As Southeast Asia’s biggest economy, Indonesia is attracting the attention of global investors because of its young, fast-growing middle class and its abundant natural resources. Therefore, it’s no surprise that PE houses are lining up to raise funds targeting the country. But the immense potential of Indonesia also brings with it a host of risks, including longer deal timelines that investors are used to, complex tax regimes and restrictions on exit options, a lack of trustworthy partners, and rules that seem to be written in water. Mitigating some of the risks is crucial to success, writes Ranajit Dam

With a population of almost 250 million, Indonesia is the largest economy in Southeast Asia, offering an attractive alternative to the increasingly crowded Indian and Chinese markets. According to Thomson Reuters data, the country’s revised GDP growth for the year ended Feb. 6 was 6.2 percent. The government has also shown signs of stability after a very long time, after holding two peaceful elections recently. What is particularly enticing is the growing group of consumers within the country. More than half of the population is under the age of 30, and there is a fast-expanding middle class as well; domestic consumption has accounted for almost 60 percent of the GDP in recent years.

According to media reports, funds have been flowing into the country. Foreign direct investment (FDI) into Indonesia totaled $13.3 billion in 2010, and is expected to reach $20billion in 2011; and there’s no surprise why. Growth is set to become exponential in consumer goods and services, such as food and beverages, retail, telecommunications, healthcare and insurance. Additionally, the high level of activity in Indonesia's mining sector is expected to continue; not just in coal but in other minerals such as nickel, gold and copper as well. Also, with its Master Plan for the Acceleration and Expansion of Indonesian Economic Growth (MP3EI), the Indonesian government is actively encouraging private sector participation in infrastructure.

Not unexpectedly, private equity houses are lining up for a slice of the action. Last year, the standout story was the $820 million raised by the PE house Northstar Pacific for its third fund – an impressive amount for an Indonesia-focused PE fund. In November, Chad Holm, a former investment banker with the Bank of America, announced plans to raise $1 billion in a new private equity fund to invest in the country. Holm’s fund, which is backed by Indonesian businessmen, will be primarily focused on financial resources, and infrastructure investment opportunities in Indonesia. Funds like Saratoga Capital, Ancora Capital and Falcon House Partners are also planning to raise private equity funds targeting Indonesia, with fund sizes varying between $300 million and $400million. With Indonesia-focused, private equity firms increasing their fundraising significantly from 2010, and big guns like KKR and Carlyle scouring the country for deals, there is no doubt that this is Indonesia’s time.

But scratch the surface, and the picture doesn’t look as perfect as the hype claims it to be. Despite the relentless bluster of the past year or two, the private equity industry manages assets of less than $5 billion, say Indonesian authorities, compared with a stock market value upwards of $400 billion, a relative “peanut”, according to Joe Bauerschmidt, partner at Jones Day (pictured). So, for all the talk about its potential, Indonesia remains a notoriously complex place to do business in. So while spotting a deal might be relatively simple, getting an accurate valuation of the deal, and concluding it within a reasonable time might be much harder. “What people need to understand is that for a number of reasons – be it cultural or not– deals take longer in Indonesia,” says Holm. Finally, foreign PE investors must prepare for a number of potential issues ranging from complex tax regimes and restrictions on exit options, to local politics, legal issues and a paucity of reliable partners. “Investors need to ask themselves a number of questions prior to investing in Indonesia,” says Stephanie Keen, partner at Hogan Lovells. “Do they have sufficient access to information? Do they understand the relevant regulations? And most importantly, are they comfortable with the investment decision?”

A DIFFERENT PLAYING FIELD

Churchill Mining’s story should serve as a cautionary one for investors – PE or otherwise – that are looking for a slice of the Indonesian pie. In 2008, the FTSE-listed miner announced that it found 150 million tonnes of coal in Indonesia’s Borneo, an estimate it later raised to 2.8billion tonnes – the seventh-largest undeveloped coal reserve in the world. By 2010, after $40million had been spent on the project, it was gone. Churchill’s licenses were revoked, and licenses were instead handed to companies affiliated to a conglomerate owned by a local politician. The subsequent lawsuit by Churchill was thrown out, and appeals to regulators fell on deaf ears.

As of the end of 2011, the company was threatening to take the Indonesian government to court, after its stock price plummeted by 90 percent. What the Churchill Mining case shows is that regulations can change very quickly, and this is enough to scare off new investors to the market,” says Keen. “Despite the fact that the country is politically stable, there is no guarantee that investors can rely on existing regulations when it comes to doing business in Indonesia.”

Indonesian regulatory policies can be complicated, in part due to the regional autonomy of regulatory authorities, says Simon Clinton, a partner at Clifford Chance. “With many complex legal and tax issues to consider, structuring transactions in Indonesia can be challenging,” he says. Other challenges include difficult legal and regulatory frameworks, government bureaucracy and widespread corruption. “The issue of rent-seeking is clearly a hindrance,” says Bauerschmidt. “While things have improved, this still remains an issue, and this is something lawyers and deal teams need to keep in mind.”

Another important trend that sets Indonesia apart from other emerging markets like China is that many of the assets available in the market have been owned by family conglomerates for a number of decades now. Most of these conglomerates are run by a matriarch or patriarch of fairly advanced age, who has a sentimental attachment to the asset in question, and is thus unwilling to let it go at a reasonable price, says Keen (pictured). Additionally, she notes, the perception in the country is that “an IPO equals being successful.” “Sometimes families decide to list on a stock exchange simply because that is what they believe is expected of them, and they don’t consider private equity as a serious alternative,” she adds. According to Keen, owners of assets are happy not to sell until they are offered an extremely high price, and that makes it very difficult for PE investors. “If you buy at a high price on Day 1, it’s going to be hard to exit with a meaningful return,” she says.

After Indonesia was burnt by the 1997 Asian financial crisis, the country was anti-private equity for a long time, as there was a lot of opposition to the leveraged buyout model of private equity investing the subsequent surrendering of control. While the market has grown to become much more receptive to private equity investment in recent years, the method of acquiring a stake is different from other markets in the sense that deals are not the typical LBO structure. Instead, investors often enter into joint venture arrangements with minority, non-controlling stakes, says Bauerschmidt of Jones Day. “This is a change in mindset that foreign investors have to deal with,” Bauerschmidt adds, and points out that this in part due to Indonesia’s so-called “negative list,” which restricts the percentage of foreign ownership in certain industries, giving PE investors no choice in some cases but to find local partners.

When it comes to operating with partners, due diligence is “absolutely crucial,” says Bauerschmidt, who cites Canadian insurer Manulife’s joint venture with DSS in Indonesia as an “extreme example.” In 2002, an Indonesian court declared Manulife’s local subsidiary bankrupt, even though it had made a net profit of nearly $9 million in 2001, after being allegedly influenced by a powerful local businessman. Lawyers say that when it comes to carrying out an investigation of a local partner, no avenue should be left unexplored, including tax avoidance, corruption and illicit payments that are in violation of international anti-corruption laws, and the keeping of multiple sets of accounts and lax corporate governance, among others. “The extent of due diligence, when compared to other markets, needs to be a lot more robust and thorough,” says Keen. “The level of detail is different when you compare it to investments in Singapore or other developed markets.”

Clinton (pictured) adds that with the introduction of the UK Bribery Act and increased awareness of the Foreign Corrupt Practices Act (FCPA), his firm is receiving more requests from American and European investors to conduct anti-corruption due diligence exercises prior to acquisitions.

RELATIONSHIPS COUNT

The way around a lot of risks for PE investors in Indonesia is to establish solid relationships with local entities – local government, well connected families and business organisations. But this, in many cases, requires a lot of hard work. “In Indonesia, it’s about who you know, and how well you know them,” says Keen. Holm, who is looking to invest $1 billion in Indonesia through his Yawadwipa Group of Companies, talks about the importance of relationships with the big families, as well as other people on the ground. “Personal relationships have to be a priority,” he says. “It’s probably the main reason why a large number of global PE houses have been unable to succeed here so far.”

Holm points out that many businesses have been operating in Indonesia over decades, and have been built on a history of trust; outsiders would find it difficult to break in. He adds that it is only when an investor in the market is active in raising their profile, can they begin to be taken seriously. Finally, he stresses on the importance of communication. “You will never make any headway unless you initiate a dialogue,” he says. “You need to communicate and understand how things work; how people think.”

Bauerschmidt agrees that a more adaptive mindset is crucial for investors looking at Indonesia. He points out that in many cases, the local party and foreign investor in a particular transaction may have very different ideas of their financial goals. “After the1997 financial crisis, one of the hallmarks of some Indonesian businesses has been their patience,” he says. “They are usually unwilling to enter into any arrangement unless it is very much on their own terms. This is complicated, somewhat by the fact that some businesses have been in the family for at least two or three generations, and the people currently running it will be unwilling to surrender control. “For this reason, there needs to be a genuine ‘meeting of the minds,’” he says. “Investors need to get in there and find a common ground.”

Additionally, Keen says that sensitivity to the cultural issues and other issues of doing business in Indonesia is critical. “For one thing, investors must understand that terms of the deal, such as pricing and so on and can change very quickly even as talks are underway,” she says. She offers two other key points of advice to PE houses eyeing the country. “First of all, make sure the deal, including the due diligence, does not take too long, because you need to realise that the same deal may be discussed in parallel with other parties,” she says. “Secondly, the general partner (GP)–limited partner (LP) relationship is vital in this respect, and you need to do everything you can to maintain it. At some point of time, you will realise that you cannot rely on legal documents alone.”

MUCH POTENTIAL FOR LAW FIRMS

The continuing interest in Indonesia means that law firms doing work in the country are much in demand, and will continue to be so. “We will continue to see high levels of inbound activity by international investors, who will require M&A and financing advice,” says Clinton of Clifford Chance. “Increased investment in infrastructure will create a demand for project finance and construction expertise. As investments mature, investors are likely to use IPOs as their exit strategy, resulting in a requirement for capital market expertise.”

To meet this growing demand, law firms will need to make sure that they have sufficient lawyers with the appropriate skills and experience, both in terms of practice area and country experience, he adds. Keen of Hogan Lovells agrees. “Law firms need to have a clear Indonesia focus, and it would help greatly if they had an office in the country,” she says. “But more than that, they need to have private equity expertise, and to be honest; not many firms can boast that at present. They need to aim to add people with a strong background in private equity.”

Finally, Bauerschmidt stresses the fact that while demand for M&A lawyers and financing specialists is set to increase generally in the near term, firms really need to plan strategically and long-term when it comes to Indonesia. “In the last 10 years, a lot of big firms in Indonesia have failed,” he adds. “This is something that firms really need to look at.” ALB