Risky Business: Investing in Cuba Is More Than Just a Financial Gamble
"It's hard to argue against weeding out corruption. Sometimes, in the process, you break a couple of eggs."
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.)
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 opportunity.
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 government.
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.
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 per-capita.
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:
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 HavanaJournal.com 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.
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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