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A blog about economics in the South Caucasus.

Fresh Capital for the Georgian Economy

Last year, Prime Minister Bidzina Ivanishvili announced his plans to set up a so-called co-investment fund. It took a year for this idea to mature, but finally a group of financially potent investors endowed the fund with 6 billion dollar. 15 % of the capital is provided by Bidzina Ivanishvili himself, the remaining 85% are held by the Abu Dhabi Group, the Ras Al Khaimah Investment Authority (both United Arab Emirates), Milestone International Holding from China, Mr. Alexander Moshkevich from Kazakhstan, capital of the late Badri Patarkatsishvili, Batumi Industrial Holdings (a daughter of KazTransOil), Chalik Holdings from Turkey, and the State Oil Fund of Azerbaijan (not SOCAR but SOFAR). The fund is registered offshore; it intends to attract further capital from other sources and primarily invest it in Georgia.


WHY FORMING AN INVESTMENT FUND?

Forming a fund instead of investing individually yields the benefit of sharing the costs of large projects among multiple investors. Likewise, the risks associated with such projects are pooled. In this way, promising projects that are too large to be carried out by individual investors become feasible. And investing in a greater number of projects than would be realizable by individual investors makes the overall portfolio return more predictable.

In addition, investing capital yields economies of scale. Most of the expenditures associated with operating a fund are essentially fixed costs: they do not depend on how much money is accumulated. The fund management can administer 1 billion dollars or 10 billion dollars, but the cost of managing remains roughly the same. Also the cost of detecting and analyzing profitable investment opportunities is not proportional to the amount of money concentrated in the fund. Hence, the more money is in a fund, the lower is the percentage that needs to be spent for its management.

The Georgian Co-Investment fund is interested to engage in the energy, manufacturing, tourism, agriculture and logistics sectors.  The fund will provide between 25% and 75% of the capital of projects that must have a volume of at least 5 million dollar.

As opposed to a standard investment fund, a co-investment fund does not finance 100% of an investment project. This reduces the risk to the fund investors for two reasons. Firstly, the party providing the remaining percentage of capital also has to be convinced that the project is profitable – hence, there is a lower risk of the fund management investing into a faulty project. Secondly, the other investors may sometimes be better acquainted with the project at hand. For example, there may be a company with substantial growth potential and some capital, yet not enough to carry out the necessary investments. The company may know its potential better than anybody else, and if it is willing to engage with at least 25% in the project, this indicates that it really believes in its potential.


UNINFORMED CRITICISM

Soon after the fund was presented, a plethora of criticism was expressed, some of which revealed startling economic ignorance.

Some politicians claimed that the new fund was not needed because the old government had already established the Partnership Fund in 2012. This is argument is mistaken, as the Co-Investment Fund and the Partnership Fund have little more in common than the word “Fund” in their names.

The Partnership Fund owns the Georgian Oil and Gas Corporation, the Electricity System Commercial Operator, the Georgian State Electro System, 25% of Telasi, and other government-owned shares. The Partnership Fund is entirely owned by the government, and so it is essentially a device of the Georgian government to organize its commercial activities.

Therefore, the claim that the Co-Investment Fund “plagiarized” from the Partnership Fund, as expressed in parliament, is pointless. Even if the web pages of both funds look similar, the Co-Investment Fund pursues an entirely different goal than the Partnership Fund. The first was set up to invest the money of its private owners and aims to generate private profits. The latter bundles the commercial economic activities of the government and thus serves public interests.

Other questions that came up in the media missed the point. For example, it was asked why the new fund was needed if the Partnership Fund already existed. The answer is that the two funds are economically completely different entities, and economically they are no substitutes for each other. Likewise, it was asked why the Co-Investment Fund was registered on the Cayman Islands, and why it had its particular objectives. The simple answer is that the owners of the fund decided to do so and that this decision was not illegal. Private business activities must be legal but do not need to comply with expectations and opinions of the general public.


HOPES AND CONCERNS

Clearly, the new fund may fuel economic activities in sectors that are in dire need of capital, in particular projects that are considered to be too big or too risky by commercial banks. Georgian banks, often slammed for high lending interest rates and what is perceived to be excessive risk aversion, will be exposed to healthy competition.

As the initiator of the Co-Investment Fund happens to be the Prime Minister of Georgia, the only serious reservation one may have against this initiative is the conflict of interest that may arise if a leading politician is so heavily engaged in the economy of his country. Bidzina Ivanishvili announced to step down from his office soon, yet there is no question that he will remain an influential person in Georgian politics. This will give him substantial lobbying power that could be used for the projects in which the fund invests.

However, in economics we learn that everything has a price. And also fresh capital does not come for free.

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Guest - NP on Friday, 01 November 2013 15:44

Very interesting topic. And very appropriate conclusion.
Having a sudden access to capital (and especially this much capital) is not always as good as it seems at first sight.
First of all, having too much capital around (compared to the investment opportunities available) can be bad. This is actually one of the consideration that makes some very big actors on the financial markets limit the possibility to subscribe to a given fund once it starts becoming "too big". While it is true that there are fixed costs whose incidence decrease the larger the amount of administered funds is, it is also true that having a lot of money managed by a few people in a small market can create problems. First of all, it is not clear how many opportunities for large profitable investments are available in the country. Selecting (or even finding) them will be difficult. Pressure to "deliver" and to put the available resources in motion as fast as possible might increase the possibility of problems.
After all also fund managers can make wrong choices, especially if they are supposed to "perform" and there is a lot of money they have to allocate while the amount of available (profitable) investment is limited. More managers managing smaller amounts might be less likely to do the same mistakes and more likely to identify smaller and maybe even more profitable initiatives.
Even without making formal mistakes, a fund like the one created is going to evaluate the available investment opportunities from a "private" perspective, therefore excluding social/environmental (and more generally, non monetary) considerations. Also in this case one might expect strong lobbying in favor of profitable initiatives despite potentially high social costs.
In all these cases managers might want to try making things go in a way that does coincide with public interests, using the "share size" of the financial resources they have to affect the market in which they operate.
Even without ex-ante political connections and the potential conflict of interests that have been mentioned, a fund whose capital is about 1/3 of a country's GDP can have a huge impact and push things in the direction its managers and/or shareholders want. This can skew dramatically the path a country takes, both economically and socially and can turn out to have huge long run costs.

Free markets, competitive markets, are nice concepts but someone (public authorities) need to have the strenght and the means to make sure the playing field is and remains leveled and the social interest is always taken into account. This should be one of the main concerns of the Georgian government. Will it be?

Very interesting topic. And very appropriate conclusion. Having a sudden access to capital (and especially this much capital) is not always as good as it seems at first sight. First of all, having too much capital around (compared to the investment opportunities available) can be bad. This is actually one of the consideration that makes some very big actors on the financial markets limit the possibility to subscribe to a given fund once it starts becoming "too big". While it is true that there are fixed costs whose incidence decrease the larger the amount of administered funds is, it is also true that having a lot of money managed by a few people in a small market can create problems. First of all, it is not clear how many opportunities for large profitable investments are available in the country. Selecting (or even finding) them will be difficult. Pressure to "deliver" and to put the available resources in motion as fast as possible might increase the possibility of problems. After all also fund managers can make wrong choices, especially if they are supposed to "perform" and there is a lot of money they have to allocate while the amount of available (profitable) investment is limited. More managers managing smaller amounts might be less likely to do the same mistakes and more likely to identify smaller and maybe even more profitable initiatives. Even without making formal mistakes, a fund like the one created is going to evaluate the available investment opportunities from a "private" perspective, therefore excluding social/environmental (and more generally, non monetary) considerations. Also in this case one might expect strong lobbying in favor of profitable initiatives despite potentially high social costs. In all these cases managers might want to try making things go in a way that does coincide with public interests, using the "share size" of the financial resources they have to affect the market in which they operate. Even without ex-ante political connections and the potential conflict of interests that have been mentioned, a fund whose capital is about 1/3 of a country's GDP can have a huge impact and push things in the direction its managers and/or shareholders want. This can skew dramatically the path a country takes, both economically and socially and can turn out to have huge long run costs. Free markets, competitive markets, are nice concepts but someone (public authorities) need to have the strenght and the means to make sure the playing field is and remains leveled and the social interest is always taken into account. This should be one of the main concerns of the Georgian government. Will it be?
Guest - NP on Friday, 01 November 2013 15:47

"In all these cases managers might want to try making things go in a way that does NOT coincide with public interests, using the “share size” of the financial resources they have to affect the market in which they operate" [EDIT]

"In all these cases managers might want to try making things go in a way that does NOT coincide with public interests, using the “share size” of the financial resources they have to affect the market in which they operate" [EDIT]
Guest - Till on Friday, 01 November 2013 17:03

I think you can tell a lot about a country's political economy just by looking at the kind of investors it attracts. For example, Mr. Alexander Moshkevich has a stake in mining operations in the Democratic Republic of Congo. Few respectable investors would even contemplate touching down in that country, because few want to get their hands that dirty.
Let's be very clear that this group of investors (apart maybe from BI himself) has no commitment whatsoever to conducting "clean" business in Georgia - politically, socially or environmentally.
Whether Georgia should welcome these kind of investors deserves debate. If I was a respectable Western investor contemplating getting into Georgia on a big scale, I'd take one look at these future peers and competitors and run a mile. You'd never lose a deal without suspecting foul play.

I think you can tell a lot about a country's political economy just by looking at the kind of investors it attracts. For example, Mr. Alexander Moshkevich has a stake in mining operations in the Democratic Republic of Congo. Few respectable investors would even contemplate touching down in that country, because few want to get their hands that dirty. Let's be very clear that this group of investors (apart maybe from BI himself) has no commitment whatsoever to conducting "clean" business in Georgia - politically, socially or environmentally. Whether Georgia should welcome these kind of investors deserves debate. If I was a respectable Western investor contemplating getting into Georgia on a big scale, I'd take one look at these future peers and competitors and run a mile. You'd never lose a deal without suspecting foul play.
Guest - Eric Livny on Saturday, 02 November 2013 13:01

there are no free lunches, Till

there are no free lunches, Till
Guest - NP on Saturday, 02 November 2013 16:33

Unless you are BOTH the one who decides the rules of the game AND one of the players :)

Unless you are BOTH the one who decides the rules of the game AND one of the players :)
Guest - Simon Appleby on Saturday, 02 November 2013 14:41

While economies of scale in fund management would appear to be logical, in practice PE fund managers charge a percentage of funds under management plus a percentage of carry. The investors in the fund do not benefit from those economies of scale, only the fund manager. For example, many emerging markets PE funds based in Hong Kong charge 2% of funds under management p.a. plus 20% of profits, regardless of whether the fund has $500 million or $10 billion under management.

I understand that most of Partnership Fund's disbursements have been in the form of debt rather than equity (or as convertible bonds), which is useful for expansion of long-established companies but somewhat risky for startups. It remains to be seen as to what instruments Co-Investment Fund will favour.

While economies of scale in fund management would appear to be logical, in practice PE fund managers charge a percentage of funds under management plus a percentage of carry. The investors in the fund do not benefit from those economies of scale, only the fund manager. For example, many emerging markets PE funds based in Hong Kong charge 2% of funds under management p.a. plus 20% of profits, regardless of whether the fund has $500 million or $10 billion under management. I understand that most of Partnership Fund's disbursements have been in the form of debt rather than equity (or as convertible bonds), which is useful for expansion of long-established companies but somewhat risky for startups. It remains to be seen as to what instruments Co-Investment Fund will favour.
Guest - Simon Appleby on Sunday, 03 November 2013 19:54

Georgia is not really in a position to make investors welcome or unwelcome based upon their perceived "virtue" or otherwise. Certainly some investors have high moral principles and others do not, but a self-interested desire to generate return on capital unites all investors, from which societal benefits accrue. As a shrewd Scottish student of human nature observed, "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."

The only realistic way of dealing with the baser tendencies of some investors is for a simple, transparent regulatory apparatus to keep egregious offences against worker safety, environmental damage and perversion of government process in check. Oddly enough, some of the worst corporate offenders in hopelessly corrupted jurisdictions actually develop into relatively good corporate citizens in countries with better governance.

Georgia is not really in a position to make investors welcome or unwelcome based upon their perceived "virtue" or otherwise. Certainly some investors have high moral principles and others do not, but a self-interested desire to generate return on capital unites all investors, from which societal benefits accrue. As a shrewd Scottish student of human nature observed, "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest." The only realistic way of dealing with the baser tendencies of some investors is for a simple, transparent regulatory apparatus to keep egregious offences against worker safety, environmental damage and perversion of government process in check. Oddly enough, some of the worst corporate offenders in hopelessly corrupted jurisdictions actually develop into relatively good corporate citizens in countries with better governance.
Guest - Florian Biermann on Monday, 04 November 2013 12:56

There are economies of scale in fund management, but they are not forwarded to the investors. This is one of the reasons why actively managed funds on average are doing much worse than market indices. One of the big paradoxes of financial markets: investors pay money for a service (active fund management) that is detrimental to their returns!

With Bidzina's Co-Investment fund, however, this problem won't come up. He and the few other investors can dictate the compensation rules for the managers, and they can set the right incentives to their managers.

There are economies of scale in fund management, but they are not forwarded to the investors. This is one of the reasons why actively managed funds on average are doing much worse than market indices. One of the big paradoxes of financial markets: investors pay money for a service (active fund management) that is detrimental to their returns! With Bidzina's Co-Investment fund, however, this problem won't come up. He and the few other investors can dictate the compensation rules for the managers, and they can set the right incentives to their managers.
Guest - Simon Appleby on Monday, 04 November 2013 19:16

If the managers in question are talented enough to manage $6 billion in a risky emerging market, and have a strong track record of meeting target returns consistently, then surely they must have a conga-line of prospective employers or partners from the international financial sector courting them with offers of very high incentives as well as substantial base fees. GCF would have to match such offers or lose the managers; talented fund managers are notoriously mobile.

If the managers in question are talented enough to manage $6 billion in a risky emerging market, and have a strong track record of meeting target returns consistently, then surely they must have a conga-line of prospective employers or partners from the international financial sector courting them with offers of very high incentives as well as substantial base fees. GCF would have to match such offers or lose the managers; talented fund managers are notoriously mobile.
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