Infrastructure investors face multiform geopolitical risk

The rule of law and its enforceability should come top of institutions' list of factors to assess before entering new markets, insiders reckon.

Perhaps it’s to do with improving technology and easier and more immediate access to information, but it certainly seems that the number of hot spots brewing around the world are on the rise, making geopolitics and the evaluation of geopolitical risk an increasingly important component of any investor’s risk assessment strategy.

“Geopolitical risk really, in my mind, is caused by tensions between different states and regional conflicts. That definitely is more of an issue in emerging markets,” says Michael Wilkins, a managing director of the infrastructure finance ratings group of Standard & Poor’s.

He adds that institutions there tend to be characterised by a lack of independence, stability and transparency compared with those in developed countries. “That’s a broad brush statement and you’ll find exceptions, but that tends to be the case.”

Douglas Doetsch, a partner at law firm Mayer Brown who heads the firm’s Latin America/Caribbean practice and co-heads its global banking and finance practice, tends to encounter a different term with his clients.

“In the deals I work on, people […] usually focus on sovereign risk which is the whole set of political and legal issues, monetary and financial issues that might exist in Argentina, Colombia or Indonesia,” he comments. “Sometimes sovereign risk is further broken down into convertibility risk or sovereign default risk if you’re talking about availability payments.”

For David Tafuri, a partner at law firm Dentons whose practice focuses on international business, international law and foreign investment, “geopolitical risk refers to the fact that events related to a country’s affairs and its relationships with other countries and non-state actors can impact the ability of investors to achieve their goals”.

MITIGATING RISK

Whatever the definition they use, one factor to consider for investors is a country’s political structure. Another is the rule of law, as well as its enforceability.

“That’s a very important nuance because in many cases rule of law exists but if something goes wrong you might not be able to or might not want to take the government to court,” an institutional investor, which asked to remain anonymous, told Infrastructure Investor.

The type of investment will also determine which criteria will be used to assess risk. Infrastructure, where assets are usually very closely tied to or controlled by government, requires a different set of criteria than private equity or real estate.

Enforceability of the rule of law is crucial since, as the institutional investor points out, “investors can’t run away with a power plant or a toll road”. One way to evaluate enforceability is by looking at precedents.

“One of the questions that always comes up in deals we’re involved in in Latin America is not just what’s in the concession agreement but what is the record of that government or that country in actually complying with those provisions? And if there is a dispute, what is the mechanism for resolving it?” Doetsch says. “I can tell you that the lenders to a project and most sponsors going into a project would much prefer international arbitration rather than taking their case to local courts,” he concludes.

Especially when talking about infrastructure, which tends to be a long-term investment, being prepared for any contingencies that may arise over the next 10 to 15 years is vital.

“You don’t know which political party will come into power or whether there will be a coup d’etat or if the government will nationalise everything,” the institutional investor remarks. “But we negotiate things like that; oftentimes we negotiate under British law or New York law in order to protect our investment.”

BEWARE THE SHOCKWAVES

Investors can protect themselves by getting to know the government of the country they’re investing in and by understanding the political situation, according to Tafuri. Forming relationships with not just the government but also key stakeholders is another measure Tafuri, whose clients invest in a variety of sectors in countries such as Iraq, Syria, Lebanon and Libya, recommends. Doing so will improve chances of investment obligations being honoured should there be a change in leadership.

While the consensus is that geopolitical risk is more of an issue in emerging markets, S&P’s Wilkins warns against discounting it completely in developed markets.

The investor who spoke to Infrastructure Investor agreed.

“The thing is that geopolitical risk is everywhere,” this person says. There’s direct and then there’s indirect risk. “Look at Europe, for example, and what happened with Russia taking over Crimea; that has affected everything,” the source comments, underscoring the link between politics and economics as Europe struggled with the decision to impose sanctions against Russia without hurting its own economic interests.

“You look at the price of oil today – how it’s affected some foreign currencies, what it’s done to oil companies. The impact is huge. I think it’s a matter of degree – it might be first degree, second degree and so forth, but geopolitical risk is everywhere.”