Managing Risk in Emerging Market Corporate Investments

While project loans have historically compared favorably with other asset classes, recent market changes cast new light on the advantages of investing in private debt, particularly in emerging markets. These shifts include the rapid expansion of the middle class and rising interest rates.

In addition to low debt and growth rates that continue to outperform their counterparts in the developed economies, emerging markets are increasingly characterized by the rise of a new consuming class. In Brazil alone, some 5.3 million households will join the ranks of the middle class within the current decade. This rapidly expanding population segment wants new goods of increasing quality. In many emerging markets, however, entrepreneurs are unable to raise sufficient local capital to satisfy this growing internal demand, presenting an opportunity for foreign lenders in advanced economies.

Yet many investors struggle to effectively manage risks in emerging markets.

Project finance overcomes this obstacle by offering a bottom-up approach to risk that has demonstrated both high recovery rates and resilience to crisis. In a distinct process that integrates risk management, contracting, and a detailed understanding of project construction, project finance raises long-term debt financing for major undertakings by lending against the project cash flow.

Several key measures safeguard the lender’s investment. A ring-fenced structure ensures the project is both economically and legally self-contained by isolating the project from external risk factors. Extensive due diligence mitigates counterparty risks by selecting parties based on experience and aligned incentives. Furthermore, comprehensive contracting further emphasizes risk allocation and mitigation; based on the recognition that changes will occur ex post, contracting is deliberately geared towards restructuring to secure high recovery rates. For example, the use of covenants protects the lenders’ security and provides advance warning of problems that might affect the project. Ultimately, lenders benefit from control of the collateral, and maintain their position at the top of the cash waterfall.

At Cordiant, we go one step further by partnering with supranational financial institutions like the IFC and EBRD to mitigate sovereign risk, as well as gain the World Bank’s Preferred Creditor Status.

Cordiant’s investment strategy has also been validated by rising interest rates because it invests in floating rate loans. While the falling interest rates witnessed in recent years previously benefited long-term, fixed-income investment strategies like corporate bonds, early May of this year brought a sharp reversal in this trend. With interest rates on the rise, floating rate loan instruments are coming out the winner.

Investing in private debt also offers another unique advantage. By funding development and generating local economic growth, project finance mitigates political risk by offering politically palatable foreign investments. Project loans are development-positive without sacrificing their return mandate.

Done right, investing in private debt offers low-risk, stable long-term returns that are well-suited to institutional investors looking to break into emerging markets.

David G. Creighton
July 2013