This is part six in a six-part series of how we think about the risks of investing in early-stage companies in emerging markets. If you are new to the series, please start here. We’ve coined the term “FIERCE” to summarize the main concerns we hear from U.S.-based investors interested in investing in Africa — Fraud, Instability, Expropriation, Regulatory, Currency and Enforcement of Contracts.
As we wrap up this series on how we approach the risks of investing in emerging economies, we dive into an elusive concept at the intersection of international law and domestic law: Expropriation. Our framework for evaluating the risk of expropriation follows in much the same way as our frameworks for evaluating the other FIERCE risks: we first seek to fully understand what the real risk is (and isn’t) and the historical precedents. We then identify potential endogenous and exogenous factors that help to substantiate the ‘level’ of risk inherent in an investment opportunity, and then highlight potential ways to mitigate this exposure where possible.
What is Expropriation and Why Should We Care?
Expropriation, also known as compulsory acquisition or the exercise of eminent domain, is generally defined as the taking of private property by the State for public-use or public-interest purposes¹. While its use has often been defended using legal doctrine, and has highlighted the “public-interest” nature of the acquisition, it is contentious almost without exception, and usually has a drastic if not catastrophic impact on the results of a related investment. However, out-and-out taking of property by sovereigns is becoming increasingly rare as global capital flows create symbiotic relationships between investors, foreign assets, and development — often making such actions seem like a clear case of “shooting oneself in the foot.” However, the more realistic, and sometimes more nefarious, version of expropriation that is still widely in use and a risk to emerging-market investors (and, perhaps, developed-market investors as well), is the use of “soft” expropriation. At this point, a definition might be helpful:
Indirect or Soft Expropriation — this refers to an action attributable to the state, where without physical seizure and transfer of legal property, the state takes possession of all rights and benefits that pertain to the property, even though title and possession remain with the private party. In this kind of expropriation, all or nearly all value is lost to the private owner, as well as sometimes the ability to control the property. Secondarily, the State may use its legislative, taxation, enforcement, or other powers to render an existing privately-owned asset worthless or of primary benefit to the State (rather than its private owner).
Understanding the Risk of Soft Expropriation for Investors in Emerging Markets
Soft expropriation is often hidden in the framework of regulatory activities such as overly punitive taxation and creating difficulties with licenses, enactment of laws that hinder an investor from selling their interest in an investment or recovering their profits from the investment, or actions that force investors to renegotiate the terms of their investment agreement or otherwise encumber the use of their investment. It may also manifest as a change of management, where the State directly appoints directors or changes the management team of a company, thereby stripping its control over its assets. In each case, the State acts in such a way that makes the asset lose some or all of its economic value.
The reason soft expropriation poses a larger threat to investors is because it may be difficult to identify or contest, or it may even have broad public support. For example, as governments in emerging markets seek to gain more control over their economies and speed development to meet the needs of their burgeoning populations, they may engage in nationalization of investments in certain industries that seem to be of national strategic or symbolic importance, poorly run, mismanaged, or otherwise operated in a way that appears to be against popular opinion. Regardless, the investor in that particular industry would find themselves significantly disadvantaged and at a possible economic loss.
These factors suggest that a nuanced and holistic view of the expropriation risk is necessary when undertaking a direct investment into an emerging market.
What Historical Precedents are Useful to Examine to Better Understand Expropriation?
Expropriation does not often occur in a vacuum. There are industries that are more susceptible to expropriation than others, particularly those perceived as being vital to the nation’s economic development or competitive edge. These industries include transport, communications, energy, natural resources, financial services, and security. A look through the historical precedence may reveal a pattern that indicates the level of risk inherent in the opportunity. For example, increased sentiments on nationalism and protectionism in South American states in the early 2000s should have served as an early warning to investors, particularly those in the natural resources industries. Below are some of these historical examples of both hard and soft expropriation around the world.
- In 2007, the Venezuelan government took a majority stake in four oil projects that amounted to approximately $30B, effectively pushing ExxonMobil and ConocoPhillips out of the market. In 2008, the authorities claimed that the increase in oil prices made the profits of large oil companies unreasonably high. They went on to arbitrarily implement a windfall tax of 50% on profits for oil prices over $70 per barrel, and 60% on profits for prices over $100 per barrel. In the following decade, as they anticipated the economic decline that would be a result of these and other politically motivated actions by the state, many international oil companies including Total and BP either partially or wholly left Venezuela, despite it being the country with the largest proven oil reserves in the world. Only one major US company remains — Chevron — and even then, outputs are at the lowest they have ever been in nearly two decades².
- Further south is Argentina, which has experienced its fair share of expropriation and nationalization-related cases, the largest and most controversial of which might be the re-nationalization of YPF, a Repsol-controlled subsidiary that earned the Spanish oil-giant considerable income. Repsol claimed that the Argentine government drove down the market price of YPF shares by more than 50% between February and April 2012, ahead of the expropriation of 51% of the company. However, this was not an action in isolation. The Argentine government had adopted an “Argentina First” protectionist stance and in the wider Central and South American region there had been a steady increase in the nationalization of oil resources. Eventually, the State agreed to pay Repsol $5B in compensation³.
In the last decade or more, there has been an increase in the number of expropriation-related cases from Latin America. In fact as of 2012, the International Centre for the Settlement of Investment Disputes, ICSID, reported 49% of its then 143 cases as originating from Central and South America. Around the same time, Venezuela joined Bolivia and Ecuador as the third country to withdraw from ICSID and Argentina may very well be inclined to do the same. What this may mean to investors is, potentially, an unclear path to resolve disputes arising out of their investment.
- Across the Atlantic, we come across the heated debate on South Africa’s proposed “Land Expropriation without Compensation” policy, that seeks to expropriate both institutional and individually-held private lands in a bid to redistribute wealth. Already, dissenters have pointed to the lands that still lie unproductive, following previously unsuccessful land reforms. It is further argued that the taking of commercial farmland for redistribution will harm the economy and reduce agricultural output, potentially increasing the poverty levels. It is interesting to note that this incident takes place in yet another nation where feelings of nationalism are finding expression among the masses⁴.
- Closely related to the South African land expropriation policy is its neighbor, Zimbabwe, and its attempts to now compensate settler farmers who were expropriated after nationalists seized privately-held agricultural lands in the early 2000s. This move, backed by the former president’s government, resulted in economic sanctions that along with other factors such as mismanagement of expropriated farms contributed to the decline of the Zimbabwean economy. In the recent past, the country has attempted to compensate affected farmers and their families, albeit sentiment that it is too little, too late⁵. It makes us wonder - will South Africa follow the same path, how far reaching is the expropriation policy, and will it affect investors outside the agricultural sector?
- In another kind of soft expropriation, we see a government change the management of a company in a bid to regain control of its assets. Following 1979 political unrest in Iran, SEDCO, a drilling company ceased its operations through its subsidiary, SEDIRAN, and repatriated its expatriate personnel. The Iranian government asked that they resume operations, to which SEDIRAN responded that they would only partially do so as certain rigs could only be operated by their expatriate staff. The government then proceeded to install its own personnel, including provisional directors, begin operations using SEDIRAN’s rigs and equipment, cancel the contract with SEDIRAN, and order for the transfer of SEDCO’s shareholding in SEDIRAN to the Iranian Government. This effectively turned what was a privately held company into a state-run institution⁶.
The effects of soft expropriation, such as the buying up of YPF shares, and those of hard expropriation, such as the taking of land in South Africa and Zimbabwe, are often felt in much the same way. It is interesting to note, that protectionist attitudes seem to be the fuel. However, can the same be said for non-physical assets expropriation? For example, one of the pain points in the US-China trade negotiations has been the latter’s practice of forced technology transfer, where non-Chinese companies often have to give away key or critical technology and information in order to be granted access to the Chinese market and this has the effect of undermining their competitive edge. This may include giving away 50% of more of the ownership of the business to a Chinese company. Despite the Chinese government giving assurances that it would roll back on such practices, foreign businesses in the country claim that the practice has in fact, increased⁷.
What Factors Do We Consider Before Investing?
In our search for attractive investment opportunities we have to ask certain questions to understand the risk of hard and soft expropriation with respect to any investment we might make. This necessarily involves two perspectives: the “macro” risk — i.e., one that asks what about the country (or state, or region), industry, and/or market might increase (or decrease) the risk of expropriation; and, secondarily, the company-specific risk - i.e., what is it about the company, its management team, business model, technology or other characteristics might heighten (or buffer) its risk for expropriation.
High-Level “Macro” Questions
- Does the country recognize and uphold the right to private property?
- Over the years, have there been occurrences of expropriation or nationalization within the country under consideration? Have these occurrences disproportionately affected foreign-owned firms or minority groups not indigenous to the country?
- Does the country have a history of requiring a certain level of local ownership of private companies?
- Has the country been party to international disputes on the matter of expropriation? If so, what was the outcome and what was argued by both parties?
- What sectors or industries within the country have high strategic or symbolic value and/or have historically faced threats of expropriation or nationalization?
- What factors does the law deem appropriate or necessary for expropriation to occur and what safeguards are in place for private investors and their properties?
- Does the law provide for a transparent process through which the government may expropriate a privately-held asset and does it provide for timely, adequate, and just compensation in line with international standards?
- Does the law allow for public participation or the participation of expropriated parties in the valuation process?
- Has the State ratified the ICSID Convention?
- Is the country party to international trade agreements, and if so, how does it view expropriation in light of foreign-backed assets?
- Is there government support, through restrictive regulations and/or policy incentives, for the sector in which we want to invest?
- Does the government have a vested interest in the sector or in a key player within the sector in which we want to invest?
- Would the government view our investment as a potential competitive threat?
- Is the company operating in a sector that is of high strategic, symbolic, or political interest to the government?
- Does the company proactively engage with the relevant government officials to inform them of their plans and to ensure compliance with applicable laws?
- If the company owns land, was the land validly acquired and appropriately documented?
- Are there restrictions on the level of foreign ownership for companies within the sector? On the other hand, does the sector favor foreign investors over local ownership?
- Could the Company’s technology be construed to have public benefit, or be of importance to the security (militarily, cyber, or otherwise) of the country where it operates?
- In the course of the Company’s operations, does it collect information that could be construed to belong to the “public”? Are there precedents in other countries where that might be the case?
- Does the management team have any ties to the current, or past, or potential future government?
- Do management teams of direct or indirect competitors have any ties to the current, or past, or potential future government?
- Does the company have insurance that provides protection in the event that the company or any of its assets is expropriated?
- What assets or property of the company are at the highest risk of expropriation? What would be the effect of such expropriation on the overall business/investment? What alternatives are available for the company should said property be expropriated?
The FIERCE: Expropriation Analysis at Work
When we invested in Tomato Jos and DrugStoc, both in Nigeria, we asked ourselves whether there was government support for their sectors? Could the Company’s technology be construed to have public benefit and thus possibly belong to the “public”? Is there a history of expropriation in these sectors? Through due diligence, we considered that it was in the government’s interest to support industries that promote import substitution as well as the self-regulation of the private sector. Currently, the government has plans to ban the importation of tomato paste by 2021, a gap that Tomato Jos seeks to fill⁸. Likewise, it seeks to end the widespread sale of counterfeit drugs, a sector that DrugStoc is addressing. On the other hand, however, the direct involvement of the government in the sub-sector also presented cause for caution.
We then had to ask ourselves what the likelihood was that the government would take the assets of the companies - for example, the nucleus farm owned by Tomato Jos. Was it more likely that they would be interested in DrugStoc’s data collection and possibly seek a partnership instead of a takeover? Is there historical evidence that shows government reluctance to outrightly seize property, particularly where foreign investment is involved? Asking these questions led us to conclude that despite the fact that there has been little in the way of investment disputes between US investors and the Government of Nigeria, it remains unclear the extent to which the government will intervene to ensure that tomato production and processing becomes local or to increase control the pharmaceutical sector. However, the available information did not imply that the government would have a strong incentive to expropriate investments such as ours, and particularly those that are foreign-owned. This led to the conclusion that the risk was Low to Medium-Low at the time of investment.
The entrepreneurs and businesses that we invest in design solutions for impact, sustainability, and profitability, either in untapped or inefficiently-run industries. As we examine the risk of expropriation, we have found it important to consider the level of involvement of the government or its actors in the sector under consideration, often opting for industries and economies where the risk is Medium-Low to Low. We also find it important to dive deeper during our due diligence into the Company-specific exposure, due to technology, business model, team or other factors, opting for Companies where the exposure is well defined and/or can be mitigated. We generally encourage founders to build relationships with the regulatory bodies that oversee their industry as a possible mitigant to this risk in the future.
While the countries into which we have invested (Kenya, Ghana, Nigeria, Rwanda and Uganda) are all ratified signatories to the ICSID Convention as well as the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (The New York Convention), we know that if we’ve reached the point where that matters, we are already unlikely to be able to meet our investors’ expectations for that particular investment. However, we do find it encouraging that the rule of law with respect to expropriation is becoming stronger, perhaps over the long term suggesting a tailwind to foreign-direct investment.
In closing, we hope that you have enjoyed reading our thoughts on the FIERCE risks of investing in emerging markets, and have taken note of the frameworks, examples, and suggestions included to better position yourself or your firm for these investments. While it’s true that investing in emerging-markets can be “risky,” - risk, in this case, need not be a dirty word if correctly identified and compensated for, and may instead represent an overlooked opportunity for those less-well positioned or prepared.
- UNCTAD Series on Issues in International Investment Agreements II | Expropriation
- Forbes | Charting the Decline of Venezuela’s Oil Industry
- Argentina’s Expropriations and the Lessons of History
- WeeTracker| The Good, Bad and Ugly in South Africa’s Land Seizure Without Compensation Plan
- BBC | Zimbabwe’s White Farmers: Who will pay Compensation?
- Jstor | Decision of the Iran — United States Claims Tribunal
- Financial Times | European Companies Forced to Hand Tech to China
- VestedWorld | Seeing Black in a Sea of Red — Why we invested in Tomato Jos