Emerging economies in Eastern Europe, South America, Africa and Asia offer a range of investment opportunities that are particularly attractive at a time when more developed economies are in slow growth, or no growth, cycles. As private equity firms, middle market companies and others look to opportunities for growth in these new markets, they need to evaluate and address political risk.
Political risk is the risk of losses to companies and investors arising out of adverse political developments in foreign countries where the companies and investors have invested in projects and businesses. Losses can be caused by political violence, such as revolution, civil unrest, terrorism or war; confiscation of assets by governments; wrongful calling of letters of credit; and business interruption. (For more on cross-border dealmaking in emerging markets, see the July 2013 cover story "10 Emerging Markets to Watch.")
Investors can protect themselves through a combination of proper advance planning, investment treaties and insurance.
Performing a risk analysis and structuring the investment to include the appropriate mix of treaty and insurance protection at the outset is essential in order to achieve maximum protection. Restructuring after the fact is extremely difficult. International project participants may look first to those developing host nations that have adequately strengthened domestic legal regimes in order to provide protections for foreign investors. Mitigation of political risk through the legal regime at the host-national level can minimize reliance on transnational political risk protection.
At the local level, where investment still takes place, there is greater inherent risk. Here, investors may want to look to involve the financing and support of an Export Credit Agency (ECA) or Multilateral Development Bank (MDB). Beyond the obvious financial tools provided by these organizations, working with an ECA or MDB may also provide a subtle political boost. Host states may be reluctant to take adverse actions affecting foreign investment when the project has the backing of government-supported ECAs or MDBs, to which developing nations may turn for their own capital needs.
At the tactical level, sponsors and lenders may look to include at least some component of locally raised financing or support to offer a measure of protection from interference with business operations. Host governments will be less likely to take an action resulting in adverse consequences for local investors.
Understanding treaties that are in effect and what countries are a party to those agreements is important when evaluating investment risk, as it may determine what country is most beneficial for domiciling the entity making the investment. Treaty-based political risk protections exist in the form of bilateral investment treaties (BITs) and multilateral investment treaties (MITs).
BITs and MITs provide compensation to foreign investors in the event of an expropriation and can apply when the local government takes a foreign investment in stages or through a series of acts collectively tantamount to expropriation.
Most investment treaties also provide for fair and equitable treatment of foreign investments; however, the exact wording of the treaty can result in meaningful differences in the extent and nature of investment protection extended to foreign investors.
The host country often legally obligates itself not to impair the management or operation of an investment by arbitrary or discriminatory measure.
Most Favored Nation clauses can incorporate protections not explicitly articulated in that treaty but that are present in the host countries’ other international commitments into a treaty.
In Zimbabwe, 40 Dutch farmers recently won a lawsuit against the government for the loss of their properties, which were protected under a Bilateral Investment Promotion and Protection Agreement. The agreement compelled the government to protect investments from countries that were party to the act, which included Denmark, Germany, Belgium, the Netherlands, Italy, Malaysia and Switzerland. In 2009, an arbitral tribunal under the auspices of the International Centre for the Settlement of Investment Disputes – a branch of the World Bank, ruled in favor of the Dutch farmers who had sought compensation for land expropriated by Zimbabwe, ordering the government to pay the farmers €8.8 million (U.S. $11.5 million) in compensation and 10 percent interest for every six months from the date the farms were seized until full payment of the amounts.
Political risk insurance is designed to mitigate the risks stemming from the exercise of political power in the country in which an investment is made. Insurable political risks include: expropriation, nationalization of assets, war, civil disturbance, discriminatory regulations and currency inconvertibility. Political risks can present themselves in numerous ways, such as in connection with applications for license renewals and budget overhauls.
Political risk insurance is often provided through public or quasi-public agencies, including the World Bank’s Multilateral Investment Guarantee Agency, the United States’ Overseas Private Investment Corporation (OPIC), the United Kingdom’s Exports Credits Guarantee Department, Japan’s Nippon Export and Investment Insurance, and China’s Sinosure. Private insurers also provide political risk insurance, and in recent years, in response to demands of the marketplace, private insurers have expanded their coverage from traditional areas of confiscation, expropriation and nationalization, currency inconvertibility and non-transfer, contract frustration due to political events and wrongful calling of on-demand contract guarantees and bonds. They are now including coverage of losses from political violence and failure of sovereign entities to honor payment obligations under promissory notes, bond sovereign loans or sovereign guarantees and failure of a sovereign entity to honor payment obligations under a letter of credit.
For example, in December OPIC approved up to $40 million in financing for a private equity investment fund that will support small and medium-sized enterprises in Russia’s outer provinces, where private equity has been largely unavailable. The fund will invest in sectors including consumer goods and services, health care, manufacturing and agriculture, information technology, telecommunications and construction, and has a target capitalization of $227 million.
Some of the greatest economic growth and concurrent investment opportunities are in countries without a history of stable politics. Given recent examples of investors experiencing the perils of expropriation in Argentina and Bolivia and the exposure to currency devaluation in Greece, investors may consider structuring transactions to benefit from treaty protections and enable access to political risk insurance. The playbook for any investor entering markets that are emerging economically and politically has to include a thorough analysis of the local political landscape and the steps that can be taken to minimize the risk associated with the investment opportunities.
Because of the ongoing evolution of investment treaty and insurance protection available in today’s cross-border investing environment, the key for each project participant is to determine on a project-by-project basis the right combination of deal structure, treaty protection and political risk insurance for securing their investments.
Michael Nolan is a partner and Mark Rockefeller is an associate in the Washington, D.C. office of Milbank, Tweed, Hadley & McCloy and are members of the firm’s litigation and arbitration group.