To Boldly Go: A Captain’s Log on M&A and Joint Ventures in Frontier and Emerging Markets

Once considered the “final frontier”, frontier markets and emerging markets now sit at the heart of the global energy transition and advanced manufacturing (consider the location of copper, lithium and rare earth mineral deposits), the rollout of digital infrastructure (consider critical fibre optic cable landing points) and even food security (consider their share of global crop production and control of vast swathes of arable land).

Offering investors what developed markets increasingly cannot — attractive demographics, access to strategic assets and availability of abundant natural resources — frontier and emerging markets are now at the centre of global competition over resources, supply chains and influence.

But notwithstanding their increased importance, frontier and emerging markets are still often misunderstood as “developed markets, just with extra risk”.

Frontier markets are typically characterised by somewhat less well-developed capital markets, regulation and corporate governance as compared to more developed markets. Emerging markets are, on average, more developed than frontier markets. They ordinarily have greater liquidity in their capital markets, more developed institutions and higher foreign investment flows. But developed markets generally have more evolved corporate governance, regulatory practices and legal systems, lower political risk and less potential for volatility. Doing business in these markets does not therefore necessarily entail “higher” risks but rather “different” risks.

Accordingly, approaching joint ventures and M&A in frontier and emerging markets as simply higher-risk versions of their equivalents in more mature markets is misguided. When frontier and emerging markets are instead understood as having certain features that are qualitatively different to more developed markets, distinct approaches can then be adopted with respect to governance, risk allocation and exit, thereby facilitating better M&A, more successful long-term business relationships and, in turn, increased investment.

1. A Different Perspective Is Needed to Adapt to Different Dynamics

In developed markets, laws and regulations typically evolve slowly and quite often with advanced public consultation. In frontier and emerging markets this is not always the case. Documentation provided for review on deals may not always be as complete as it is with the equivalent developed market deal. There are therefore often more “unknown unknowns” that need to be appropriately managed in many frontier and emerging markets. Robust warranties and indemnities are important, but it’s also necessary in many cases to take an informed commercial view on the real risks in practice.

Sometimes there may be a few more delays, surprises and “agreed points” that are reopened, but these can be managed:

• Limiting delays: If an antitrust or financial services approval is required, seek to increase oversight, enhance accountability and actively manage the process. Require each party to update the other on material developments in obtaining the approval, impose timebound obligations on the local joint venture partner to assist with the approval process where they have an understanding of “how the process really works” and actively manage the risk of a regulator not responding if it’s uncertain that an approval is actually required by considering the inclusion, in appropriate circumstances, of a cut-off date and a presumption that the condition precedent is satisfied after a certain point in time.
• Managing surprises: If there’s a gap between signing and closing, investors should manage the downside risk of negative events occurring during this period by repeating warranties at completion and negotiating a walk-away right for material breach of warranty. Investors in a strong position should also request a MAC. Walk-away rights will often be quite a bit wider than in western markets but will typically be tied to a limited number of specified matters that would directly impact the business.
• Reducing the reopening of agreed points: Investors should insist that the parties agree a term sheet and then negotiate focussed issues lists before drafts of long-form documents are turned. If the counterparty seeks to deviate from what was agreed in the term sheet or issues lists, investors should hold them to account.

2. Be on the Lookout for Different Types of Issues 

Due diligence in more developed markets revolves around financials, contracts and compliance. But frontier and emerging markets are often characterised by a higher degree of state involvement in assets and industries, more sensitive ownership structures, and a need to manage dynamics that may sit outside of formal legal structures. Investors into these markets therefore also need to assess the political exposure of counterparties, family-based related party transactions and the nature of state interests. What is the practical likelihood that a licence will be revoked if there is a change in government? Will an important customer really renew its contract with the target group if it’s a related party of a large family conglomerate seller which is fully exiting the business? Can a foreign investor safely agree to a request from a state-connected prospective joint venture partner to freely transfer its shares inside a lock-up period to entities over which it has merely informal influence rather than legal control? Investors need to evaluate the wider matrix of stakeholders they are dealing with and factor the associated realities into their assumptions, models and projections.

Enhanced sanctions and corruption screening is often advisable with certain frontier and emerging markets deals. If they are not already in place, more robust compliance frameworks may need to be introduced to the target group, either as conditions precedent or, often more likely, as conditions subsequent or action items that parties commit to addressing in the first 100 days following completion, if the seller is remaining in the business. The inclusion of audit and reporting rights may be advisable to oversee any particularly high-risk aspects of the business and potentially even the compliance function itself, such as a right to veto proposed changes to compliance manuals.

Investors into frontier and emerging markets are generally better off pushing for a completion accounts mechanic as opposed to a locked box. As is the case with a business in any part of the world, if there are gaps in — or quality issues with — the accounts, investors should always think twice before agreeing to a locked box deal where they will not have the opportunity to make a downward adjustment to the purchase price post-completion unless the matters in issue constitute non-permitted leakage. The higher incidence of related party transactions within frontier and emerging markets businesses also means that leakage and permitted leakage concepts can be more challenging to apply in practice as compared to more developed markets. Attractive investors should ordinarily be able to win this argument because across most sectors in the majority of frontier and emerging markets, completion accounts deals generally remain more commonplace than locked box structures.

Remember that in frontier and emerging markets, the foundational developed market assumptions don’t always hold. Capital mobility may be taken as a given in mature markets. but in frontier and emerging markets capital controls are real risks. Investors should have a clear plan as to how to repatriate dividends in a legal and tax efficient manner before the deal even signs, let alone closes. But if there are existing issues, investors should not just assume the deal will close: if there are unremedied historic capital control breaches in the target group, government authorities may refuse to approve share transfers.

In markets which are generally more relationship-driven, perhaps the best advice for direct investors is to invest alongside a trusted, credible and reliable local joint venture partner on the ground who can help smooth day-to-day operations. A local joint venture partner may, in any event, be a practical requirement of “getting business done” in a jurisdiction, or even a formal legal requirement, if there are sector-specific or even blanket foreign investment restrictions limiting the permitted percentage of foreign shareholder involvement in a business.

3. Keep Enforcement Risk in Mind

In developed markets, courts and regulators are often assumed to be reliable and predictable. In less developed markets, courts and regulators may sometimes have greater discretion.

Offshore holding structures should be considered in order to invest through corporate vehicles outside the jurisdiction. International arbitration (such as the ICC or LCIA) utilising experienced commercial arbitrators, with any dispute physically taking place in a neutral jurisdiction (such as London), is often preferable to relying on local courts to adjudicate shareholder disputes. There are exceptions, especially when dealing with government-related entities in certain jurisdictions, but most counterparties will agree to adopt English law for the transaction documents. This is advantageous to investors as English law is generally regarded as the system of law which is the most stable, predictable and supportive of freedom of contract, helping to ensure that the clear intent of the parties prevails in the sale and purchase agreement and shareholders’ agreement.

4. Appreciate That Governance Takes On a Different Level of Importance

Investors can take great comfort from minority protections and shareholder rights in more developed markets. There are typically well-trodden statutory regimes and a court system which is well versed in resolving shareholder disputes. In less developed markets, this is not always the case. There is also often greater need to formally document ongoing expectations in enforceable written documentation. This calls for a strong set of reserved matters, including appropriate controls over — and oversight of — the budget, business plan and bank account, amongst many other items. Using an offshore holding company in a tax efficient jurisdiction also assists with enforcement. Additionally, investors should also carefully review delegations of authority and ensure that appropriate controls exist around powers of attorney that may be granted to management or individuals in operational roles.

As a rule of thumb, minority investors with a 10% or more shareholding should generally insist on board observer rights (if available in the jurisdiction in question), and may even seek to obtain a board seat, depending on the size of the board. Investors with as little as a 5% shareholding should at least attempt to secure board observer rights. Any shareholder holding at least 20% of the equity should insist on the right to appoint at least one director.

5. Strategise Exit Before Even Entering

Trade sales and IPOs are viable and widely available in developed markets. In frontier and emerging markets, by contrast, capital markets are less liquid and there is often a shallower pool of realistic domestic buyers. Direct investors into frontier and emerging markets should therefore go into their venture with a clear thesis as to who they will likely exit. Investors commonly insist on the inclusion of put options and tag-along rights in shareholders’ agreements, although their enforcement often needs to be managed carefully (another reason why offshore holding companies are often used on frontier and emerging market deals).

Final Thoughts

What were once the world’s “final frontiers” are now far closer to its strategic core. It is interesting, but ultimately entirely logical, that it is Middle East investors, especially its pools of sovereign-related wealth, that have so far been amongst the most successful at getting deals done in frontier and emerging markets. After all, these investors are in fact uniquely well-positioned for these markets: they generally appreciate the advantages of taking a long-term view and are particularly skilled at navigating not just the commercial but also wider dynamics of deals. Others who also appreciate that investments into these jurisdictions need to be approached, structured and managed differently to deals in more mature markets will also find themselves well-placed to navigate the universe of opportunity that awaits.