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Source: Asian Venture Capital Journal | 16 Feb 2011 | 11:00

Asian Venture Capital Journal: Miracle or mirage?

by: Brian McLeod 

International strategic and SWF investment in the country is ramping up, though private equity’s engagement remains tentative. But some early movers say that is changing.

Despite being a vast, remote country with less than 3 million people - the majority of whom were animal herders until fairly recently - Mongolia in 2011 looks more and more like Asia’s next best foreign investment opportunity. The prospects are being driven by its prodigious mineral wealth, proven and inferred, and the voracious demand for commodities emanating from its next door neighbor China, and also from Korea and Japan.

According to Luke Leslie, country manager with Beijing-based private equity firm Origo Partners plc, only 27% of Mongolia has been mapped to a scale of 1:50,000. This underscores the enormous opportunities for new mineral discoveries in a very prospective environment with estimated reserves now valued at $1.3 trillion. “The country is a largely unexplored mining frontier, which is why it’s set for a remarkable period of economic growth,” he told AVCJ.

Origo is a true believer. Its acquisition of a 30% stake in Altan Takhi Company (ATC) for $3 million cash last November - which it has since exited, selling the stake back to the majority shareholder - marked its third investment into Mongolian copper-gold prospects, and its sixth in companies with Mongolian assets positioned to supply natural resources to China.

“Following the repeal of the 68% copper windfall tax last month, with the intense competition for Mongolian coal, we expect the focus to shift to the country’s copper potential, reckoned the second largest in the world.”

Mandar Jayawant, managing partner with Mongolia Opportunities Fund, which boasts some $25 million in hard commitments - with IFC and EBRD as cornerstone investors, and DEG and two other corporate strategic investors - concurs, while offering a broader take on the current opportunities set.

He cites mining, mining services, infrastructure and regional export-oriented industries as offering the best of these. “The first three are driven off the sharpening demand for Mongolia’s minerals by the three North Asian industrial economies while the fourth is a function of mining-led domestic infrastructure development.”

But he adds a cautionary note, particularly for private equity investors. “While the Mongolian investment climate is attractive for foreign investors in general, the resource costs of executing transactions and managing them post-investment are very high. Mongolia is not a fly-in, fly-out investment scenario. Local networks and ground presence are essential.”

Public equities buoyancy

The country’s public markets are certainly effervescent. According to data just released by MonBiz Media Ltd and Eurasia Capital, the MonBiz Mongolia Index was up 30.5% in 2010, most driven by the outstanding performance of over half the index members, from large caps like Ivanhoe Mines (+ 66.4%), Centerra Gold (+ 83.7%), Mongolia Mining Corp (+23.4%), Winsway Coking Coal (+26.2%) to the triple digit gains seen in 12 smaller companies (from +155% for Prophecy Resource Corp to a whopping + 757% for Aspire Mining).

This has a knock-on effect for private equity, Jayawant notes. The over-performance has been spurred on by a global rebound in commodity prices along with growing Chinese demand and the limited opportunities to gain exposure to the strong Mongolia story.

“The latter factor is something we intend to capitalize on as we exit,” he notes.

Wider opportunities

Apart from mineral wealth and potential per see, the speed and scale at which the development of these assets is being pursued means a similarly rapid development of the necessary infrastructure and housing requirements essential in transforming Mongolia’s traditional culture into a much more urbanized, industrial society.

As an example, there is currently a torrent of people abandoning their migratory life in the far-flung countryside (enhanced by harsh weather and its effects on their herds) and making their way to the capital, Ulanbaatar, or to the major mining sites being built in search of employment. In UB, more than half of the population is now housed in a tent city of gers that lacks even basic amenities like water, sewage facilities and electric power. Meanwhile most of the roads there are pot-holed, unpaved tracks.

Further afield, most of the mining camps now and to come need to be built to house much larger populations, along with proper road and rail linkages.

Says Origo’s Luke Leslie, “Ulaanbaatar’s population increased by 30% between 2007 and 2010. And with 59% of Mongolia’s population under 30 years of age, many will be looking to find a new home of their own. So with spatial constraints imposed by the surrounding mountains, worsening traffic congestion plus the rapid influx of expatriates, and the expected tripling of GDP per capita by 2015, the result is likely to be strong growth for centrally located properties. Average current property prices of about $800 per sq meter are still low compared to other Central Asian capitals.”

Risks and rewards

Not surprisingly, and as with all frontier opportunities, there are commensurate risk factors. And the property segment reflects plenty of same, according to reports.

Like mining boom towns since the year dot, would-be real estate moguls sensing an impending demand spike (especially for upmarket residences) kicked off a development frenzy between 2005 and 2008. The GFC, the sudden (albeit brief) drop in demand for commodities, and the lack of bank lending, as well as opaque property regulations have all led to a supply overhang. As a result, many of these touted luxury residences remain castles in the air with little more to show for the intervening years than cement and re-bar skeletons and holes in the ground.

Today, with the bigger mining ventures once again on the upswing, optimism has bloomed anew. But the concerns cited above remain, which is why the Mongolia Opportunities Fund, for one, gives the sector a miss. “Our fund does not focus on the property space for precisely these reasons,” Mandar Jayawant told AVCJ. “We find data hard to come by and many investments to be speculative at best.”

Filling the capital shortage gap

Despite what the real estate story may say about overinvestment in a very small niche, a shortage of capital is a major challenge for much of the Mongolian development story. Origo Partners points out that even though foreign direct investment is forecast to reach $11 billion by 2015 and is growing at a 30% per annum clip, there is a considerable requirement for capital to develop Mongolia’s mines and associated infrastructure. The bill for the latter over the next ten years is estimated to be in excess of $5 billion. Additionally, the Taven Tolgoi and Oyu Tolgoi mining operations are expected to need $10 billion between them, with an industrial complex at Sainshand needing a further $10 billion.

This underscores why domestic loans are so expensive, with interest rates of 14% per month not uncommon. For private equity, this adds up to an opportunity to help fill the gap.

“Private equity investors are able to project manage companies to an IPO and can help to refine strategies, build a management team with international expertise while also providing access to other sources of international capital,” Leslie contends.

Various sources on the ground say a particular attraction of Mongolia as an investment destination is its dissimilarity to other countries in Asia. Lee Cashell, chairman and managing partner of Asia Pacific Investment Partners, has been a prominent investor in Mongolia and a promoter of the country’s opportunity set since 2001. He explains, “Mongolia is a market-based economy with a free floating currency. It’s also a parliamentary democracy with low taxes; so in all these ways it’s different than China. And there are no requirements, such as you find in Thailand, to have a local partner. There’s no restriction on the ownership of Mongolian companies.”

The country is on a learning curve though, looking at better regulating the stock market, financial system and mining investment into the country, he adds. Precedent set in other emerging markets is being studied to learn how to handle these types of issues.

“The foreign investment law in Mongolia provides similar treatment for foreign and domestic investors in the control and use of their investments,” Leslie explains. “Importantly, foreigners can repatriate income and profits earned. And the progressive tax on minerals is competitive on an international level.”

Foreign investors can own 100% of any registered business with the exception of strategic assets, which are effectively determined as those yielding revenues greater than 5% of GDP. Currently there are 15 of these; and the fact that foreign companies own 30% of Mongolia’s exploration and mining licenses is a demonstration of this openness.

Mandar Jayawant agrees, but adds a sobering sidenote. “The enforcement of the legal framework is untested in many cases. Precedents for legal decisions are few and this makes for lengthy litigations. But judgments are, in most cases, reasoned and fair.”

Interestingly, the short history the country has in dealing with more complex issues echoes the commercial attitude Mongol khans once took in their epic empire nearly a thousand years ago.

The government is not looking to let the international community soak up all of its natural resources, however. President Tsakhia Elbegdorj said the government believed many companies were not living up to their obligations, and a summary freeze on the issuance of mining and exploration licenses was put in place last November. The consensus seems to be that this will last until stricter laws are put in place, but no deadline has been cited and there are concerns that, given Mongolia’s reputation for having a foot-dragging bureaucracy, this could take considerable time - with a retardant effect on FDI inflows.

Still, those on the ground say they’re undeterred, and that the move is simply a speed bump which will ultimately lead to a clearer regulatory regime.

Meanwhile, as Mongolia Opportunities Fund’s Jayawant points out, the broadening development story continues. And with reference to private equity investors, he adds:

“With the entry of international companies into Mongolia, and with Mongolian exports growing, Mongolian businesses are increasingly interfaced with international companies, eg as subcontractors to international mining services or infrastructure companies, or as service providers to international mining companies or as suppliers to international buyers.”

And Origo’s Leslie concludes, “We continue to see healthy deal flow and remain attracted to those Mongolian resources assets which are set to benefit from ongoing Chinese demand growth.”