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       *Columbia FDI Perspectives*
Perspectives on topical foreign direct investment issues by
the Vale Columbia Center on Sustainable International Investment
No. 111   December 23, 2013
Editor-in-Chief: Karl P. Sauvant ([log in to unmask])
Managing Editor: Shawn Lim ([log in to unmask])
       *Minority rules:  State ownership and foreign direct investment risk
mitigation strategy*<http://columbia.us6.list-manage.com/track/click?u=ab15cc1d53&id=9628d8fbec&e=5eb397be70>
by
Barclay E. James and Paul M. Vaaler* <#1433623f69b5598e__edn1>

Business researchers, executives and regulators may assume that state
ownership in firms raises risk for private co-investors. After all, private
investors are seeking profits while states are seeking welfare. Giving them
both equity only confuses the aims of an investment project, complicates
the job of investment project managers and raises the overall risk of
investment project failure. But these assumptions do not fit the evidence
as demonstrated by a well-known risk indicator observable in hundreds of
investment projects located in dozens of countries: in countries where
initial investment terms are more vulnerable to renegotiation by host
country governments, we found that “minority rules” apply whereby a
non-controlling, but still substantial equity investment by a host country
government can play a risk-mitigating role.

One of the oldest political risks facing foreign (and domestic) private
investors is that initial, often quite favorable, terms for long-term
investment projects in mining, manufacturing and power generation
industries can be unilaterally upended by host country governments. A
government official may decide that initial terms setting low tax rates on
project profits were too generous, or that local hiring targets were too
low. In demanding renegotiation, host country governments have an
advantage. Private investors often have substantial plant, property and
equipment vulnerable to hold-up, maybe even outright expropriation, if
demands are not met.

In response, private investors should consider enlisting the host country
government as a minority co-investor, but only where the broader risk of an
investment policy change is substantial. Our contingent recommendation
follows from analysis of more than 900 project finance-based foreign direct
investment (“project”) deals announced in 53 countries from 1990-2006.
These were typically not previously state-owned enterprises undergoing
privatization; rather, they were more likely new, greenfield projects like
Acciona’s wind farm project in Mexico, dubbed the 2012 Deal of the
Year by *Project
Finance Magazine*, or Enron’s Dabhol power project disaster in India during
the 1990s. In the Acciona and Enron examples and others, project capital
structure provides a window on project risk. Where there was more equity as
a percentage of overall capital funding a project, we inferred more project
risk in the near term. That is because project creditors, large commercial
banks such as Barclays, Citibank and the Bank of Tokyo, usually lend less
to projects more vulnerable to near-term failure.

In the projects we reviewed, equity as a percentage of overall capital
tended to increase for projects announced in countries given to sudden
policy changes. Increasing project risk with increasing policy instability
was interesting. Perhaps more interesting was the contingent
risk-mitigating role of state ownership we observed. Project equity as a
percentage of overall capital and, thus, project risk *decreased* in
countries with low policy stability, but *only* when the government entity
held a *minority* (less than 50%) equity stake. Project equity percentages
and risk went back up when there was no government equity stake or when
government held a majority (greater than 50%) equity stake. The
risk-decreasing effect of minority equity holding by the government was
greatest when the equity stake was in the 21-30% range.

State ownership in projects sends at least two signals to private
investors. One signal is assurance that original policy terms will not be
reversed lest the state share in losses from the policy reversal. Another
signal relates to possible state interference in the project to achieve
broader welfare-oriented goals, such as decreasing unemployment. In
countries where policy reversal is more likely, minority co-investment by
the state sends private investors this mix of signals: a strong signal
assuring private investors that original deal terms will be upheld; but
also a weak signal of state interference under those original deal terms.
The overall signal is favorable and decreases project risk.

What about projects located in countries with substantial policy stability?
There, initial project terms are less likely to change significantly over a
project’s life.  In this context, state equity stakes only add to overall
project risk even at relatively low (less than 5%) equity levels. Here, a
stronger signal of assurance is redundant. Stable policies provide the same
assurance to private investors. All that is left is a stronger signal of
state interference in project management under the original terms. The
overall signal is unfavorable and increases project risk.

Take-aways from our study include the following: 1) countries given to
sudden policy shifts impose greater risks for investors leading projects
located there; 2) in these sudden-change countries, a host country
government equity stake in a project may decrease overall project risk by
giving the state a reason *not* to demand a renegotiation; 3) the
risk-mitigating effects of state ownership are contingent on limiting the
state to a substantial but still minority stake in a project with a “sweet
spot” of somewhere from 21-30% of overall project equity; and 4) giving
states majority equity stakes in less stable (often developing) countries
may prompt them to maintain original investment terms, but still prompt
some threat of interference with project management under those original
terms. Our minority rules can help mitigate project risk, but they cannot
make it disappear altogether.

------------------------------
* <#1433623f69b5598e__ednref1> Barclay E. James ([log in to unmask]) is
Assistant Professor of Management at the Ourso College of Business at the
Louisiana State University; Paul M. Vaaler ([log in to unmask]) is Associate
Professor of International Business at the Carlson School of Management at
the University of Minnesota and an affiliated faculty member at the
University of Minnesota Law School and Oxford University’s Saïd Business
School. This article is based on findings in their working paper entitled
“Minority rules: Credible state ownership and investment risk around the
world,” available at
http://www.csom.umn.edu/faculty-research/vaal0001/Paul_M_Vaaler.aspx<http://columbia.us6.list-manage.com/track/click?u=ab15cc1d53&id=f52879e070&e=5eb397be70>.
The online version of this *Perspective* (available at
http://www.vcc.columbia.edu/content/fdi-perspectives<http://columbia.us6.list-manage.com/track/click?u=ab15cc1d53&id=5e35400b4d&e=5eb397be70>)
includes a figure showing the relationship between investment risk and the
percentage of state ownership in countries with high and low policy
stability. The authors are grateful to Persa Economou, Theodore Moran and
Louis Wells for their helpful peer reviews. *The views expressed by the
authors of this Perspective do not necessarily reflect the opinions of
Columbia University or its partners and supporters. Columbia FDI
Perspectives (ISSN 2158-3579) is a peer-reviewed series.*

*The material in this Perspective may be reprinted if accompanied by the
following acknowledgment: “Barclay E. James and Paul M. Vaaler, ‘Minority
rules: State ownership and foreign direct investment risk mitigation
strategy,’ Columbia FDI Perspectives, No. 111, December 23, 2013. Reprinted
with permission from the Vale Columbia Center on Sustainable International
Investment (www.vcc.columbia.edu <http://www.vcc.columbia.edu>).” A copy
should kindly be sent to the Vale Columbia Center at [log in to unmask]
<[log in to unmask]>.*
       For further information, including information regarding submission
to the *Perspectives*, please contact: Vale Columbia Center on Sustainable
International Investment, Shawn Lim, [log in to unmask] or
[log in to unmask]

The Vale Columbia Center on Sustainable International Investment (VCC), a
joint center of Columbia Law School and the Earth Institute at Columbia
University, is a leading applied research center and forum dedicated to the
study, practice and discussion of sustainable international investment. Our
mission is to develop and disseminate practical approaches and solutions,
as well as to analyze topical policy-oriented issues, in order to maximize
the impact of international investment for sustainable development. The
Center undertakes its mission through interdisciplinary research, advisory
projects, multi-stakeholder dialogue, educational programs, and the
development of resources and tools. For more information, visit us at
www.vcc.columbia.edu<http://columbia.us6.list-manage1.com/track/click?u=ab15cc1d53&id=2adb037181&e=5eb397be70>
.

*Most recent Columbia FDI
Perspectives*<http://columbia.us6.list-manage.com/track/click?u=ab15cc1d53&id=facc175257&e=5eb397be70>

   - No. 109, Xavier Carim, “Lessons from South Africa’s BITs review,”
   November 25, 2013.
   - No. 108, John Gaffney and Janani Sarvanantham, “Achieving sustainable
   development objectives in international investment: Could future IIAs
   impose sustainable development-related obligations on investors?,” November
   11, 2013.
   - No. 107, Nikia Clarke, “Go out and manufacture: Policy support for
   Chinese FDI in Africa,” October 28, 2013.
   - No. 106, Karl P. Sauvant, “Three challenges for China’s outward FDI
   policy,” October 14, 2013.
   - No. 105, Marino Baldi, “Are trade-law inspired investment rules
   desirable?,” September 30, 2013.

*All previous FDI Perspectives are available at *
*http://www.vcc.columbia.edu/content/fdi-perspectives*<http://columbia.us6.list-manage1.com/track/click?u=ab15cc1d53&id=4c9deea5e5&e=5eb397be70>
*.*

Vale Columbia Center on Sustainable International Investment
Columbia Law School - Earth Institute
Columbia University
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New York, NY 10027
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