Risks associated with investing in emerging markets – Nigeria in focus
March 2017 | SPECIAL REPORT: EMERGING MARKETS – OPPORTUNITIES AND RISK MANAGEMENT
Financier Worldwide Magazine
Nigeria has been described by Goldman Sachs as one of the next 11 economies with a high potential to become one of the world’s economic powerhouses in the 21st century. The country’s economy is an emerging one that demonstrates diversity in terms of available opportunities including power, oil & gas, transportation, telecommunications and agriculture. It is expected to become the largest economy in Africa, overtaking South Africa in the near future, and become one of the top 20 economies in the world by 2050. Although the country boasts numerous new and uncharted opportunities for the desirous investor, there are, as with other economies, risks associated with potential investments in the country. These risks may be of a socioeconomic, fiscal or political nature.
The risks and challenges attendant to doing business in a developing economy such as Nigeria are capable of affecting local and foreign investor appetite negatively. Such risks are at least partially responsible for the fact that Nigeria’s position on the ease of doing business index has been so low. The country is ranked 169 out of 190 countries by the World Bank in its report ‘Doing Business 2017: Equal Opportunity for All’. This notwithstanding, the potential viability of doing business in Nigeria has led investors to develop practical commercial solutions to mitigate these risks and optimise the profitability of their business interests. Due to these risks, more than $1bn has been moved to other emerging economies such as Indonesia, Mexico and Turkey from the Nigerian equity market over the last 12 months.
Generally, where an investor brings funds into Nigeria through a government-approved channel (an authorised dealer) the government guarantees such an investor easy repatriation of capital and profits in foreign currency out of the country. Over the past couple of years, however, the foreign exchange policies of the Central Bank of Nigeria have caused delays in acquiring foreign currency or an inability to convert local currency to foreign exchange. Investors are therefore exposed to the risk of being unable to repatriate capital and transfer profits earned from their investment, leading to net losses in terms of total returns when converting back to their foreign currencies.
Expropriation, particularly indirect expropriation, also poses a major risk for investors. Indirect expropriation could come in a number of ways, including a refusal to renew or the withdrawal of a necessary licence or permit without any legal cause. Contracts may also be terminated arbitrarily, or confiscatory taxes imposed. The general trend of the government is to seek to justify the expropriation of the investment and thereby not pay any compensation, or claim that no expropriation has taken place and therefore no compensation is due.
The potential political instability in emerging markets such as Nigeria portends another huge risk for local and foreign investors. Investment in emerging economies is usually threatened by uncertainty regarding political decisions. A government may also arbitrarily change its laws or regulations or fail to enforce them in a way that will reduce an investor’s financial returns. The AON political risk map gives Nigeria a ‘high’ rating with regard to the risk of political interference in private sector investment in the business climate, and a ‘very high’ rating with regard to the risk of political violence.
Emerging economies such as Nigeria’s usually have to grapple with the threat posed by the increase in activity by terrorist groups. These groups have, for a number of years, threatened the lives, property and business interests of citizens and residents, including local and foreign investors. Their activities have also caused Nigeria to be listed among terrorist nations. Investors’ fear of loss of life and property discourages investments, especially into the northern part of the country.
Changes in law and policy
Emerging markets are also generally more susceptible to sudden changes in law. These could occur not only through variation, amendment, implementation or introduction of new laws, but also through a unilateral variation of existing contracts using executive powers (including circulars, directives, administrative orders and other similar instruments). These risks are more than capable of discouraging potential investors from doing business in Nigeria.
Although there are a number of risks that negatively affect investor appetite, there are also a number of solutions adopted by investors to mitigate and manage these risks while maintaining the viability of their investment.
Bilateral investment treaties (BITs)
For investments in developing countries like Nigeria, foreign investors typically structure their investment vehicle to benefit from the cover provided by BITs. This is done by establishing their investment vehicle within a country that has executed a BIT with Nigeria the host country. While there are indicators to measure the protections afforded an investor (including fair and equitable treatment, most favoured nation, among others), there are also globally-tested dispute resolution mechanisms in BITs which have been very effective in helping investors make successful claims against host governments. The most frequently used institution for investment dispute arbitration in BITs is the International Centre for Settlement of Investment Disputes (ICSID).
The protection afforded an investor by a BIT is that a host government will be less inclined to breach or act contrary to obligations owed to another state under international law, than it will be to a breach of its own domestic laws on investment protection. The need to maintain its integrity and credibility on an international level will incentivise the host government to honour its obligations and adhere to the protective measures for the investments of foreigners under BITs.
Political risk insurance
To mitigate political risks, investors in large scale projects such as those involving power, infrastructure and oil & gas have learnt to take out political risk insurance cover. Although expensive, this could protect against any unfair political action or inaction by the Nigerian government that could cause damage, financial loss or business disruption to their investments.
This insurance may be general or protect against specific political risk like currency inconvertibility, which would be designed to guarantee conversion and repatriation of earnings and capital, principal and interest payments. Institutions like AON and the Multilateral Investment Guarantee Agency of the World Bank Group have been known to provide political insurance cover over the years. The extent of cover available to the insured for political risk would typically be dependent on how expansive the definition of insurance cover is in the insurance policy.
Hedging and risk sharing arrangements
Investors may also explore the option of entering hedging and risk sharing arrangements with counterparties to hedge political risks. Investor companies may also ensure that any loan agreements between the companies and their creditors be drafted to reflect a contractual sharing of political risk between the lenders and promoters/investors in the companies. One method of achieving this is by providing that the investors or companies will guarantee or continue to service the loans unless the loss is caused by a specified risk, such as expropriation without compensation.
The use of stabilisation clauses
Investors may also enter host government agreements (HGA) with stabilisation clauses, to mitigate or manage the political risks associated with their project. The clauses can be drafted to ensure that for the term of the project the applicable domestic legislation or regulations affecting the project remain unchanged. A stabilisation clause may also serve to require the host government to indemnify the investors of any cost of complying with any changes in the laws applied to the project. The use of foreign governing laws and jurisdictions in agreements may also, although to a lesser extent, insulate contracts from sudden changes in local law.
Political pressure points
Local and foreign investors can manage some of the risks that plague their investments in developing countries by the use of political pressure points. In a country like Nigeria, investors, especially international investors, have made the business climate more favourable by establishing strategic alliances with domestic governments and communities. For example, Agip KCO adopted a business model that responded to the social and economic needs of Kazakhstan by favouring Kazakhstan national suppliers over non-national suppliers. The company also funded the construction of various public facilities such as computer labs, housing units for the less privileged and a national library. Through such initiatives, investors have successfully demonstrated a commitment to the wellbeing of host communities, and have thereby created a more favourable climate for their investment.
Investors should carry out due diligence before investing in any business to highlight and mitigate any possible risks. However, due diligence exercises may be difficult to conduct in Nigeria because Nigerian institutions are not fully developed and their information framework is not easily accessible. Due diligence that is carried out by independent professionals who have the capacity to recognise possible problems that may be encountered, will go a long way to identifying the risks to investors.
Emerging economies such as Nigeria’s are evolving at a rapid rate and the commercial atmosphere is relatively conducive for the satisfactory conduct of business operations. Unfortunately, although investing in emerging markets can produce substantial returns for the investor, they also pose substantial risks. It is therefore necessary for prospective investors to be well guided before commencing business operations in the country. Special attention should also be paid to the legal and regulatory framework of the desired market, in order to enable all concerned to maximise the potential of the Nigerian business environment.
Professor Konyin Ajayi is the managing partner, Damilola Salawu is a senior associate and Arnold Mac-Ebong is an associate at Olaniwun Ajayi LP. Professor Ajayi can be contacted on +234 1 270 2551 ext: 2901 or by email: firstname.lastname@example.org. Mr Salawu can be contacted on +234 1 270 2551 ext: 2722 or by email: email@example.com. Mr Mac-Ebong can be contacted on +234 1 270 2551 ext: 2723 or by email: firstname.lastname@example.org.
© Financier Worldwide
Professor Konyin Ajayi, Damilola Salawu and Arnold Mac-Ebong
Olaniwun Ajayi LP