Environments
Know when you can’t win, and switch from buy-and-hold to buy-to-sell
A third possible strategy is to switch from buy-and-hold to buy-to-sell, although this is a diversion from the central objective of this book. I still believe that the most attractive returns come from capturing growing economic value (per share) over the long term. So I have not focused much on short-term strategies, which are fairly well known. But when dealing with very difficult environments, it is worth pointing out the third option of buying with the requirement of selling in 1 or 2 years.
Telecommunications and media industries in state-capitalist systems are these kinds of exceptionally difficult environments. Unlike the discussed automotive examples, which were a mix of commercial and government interests, state-capitalist TMT (technology, media, telecommunications) is usually all government all the time. This is a situation where switching to buy-to-sell is likely the only viable option. The following sections summarize two cases of foreign investment in Chinese TMT.
Case #1: Rupert Murdoch in Chinese Media
Rupert Murdoch’s Chinese investments have been well documented. Bruce Dover’s book Rupert Murdoch’s Adventures in China is particularly good reading. From buying Phoenix Satellite Television to launching some of the first Mainland Chinese websites, his attempt to enter the Chinese media industry was impressive in its pure dogged determination. But his aspiration of capturing a significant portion of the Chinese market was not achieved.
By any standard, Murdoch has outstanding capability keys in the media space. His portfolio of content houses and publishing/broadcast platforms is already global. His failure to capture much of the Chinese market is an example of strong management and outstanding capability keys confronting a just-too-difficult environment. Significant, let alone controlling, long-term ownership of Chinese media assets is next to impossible for foreign investors. This situation is not unique to China. Foreign investors cannot acquire controlling ownership in media assets in most state-capitalist or godfather-capitalist systems.
The story of Rupert Murdoch in China is not repeated here. The key takeaway is that if Rupert Murdoch (and Google) can’t do majority or significant minority buy-and-hold in Chinese TMT, it probably can’t be done.
Case #2: Softbank Succeeds in Chinese TMT
In contrast, Softbank, a Japanese telecom and media company, has enjoyed significant success in China’s TMT sector. It entered the Chinese market in the late 1990s with strong capability keys in the telecommunications and media sector, but with a buy-to-sell growth strategy focused on private investments.
Reviewing Softbank’s investment history, one can see that it has positioned itself smartly along the development curve of the industry and has conducted a series of successful deals. In 2000, Softbank partnered with IDG to make a joint investment in search engine Baidu’s second venture capital round. It was a standard growth equity investment but is notable for being successful in a space in which Rupert Murdoch and later Google would both fail. It’s a straightforward buy-to-sell investment that leveraged their deep capabilities in the space at the right point in the industry’s development curve.
Their 2004 investment in Alibaba was similarly successful. Softbank, which is one of the top shareholders of Yahoo!, invested $60 million and acquired 20% of Alibaba which resulted in a large return through Alibaba’s 2007 Hong Kong IPO. This investment also had the additional twist of being leveraged into a new Japanese venture. They launched Alibaba.com Japan, a company focused on connecting Japan’s small and medium enterprises with international suppliers. Their deal paired a short-term private pre-IPO investment in Alibaba in China with a longer-term capabilities deal in their home Japanese market. This type of cross-border capability deal is similar to Waleed’s Qatar-Fairmont play.
The key takeaway is that buy-to-sell combined with capability keys can work well even in the most difficult of environments. And buy-to-sell can sometimes enable other cross-border buy-and-hold investments.
Foreign Versus Local, Capability Stampedes, and Global Wing Walking
Using capability keys surgically is somewhat tricky
Using capability keys in practice can be both powerful and a bit tricky. The goal is to extend value investing to more hands-on deal-making. In doing so, you dramatically increase the number of companies that can be targeted with a long-term approach. You also create a host of tools that can be used to address the access, uncertainty, and control problems. However, it is easy to get sucked into business development and ongoing management which is something you want to avoid. The objective is to leverage in a very surgical value-add at the company and deal level. It’s like corporate raiding in reverse. The next sections discuss a couple of key points in this approach.
It Is Important to Distinguish Between Foreign and Local Capability Keys
I am currently investigating projects between the University of Cambridge and various Saudi Arabian companies. It’s not a huge deal, but it’s kind of interesting. The idea is to create Saudi Arabia’s first internationally recognized MBA program. Combining Cambridge’s educational expertise and reputation with Middle Eastern wealth is a compelling story. Cambridge, which reached its 800th anniversary a couple years ago, arguably is one of the world’s top universities. Saudi Arabia is a young country by comparison but commands a powerful strategic position in the world economy.
Creating a joint graduate school of business is an easy-to-understand capabilities deal. It’s also one of those situations where flying between historic Cambridge and Saudi’s desert capital has me wondering a bit about the path my life has taken. I am a long way from the physics lab.
But even within very compelling capability-driven deals, who is foreign and who is local is always important. And the Cambridge-Saudi deal highlights an important distinction within the capability keys—that they can be subdivided into foreign and local types.
We’ve discussed how Western capabilities are migrating to developing economies, but some of these capabilities will become localized, and others will not. For example, the migration of Western- (and Hong Kong-) trained investment bankers into Shanghai was a localization of banking capabilities into the country. Investment banking divisions were created, and young local associates were trained. If the Western-trained bankers later go home, the capability stays. However, Cambridge University degrees in Saudi Arabia will remain foreign capabilities indefinitely. They cannot be replicated by local competitors, and if Cambridge decides to leave, the capabilities (such as a prestigious Western degree) leave with them. Foreign capability keys can include foreign customers or contracts, technology, credentials, natural resources, and others.
This distinction between local and foreign capabilities is particularly important in highly competitive markets such as China and India. Localized capabilities can be rapidly copied and any competitive advantage rapidly diminished. Foreign capabilities tend to have more sustainable value at both the company and deal level. Bosch’s use of advanced engine systems out of Germany is, to some degree, a foreign capability key strategy.
When looking at an investment in a particularly daunting environment, the mental image I stick to is one of wing walking. Wing walkers, the acrobats who walk on the wings of biplanes at air shows, really have only one rule. You never let go of one pole until you have your hand firmly on the next one. In difficult environments, I never let go of one value-add until I have my hand firmly on the next one. Many of the examples in this book are about foreign companies entering a market, doing well, and then getting blown off the wing a couple years later. Foreign capability keys tend to be the most sustainable advantages.
Draft Stampedes When You Can
The local-versus-foreign capability distinction is also important when a developing market is exhibiting a “capability stampede.” As a significant new capability is brought into the market or a new industry sector opens up for private investment, the large companies and investors all charge after the opportunity (yet another permutation of Mr. Market). The big animals stampede in that direction, launching joint ventures, cutting deals with Western partners, and bringing in new capabilities. For example, the Middle East and India have both witnessed a stampede into private healthcare in the last 5 years. As the private sector opened up, lots of new private hospitals were launched, and lots of new capabilities flooded into the regions (hospital managers, billing systems, insurance underwriting).
The problem is that although 20 new private hospitals can arrive in Bombay in 2 or 3 years, the consumer market for private healthcare services may take 5 to 10 years to really emerge. And the regulatory structure is almost never in place in time, which is important in hospital operations and insurance pricing. Such a lack of regulations is typically good for the insurer but bad for the hospital. The net result of such stampedes is most often weak demand, oversupply, written-off capex (capital expenditures), and difficult politico-economics.
However, as always in investing, one person’s problem can be another’s opportunity. The trick is to benefit from bringing new capabilities into markets and also to benefit from those who stampeded and are now struggling. My general approach is to draft the stampedes whenever possible.
For example, about 7 years ago a university stampede occurred in Saudi Arabia. The government began issuing licenses for private universities, and every prince wanted his own university. By 2002–2003, it was rumored that more than 20 major universities were in various stages of development, most in the $100–200 million investment range. (I ended up killing the proposal for a $200 million university for Prince Waleed.) And in classic stampede fashion, the capabilities and infrastructure all arrived much earlier than a significant market demand for private higher education. Supply was high, and demand and pricing were low, particularly with the government still offering free university education (it’s hard to compete with free). The billions invested in campuses across the country quickly became write-offs.
This created a drafting opportunity. In this case, the strategy was to use a foreign capability key such as a Western business degree about 5 years after the university stampede. At this point, a Western partnership can add significant value to over-built universities struggling to differentiate themselves amidst too much supply. And unlike universities, with their large campuses and capital requirements, a prestigious business school has more attractive economics. They can charge higher prices, offer executive education, raise large endowments from companies and wealthy alumni, and they have few real capital costs (you don’t need science labs or dormitories). By drafting the stampede, you both avoid the initial difficult economics and place yourself in a position to add significant value to lots of large and already financially committed players.
Lessons from the Saudis
A few last takeaways on capability deals from the world’s first cross-border investors
The first blessing for the historically desert-living Saudis was discovering 20% of the world’s conventional oil reserves underfoot (technically, under sandal). This blessing is still going strong for them, much to the consternation of the historically educated but perpetually struggling Lebanese, Syrians, and Jordanians of the Levant.
The second blessing for the Saudis was that they were forced into cross-border investing 30 years before the rest of the world. Not only did they have far too much capital to invest in their small domestic markets, but they also realized early on that they were at a very large disadvantage when going into foreign geographies. They were far away. They faced language and cultural gaps. And they did not have the technical abilities of U.S., UK, and European investors. They understood the “foreigner disadvantages” previously discussed very early on. They struggled but eventually found tactics for being successful when investing across borders. They became the world’s first successful cross-border investors.
Based on this, I have compiled a short list of takeaway lessons on cross-border investing and capability deals based on my experience with the Saudis.
Lesson #1: A Foreigner and His Money Are Easily Parted
The framework presented is simple but is a surprisingly good predictor of success and failure. Is the company good or great? Did you get a cheap price? And, most importantly for going cross-border, is the margin of safety capturable and sustainable? This third question is all about having advantages at the deal level, both initially and sometimes in the long-term, eliminating uncertainties, and strengthening your claim to the asset. If you don’t have a strong advantage at entry, a little alarm should go off in your head. Did all the local investors already pass? Am I the dumb money? And if you are in a difficult environment with a declining position, all the alarms should go off. A long list of prestigious investors and multinationals have fallen prey to such cross-border situations. I am surprised how frequently the same bad strategies are tried. Value investing’s number one rule is to never lose money. The global version of this rule is to be hypercautious about the very effective tactics for separating foreigners from their capital.
Lesson #2: Never Try to Date the Prettiest Girl in School
Everyone who goes to India wants to meet with Reliance. Going to Abu Dhabi, everyone wants to meet with ADIA. To China, with CIC and CICC. These companies are prestigious and great partners, and they serve the best tea, but they have lots of suitors. Most investors are far better off focusing on smaller and less famous companies for investments. Avoiding the really pretty partners also has a big impact on pricing and how much value-add you bring to the table. The big, famous companies just don’t need much from anyone.
Lesson #3: Be Clear if You Are Dating or Marrying
The level of commitment of parties often varies significantly when crossing borders. Many companies are willing to franchise their brands or operating capabilities with foreign partners but not much else. These are limited-commitment arrangements. Other companies are interested in equity and long-term operating partnerships. It’s good to be clear about such interests at the start. A common source of conflict when going cross-border is when one partner wants to marry and the other wants to date.
Lesson #4: Make Your Friends Before You Need Them
Cross-border deals are rife with behavioral finance issues. Flying in and closing a deal quickly is very rare. You need communication and/or a commercial relationship over time to build trust between parties. And from these relationships over time, deals and investment opportunities will eventually emerge. Building relationships, and your reputation, before you actually need them is critical.
Lesson #5: Think Like an Industrialist
If you have a critical mass of capability keys, you will find there are opportunities almost everywhere. Rupert Murdoch can leverage his media assets into deals in Qatar, Africa, Europe, and the U.S. Waleed’s hotel empire can continue to expand to virtually every major city in the world. This sort of almost industrialist approach to value investing tends to be a helpful mindset. And as will be detailed in the following chapters, capability keys can be amplified when combined with reputable and political access.
Lesson #6: Don’t Get Caught Up in Geographic Strategies
If you think of investing in terms of capabilities and surgical approaches to capture or add value, the world begins to look mostly industry-specific. Geography tends to be a second thought. If you have gaming capabilities or expertise (human resources, travel, media, entertainment, gaming), you tend to be in Macau, Singapore, or Las Vegas. If you have mining capabilities (drilling, logistics, exploration), you tend to end up in Africa, Latin America, Canada, or Australia. Petrochemicals are in Russia, the Gulf Cooperation Council (GCC), and Texas (I always feel somewhat sorry for people who work in this field). But the more you think about capabilities and expertise, the more industry-specific the world looks.
Additionally, a strongly geographic focus can lead to questionable investment strategies. Certainly the U.S., China, and India are large markets that can support focused regional strategies, but is Mexico really large enough, with enough deals, to support a dedicated private equity strategy? Does combining Mexico with all of Latin America in a regional strategy really make sense? There are plenty of examples of firms doing types of deals they shouldn’t and expanding into geographies they shouldn’t just for the sake of a regional footprint. Going global, I focus overwhelmingly on industry-specific strategies. That tends to get me to the right places and keep me out of things I should avoid.
Lesson #7: Capabilities, Like Capital, Are About Timing
You need to deploy your capability while a gap still exists and while the capability can capture the most value. A carmaker entering China today would have few capability advantages. However, companies such as UAES and Softbank are continually adding capabilities and staying at the front of the development curve of their industry. Similar to deploying capital in downturns, timing is important in capability deals.
Lesson #8: Never Go Hostile as a Foreigner
Nationalist, cultural, and religious tensions—and all the other human fault lines—are always just below the surface. Going into a geography as a foreigner and doing hostile acquisitions or other aggressive actions can easily become consumed in such issues. I follow a structurally positive strategy of both searching for and adding value. Going hostile is not part of the investment thesis. It works well as a strategy but it also tends to keep me out of hostile situations, which is a good idea in itself if you’re the foreigner.
That is more or less the extent of the theory in this book: a value-added strategy to complement traditional value investing. In the next chapter, we put it all together and focus on particularly large, aggressive “go for the jugular” deals that combine all the keys at once into hopefully ridiculously large return investments.