Markets Need Capital, Investors Need Comfort

Markets Need Capital, Investors Need Comfort
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Rick Tap

Despite all the headlines about risk and uncertainty – of which I have been a serial contributor – the world is flush with cash and ripe with opportunity. While the backdrop of this potential risk-reward trade off seems dire, especially with the return of economic nationalism, there are nevertheless many opportunities to bridge the “capital and comfort” gap. The first step is to identify which markets and which industries are investment grade, despite the potential political risk factors in a given country. Similarly, it is critical for investors to make risk and risk transfer a front-end determination as opposed to an investment afterthought. All of this, of course, presupposes a profound shift in attitudes in investment committees about what constitutes “investment grade” and “acceptable risk” in the first place.

It is said that risk can be measured, but uncertainty cannot. Chaos loves a vacuum and in uncertain environments capital flies to perceived quality and low risk environments. This flight occurs at the expense of yield, market share and market access. Needless to say, the void also comes at the expense of a first mover advantage, political influence and defending supply chains. This void is being filled by a multitude of actors, including sovereign wealth funds, venturesome corporate capital and other sources, such as bartering. This explains the insidious effect of low yield or negative yield investments in many advanced economies. Consider negative yield an emblem of the lack of imagination among many large asset holders, their general conservatism in their investment thesis, and a form of risk premia in exchange for forgoing market access. This phenomenon was at its peak during the Greek financial crisis, and many of the pre-conditions remain in place in continental Europe, which is breaking apart at the seams with the return of economic nationalism and populous sentiments. The question then is if long-range asset holders are prepared to except premiums or low to negative yield investments for the perception of safety, why are they not prepared to take market risks for which premium can also be attached?

If markets and business opportunities need capital, then investors need comfort. One form of comfort that can help mobilize capital and get long-range asset holders off the sidelines is to use insurance as a strategic part of their investment approach. The first step however is to confront the inherent flaws in the predominant investment philosophy, which would hold that investments south of the Mediterranean are either too risky, two small, or that markets are two illiquid and opaque to warrant any capital deployment at all. By this measure the only place to put any money is in the same crowded red oceans where every other investor is vying for opportunities, safety, and market share. The challenge with this approach, as we have seen over the last decade, is that despite the perceived flight to safety, many advanced economies are themselves beginning to resemble the very developing and emerging markets investors are weary of. Besides the concept of “fortress balance sheets” and “fortress nations” are proving to be of little solace in the era of man-made risk.

The political risk expert, Ian Bremmer, says that an emerging market is a place where politics matters at least as much as economics. By this measure, the whole world is beginning to take on the appearance of an emerging market. In these moments, great market opportunities can be uncovered. Doing so, however, requires that investors break the pattern of pursuing the same "investment grade" opportunities, and genuinely take strides to carve out new terrain and to use their economies of scale to shape desirable social, environmental and economic outcomes. In the development finance universe, for example, which is driving an agenda of moving from billions to trillions in combined capital to achieve the Sustainable Development Goals (SDGs), most capital projects look and feel exactly the same. This is in part driven by the complexity of being underwritten both for the financing and risk transfer sides of these projects. As a result, most development agencies are in effect crowding out so called “un-bankable” or smaller scale investments that are harder to underwrite. Worst still, project teams, investment sponsors and others, package projects to suit the investment rubric of these institutional players. Thus, most capital is deployed to the same type of investment, such as power plants, renewable energy projects, among other large marque investments – ones where ribbons can be cut. The other principal challenge in the development finance world is the time to decision on the provision of capital or risk transfer solutions, which can take up to 24 months if a determination is made at all. The span in between is known as opportunity costs or where good ideas go to die and good capital seeks alternatives.

In order to mobilize capital, whether it is from the public or private sectors, towards opportunities in new markets, the right risk-reward balance must be struck. One of the most underutilized instruments in providing this type of comfort is the domain of political risk and investment promotion insurance. All too often these policies are leveraged as a precondition of a large investment, typically in a risk-prone industry, such as energy extraction or industrial production, in a risk-prone country. This is the very definition of adverse selection, wherein only the worst risks reach the market, as opposed to a more diversified approach that would not only increase market capacity and interest, but would help drive down pricing for these risk transfer solutions. The powerful intuition behind leveraging insurance and risk transfer upfront as a part of an investment thesis is the fact that these instruments are credit enhancing. This can have the effect of improving investor interest in a prospective project while easing investor disquiet about a potentially “exotic” country. In short, making country risk a null hypothesis can profoundly change investor attitudes and appetite.

Private sector interest in de-risking an investment, even in the most complex countries or market segments, sends a signal to prospective investors that thorough due diligence has been conducted and that in the event of a worst-case scenario a liquid financial instrument in a legal domicile investors understand is available. While not all risks can be transferred from these scenarios, again without risk there is no reward, many of the most paralyzing investor risks, such as war, terrorism, political violence, expropriation, currency inconvertibility and many others in a series of unfortunate events, are readily insurable today. Normalizing this insurance market, can help normalize these investment flows. In addition to this private market readiness, the speed to decision making and the ability to leverage a “stacked” solution that brings to bear multilateral agencies such as the U.S. Overseas Private Investment Corporation (OPIC), the World Bank Group’s best kept secret the Multilateral Investment Guarantee Agency (MIGA), among others, stands to improve investor interest. In a world flush with cash, rife with uncertainty and with perennial human suffering, long-range asset holders who sit astride more than $35 trillion in assets have a unique obligation to pre-invest in the very stability they thrive on for their economic models to hold. Doing so will not only for fulfill their fiduciary obligation to their stakeholders, in the long run it will produce better investment returns.

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