Libya, Frontier Markets FX and “Streaming” Agriculture

We’ve written a bit herein about our friend and colleague, Kevin Virgil. Kevin is a West Point graduate, veteran of the US military and a true boots-on-the-ground frontier markets investor. He’s also a damn nice guy!

You can get a bit more background by reviewing our posts: Libya – The Real Story and Why Libya.

Chris and I first met Kevin in Mongolia at our Meet Up. We had spoken to him quite a bit prior, but our first face-to-face was in Ulaanbaatar. That’s when we got the full download on Pathfinder Ventures, which is Kevin’s frontier markets investment firm.

Together with his partner Kit in London, Kevin has put together an intriguing shared office project in Libya, is working on a frontier markets FX fund and is also creating a frontier markets agriculture fund (in full disclosure, Chris and I will be participating as investors and advisors to Pathfinder and its projects, mainly the FX fund and the ag fund).

I wanted to touch base with Kevin to get an update on the projects that they have going, and also to get his continuing updates on the situation in Libya, which we are watching intently.


Mark: Kevin, for the benefit of new readers, and also to fill in some of the blanks on your background and your interest in frontier markets, give us a refresher.

Kevin: Sure. And thanks again for the opportunity to speak with you and your readers once more.

Kit and I conceived of Pathfinder a little over a year ago in response to an under-served market for true frontier market investment advisory and new venture creation. The idea was further refined during the final days of the Libyan revolution in late 2011. Kit and I met in a hotel lobby while working for different corporate employers, and since we were almost the only Westerners on the ground in those days, we began helping each other out. Ultimately we formed a partnership to begin working in Libya, which has expanded quickly to become Pathfinder in its current form.

The Pathfinder concept came about as the result of two recent experiences. The first was a long-term project on behalf of a private client where I conducted due diligence on potential acquisitions in developing countries. That work proved to me the value of asymmetric information in the marketplace, and how planting one’s “boots on the ground” is critical to the emerging/frontier investment process. I learned many lessons about how a company’s market share and shareholder register are far more indicative of its future success than ‘audited’ financial statements or a slick Powerpoint presentation.

Both of us have extensive military backgrounds (Kit with UK Special Forces, me with the US Army Rangers and, ultimately, diplomatic service with the State Department). We have both served within teams that (unlike most military units) encourage self-sufficiency and independent thought. The operational exposure we acquired has also served us well in our civilian careers, as we have worked on projects in far-flung locales including Nepal, Libya, and South Africa.

Mark: Kevin, as an ex-military guy I’m sure you have a keen feel for these things, so give us a brief on the security situation on the ground in Libya since our last discussion. At that time you mentioned that while walking through the streets of Tripoli you were seeing trucks with anti-aircraft weaponry driving around. What’s it like today?

Kevin: We have been traveling to Libya regularly for the past 18 months and I can definitely say that the security situation has improved since the revolution. Thankfully most of the roadblocks and heavy weapons have disappeared, and we are seeing a (very) gradual infusion of law and order in the country.

That being said, security – especially in the major cities – remains the nascent government’s top priority. Many militia brigades that were formed to fight the regime two years ago have refused to lay down their arms, and have evolved into heavily-armed ‘neighborhood watch groups’. This is clearly unsustainable and they must be either brought into the national security apparatus or forcibly disbanded. The national and local governments are negotiating with different groups to bring them into the central security apparatus. This process takes time, as each group insists on applying maximum leverage for themselves and their tribes.

Most cities, especially Tripoli, remain relatively safe. We are seeing fewer incidents between militias, as the groups seem to have achieved a sort of equilibrium with each other. Confrontations are still common, though; last week an armed group stormed the national parliament in protest of what they felt was insufficient monetary reward for their role in the revolution. Most disputes begin for this reason – one group or another feels that they fought and bled in the armed struggle, and that the government is neither generous nor efficient in dispensing cash.

After the 11 September attacks against the US consulate, the Western media did a very effective job in portraying Benghazi as a post-apocalyptic war zone. What they did not show, however, was the immediate backlash against the Ansar-i-Sharia group that was behind the attack, or the ‘peace rallies’ that were held in the city center in support of the US government. The vast majority of Libyans remember that the US played a critical role in stopping Qaddafi in his tracks as he was driving east toward Benghazi to demolish it in the spring of 2011, and are very grateful for that assistance.

Mark: So, it seems it’s still a bit volatile then? What’s the most likely timeline to “stability”, if you had to hazard a guess? And, do you find that Libyan’s are optimistic and are moving forward?

Kevin: As mentioned earlier, the Libyan government’s critical task is to restore order and rule of law through a stronger central government and well-trained police force. Let’s face it, this is a massive task. Libya was economically devastated by 42 years of corrupt and inefficient government, and it will need to be rebuilt one building and bridge at a time. People who have relied on free handouts from the state for their entire lives are going to have to gradually come to grips with the concepts of a (somewhat) free market and economy. For most Libyans, the next couple of years are going to be every bit as painful as what the average Russian endured in the first half of the 1990s, in the wake of the Soviet Union’s collapse.

As far as a time line to ‘stability’, I suppose it depends on how you define it. I believe that the drafting of a new constitution, which is on track to be completed this year, is a critical step. An even more important event will be parliamentary elections, scheduled to take place in mid-2014. And, as earlier mentioned, the militia brigades need to be either co-opted or disbanded. If these milestones can be achieved within the next two years then we will have seen remarkable progress in a very short time.

Mark: Our colleague Scott wants to chime in a bit Kevin.

Scott: Libya is fraught with “clans”. Given this reality, do you foresee structural disturbances to the development of the country, things like civil war or an insurgency?

Kevin: At present I think that the risks of any kind of organized insurgency or civil war are quite remote. Qaddafi loyalists have for the most part kept quiet, and no one wants to see another strongman come to power. There were some concerns last year that the eastern half of Libya might attempt to secede, but for the most part this was simple rhetoric ahead of elections. My estimate is that you will see some variant of federalism implemented in the new constitution, whereby many regulatory powers are returned to the outlying cities and away from Tripoli where it has been centralized for so long. But overall, Libyans are tired of war and exploitation and quite eager to get on with rebuilding the country.

Scott: Kevin, in frontier economies it is usually the case that people who have the money hold the power. Based on that premise, assuming it holds true in Libya as well, who holds the power there right now?

Kevin: Great question Scott. I still don’t see an individual or group that has established themselves as a clear front-runner at the national level. The current prime minister, Ali Zeidan, seems to have done a fine job of establishing a cabinet after the two miserable failures (both of whom were career academics) that preceded him.

The fact is that Libya, despite its current problems, is a very wealthy country. It has the highest per capita income in the region, and its hydrocarbon output will likely double within three years. Many people were impoverished by the revolution, while others stole from the government amidst the chaos and became staggeringly rich. I don’t believe that we’ll know who the truly wealthy Libyans are until the security situation improves to the point where they feel safe enough to begin demonstrating their affluence. Right now you would have to be insane to drive a Ferrari through the streets of Tripoli, but I can vouch for the fact that there are quite a few parked safely behind locked doors.

Scott: That’s fascinating! What about Russia? They had an interest in Libya during the days of Qaddafi. As the country goes through this transition who are the likely “go to guys”? The Russians again? The Americans? The Chinese? Or, could it be a true international consortium? And, what will drive this decision in your opinion?

Kevin: At present the Libyan political class is strongly supportive of those who helped them during the revolution. Despite what happened in Benghazi, most Libyans are eager to do business with the US, France, Britain and Italy.

The Russian state-owned arms export company lost a good customer when Qaddafi died, and I doubt they’ll achieve their previous level of influence anytime soon. Contrary to what you’re seeing in the rest of Africa, the Chinese have limited influence as well. Neither country voted in favor of the UN resolution to back the Libyan rebels, and they are now paying the price for that lack of support. I doubt that this will hold true indefinitely – the Chinese are the low-cost provider of labor and infrastructure – but for now they are out of favor.

If I had to mention one country that has outpaced all others in expanding their sphere of influence into Libya, I would point to Turkey. The Turks have done an amazing job of promoting their ‘soft power’ in Libya since the war through favorable trade deals, emergency aid, and aggressive support of Turkish business. They are on the ascent in the MENA region and have firm support throughout the Libyan government.

Scott: So as Libya trucks along the path to rebuilding, how does the government go about liberalizing the economy and enhancing the judiciary system to cut down on bureaucracy and corruption?

Kevin: As I mentioned earlier this is a process that will take years. If this new government wants to succeed then it absolutely must succeed in two tasks: it must improve internal security, and prevent civil unrest. The country’s massive hydrocarbon wealth will ensure that they always have enough hard currency to address other priorities.

Throughout the past 40 years Libyans have become accustomed to state largesse and free handouts. They have come to rely on price controls, market manipulation and public sector pensions. You cannot remove these measures immediately; the process of moving labor and capital from the public to the private sector will take a long time.

Mark: Given that backdrop, what kind of progress are you making on the ground with your shared office project?

Kevin: You’re referring to Renaissance Offices, which will be the first provider of serviced offices to foreign companies in post-revolution Libya. It’s taken some time to navigate local laws regarding property rights and foreign ownership, but we finally have a solution and are about to sign our first lease.

We believe that this business is the right model for our first investment in Libya. Even though the situation is improving, Libya remains a difficult place to live and work – especially if you don’t speak Arabic. We believe that expats will pay a premium to anyone who can simplify their experience while working in Libya, which is at the core of what we aim to do. We are seeing a sustained increase in the number of foreign companies entering Libya and the demand for office space is only going to increase as most quality buildings are running occupancy levels near 100%.

We have identified the property where we want to open our first location. Our initial locations will be leased as we don’t believe the time is right to buy in Tripoli; a combination of speculation and money laundering has bid prices to a point where a property crash is inevitable, probably within the next couple of years. That being said, we do intend to obtain funding so that we’ll be in position to acquire some quality assets once the dust settles.

We have commitments for a majority of the required start-up capital so we will proceed as soon as we obtain the relevant local operating license. The process has taken longer than we had originally hoped, but we strongly believe that the additional due diligence and legal safety measures will pay dividends.

Mark: Kevin, you’re also working on a project in the FX market, which we’ve discussed at length. Your focus is frontier markets currencies like the Mongolian Tugrik, the Uruguayan Peso and the like. You also believe, as we do, that the Yen will continue depreciating, which is the currency you plan to use as the “funding” currency. We share your view on the Yen and think that’s a smart move. Give us a brief on the opportunity as you see it in the FX market, as it relates to frontier currencies, and how are you structuring your FX trading strategy to take advantage of events as you see them likely to unfold?

Kevin: We believe that market conditions are right for a fund that focuses on higher-yielding frontier currencies. The G7 countries, which are trapped in a cycle of low growth and anemic consumer spending, are engaged in an ongoing contest to weaken their currencies in order to boost their own exports and GDP growth at the expense of their trading partners. For the individual investor, the result of this currency debasement is the gradual destruction of their dollar, or yen-denominated savings.

Investors are (correctly) concluding that the only way to avoid this trend is through a shift into riskier assets, or into assets not denominated in dollars. The Fed wants investors to shift into US stocks and real estate, thereby forcing liquidity off the sidelines. However it is clear that current price levels for these asset classes are not fundamentally driven, but rise and fall at the Fed’s whim. For verification, just look at the immediate sell-off in the US equity markets whenever a Fed chairman makes a casual reference to rate tightening.

We believe that a better approach is to focus on faster-growing frontier economies with more positive fundamentals. Unlike the US or Japan, there are many countries in our coverage universe that maintain a positive balance of payments and growth rates in excess of inflation. By investing in short-term deposits in those countries, we believe that we can generate higher returns with a lower risk profile than what one can find in supposed ‘investment grade’ fixed income. And, because we’re relatively small and flexible we can take a position in a frontier currency like the tugrik without moving the market – unlike a large asset manager who would have to come in with enormous relative size in order to realize sufficient gains.

As you pointed out, our returns can be magnified if we use the USD or JPY as our base currency. As an example, the Russian ruble appreciated +5% against the dollar last year – and that does not include the nominal +8% yield that we can receive on a term deposit. And, in many of these markets, large depositors can negotiate above-market rates of return.

Mark: What about hedging the downside? Any thoughts on hedging with something like precious metals?

Kevin: Our hedging strategy focuses on duration of term deposits, and diversification into different geographic regions. By only buying short-term securities we minimize volatility and counterparty risk. We also take exposure to a geographically diverse basket of currencies. Therefore the effects of a negative geopolitical event (e.g. a regional financial crisis) won’t be felt equally across our overall portfolio. We prefer to hedge structurally, rather than through purchase/sale of offsetting futures, as that can significantly reduce returns. There are quite a few actively managed FX funds out there that only yield 2-3% after hedging, which calls into question the higher fees that those funds often charge.

You and I have a similar view on the long-term value of precious metals – especially when priced in USD or JPY terms. We intend to include them within our mandate.

Mark: Let’s talk agriculture. Chris and I have a very savvy reader who brought to our attention a streaming agriculture deal he put together in Canada. It was much too large for us to participate in, but we loved the idea and mentioned it to you, and also to Chip Feiss, one of our advisors and friends who lectures on Impact Investing at Harvard’s Kennedy School of Government. Our take was to apply the model to frontier markets, couple it with a social element and structure an investment around the concept. So, in full disclosure to our readers it’s something we are working on with you directly. Give us a brief on the model.

Kevin: Of all the projects in which we are currently engaged, the frontier agriculture fund is the one that has generated the most interest. We are excited at the prospect of rolling it out later this year.

There are three underlying trends behind our investment hypothesis. First and foremost is the ongoing secular bull market in commodities, particularly grains. That market is driving global farmland prices higher; for example, prices in some parts of the US have increased as much as 35% in the past year. This bull market owes much of its momentum to loose central bank monetary policy and wasteful ethanol legislation, but it is also fundamentally driven through increased global demand for food.

Second is the emergence of frontier markets – especially Africa – as agricultural breadbaskets. Many countries are now buying African farmland in order to ensure a reliable supply chain. China, Korea and the GCC are especially aggressive on this front but many others are also doing so.

Finally, we are seeing an increased interest in social and impact investing among both institutional and individual investors. Several funds now include a social/impact mandate, and a few have an exclusive mandate for ‘socially responsible’ investments.

Our vehicle will seek to benefit from all three of these trends. We will provide working capital to farming operations in our target markets, but instead of receiving cash interest payments in return we will negotiate ‘streaming agreements’ that provide us with the right to buy a percentage of the borrower’s grain production at a deep discount. A streaming agreement is effectively a long-dated call option to acquire cash crops. The agreements are structured so that the ‘option’ will always be deep in the money, and the option ‘delta’ increases even further over time as global grain prices continue to rise. The economics also make sense for the farmer, as he receives working capital at a lower cost than he could expect to achieve through a typical lender.

Mark: The streaming model is pretty mainstream in resources, but it’s novel in the world of agriculture. YOu said that the project has generated some interest generally, but what’s the reception been from your pals at the World Bank and the like to the idea?

Kevin: We have briefed our intended strategy to several developmental finance institutions and the reaction has been positive. Farming is a capital-intensive business with inherent risks; aside from the dangers of floods and droughts, the lack of access to financing and insurance can lead to serious difficulties. In certain frontier markets the cost of debt is as high as 20%, which makes our service very compelling to a farmer in need of working capital.

We are in discussions with several international finance institutions to provide our fund with overhead insurance protection. For example, both the US government and the World Bank offer programs that provide political risk insurance for a majority of the invested equity capital in a venture such as ours. In addition to crop insurance, we can maintain a policy that protects us from expropriation, counterparty default, currency risk and force majeure. The application process for these programs is quite robust, though once in hand they can substantially improve our investment case.

Mark: Absolutely. We agree that’s a key to attracting larger pools of capital. Kevin, contract farming is a large component of frontier markets commercial agriculture. Do you intend to participate in funding organizations that need supply for their processing facilities, so as to take a percentage of milling profits for example, OR simply concentrate on delivery of a percentage of the harvest?

Kevin: That is certainly an interesting idea. The large commodity trading houses (e.g. Bunge, Cargill, Dreyfus) have achieved complete vertical integration throughout the food chain. It makes good sense for us to do the same by gaining exposure to ‘downstream’ processes as well, though the streaming model will be our core business.

Another alternative would be to apply the streaming model to other areas of agriculture. Timber, cattle and aquaculture carry similar characteristics as cash crops – they are capital-intensive businesses, and demand for those products will experience similar growth trends in the future.

Mark: So this ag fund will essentially be providing enormous leverage to things like Wheat in countries where cash yields are relatively high due to lower land costs, yet ownership of and management of land is not a risk the fund itself intends on taking, correct? And, do you plan to be funding small holder farmers only, or also commercial growers who already have an operation but need growth capital to expand?

Kevin: Most of our targeted frontier markets prohibit foreign land ownership, or place onerous restrictions on them. Some countries offer long-term leases of up to 99 years, but those frequently include potentially adverse conditions. However, some regions – South America and Central Asia in particular – do offer attractive options for ownership of farmland.

We will include ownership of farmland in our mandate, but we will not operate the land ourselves as we want the farmers to bear that risk. We will seek to acquire land where we see strong rule of law and property rights, and can find acceptable yield levels for cash rental to local operators.

With regard to your question about the type of farmer that we intend to work with, we want to focus on larger farming operations with successful track records and audited financial results. It makes good business sense and, frankly, many insurance underwriters will require it. However, the fund will maintain a strong social/impact mandate and we want to support local economies and job creation to the maximum extent. A percentage of our assets under management will be devoted to the support of smallholder and independent farmers, through the issuance of financing and implementation of local aid programs.

Mark: What about the restrictions on farmers? For example, I know we’ve discussed GMO’s, and not wanting anything to do with them. You also want to focus on sustainability and organics where possible, correct?

Kevin: This is a personal passion for me, and you as well. The negative effects of processed food and GMO are plainly evident and we do not want to devote effort or our investors’ capital toward their continued proliferation. In the US, farmers are faced with a moral dilemma – Monsanto GM crops can produce yields as much as 2x higher than what can be achieved through organic methods. Everyone uses state-of-the-art technologies and techniques here, so the only way to remain competitive is through use of GMO crops. Until consumers begin rejecting GMO crops for health and safety reasons (which unfortunately won’t happen anytime soon) they are here to stay in the US, and increasingly in South America.

We have an opportunity to limit their use in other regions, through education and implementation of farming practices. This is why our fund will put two conditions on anyone to whom we lend capital. First is that they must adhere to non-GM and sustainable farming practices. That means zero tolerance for biotech or gene-altered seeds, and regular sampling for quality control. Second, we will require our borrowers to work with a trained agronomist who will ensure that ‘best practices’ are implemented. We want to help our borrowers achieve substantial yield improvements so that the net costs of our financing are minimal.

Mark: Kevin, it’s great that we agree on the GMO issue. Like you I have a zero tolerance policy for the crap.

So, on to Pathfinder. Tell me the role Pathfinder plays and will continue to play in these businesses that you are involved with or getting involved with. Is there room to expand into other areas or are these the focus, at least for the mid-term?

Kevin: Pathfinder is the umbrella under which these three businesses will operate. We share ownership of the Libyan venture with our local partners, and 100% of the Frontier Agriculture and Frontier FX funds. Everyone who joins the team for either of the two macro funds will be a Pathfinder employee. Likewise, our investors get exposure to all of our ongoing projects, particularly the Agricultural and FX funds.

We are a small firm and expect that these projects will require a significant percentage of our bandwidth in the near term. We are constantly keeping our eyes and ears open for other opportunities though, as we did in the past two months when we structured two mini-funds to participate in ongoing opportunities in Iraq and Mongolia.

Mark: We know you’ve been speaking to investors for a few months now. What kind of reception have you been getting to the concepts you’re focusing on and the planned direction for Pathfinder?

Kevin: The response has been very positive. Most investors agree that the macro fundamentals of each platform are clear and compelling, and that we can introduce measures that will reduce risk to an acceptable level.

Despite the ongoing chaos in the markets, a balanced and diversified portfolio is still the best strategy. Our goal is to become the preferred provider for investment strategies for that last 5% of an investor’s portfolio that is reserved for ‘alternative assets’. We think there is plenty of room in the market for a firm like Pathfinder that focuses exclusively on finding and creating such opportunities.

Mark: Thanks Kevin, great information and useful insights as always!
Kevin and Kit are tried and true boots-on-the-ground investors. We liked Kevin from the first time we spoke to him, and after meeting him that was just reinforced.

In fact, we have worked with Kevin on a couple projects, and plan to work with him long into the future, including with the agriculture and FX projects.

– Mark

“The greatest advances of civilization, whether in architecture or painting, in science and literature, in industry or agriculture, have never come from centralized government.” – Milton Friedman


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