So-called ‘frontier markets’ hold no fears for some investors. Edward Russell-Walling reports on how broker-cum-investment bank Exotix went digging for profits in the zinc mines of Yemen.

The word ‘emerging’ used to define the evolutionary state of certain faraway markets with comforting precision. No longer is this the case. It now embraces everything from ‘really quite sophisticated’ to ‘here be dragons’, and Yemen is definitely at the reptilian end of the spectrum. Yet capital can be attracted even to Yemen if you have local knowledge, inventiveness and persistence. Broker-cum-investment banker Exotix clearly has all three.

Exotix specialises in what are known these days as ‘frontier’ markets, particularly in Africa, in generally off-limits jurisdictions such as Cuba and North Korea, in the wilder corners of Latin America (which these days includes Argentina) and the Balkans. It began in 1999 as a distressed debt specialist and has been putting the knowledge gleaned from that exacting trade to wider use.

The firm is backed by one of the market’s shrewdest players.

cp/14/p50exotixteam.jpg

Wild frontier (l-r): Chris Priebe, Alan Caspi, Peter Bartlett and Andrew Chappell

Interdealer broker ICAP recently reduced its stake to 20%, which allowed Icap CEO Michael Spencer to acquire 43% via his private investment vehicle, IPGL. Some of the Icap holding also went to Exotix employees, who boosted their combined stake to 37%. Distressed and illiquid emerging markets debt remains at the heart of the business, but there are now three other arms.

Since 2005, Exotix has developed an equity platform. “This is a one-stop shop, substantially a stockbroking business, for international investors looking to invest in sub-Saharan Africa,” explains Exotix CEO Peter Bartlett.

The newest venture is Insparo Asset Management, which hopes to launch in March. One-third owned by Exotix, one-third by its own staff and one-third by a US seed investor, this will invest in sub-Saharan Africa and other frontier markets. Unusually, Insparo will invest across all asset classes instead of specialising only in equity or debt.

Raising capital

The final activity, and the one that concerns us here, is structured products and origination. This means raising capital for small to medium-sized companies in emerging markets – companies which typically find it hard to raise funds. Exotix was placement agent for Ghana Telecom’s recent $200m issue, placing the majority itself. It also raised $89m for Ghana’s National Investment Bank in two separate placings and another E80m for the government of the fragile Ivory Coast. The firm’s recent Yemeni deal takes it into new and equally challenging territory.

Head of origination and structured finance Alon Caspi points out that the frontier markets’ corporate sector is beyond the radar of the big investment banks.

“We have a higher concentration of expertise and an on-the-ground presence in these markets,” he says. “So we are much more focused on countries that the big boys are only just starting to look at.”

Joint venture

Alternative Investment Market-listed ZincOx Resources of the UK and its Yemeni partner, Ansan Wikfs Investment, have a joint mining venture, Jabal Salab (52% owned by ZincOx). It intends to develop the Jabali zinc deposit, 100 miles north-east of Yemen’s capital, Sanaa. Some say this is the site of King Solomon’s mines, a description that may be more colourful than accurate.

Whatever its history, the zinc is high-quality and high-value because, unlike most mined zinc product, it does not need to be smelted before sale to end users in the ceramics and rubber industries. The cost of the open-cast project is $216m, and the sponsors were looking for debt to reduce their equity contributions. Traditional project finance was not available at an affordable cost, not least because political risk insurance for Yemen was hard to find and very expensive.

Another obstacle was the difficulty in securing offtake agreements – a staple of standard project finance – for the mine’s output. In the fragmented ceramics industry, a long-term agreement stretches to “one month”, as Mr Caspi puts it, and tyre manufacturers require exhaustive quality assessments before making any promises.

So it was after attempting the project finance route for a couple of years that ZincOx came calling at Exotix.

“This was a classic opening for us,” Mr Caspi observes. “We said we could put together a deal using a lot of traditional project finance mechanics, but making it more interesting and imaginative to attract the more aggressive investment community of hedge funds and specialist emerging markets fund managers.”

It all boiled down to a matter of risk and return. While project financiers try to strip away as much risk as possible, more adventurous investors are happy to take on the risk, providing they feel adequately rewarded. The challenge was how to generate those returns in a way acceptable to both sides of the transaction.

What Exotix came up with was a limited-recourse, high-yield bond, sweetened with an innovative kicker linked to metals prices. The firm arranged a six-year borrowing facility of $120m, with an 11.5% coupon, securitised into notes. For the first two and a half years – the construction period – the borrower pays a reduced coupon of 6%, with the balance being capitalised.

“The initial stage of payments is designed not to overburden the operation with heavy outgoings,” says Mr Caspi. “After 30 months, when the deferred payments are rolled up into the principal, they start to pay interest on the whole, and the loan starts to amortise in seven equal instalments.”

Risk and return

Next, Exotix needed a way to increase investors’ rewards in return for the considerable risk they were taking.

It came up with the Zippo. The tradable ‘zinc-indexed price payment obligation’ is the first instrument of its kind in the metals sector. It pays 16% of the difference between a floor of $1300 a ton and the average international zinc price. In other words, for every dollar that zinc trades above $1300, investors receive 16 cents for every ton that Jabal Salab produces.

“The added revenue is shared pro rata by the investors, so they share in the success of the mine,” says Mr Caspi. “The floor makes sure that the company is not paying out if it is getting close to breaking even.” The Zippo and the loan are split into two notes so that they can be traded separately.

Workable structure

The Zippo gives investors equity-like participation. “Yemen is a juvenile country in terms of its economy and financial infrastructure, so no one feels comfortable taking equity there,” says Mr Bartlett. “We have tried to come up with a product that replicates equity as best we can. In Russia, India or Brazil, with mature stockmarkets and sophisticated guidelines, you could give investors equity warrants or options. But in Yemen the investment laws could change overnight.”

Coming up with a viable structure was only half the battle. Selling it into the marketplace was another story. Getting approval from the Yemeni financial authorities took longer than anticipated, and then: the crunch.

“Between August and December we did a lot of juggling around,” says Mr Bartlett. “Every time we thought it was fully sold, someone else pulled out because they were hit by the liquidity squeeze.”

The downwardly mobile price of zinc did not help, falling from about $4500 a ton in late 2006 to $2200 as the transaction was coming to fruition. By early 2008, however, the deal was effectively done, with most of it taken up by UK-based hedge funds and emerging markets specialists. A key attraction for investors, Exotix says, was the diversification on offer – into zinc as well as into Yemen.

The firm considers that the deal is a template for other emerging markets projects looking for less cumbersome and costly finance than that offered by traditional bank project finance. And the Zippo points the way for commodity projects beyond the oil and gas industry.

“The Zippo is the first tradable instrument of its type to be launched for a metal-related transaction,” Mr Bartlett concludes. “It represents a significant expansion in the range of financing options available to projects in frontier emerging markets.”

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