Monday, April 5, 2010

Arrrgh! Pirate Finance – Emerging Market Success?

The piracy finance model excerpted (with minor edits) below appeared in early March in a UN report, and has gained interest through more recent republications, first in UN Dispatch, then Alphaville. The model is fascinating – so is what it tells us about Somalia, an area that, right now, can only aspire to be an emerging market:

The success and expansion of pirate militias requires new organizational arrangements and practices. Although leadership of pirate networks remains anchored in Puntland and central Somalia, participation in maritime militias and investment in pirate operations is open to a broad cross-section of Somali society. The refined finance model guarantees every participant in the operation, if successful, a well-defined percentage or share of the ransom money.

A basic piracy operation requires a minimum eight to twelve militia prepared to stay at sea for extended periods of time, in the hopes of hijacking a passing vessel. Each team requires a minimum of two attack skiffs, weapons, equipment, provisions, fuel and preferably a supply boat. The costs of the operation are usually borne by investors, some of whom may also be pirates.

A would-be pirate should already possess a firearm. For this contribution, plus, his services, he receives a class A share. Pirates who provide a skiff or a heavier firearm, like an RPG or a general purpose machine gun, may be entitled to an additional A-share. The first pirate to board a vessel may also be entitled to an extra A-share.

At least 12 others are recruited as militiamen to provide protection on land if a ship is hijacked., In addition, each member of the pirate team may bring a partner or relative to be part of this land-based force. Militiamen must possess their own weapon. Each receives a ‘class B’ share — usually a fixed amount equivalent to approximately US$15,000.

If a ship is successfully hijacked and brought to anchor, the pirates and the militiamen require food, drink, fresh clothes, cell phones, air time, etc. The captured crew must also be cared for. In most cases, these services are provided by one or more suppliers, who advance the costs in anticipation of reimbursement, with a significant margin of profit, when ransom is eventually paid.

When ransom is received, fixed costs are the first to be paid out. These are typically:

  • Reimbursement of supplier(s)
  • Financier(s) and/or investor(s): 30% of the ransom
  • Local elders: 5 to 10 %of the ransom (anchoring rights)
  • Class B shares (approx. $15,000 each): militiamen, interpreters etc.

The remaining sum - the profit,- is divided between class- A shareholders

Wow. The model has sophistication, with four classes of securities: 1) investors get a super share that splits 30% of the gross; 2) suppliers essentially get a subordinated preferred – payment is contingent on a successful hijack and ransom but return is a fixed percent of value supplied; 3) land based militia also get a lesser preferred, with a fixed sum contingent on success; 4) marine pirates get common.

The model assumes compliance with the deal terms by pirates, not generally known as a law abiding group. Is this driven by fear of retribution, the need to preserve reputation so that future missions can be staffed and financed or some other force, such as clan relationships? Really the model assumes more than just compliance. Since the supplier has limited upside, the supplier's investment probably makes sense only if the supplier can count on investing in multiple operations, with some chance to recover in the event the failure rate is high on the first few operations in which the supplier participates.

Finally, the model has some pieces missing. Who is the organizer and how are they compensated? Is it the primary investor? If so, does the lead get a share of that 30% that exceeds the pro rata share attributable to his investment?. Is the captain of the ship the organizer? If so, isn't this worth a couple of extra Class A shares? Who, in general, are the financiers? What percentage of Somalia's can afford to be venture capitalists?

In an emerging market with no consistently functioning educational or judicial systems, the pirates are pulling off some fairly sophisticated financing. Aside from how to be a pirate, what's the lesson? The pirate model probably tells us something about the capability and resiliency of the Somalians, if this lawless territory could somehow turn itself back into a nation and offer legitimate opportunities that would attract the same ingenuity. It may even tell us something about the prospects for investment and assistance for the Somali private sector from the outside world. Apparently, Somali's can run a business, but the outsider who is not viewed as part of the crew may end up walking the plank.

Photo credit: darkpatator

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