Kroll Quarterly M&A Newsletter – Jan 2014

Building Southeast Asia’s futureWe are pleased to present the latest edition of Spotlight Asia, Kroll’s quarterly M&A newsletter, produced in association with Mergermarket. Contents include:

• An overview of infrastructure-related M&A in Southeast Asia for November 2012 to October 2013, including trends and stand-out deals

• A look at the Transportation and Construction sub-sectors

• Potential investment points and the associated risks across the region

• An interview with Omer Erginsoy, Senior Managing Director at Kroll, on opportunities and risks when investing in the infrastructure space

Subscribe at http://asia.kroll.com to make sure you receive our next Spotlight Asia issue on Japanese outbound M&A into Indonesia

Spotlight Asia Kroll Quarterly M&A NewsletterJan 2014

Population growth and breakneck industrialization are placing heavy strains on infrastructure across Asia-Pacific, creating not only an abundant need, but also abundant opportunities for investment. The Asian Development Bank (ADB) estimates that US$8tn will be needed between 2010 and 2020 to build or upgrade the region’s transportation, telecommunications and power networks.

To maintain economic growth and job creation, Southeast Asia in particular needs long-term investment in critical infrastructure. The ADB estimates that Indonesia alone requires US$150bn for such investment. In Thailand, government approvals have paved the way for close to US$70bn in road, rail and water projects. Smaller economies like Vietnam, Cambodia, Laos, and Myanmar also stand to benefit as they open infrastructure sectors to private capital.

Partnering with private investorsLooking to bridge the gap between what is spent and what is needed for infrastructure projects, governments across the sub-region are turning to Public-Private Partnerships (PPP). Aside from the immediate financial benefits, private investors also act as project gatekeepers, adding an additional level of screening to prioritize investment into the most needed projects. This can help raise the efficiency of project execution and prevent waste of already scarce public funds.

However, attracting investors can prove difficult, as immature regulatory or legal frameworks, politicized decision making, and land acquisition issues create deterrents for investment. Efforts to improve transparency at government levels to encourage these partnerships are taking root across the sub-region – but there is still work to be done.

Recent cases have highlighted challenges the infrastructure sector faces, from corruption to partner disputes, to protests by the local population once the project is underway. In Kroll’s 2013/2014 Global Fraud Survey, the construction, engineering, infrastructure

Kroll Quarterly M&A Newsletter – Jan 2014

sector was one of the worst affected sectors reviewed. Common fraud issues experienced by companies in this sector included management conflict of interest, corruption and market collusion. Respondents noted that they feel most vulnerable to risks relating to management conflict of interest (72%) and corruption (79%).

Investing through M&AAside from PPP, M&A offer investors an alternative investment channel. Since 2007, Southeast Asia has seen close to 300 infrastructure transactions worth close to US$60bn, according to Mergermarket data. Deals focused on acquisitions into various infrastructure spaces – transportation, power, water and utilities, and telecommunications – and the construction companies that build and maintain these links.

Historically, dealmakers have leaned toward transportation (36% of deals) and construction (34%) acquisitions. Transportation M&A included investments into airports, shipping facilities, railways and affiliated services. Construction transactions involved heavy construction companies and related engineering services.

Power generation and transmission, water and sanitation, and telecommunications accounted for much smaller pieces of the M&A pie, with combined figures reaching only 30%. The sensitive nature of telecom buys and deals involving power and water infrastructure means foreign investors must pass an arduous and time-consuming approval process. In some instances, they are barred from investing altogether.

SingaporeSingapore’s mature business environment and transparent political and legal systems have made it a preferred destination for infrastructure capital. This bodes well for investors, particularly private equity, looking for stable and reliable returns.

While the city-state already boasts advanced infrastructure, investment opportunities are far from rare. In the M&A vein, since 2007, Singapore has seen 105 transactions (35% of volume) worth US$16bn (27% of value). Deals in power infrastructure accounted for the largest percent of value (60%), according to Mergermarket.

The coming years will see a number of transportation projects leave the pipeline. In February 2013, Changi Airport Group (CAG), operator of Singapore’s international airport, began building a larger terminal to expand passenger handling capacity. That same month, Singapore and Malaysia announced plans for a high-speed rail linking Kuala Lumpur to Singapore.

MalaysiaA robust economy and supportive government have helped transform Malaysia into an attractive investment destination. To maintain its current economic momentum, the government has prioritized investment in infrastructure, believing that upgrading existing links and building new roads and rails will help Malaysia achieve developed nation status by 2020.

While government support for public projects has been strong, Malaysia currently faces capital constraints and credit risk pressures. The result has been a build-up of projects unable to leave the pipeline. This has opened the door for PPPs as the government searches for partnerships to deliver projects while minimizing the impact to its budget.

Recently announced projects in Malaysia include the US$12bn Kuala Lumpur MRT system, the expansion of Kuala Lumpur’s international airport, and plans to build various power plants.

IndonesiaThe Indonesian government recently announced plans to offer 30 sizeable infrastructure projects covering dams, airports, railways, ports, toll roads and power generators totalling US$32 billion next year under a PPP scheme. Despite these promising plans, Indonesia’s first PPP project is still seeing delays.

A US$4 billion Japanese project to build a coal-fired power plant in Indonesia’s Batang regency was stalled earlier this year due to land procurement issues and opposition from locals and environmental groups, according to news reports. In a separate development, a mini hydro project to be developed by Prisma Karun Energy in Indonesia was halted by the local government amid a bitter dispute between the developer’s shareholders.

In developing markets like Indonesia, it is important for investors to conduct an assessment of probable risk scenarios at the outset of the infrastructure project. The assessment should cover not only political risk but also understanding how the project is perceived by local residents, organized labor, environmental NGOs as well as undisclosed stakeholders, notes Omer Erginsoy, senior managing director at Kroll.

Southeast Asia

Southeast Asia infrastructure target sectors (2007-YTD 2013)1

Deal volume Deal value

0%

5%

10%

15%

20%

25%

30%

35%

40%

TelecommunicationsWater and sanitation

Power generation and transmission

ConstructionTransportation

36%

21%

34%

30%

11%

5%

10%

29%

9%

16%

1 YTD refers to data available as of 21 October 2013

Kroll Quarterly M&A Newsletter – Jan 2014

Weighing the risks of investing in infrastructure

To keep pace with economic growth, Southeast Asia is stepping up infrastructure construction. Already, governments are turning to foreign investment to finance these projects.To discuss the financial rewards and risks of such ventures, Mergermarket spoke with Omer Erginsoy, Senior Managing Director at Kroll.

Where are the risks when investing in Indonesia and the Philippines, two countries that despite easing regulations toward FDI continue to pose challenges to investors?Longstanding issues like corruption, lack of transparency, lack of judicial independence, and political uncertainty are still big concerns for investors, with corruption probably topping the list when it comes to Indonesia and the Philippines.

For infrastructure investment specifically, land use rights continue to pose challenges. Whilst both countries have recently introduced new legislative and regulatory measures around land rights, it has not necessarily resolved the problems facing investors.

There is the case of a Japanese company that is building a power plant in Indonesia’s central Java to deliver power to 8 million people. While central governmental approvals have been granted, the project has been severely delayed by land owners refusing to sell their land, protests from environmentalist NGOs and even the refusal by district authorities to issue permits. At one point, the Japanese company faced the prospect of losing the concession. One can see that the much lauded 2012 Law on Land Procurement has not necessarily resolved the many risks facing FDI in projects of this kind. The case shows that due diligence needs to go very deep indeed: looking at a broad array of potential stakeholders at the national, regional and provincial levels.

Dispute resolution is another investor concern. In the Philippines, Executive Order #78 of 2012 established alternative mechanisms for resolving disputes for most types of infrastructure investment projects. But it has not yet been properly tested.

How do risks differ in Singapore, Malaysia and Thailand from the rest of the sub-region? The city-state suffers from a shortage of skilled labor and investors also face a number of challenges once a project is completed. Infrastructure is ultimately an investment in an operating business. So, just like everywhere else in the world there is the potential for fraud.

Malaysia has a deeper financial market which allows it to raise financing for infrastructure projects without having to rely on foreign investors. They are looking for smart investors who can transfer technology and industry knowledge into these investments. Also, Malaysia has a number of well-established infrastructure companies which not only operate in Malaysia but even export their services abroad.

However, despite its more advanced position in the region, fraud risk is still high in Malaysia, especially procurement fraud.

Investors need to mitigate these risks at both the pre-investment and post-investment stages, less they escalate into a Foreign Corrupt Practices Act or UK Bribery Act investigation.

Thailand, despite its perceived level of development, is at a much lower base than Malaysia mainly due to funding constraints, bureaucracy and the volatile political climate. Fraud and corruption risk also need to be considered. Financial misstatements and incidences of theft of high-value inventory are also common.

What approach must investors take before engaging in Private-Public Partnerships (PPP)? PPPs are perceived to reduce the risks of private sector participants because the projects are ultimately underwritten by the government. In effect, the risks of cancellation or expropriation are theoretically lower. PPPs also make social infrastructure projects like schools and hospitals more likely to be completed.

However, every partnership comes with risks and they are not very different from the risks FDI face in any emerging market. These include political interference – very likely given the reputational stakes of political backers; the possibility of civil opposition; bribery and corruption; and commercial competitors undermining projects using administrative means. Some industries, such as telecoms or mining, are often considered “strategic sectors” and therefore government interference is inevitable. The key issue for investors is to cast a very wide web when conducting due diligence.

Compliance monitoring of the PPP is also important, especially with respect to bribery and corruption. Completing a large project is not worth the financial and reputational impact of being indicted under the US Foreign Corrupt Practices Act or the UK Bribery Act.

How viable are markets like Vietnam, Cambodia, Laos and Myanmar as targets for foreign investment in infrastructure?Investing in these frontier markets usually requires having local partners. This brings a whole set of risks to consider. You want your partner to be well-connected, but in a good way, not a corrupt way. Also, we sometimes see investors pushed by the host government into partnering with a specific local company.

Cambodia and Laos offer abundant opportunities, with think-tanks concluding that Cambodia alone needs US$16bn in infrastructure investment for power plants, hydropower dams and upgrades to a dilapidated rail system. But like Vietnam, investors should tread softly, analyzing the situation, asking the right questions and making sound decisions based on thorough due diligence.

In Myanmar, investors must also consider the reputational risks of being associated with parties affiliated to the country’s former regime. The country is in transition but nobody really knows how things will turn out. A number of high-profile businessmen and military-linked holding companies remain sanctioned by the United States, and the list of sanctioned parties may yet change. It is therefore essential for investors to conduct due diligence on potential local partners to see how exposed they might be if such affiliations surface.

The information contained herein is based on currently available sources and should be understood to be information of a general nature only. The information is not intended to be taken as advice with respect to any individual situation and cannot be relied upon as such. This document is owned by Kroll and mergermarket, and its contents or any portion thereof, may not be copied or reproduced in any form without permission of Kroll. Clients may distribute for their own internal purposes only.

All deal details and M&A figures quoted are proprietary Mergermarket data unless otherwise stated. M&A figures may include deals that fall outside Mergermarket’s official inclusion criteria. All economic data comes from the World Bank unless otherwise stated. All $ symbols refer to US dollars.

EMEA: Neil Kirton nkirton@kroll.com+44 207 029 5204

Contact us Americas: Robert Brenner rbrenner@kroll.com +1 212 833 3334

Asia: Richard Dailly rdailly@kroll.com +65 6645 4520

Asia: Omer Erginsoy oerginsoy@kroll.com +65 9738 4514

Adrian Ngadrian.ng@mergermarket.com +852 2158 9743

Southeast Asia

PhilippinesLike Indonesia, government officials in the Philippines see PPPs as key to financing infrastructure projects and recently announced plans to increase infrastructure spending. The government recently announced plans to increase its infrastructure spending from 3 percent to 3.5 percent of the country’s projected gross domestic product. In addition to attract foreign infrastructure funds, the Philippines will be passing new legislations to improve cooperation with the private sector.

However, weak structure and limited track-records of returns have left private investors wary. Resistance from environmental groups, difficulties with land acquisition, bureaucratic difficulties, corruption, and shareholder disputes are all common challenges investors face in Philippines. Unfortunately without conducting a detailed risk assessment upfront, investors only come across these issues late into the implementation phase – creating a costly dispute or exit.

ThailandNowhere is the need for infrastructure more pressing than Thailand, especially in the run up to the ASEAN Economic Community (AEC) in 2015. Trade with neighboring countries Cambodia, Laos, Myanmar and Vietnam has come to play an important role in Thailand’s economic growth. Credit Suisse figures show these countries made up 7.8 percent of Thailand’s exports in 2012, up from 3.8 percent five years ago. These numbers are expected to increase, especially as Myanmar continues to open up.

The Thai government recently approved plans to build new rail, road and water networks to turn the country into a key conduit over the next six years – all at a cost of US$68bn.

Bangkok’s SkyTrain continues to provide hope for infrastructure fundraising. The SkyTrain’s IPO in April 2013 raised US$2.1bn, money that will be used by owner BTS Group to expand its rail system in the Thai capital.

Thailand’s export potential, however, remains tied to neighboring countries. No matter how developed Thailand’s highways and railways are, shoddy or non-existent links in Myanmar, Laos and Cambodia continue to pose significant speed bumps to Thai trade.

Corruption is still a major challenge for investors in Thailand, as many are still haunted by concerns that loans made to infrastructure projects in previous years were siphoned off to benefit people close to the government.2 Needless to say, this challenge is heightened by the recent wave of political instability.

MyanmarUS$300 billion3

Regulatory uncertainty, corruption, political stability, reputational risk, political liabilities

ThailandUS$72 billion

Fraud, corruption, political stability

VietnamUS$ 110 billion

Construction security, corruption, reputational risk, regulatory uncertainty

CambodiaUS$16 billion

Construction security, corruption, fraud, political stability

MalaysiaUS$45 billion

Fraud, corruption

PhilippinesUS$70 billion

Immaturity of legal framework and limited track record, corruption

IndonesiaUS$150 billion

Corruption, political stability, global connectivity, legal framework

LaosData unavailable

Construction security, corruption, skill shortage

CountryEst. infrastructure investment needs (2012-2020)

Risks

Key:

SingaporeInvestment needs minimal

Labor shortage and limited pool of talent , government regulation on semi-skilled labour force

Source: Goldman Sachs Global ECS Research estimates; World Bank estimates; Cambodia Daily; Project Syndicate; Infrastructure for a Seamless Asia; Asia Development Bank

2 http://www.nationmultimedia.com/politics/Bt2-trillion-plan-raises-fears-of-graft-30198552.html

3 Figures for Myanmar are for the period 2012-2030

Infrastructure needs and investment risks in Southeast Asia

In the construction phase of the investment cycle, supply chain issues always surface. Fraudulent collusion between suppliers and local managers (or managers of JV partners) can give rise to large financial losses and cause delays in the project, heightening completion risk. If bribery and corruption issues emerge, the project be embroiled in debilitating controversy and serious legal problems, local and internationally. Kroll is frequently asked to conduct regular fraud reviews and contract audits to reduce risk of overpaying.

An inside look