SOPHISTICATED FINANCE

Interview: Emprendedor Universal

A website in Mexico specializing in entrepreneurship, Emprendedor Universal, did an interview with me (in Spanish). Link is here. One of the more thoughtful set of interview questions I have had.

Family Office 2014 Outlook

On Thursday, March 20 I will be speaking at Family Office 2014 Outlook in Miami. As might be expected the conference is for family offices and their investment advisors. I will be speaking on "social impact" investing in Latin America. The pace of solutions to social problems is accelerating as investors and social organizations from outside LATAM enter the market. Also, more private sector groups in LATAM are providing traditional social services. K-12 schooling would be a noteworthy example.

New audience for me but an attractive group to interest in solving social problems outside the U.S.

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New Model to Address Healthcare and Poverty

The Physics arXiv Blog had an interesting story, "Poverty Escape Plan Revealed by Computer Model of Economic Vicious Cycles". Georg Goerg a PhD student at Carnegie Mellon University has developed a model that shows how disease spreads through a country and the resultant effect on that economy. The basic assumptions is that disease debilitates people to the point where they cannot work or they work less days, resulting in less economic output for the country and poorer individuals. As the economy shrinks there are less healthcare resources available, which leads to more sick, poor workers in a vicious downward spiral of less healthcare, less economic output and more poverty.

Goerg's model tested two curative scenarios:

1. A large injection of outside capital
2. "the country increases the proportion of GDP it spends on healthcare, to bootstrap its own way out of the cycle"

Goerg's "conclusion is that increasing the proportion of GDP spent on healthcare cannot release a country from this kind of poverty trap. Indeed, it can do the opposite and trigger a vicious cycle of decline." Effectively, a poor country cannot deal effectively with a health emergency, such as an epidemic, using its own resources. The likely outcome will be a marked decline over a long period in GDP which will reduce healthcare for a long period.

The preferred approach to address healthcare in poor countries, as shown by the model, is to seek out a large amount of foreign capital. Alternatives might include:

1. Development aid
2. Sale of minerals (Saudi Arabia)
3. Sale of future mineral deliveries (Venezuela)
4. Organizing large pools of private capital for "public good" (Israel, Chile)

Regardless of how the pool of capital is put together, it is not necessarily the case that a healthcare program has to be administered by a national government (even if they raised the capital).

 

 

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Bill Gates: Malaria vs Information

The Gates Foundation is commendable for its focus on the "big problems" and the use of more rigorous selection and evaluation criteria for grants. One of Bill Gates' recurring themes is that the founders of Google and Facebook should not be prioritizing Internet access over projects such as a malaria cure. I think Gates is wrong.

As Nobel economist Michael Spence explains in The Next Covergence, poverty is caused by the absence of information. One's net worth is constantly depleted because one lacks the information to price transactions correctly. If information is easily available through the Internet and the recipeient has basic reading skills, then the idividual has the necessary foundation to manage their own life (assuming no discrimination). Information availability is the most challenging ingredient to achieve individual empowerment, but with individual empowerment people can then address their own economic, health and political problems. 

One could argue that if the people die from Malaria, then individual empowerment never has a chance to operate. One could argue that if they don't die from Malaria, the poor could die from Aids, political insurrection or one hundred other causes. 

The scale of the social problems suggests to me that focused approaches such as Gate's malaria research will not make as much of an impact as the Internet-Information approach that lays the groundwork for individual empowerment. Basically, what Gates appears to miss is that education and information availability are the best way to mobilize sufficient people to solve the large social problems.

 

 

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Calculating International Cost of Capital.

Foreign acquisitions have become increasingly popular with the trend toward globalization. Changes in the political environment frequently spur increased acquisitions. For example, the death of Hugo Chavez in Venezuela has spurred increased acquisition activity of Venezuelan companies. Valuations there are depressed due to recent history but the future outlook is better (in the opinion of some).

Everyone learned in introductory finance class that one takes forecasted cash flows and discounts them by the weighted average cost of capital (WACC) to arrive at a valuation. What everyone missed in finance class (because you were texting) is that for foreign acquisitions you use the acquisition's cost of capital and not the acquiror's cost of capital. Sounds pretty simple, until one tries to do a calculation of, for example, WACC in a Venezuelan company. 

The WACC formula (1) is :

 WACC=E/V *Re + D/V *Rd*(1-Tc)

Where:

Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D
E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = corporate tax rate

(1) Investopedia

The problem in using this formula comes in determining the cost of equity (Re). Traditional theory says that one would use the Capital Asset Pricing Model (CAPM), defined as:

Cost of Equity= Rf + Be * (Rm-Rf)

Where:

Rf= Risk free rate

Be= Equity Beta

Rm= Expected return on the equity market 

The problem in this formula is in determining Rm, expected return on the equity market, and Be (equity beta).  Many countries have small publicly traded equity markets or stocks have very small daily or annual trading volumes. Such a shortage of reliable data makes the determination of Rm and Be questionable.

Instead of using CAPM I use the following formula:

Cost of Equity= Rd +(Rmu-Rfu) + (Rfx-Rfu)

Where:

Rd= cost of debt of the acquired company

Rmu= Expected return on the equity market in the U.S.

Rfu= Expected risk free rate in the U.S.

(Rm-Rfu is the premium for equity risk in the U.S.)

Rfx= Expected risk free rate in the country of the acquisition

(Rfx-Rfu is the country risk premium (based on the difference in yield for soveriegn bonds)

The advantage of this formula is that almost every company anywhere in the world has a cost of debt and debt cost is almost always a free market determination. To the cost of debt what the formula does is add the premium for equity in the U.S. plus a country risk premium, which adjusts the U.S. equity premium upward to consider country risk. 

Question: what do you do if the foreign country has no sovereign debt? First I would reconsider the acquisition because the country is very undeveloped and it might be less capital at risk to build a company from scratch. If you still want to do an acquisition, I would use the interest rate of the largest company in the country that has issued public or private debt as a surrogate for sovereign debt (your local banker can tell you this rate). The government should have a lower cost of debt than a private company but this company's cost of debt is an objective number and a bit conservative (which is not a bad thing in a foreign acquisition).

 I have used this cost of equity technique for years. It is not pure theory like CAPM but it use a logic based on theoretical finance (equity is more expensive than debt) to determine cost of equity and it can be used in every country in the world to calculate realistically the WACC.

 

 

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Another Look at ROI

Why I Teach-II

I have written several times on why I teach. My favorite post is "A Proud Professor" about a student that went to Rwanda to work with children.

A former student wrote to me over the weekend. He said his three year old business now had revenues of $xx million and that he thought $100 million in revenue was a realizable goal. That was nice, but what made me feel even better is that he is starting a foundation in his home country of the Dominican Republic to focus on either housing or education.

There are two choices for how to combine entrepreneurship and socially beneficial activities, as explained in this post--"Social Entrepreneurship vs Corporate Social Responsibility". I think either approach is worthwhile and this student has chosen corporate social responsibility. My advice to him on starting the foundation was:

1. Focus on a single social issue
2. Prepare a plan similar to what is done in a for-profit company
3. Plan to partner for additional funding in order to achieve scale

An excellent example of the corporate social responsibility approach is the Zamora Teran Foundation in Nicaragua, which is funded in part by the owners of Banco Lafise.

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China Largest Development Lender in Latin America?

McKinsey Quarterly has a special issue on China with an executuve summary, "Ten Forces Forging China's Future". Section 8, "Financier to the World?", includes an interesting snipet:

"Since 2009, Chinese loans to Latin America have exceeded those of both the Inter-American Development Bank and the World Bank."

The GDAE at Tufts University analyzes gobal development and reports:

• "Since 2005 China has provided loan commitments upwards of $75 billion to Latin American countries."
• "China’s loan commitments of $37 billion in 2010 was more than the World Bank, Inter-American Development Bank, and the United States Export-Import Bank combined for that year."

Loans by country for various lenders including China, as reported by GDAE, are shown below.

(Chinese loans to Venezuela are discussed in this post, "Venezuela Mortgages its Oil to China for $30 billion".

The data from GDAE does not unequivocally document China as the largest development lender in LATAM but it strongly suggests China is. 

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Diaspora Management

I have spent the last two days in Jamaica, including some time at a convention devoted to the 4-5 million Jamaicans that live outside the country. Currently Jamaica has a local population of 2.3 million. The Jamaican Government call this overseas population the Diaspora. The Government went to Israel to study how that country manages their diaspora or overseas population of religious followers. There are even academics who have developed a set of five best practices for diaspora management. They are all so obvious that I will not repeat them.

As near as I can tell, diaspora management is designed to guilt the overseas population into investing in the homeland as a means to foster economic development. Economic development theory has baffled me for years, despite quite a bit of study of the subject. As this previous post on economic development makes clear, the subject is overly complicated and therefore much of the theory appears to have limited applicability.

Diaspora management appears to me to be another part of economic development theory that is overly complicated. If you want to attract foreign investment, regardless of the source, you need to satisfy four conditions:

1. Free movement of capital across borders
2. A legal system that protects investor rights at the level of developed countries
3. An economic performance that has sufficient stability and growth to attract investors 
4. Market rates of return for the perceived level of risk that are attractive compared to alternative investments (in other countries)

Jamaica is making progress on the necessary conditions outlined above. Personally I think diaspora management is a distraction that will have limited effect on economic development. Increased efforts to build an economy that attracts more foreign investors would be my strategy for Jamaica.

Areas that look particularly attractive to me for investment in Jamaica are agriculture and alternative energy, which are also key industries in the government twenty year plan (in addition to tourism and logistics). Interestingly, Jamaica is trying to build an enormous transhipping facility to take advantage of the expanded Panama Canal in 2014. Project is in the early stages but foreign investors are showing interest. Miami beware!!

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Carao Ventures--Central America VC

I met Adrian Garcia several years ago when he worked at MesoAmerica, perhaps the first venture capital firm in Central America. I would also point out that Adrian is a graduate of the MIT Sloan School, so we have some other shared interests.

Recently Adrian and a partner, Allan Boruchowitz, founded Carao Ventures, a venture capital firm that specializes in early stage tech companies targeting the Latin American market. What differentiates Carao from most VCs is their approach, which I quote below:

"Carao Ventures has an early stage startup program where one of our partners takes an active role in the startup through the next stage of company development, participating in relevant roles such as strategy, finance, marketing and others."

Carao is headquartered in San Jose, Costa Rica. 

Pipeline Brickell--Miami Accelerator Meets Shared Workspace

Jerry Haar, the Director of the Pino Entrepreneurship Center at FIU (where I am on the Board), introduced me to Todd Oretsky, the Founder of Pipeline Brickell. Pipeline Brickell is a somewhat unique concept which combines shared space with mentorship and access to capital for startups and early stage companies. What makes the concept different is that mature high tech companies, such as Google, and services providers, such as IP attornies, also use the space. Looking for an expert on an issue, the answer may be just down the hall. 

Pipeline Brickell has as well thought out office space as I have seen anywhere...in the world and beautifully done. Definitely designed for collaboration and creativity. Perhaps not surprising given that Oretsky came from the world class law firm of Skadden Arps. Oretsky plans to expand Pipeline to cities in Latin America and to link networking opportunities across multiple cities.

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FIU's AVCC announces presenting companies

The Next Silicon Valley

My friend Mariana (@Yaquesita) is one of the best sources of excellent articles and blog posts I don't find myself. She covers a wide range of subjects, including education, gadgets, tech, entrepreneurship and all things Mexico to name a few subjects. She is well worth a follow on Twitter. Today she sent me a post “Can our country be the next Silicon Valley?” from Tech Crunch.

The article lists six factors to duplicate Silicon Valley, which are:

1. Market
2. Capital
3. People
4. Culture
5. Infrastructure
6. Regulations

I think this list misses the point. To foster great entrepreneurship requires three factors:

1. Available capital to finance early stage companies
2. Great universities, such as Stanford and Cal Tech
3. A culture of business people (this is a difficult point to explain at the risk of being discriminatory, but certain groups have thousand year cultures of doing business)

You also need a regulatory environment sufficiently permissive to allow individual empowerment. Not a full fledged democracy, but a certain permissiveness that allows business formation.

In many countries the biggest challenge is the lack of great universities (Latin America). In an equally large number of countries there is no long standing culture involved in business (perhaps much of Africa). Everywhere access to early stage capital is an issue, even in Europe.

If we reduce the scope of the analysis to regions like Silicon Valley or cities, the possible centers of entrepreneurship are reduced further. For example, in Asia there may be only 5-6 cities that have a great university devoted to technology, but 4-5 of these lack multiple sources of organized capital for early stage companies.

Re-creating Silicon Valley is not impossible, but I would start by attracting a great technology oriented university to the area. Two would be better as Silicon Valley shows with Stanford and Cal Tech. Also, note that Boston has both MIT and Harvard.

My last article on this theme is here.

Smart Cities--Smart People?

The "smart city" project is designed to introduce better, more environmentally friendly technology into larger urban areas to improve the overall quality of life. Much of the early work was done in Europe but now the movement is spreading to lesser developed areas including Latin America. This story from Co.EXIST, "Filling South America With Smart Cities", highlights a project in Santiago, Chile.

I think the "smart city" project is a great idea particulalrly given the dramatic growth in urban population. Free ubiquitous Internet access, solar powered everything and better mass transportation all sound attractive. I have only one question? Where are the smart people who will inhabit the the smart city? Without equal emphasis on improving education for the poor and disenfranchised, smart cities will only further exacerbate the class discrimination so prevalent in Latin America and other parts of the world.

Previous thoughts on urbanization are here, here, here, and here.

Image credit: faculty.fairfield.edu

Update on Latin America Economic Performance

The Center for Hemispheric Policy at the University of Miami has released a new research paper, "Latin America in the Age of Globalization: A Follower or a Force of its Own?” Key findings from the paper include:

- Average annual growth in GDP in LATAM trailed the world average in the period 1998 to 2008 but surpassed world averages in the period 2009-2011 on the back of strong commodity prices.
- The ratio of exports to GDP is growing faster in Latin America than in any other part of the world in part due to new trading partners in China and India.
- in 2011 foreign direct investment amounted to US$ 150 billion, a 31% increase over 2010.
- Latin America continues to have the highest Gini coefficient, which measures the concentration of wealth, with a coefficient of 50%; 30.4% of Latin America's population is poor or indigent.
- Total factor productivity has shown little improvement in the last 40 years in Latin America, while countries such as Korea, Malaysia and Thailand have demonstrated marked improvement in productivity.

The paper concludes:
"If Latin America does not change its policies substantially, the prospects for the region to remain a relevant partner in an increasingly integrated world would be poor. Latin America may grow by the current rate on a per-capita basis, possibly in the order of 2 1⁄2 percent a year, but the world will be growing faster. Latin America’s income may stay at a constant ratio to advanced countries, with Mexico and Brazil possibly posting growth rates close to that of the United States, but this performance means that Latin America may slowly loose global relevance, especially in comparison to East and South Asia."

Wednesday I will be speaking at a conference in Lima on ICT. My themes will be education and social inclusion in the digital era. A timely speech given this research report.

Full report is at: https://www6.miami.edu/hemispheric-policy/Task_Force_Papers/Loser-GlobalizationTaskForce.pdf

Education and Social Inclusion

The quote below by Richard Wolin in the May 21, 2012 issue of The Nation explains the relationship between education and social inclusion.

"For the first time, men and women of diverse social backgrounds were afforded the opportunity to cultivate the knowledge and self-understanding necessary to surmount the oppressive constraints of class, race and gender."

The reference is to the GI Bill that paid for WWII veterans to attend college in the U.S.

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The Economist Wrong About OLPC in Peru

In a recent article The Economist magazine reviewed the results of an Inter-American Development Bank report on the OLPC project in Peru. While known for its insightful writing, in this case The Economist missed the point. While correctly pointing out that math and language skills showed no noticeable improvement after the children started using their XO laptop, The Economist missed the most important point. In Peru children showed a marked improvement in cognitive skills.

Cognitive skills are important as evidenced by their inclusion in the international PISA tests, which are the bench mark for measuring educational effectiveness worldwide. PISA describes cognitive skills in their 2003 Evaluation Framework as follows:

"Problem solving is an individual's capacity to use cognitive processes to confront and resolve real, cross-disciplinary situations where the solution path is not immediately obvious and where the literacy domains or curricular areas that might be applicable are not within a single domain of mathematics, science or reading." 

Cognitive skills are the higher order skills required to properly process information, evaluate the information in terms of critical thinking and draw original, creative conclusions. While math and language skills may have been of paramount importance in the industrial age, many commentators have identified cognitive skills as critical for success in the digital age of the 21st century.

The 21st century will be a period of individual empowerment with much less reliance on corporate infrastructures and other traditional institutions. The successful individuals will be masters of creating original content, packaging it in multiple forms and marketing it globally. While traditional industries such as agriculture and manufacturing will still make a significant contribution to the world economy, the new opportunities from the digital age will make an increasing economic contribution. However, this contribution is much more likely to come at the individual level rather than through institutions.

Perhaps The Economist needs to update its business model for the 21st century. Then, perhaps The Economist will realize the really meaningful results from the increase in the cognitive skills of the children in Peru. As OLPC is always quick to point out, the children do not need to learn computing but rather learn through the computer. The children of Peru in their environment of limited resources and undertrained teachers have learned the most important skills--cognitive skills. Now we just need for The Economist to recognize it. 

 

Brazil Auto Industry-Troubling Signals

Image via Wikipedia

Brazil is now the sixth largest economy in the world. Brazil is enjoying an economic boom, in part due to the reasons discussed in this presentation. The prosperity is flowing down to the middle class. AP reports that Brazilian tourists spent $5.9 billion in the U.S. in 2010. Many would say that the Brazilians, bolstered by a strong currency, saved the retail industry in Miami the last 2-3 years.

Despite the wide reaching economic prosperity in Brazil, there is one area that concerns me. Imports to Brazil have always been tightly controlled in order to protect local industries. This strategy may have been effective when Brazil was a struggling third world country, but today Brazil is emerging as an economic powerhouse with international political aspirations. 

Latin Business News reports that Brazil has requested that Mexico reduce auto exports to Brazil by 33% or $1.4 billion this year. If Brazil is going to aspire to a position of international leadership, it should be fostering more trade in LATAM. Such an approach to trade would increase its political clout.

If Brazil were to expand its political influence, especially in LATAM, such an approach would force the U.S. to pay more attention to LATAM. More attention from the U.S. would theoretically foster greater economic development in LATAM and benefit Brazilian exports.

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Coffee Substituted for Coca Production

Time reports that Bolivian coca growers are switching to coffee, helped in part by a US AID program. As pointed out in the article, for poor farmers it is simply an economic decision. Coffee is a more valuable crop than coca when coffee prices exceed about $3 per pound. Coffee prices have been rising steadily since 2003, as shown in the chart below. 

Source: Wolfram Alpha

U.S. Latin America Cancer Plot

Venezuelan President Hugo Chavez is speculating that the U.S. has developed the technology to cause cancer in leftist leaders in Latin America, according to this article from the BBC. The most recent head of state to suffer from cancer is President Cristina Kirchner of Argentina, who underwent emergency surgery recently for thyroid cancer. Chavez went through chemotherapy for an undisclosed cancer earlier this year.

While Chavez is renown for his baseless speculations, a negative view by the U.S. government of leftist governments in LATAM is widely believed in the southern hemisphere. Given the strategic importance of LATAM to the U.S. as a market for exports and as a source of natural resources, perhaps it is time for the U.S. to give a priority to better relations with the countries of LATAM regardless of where they lie on the political spectrum.

The election successes of leftist governments across Latin America is a trend that will not be reversed for a long time. As long as Gini coefficients remain high, oligarchies control the economies and indigenous peoples are discriminated against, populous, leftist governments will continue to have electoral success.

This story was inspired by a story in Latin Business Chronicle, which provides an excellent daily English language summary of LATAM events. Unfortunately, I cannot find a link to the email subscription I receive.

 

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Startup Fund Abandons Chile

Arnon Kohavi, an Israeli venture capitlist, tried to start a venture fund in Chile according to this story in TNW. After six months he pulled out. His reasons, as reported in TNW, are below:

"I took off because it will take longer for Chile to reach the tipping point. Good will from the government and a few people isn’t enough to re-create what places like Silicon Valley, Israel and Finland have.

The heart of the problem is Chile’s dramatic generation gap, between young entrepreneurs and the old generation. The Chilean society is less dynamic than Asia or the US; a handful of monopolistic families control the country, and won’t move.

Worse, these families don’t care about anything (the young, the poor…) besides their money. They don’t have to: the country’s natural resources (copper, etc.) are a disadvantage here, because it means the rich don’t need to work hard. The Asian model is better, because it focuses on exporting manufactured goods.

Chilean family offices may still give money to Endeavor, but for them it’s not about entrepreneurship – it’s just a way to brush their ego, and they only do it because it is all conducted in Spanish.

I know people were disappointed when I left, and the Chilean government would have supported my fund, but I also wanted a commitment from the elite, and it didn’t happen. Yet, I’d be happy to come back and do business when the country is ready."

I suspect the same result would have happened in ten other countries in LATAM. Organized and supported entrepreneurship struggles in most of LATAM with the exception of Brazil. I am working with a group to organize a high tech entrepreneurship center in Colombia that is supported by the private sector, municipal and state government and local universities. With such widespread support maybe we will do better.

Venezuela Mortgages its Oil to China for $30 billion

The LA Times reports today that Venezuela has arranged a new loan for $4 billion from China, secured by future deliveries of oil. Loans of this type with China now total $30 billion. A few observations:

1. With future oil revenues already spent, Venezuela post-Chavez will have few resources to rebuild the country and the economy. 
2. Natural resources will increasingly become the point of friction between the U.S. and China as China increases its sourcing in the western hemisphere
3. The U.S. needs a much more active policy of engagement with LATAM in order to shore up natural resource supply from the locally popular, left leaning governments in Brazil, Peru, etc.