Postcards from the edge

The Blue Canyon Country Club, 720 acres of lush woodlands and rolling fairways, is nestled between the Phang Na Mountains and the Andaman Sea on the island of Phuket, just off the southern coast of Thailand. A former rubber plantation, the property was converted almost 20 years ago into a luxury golf resort that has hosted the likes of Tiger Woods and Colin Montgomerie. Today, guests can play a round on one of Asia's most prestigious golf courses, visit the sandy beaches nearby or simply luxuriate in the seclusion of one of Blue Canyon's private villas.

It sounds like paradise. And it probably is, except perhaps for the private equity real estate firm that owns it.

In December 2005, RREEF, the real estate arm of Deutsche Bank, invested approximately $50 million (€38 million) into Murex, the owner of Blue Canyon, which was undergoing a bankruptcy reorganization at the time. Murex was also involved in a legal dispute with Rawat Chindapol, a Murex creditor who claimed that his holdings in the company were illegally diluted both before and after the Deutsche Bank investment. Although Murex eventually emerged from bankruptcy, Chindapol, who is rumored to have high-powered political connections, has been able to wrest back control of Blue Canyon. According to Thai newspaper reports, the Phuket Provincial Court issued an order in October 2006 to install seven new directors on the Murex board friendly to Chindapol's claim. Shortly thereafter, police officials seized documents from the country club. Because of an ongoing legal battle, representatives of Deutsche Bank declined to comment, but according to a private equity real estate executive with knowledge of the deal, the investment bank has a long, hard road ahead.

“China lives in dog years—every year is like seven compared to the developed world. Things change very rapidly. In the mid-90s, when the Shanghai Links project was evolving, there was a ‘Wild West’ aspect of doing business because things were just at the beginning stage.”

In recent years, private equity interest in emerging markets has grown at a relentless rate. Two years ago, for example, almost no opportunity funds had invested in China; today, the cities of Shanghai and Beijing are so flooded with capital that foreign firms are making inroads into second- and thirdtier cities in order to find sensible risk-adjusted returns. To the east, India has quickly become as competitive (and expensive) as much more established markets, even though one private equity real estate pro notes that the country has “no infrastructure.” And then there are places like Vietnam and Kazakhstan, two countries far off the beaten path—the former a Communist state, the latter known primarily as the home of a fictional Sacha Baron Cohen character—that have nevertheless piqued the interest of opportunistic players.

“There are not enough emerging markets left,” Chris Fiegan, chief financial officer of Equity International, the private equity real estate firm co-founded by Sam Zell, told a group of conference delegates last November. “There used to be, but they are going from emerging to emerged overnight, even in the absence of real transactions, which is part hilarious and part really frightening.”

From Bangkok to Budapest, opportunistic real estate investors have long been lured to emerging markets by the promise of spectacular returns. But as the tribulations at Blue Canyon make clear, the potential for exceptional rewards comes with exceptional risks. In the late 1990s, for example, plenty of investors got burned in Russia and Asia following currency crises in each region. And South America was the bane of some notable LBO investors who ventured there during the technology boom of the last decade.

Today, emerging markets are clearly back in vogue, particularly as the developed world presents fewer opportunities for the types of historical returns enjoyed by opportunistic players. Yet as a huge amount of institutional capital flows so quickly into many emerging economies, some observers question whether investors, eager to cash in on the next big thing, are discounting the inherent risks.

As the two case studies below make clear, those risks are all too real. Relative to more developed markets, emerging economies present huge challenges, from the possibility of political turmoil to spotty partner quality to poor legal safeguards.

If emerging markets can yield both profit and peril, they can also yield valuable lessons. The two investments presented here each occurred more than five years ago, but the mistakes made and the insights gained still resonate today—perhaps now more than ever. Investors trawling the far-flung markets of the real estate world would do well to pay attention.

Timeline of trouble

Chavez' revenge
If the government in China is becoming more sophisticated and receptive to foreign investment, then the story is the complete opposite in Venezuela. Following the rise to power of the country's leftist president, Hugo Chavez, the oil-rich nation has become increasingly confrontational with the US and its economic interests.

Back in the late 1990s, however, Chavez was merely innocuous. And Venezuela was a relatively prosperous country sitting on some of the largest oil reserves in the Western Hemisphere. Nevertheless, South America is a region synonymous with political unrest—Chavez himself led a failed coup in 1992. And if a firm is going to make an investment in the region, it's probably not a bad idea to do some political due diligence—which is why Gary Garrabrant, the chief executive officer of Equity International, found himself face-to-face with Hugo Chavez a number of years ago. At the time, the Venezuelan president was in Washington DC promoting a sovereign debt offering.

“We've met a bunch of presidents,” says Garrabrant, who notes that the introductions are usually facilitated by Equity International's well-connected operating partners. “And Chavez is certainly the most colorful. I met his wife, too. She was funny. It was lively. He actually cared about the US liking him and liking Venezuela.”

Garrabrant's interest in the South American country stemmed from his interest in Fondo de Valores Inmobiliarios, a Caracas-based real estate company that he calls “one of the bright lights in the office space on that continent.” At the time of Equity International's investment in the company, FVI reportedly owned 30 percent of the premier office space in the Venezuelan capital.

“I don't know if you've ever been to Caracas—you probably won't go now—but it has a real office market occupied by multi-national tenants—Exxon, BP, Shell Oil, Citigroup—paying, at the time of our entry, US dollar rents,” says Garrabrant.

In 2001, Equity International invested $60 million in FVI in order to facilitate an expansion of the company's office platform throughout South America. The initial plan was to acquire a portfolio of commercial properties with a view to one day taking that portfolio public in the US. Together with FVI, run by Luis Emilio Velutini, the private equity real estate firm spent several years exploring the office markets of Bogota, Lima, Montevideo, Sao Paolo, Rio de Janeiro, Buenos Aires and Santiago. And what they discovered, much to their chagrin, was that their original plan was simply not feasible.

Given the dearth of debt financing in many of these cities, developers must often sell office buildings floor by floor in order to raise the capital for construction. Stratified title, as it is often called, creates a very complicated ownership structure that makes it nearly impossible to acquire a property.

“We had always assumed that we could replicate the EOP model and yet, we were just flabbergasted that we couldn't,” says Garrabrant, who notes that such a lesson could only have been learned by partnering with FVI. “You can't just troll around and have a presence and speak as a principal,” he adds.

With their initial strategy at a dead end, Equity International and FVI branched into another sector, the retail market, where Venezuela's booming economy was fueling growth in consumer spending. In addition, shopping centers were typically financed with a much more logical structure, thereby allowing for a simpler transfer of ownership. Today, FVI has a burgeoning entertainment and retail portfolio, including two of the most highly regarded shopping centers in Caracas.

Yet just as the joint venture's new strategy began to prosper, another, even more pressing, challenge loomed: Hugo Chavez himself.

Backed by rising oil prices and the economic freedom it provided, Chavez had quickly become one of the most vocal critics of the US government, his reference to US President George W. Bush as “the devil” merely the latest in a string of moves that have scared off international investors. In addition to denouncing the economic policies of the US, Chavez has moved to nationalize certain industries and forced the sale of a number of foreign-owned assets, for example, pushing Verizon to sell its stake in a Venezuelan telephone company at a loss. As a result, foreign direct investment into the country has all but disappeared.

“At an institutional level, liquidity in Venezuela does not exist,” says Garrabrant.

Given the increasingly limited prospect that it would be able to exit its investment, Equity International sold 50 percent of its FVI stake back to the company in 2005. Last year, the firm sold its remaining interest to a group of private investors that had been organized by Velutini—someone Garrabrant describes as “a world-class partner.”

“Despite the fact that he lives in the most challenging environment on the face of the planet outside of Baghdad, he acted throughout in superb fashion,” adds Garrabrant.

Although Equity International suffered a loss on its $60 million investment—it declined to give specifics—the mere fact that it recovered anything at all was an achievement in and of itself; at the time of the firm's exit, it was extraordinarily difficult for any investor to expatriate capital out of the country.

“If Sam was on this call, he'd be smiling,” Garrabrant says, referring to Zell. “He was very proud. We tried, but our experiment didn't work as planned.”

Even more important than the partial recovery of the firm's capital were the lessons that Equity International was able to apply to future investments. After recognizing the difficulties inherent in acquiring office properties in South America, the firm focused instead on the residential sector, particularly in Brazil, where it acquired a stake in Gafisa, a publicly traded homebuilder that recently listed on the New York Stock Exchange. Furthermore, the firm's retail experience with FVI paved the way for future investments in the sector: Last year, Equity International purchased stakes in ECISA, a Rio de Janeiro-based owner of Brazilian shopping centers, and Parque Arauco, a Santiago-based retail developer that owns malls in Chile, Argentina and Peru. And finally, as the firm continues to move into emerging markets throughout Asia, South America and even the Middle East, it has perhaps learned the most valuable lesson of all: You can never be too careful.

“The key lesson we learned: We cannot quantify political risk,” Garrabrant says. “It's not about 200 basis points. Political risk will create absence of liquidity. And when there's no liquidity, there's no value.”