Thursday, June 21, 2012

Risky Business: Investing in Cuba Is More Than Just a Financial Gamble

Risky Business: Investing in Cuba Is More Than Just a Financial Gamble
By Justin Rohrlich Jun 20, 2012 1:45 pm
"It's hard to argue against weeding out corruption. Sometimes, in the
process, you break a couple of eggs."

MINYANVILLE ORIGINAL Investment risk can mean a number of different
things. This past fall, British businessman Amado Fakhre took a
particularly severe type of loss: His freedom.

October, 2011: Fakhre, the Lebanese-born, Havana-based CEO of Coral
Capital -- which claimed to have invested $75 million in Cuba, with more
than $1 billion worth of projects in the pipeline -- is woken at dawn
and arrested by Cuban authorities. Coral Capital's offices are shuttered
and declared a crime scene. Fakhre has been held without charges ever since.

April, 2012: Coral Capital's COO Stephen Purvis, is picked up by Cuban
government agents as he prepares to walk his children to school. He too,
has been held without charges, and no mention has been made of either
case in Cuba's state-run media.

Before their disappearances, Fakhre and Purvis seemed to have no
shortage of confidence in Coral's ventures.

"We're not virgins at this," Purvis told a reporter, regarding the
Bellomonte Golf Club, a 650-acre property under development at the time
of his arrest.

Indeed, Purvis and Fakhre were not beginners -- Coral Capital was formed
in 1999 to invest in Cuba and successfully restored Havana's Hotel
Saratoga, where rates climb as high as $900 per night. They also opened
the island's first Land Rover dealership, which was admittedly a work in
progress (they sold a total of one car, to themselves…but these things
take time).

Coral Capital was not the only foreign company paid back by the Cuban
government with a complimentary stay at Villa Marista, the state
security torture facility that apparently also doubles as a guesthouse.

Vahe "Cy" Tokmakjian, CEO of Ontario, Canada's, Tokmakjian Group, which
sold buses, trucks, and mining equipment to Cuba and served as Cuba's
exclusive distributor for Hyundai, was an experienced Cuba hand.

"I came to Cuba 21 years ago when the times of economic trouble began
and, despite my banker's advice, I considered I could trust Cubans; so
that's how I came here, why I'm here now and why I will continue to be
here," he told Cuba Plus, a publication produced by Vancouver's Taina
Communications in partnership with the Cuban government.

To be sure, Tokmakjian, whose company did an estimated $80 million worth
of business with the island annually, continues to live in Cuba -- held
without charges since September 2011, when he was taken into custody by
state security and his company closed. (A second Canadian, Tri-Star
Caribbean CEO Sarkis Yacoubian, has been held by the Cuban government
without charges for almost a year.)

What Happened?

As Fakhre, Purvis, et al (over the past two years, Cuba has sent 52
foreigners, as well as hundreds of Cuban ministers and officials to
jail, and has expelled more than 150 foreign business owners and
operators) have now discovered, part of the reform process appears to
include President Raul Castro making good on a 2008 vow to root out the
rampant corruption that has been a part of daily life for decades.

A noble goal, hampered by the fact that no clear definition exists of
what, exactly, constitutes "corruption."

A centrally-controlled command economy such as Cuba's, with a near-total
lack of transparency, ensures that "every act is fraught for anybody
trying to exist, from businesspeople to the average Joe," says a
diplomatic official who agreed to speak to me anonymously.

"The Cubans have very publicly made examples of what they perceive to be
corruption issues," the source explains.

One of those, in an interesting reversal of the norm, is what might be
referred to as a "maximum wage law," which reportedly hovers around $20
per month. According to the Economist, Raul Castro "considers letting
foreign firms pay market wages a step too far," forcing companies "to
break the law -- and run afoul of his newfound efforts to enforce it."

"We are somewhat in the dark here," said a European businessman based in
Havana. "If I pay my manager an extra $100 a month, as I feel I should,
is that a crime against national security?"

The answer is, in a Communist country, yes. Money is power, and the
inevitable income disparities that result from capitalistic concepts
like bonuses collapse the order of a "classless society."

Here's former UK Ambassador to North Korea, John Everard:

The regime's distaste for markets is easy to understand. Because of
the markets, people who had been brought up to depend on the state to
provide everything had developed some economic independence. Customers
had learned the importance of price and had learned to choose their
purchases, while market traders had emerged who had learned the
subversive skills of bargaining, procurement, and logistics. People had
also learned the usefulness of markets as sources of news and gossip
outside official control. The results of decades of ideological work
were at risk.

Sometimes, the bribes are blatant, like the "free trips abroad,
computers, flat-screen TVs or large deposits of cash in foreign bank
accounts for senior officials" reported by a South American importer
doing business in Cuba before he was accused of corruption and expelled
in 2009. Other times, they may be inadvertent (a few dollars for gas) or
perfectly acceptable in market societies (paying commissions).

"The forms of persuasion -- let's call it that -- are nearly infinite,"
said the importer.

And illegal. As one Facebook commenter who appears to be acquainted with
Stephen Purvis, writes: "Steve has meant well by 'subsidising' the
marginal salaries of Cuban management staff -- but we all know that ANY
payments of foreign currency to Cubans is strictly prohibited and is
regarded as paying bribes."

Some have suggested that the Cuban leadership simply looked at its
runaway accounts-payable column and decided to have the intelligence
services "buy out" the government's foreign partners at an extremely
favorable price.

Foreign investors in Cuba have dealt with this before. A backgrounder
from the UK Trade & Investment office describes the events of early
2009, when the global financial crisis "sparked a shortage of hard
currency on the island and led Castro to freeze the bank accounts of
joint ventures operating there." Castro has been slowly paying out the
money, estimated at more than $800 million, since then."

Sometimes, this is what doing business in a Communist country entails.
And, in fact, it's something a certain type of investor needs to expect.

Why Cuba? What's Wrong With a Mutual Fund?

Investors in emerging markets -- and emerging emerging markets, commonly
known as "frontier markets" -- tend to be attracted to accordingly
outsized returns. For them, the potential rewards of frontier markets
means parking their money far -- both literally and figuratively -- from
Wall Street or Canary Wharf. (The countries currently included in the
MSCI Frontier Market Index are: Argentina, Bahrain, Bangladesh,
Bulgaria, Croatia, Estonia, Jordan, Kenya, Kuwait, Lebanon, Lithuania,
Kazakhstan, Mauritius, Nigeria, Oman, Pakistan, Qatar, Romania, Serbia,
Slovenia, Sri Lanka, Tunisia, Ukraine, United Arab Emirates, and Vietnam.)

Once a country goes from being a frontier market to an emerging market
-- and in the case of China, all the way on to a developed market, it
can "start to focus on sustaining its own wealth within its own
economy," says Michael St. Germain, a research analyst at Brighton House
Associates. And that's when new frontier markets like Kenya, and yes,
Cuba, replace them.

"If you go back 12 years, most emerging markets were essentially
frontiers in one way or another," Stuart Culverhouse, chief economist of
frontier market investment banking boutique Exotix Ltd., tells me. "As
people have become more comfortable with the idea of emerging markets,
as the Malaysias, the Turkeys, the Brazils of the world all become more
mainstream, it has made investors look beyond those countries" to find

Naturally, for every reward, there exists a risk. Here's St. Germain,
writing in the BHA Investor Monitor:

There's no doubt that frontier-market investing has its risks.
Geopolitical risk is the most inherent issue. These burgeoning nations
are susceptible to political and social instability, which causes their
stock markets to be highly volatile. Additionally, investors can find
themselves victims of nationalization. Although frontier governments are
opening their markets to outsiders, they often remain apprehensive of
foreign investment. As companies grow, therefore, and foreign investment
and control increases, they are susceptible to nationalization by the

Frontier markets also lack infrastructure. Safeguards such as
regulatory oversight that are provided by developed and many emerging
markets simply do not exist in frontier markets. As a result, investors
are exposed to currency corruption and other risks.
Perhaps the largest risk, though, is illiquidity. Being small in
terms of capitalization and trading volume, frontier markets are by
nature illiquid meaning it can be difficult for an investor to extract
himself from a position, if not impossible. Although you can buy your
way in to these markets, you may never be able to cash out of your position.

In addition, frontier markets, for the most part, do not have many
ETFs or index funds, and for those that do exist, the lack of investor
demand decreases liquidity further as well as poses the threat of
traders selling at a discount. Generally, the main reward for taking
such risk is larger returns, albeit significant ones.

Overall, the sheer scale of the frontier market combined with its
demographic trend paint a rather positive picture.

"Twenty-three percent of the world's population lives in these
frontier markets," St. Germain tells me. "That number in itself is
staggering. Plus, the available working population is over 10 years
younger than those in developed markets. Over the past decade or so, the
effects of technology and globalization have given these markets the
ability to cheaply educate their people, and such a ready workforce
makes frontiers a logical place to invest long-term."

That can mean any one of a number of places. Stuart Culverhouse likes
Sub-Saharan Africa. Michael St. Germain likes Nigeria and Sri Lanka.
Regarding Cuba, the law doesn't apply to Exotix, which is headquartered
in London, doesn't do business in the US, and is off-limits to US
residents (and, in turn, US regulators). Culverhouse is "optimistic over
a longer time horizon."

"There is a significant scope in the country essentially untapped," he
says. "It requires moves both on the Cuban side and the American side;
the transition from Fidel to Raul introduced a more pragmatic and
commercial agenda and there has been some indication from the US in
recent years about a reform agenda, and we have some optimism about
where that might lead."

Is This for Real?

Such endeavors as extralegal payments to staff may be an attempt to
speed the change that Kirby Jones, a Washington, DC, consultant
described by the New York Times as the "man to see about business in
Cuba," maintains is coming -- only at the Cuban government's own pace.

"In America, we like immediate change, overnight success," Jones tells
me. "I have been struck by the speed at which Cuba has been changing,
though by 'speed,' I mean in a Cuban context, not a US one."

Jones, who has advised companies including Abbott Labs (ABT), General
Electric (GE), and Caterpillar (CAT) on Cuba issues, says Cuba's reserve
stems from their determination not to mimic the Soviet Union's wobbly
transition to capitalism.

"I remember walking through Moscow with a World Bank official way back
when," Jones recalls. "He pointed out a McDonald's (MCD) and said, 'Look
at that -- that's real progress.' To him, it was a victory; a symbol of
the defeat of Communism."

But Jones explains that symbols don't necessarily represent true change.

"It worked well for some -- the oligarchs, the mafia," he says. "In
terms of building a base for fundamental, long-term change, I think the
jury is still out. Cuba sees what happened in Russia and is saying, 'We
don't want that.' Corruption is a disease that strikes even the most
sophisticated countries, including ours -- look at Enron."

Jones says those doing business in Cuba need to be aware of what has
occurred in recent months, though how the corruption crackdown will
affect future investment can be a matter of perspective.

"As far as the arrests are concerned, you can spin that negatively or
positively," he says. "It's hard to argue against weeding out
corruption. Sometimes, in the process, you break a couple of eggs."

Hal Klepak, a Canadian military historian and author of two recent books
on the Cuban military and Raul Castro, sees the crackdown as a bullish sign.

"In a country where small-scale but widespread corruption is the rule,
if the government is to be seen to be serious about rooting out the
scourge, it must show it is doing so at the very top and doing so in a
dramatic way," Klepak told Reuters after Amado Fakhre's arrest last year.

"I do not see it as bad at all for foreign business in Cuba, probably
just the opposite in the mid- to long-term," he explained. "But there is
also little doubt that it does make many jittery when the problem is
such a generalized one."

At the same time, there is a case to be made for not providing a crucial
source of hard currency to a regime described by the 2012 Human Rights
Watch World Report as "the only country in Latin America that represses
virtually all forms of political dissent."

"The government increasingly relied on arbitrary arrests and short-term
detentions to restrict the basic rights of its critics," the report
says, "including the right to assemble and move about freely. Cuba's
government also pressured dissidents to choose between exile and
continued repression or even imprisonment, leading scores to leave the
country with their families during 2011."

Further, Cuba hasn't done much to burnish its FICO score over the years.
It has been called a "debt-market pariah," in an exclusive club that
briefly welcomed Argentina in 2001 as it defaulted and devalued its
currency and admitted Pakistan as a member in 1998, when it was isolated
internationally for conducting nuclear tests. Cuba is the veritable
chairman of the board, having served continuously since 1999.

From Moody's:

Cuba's Caa1 sovereign ratings reflect a debt moratorium, in place
for more than 20 years, which has led to the accumulation of principal
and interest arrears. Cuba's ratings incorporate very low economic
strength largely on account of the small size of its economy and low GDP

Very weak institutional strength reflecting governance problems are
factored into Cuba's ratings, along with considerations related to
limited availability of information and a lack of transparency.

In addition to weak government financial strength, Cuba's ratings
incorporate: (i) the economy's extreme dependence on imported goods,
(ii) restricted access to external financing, and (iii ) ongoing
political uncertainties.

Which means, in so many words, "good luck."

Yankee, Stay Home

Though the State Department describes Cuba as having "a hostile
investment climate, characterized by inefficient and overpriced labor,
dense regulations, and an impenetrable bureaucracy," there are strict
rules to further dissuade stateside investment. Under US law, Americans
doing business in Cuba face swift, severe (and constitutional)
penalties. From the website of SGR LLP:

Punishment for violations of the sanctions can be severe. Civil fines
range from $11,000 to $1 million for each violation. Civil fines may be
imposed even if the violation was committed unknowingly and with
innocent intent. The majority of the fines imposed are most likely the
result of corporations simply failing to recognize trade transactions
involving a targeted country or SDN. Additionally, criminal penalties
may be levied for willful violations and include fines from $50,000 to
$10 million and imprisonment from 10 to 30 years.

This, obviously, leaves more opportunity for Europeans and South
Americans, minus the Canadian, French, Czech, Chilean, and English ones
who have been jailed or summarily deported.

One of the Cuba success stories is Spain's Meliá Hotels International,
the world's largest resort hotel company, currently operates 25
properties throughout the country.

It's a market Meliá's US-based competitors have (cautiously) desired for
quite a while. In 2008, executives from chains including Marriott (MAR)
and Wyndham (WYN) expressed interest in Cuba, according to a Bloomberg
report, as did Orbitz (OWW) and Royal Caribbean Cruises (RCL), whose CEO
called the island "the Holy Grail of cruising."

It would also open up a market previously closed to American credit card
issuers like Visa (V) and Mastercard (MA), which could serve at least a
portion of Cuba's estimated three million annual tourists.

Domestic firms will face a steep learning curve when and if the trade
embargo that has made it illegal for US firms to do business in Cuba
since 1962 is lifted. But Meliá, industry insiders say, will benefit
immediately, building on two profitable decades there.

"They've been thriving with their joint ventures in Cuba for 20 years,
they've expanded year after year, and I've never heard anything bad
about them from the Cuban government," Rob Sequin, publisher of news
service tells me. "Whatever they're doing, they must
be doing right."

What Meliá has been doing -- right or wrong -- is business with Cuba's
Fuerzas Armadas Revolucionarias, or Revolutionary Armed Forces.

The State Department describes the FAR as playing "a dominant role in
the economy, particularly in tourism, civil aviation, foreign trade, and
retail operations." Of course, President Raul Castro was General Raul
Castro until Fidel handed him the keys to the store in 2008.

The Institute for Cuban and Cuban-American Studies at the University of
Miami describes the structure as follows:

The man behind the transformation of Cuba's Fuerzas Armadas
Revolucionarias (FAR) into a major economic force is Gen. Raul Castro,
Cuba's defense minister and designated successor to elder brother Fidel.
Beginning in the late 1980s, as materiel and subsidies from Moscow
progressively dwindled, Raul Castro introduced the "Sistema de
perfeccionamiento empresarial (SPE)," or enterprise management
improvement system, that streamlined the Cuban military's operations.
With the disappearance of the Soviet bloc by 1991 and the ensuing severe
economic crisis that threatened the regime's survival, the younger
Castro went further and established state corporations like the Gaviota
tourism group for joint ventures with foreign capital. Today, the
military is not only a largely self-financing institution but a major
player in the overall Cuban economy.

Raul Castro entrusts a military managerial elite for the day-to-day
oversight of the FAR's business empire. Vice minister of defense,
General Julio Casas Regueiro, and Maj. Luis Alberto Rodriguez
Lopez-Callejas, son-in-law to Raul Castro, serve as GAESA's chairman and
CEO, respectively. Key money-making enterprises are also headed by
high-ranking officers, as in the case of Gaviota whose CEO is Brig. Gen.
Luis Perez Rospide.

What's Next?

The short answer is, no one knows.

Cuba policy and the future of the trade embargo have been hotly debated
for years, without much movement.

The US Treasury has issued a handful of travel licenses, which permit
American travelers to visit Cuba on "people-to-people" cultural
exchanges, defined as trips that "have a full-time schedule of
educational exchange activities that will result in meaningful
interaction between the travelers and individuals in Cuba."

However, as Rob Sequin points out, it remains illegal to bring so much
as a bottle of rum back with you.

Kirby Jones has been waiting for the embargo to be lifted since his
first trip to Havana in 1974.

"Everyone is there, except us," he told a group of travel agents,
hoteliers, tour operators, and charter companies in 2010. "There are
offices and representatives of over 500 companies around the world.
Nobody knows when it will open up for Americans, but it will."

While movement on the US side has been glacial, Cuba continues to move
forward without us, in its own way.

"If you told me back in the '70s that I would see what I'm seeing today,
I'd say you were nuts," he says. "After the state cafeterias started
closing in the factories, people were on their own; they had to get
their own lunch. That led to a birth of private food stands. In Cuba,
you now see a growing entrepreneurial class; 300,000 Cubans now operate
their own businesses. They may not be the kind of businesses we're
accustomed to seeing, where you hang out a sign that says 'Joe's
Plumbing Store,' but you have plumbers working and doing business --
just without the trappings of a business."

The gamechanger for the island as a whole, Jones says, will be the
successful discovery of oil in Cuban waters, though he does see one
societal shift that may be even more transformative than the elusive
Gulf crude that may or may not be sitting offshore:

"For years, the Cuban system was built on the philosophy of, 'If I can't
have it, you can't have it either,'" he says. "Now, certain people will
have more than others, which will lead to certain inequities. That's a
big change, but that's the new Cuba. And they'll get used to it."

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