November 15, 2011 10:32 am

Mongolia dealmakers see strong pipeline

This article is provided to FT.com readers by mergermarket—a news service focused on providing actionable, origination intelligence to M&A professionals. www.mergermarket.com
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Dealmakers operating in Mongolia will find many companies looking for funding but face hurdles such as little understanding of valuation metrics and overly optimistic growth projections, industry practitioners told mergermarket.

As acquisition activity heats up in the country, structuring deals using earn-outs and other performance payments can help bridge the wide gaps between how buyers and sellers value a business, panelists said at “Mongolia: New Frontiers in M&A and Private Equity,” a mergermarket forum held in Ulaanbaatar on 8 November.

“One of the biggest challenges we’re facing is the seller mentality and educating the seller on the very basics of corporate finance and M&A transactions,” said Bold Baatar, a former JPMorgan banker who chairs the country’s stock exchange.

There is no lack of deals in Mongolia, as many businesses are looking for cash, said Mongolia Opportunities Partners managing director Mandar Jayawant. However, there is “very little precedent” in Mongolia on how to structure deals, what role a private-equity investor plays in a business and how businesses are valued, he said. In addition, some business owners have “quite unrealistic expectations of valuation,” Jayawant said.

“Every day, a couple of deals come across our desk, but a lot of them are really more appropriately suited to credit financing,” he said.

Matters are made worse by business owners’ familiarity with the model of local valuation companies, who value a company’s hard assets ahead of a domestic stock-market listing, Jayawant said. Private-equity investors care about management’s ability to generate cash flow, rather than the value of the land a company’s factory sits on, he said.

Private-equity investments in Mongolia are mostly growth equity, where investors want the company owner to remain with the business, rather than the later-stage private-equity in the West that is heavily debt-financed, Bold said.

“You don’t have financial engineering to get your IRRs, which means you don’t have a lot of room for mistakes,” Bold said, referring to how investors measure internal rates of return. “If you do ten deals and one goes sour, that could wipe out all your IRRs.”

When doing deals in Mongolia, investors need to look at not just the value of the business but how much value the business owner himself adds, Bold said. Private-equity investments in the country can be staged in tranches to prevent the business owner from cashing out and leaving, allowing more money to be committed as various milestones are met, said Mark Lehmkuhler, a Hong Kong-based partner at Davis Polk & Wardwell.

Structures like earn-out payments and ratchets can be useful in acquisitions in Mongolia to bridge the wide gaps between how buyers and sellers value a business, Lehmkuhler said.

“For mining assets, the buyer and seller could disagree about all sorts of things,” he said. They might disagree on the amount of resources in the ground, how much can be extracted at a certain cost, the future price of the commodity and the availability of infrastructure around the mine, Lehmkuhler said.

When Malaysian tycoon Robert Kuok sold QGX Coal to Mongolian Mining Corp. [975:HK], the transaction involved an initial up-front payment of USD 464m. However, the total deal size can be adjusted up or down, possibly rising as high as USD 950m, depending on changes to the coal reserves and mine life.

“Earn-out structures…allowed both the buyer and seller to get comfortable and proceed with the transaction,” said Douglas Farrell, Citigroup’s director of mergers and acquisitions for Asia Pacific. Citigroup advised Mongolian Mining Corp. on the deal. “It may not necessarily be unexpected or a bad thing if initially there isn’t a meeting of minds between the buyer and seller.”

Jayawant said his fund often uses ratchets as it invests based on forward cash-flow projections. Ratchets allow a private-equity investor to lower their investment cost down if the target company later raises more funds at a lower cost.

“There’s likely to be a large divergence between what management thinks they’re able to achieve and what we think is realistic,” Jayawant said. “If certain numbers are met, we have no problem giving up value to the owners, but we also have to protect our downside.”

Most of the investment interest in Mongolia is coming from strategic investors like Japanese and Korean companies, rather than investment funds out of New York or London, Jayawant said. Sovereign-wealth funds China Investment Corp. and Temasek have invested hundreds of millions of dollars in coking coal producer SouthGobi Resources [SGQ:CN] and Lung Ming, which owns the Eruu Gol iron ore mine.

The Mongolia Opportunities Fund, which bills itself as the country’s first private-equity fund, targets an “underfunded niche” of USD 5-10m deals, Jayawant said. The fund focuses on mining services and infrastructure, and will opportunistically look at investments in financial services and export industries. It aims to grow companies to a size where they could be sold later to larger investors like CIC and Temasek, he said.

Ultimately, dealmakers need to help explain the value of mergers and acquisitions to a country that can be skeptical of them, Lehmkuhler said. Members of the Mongolian parliament have recently sought to renegotiate the investment agreement with Ivanhoe [IVN:CN] over its giant Oyu Tolgoi copper-gold mine, saying they want to return resources wealth to the people.

“Having an active M&A market means that investors who want to come in here know there’s an exit…beyond just running a mine for 30 years,” Lehmkuhler said. “There are all sorts of possible sources of capital that can come into a country that aren’t going to come in on a greenfield basis…but they will come in and buy a company that has reached a certain stage.”

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