Article Review- Corporate Finance

Retrieved from Journal of Accountancy

Lessons on Managing Risk in Emerging

Markets

BY MICHAEL FERGUSON, CPA

July 28, 2011

In recent years, as economies in developed countries have slipped and stagnated, a

number of U.S. and other companies have sought to fuel growth by investing in

emerging markets. There are many benefits to employing such a strategy: By and

large, developing countries promise access to new, untapped markets; rising levels

of consumption, driven by rapidly growing middle classes; and access to inexpensive

labor and materials.

Indeed, with each passing year, the barriers to international trade are being whittled

away. Common currencies, more-liberal trade agreements and enhanced

communication and cooperation between countries have eased the process of finding

lucrative new markets. The possibilities for expansion are immense.

However, emerging markets also pose significant perils, as I learned while on a

recent consulting engagement in India. These perils—in this case, bureaucratic

delays, unanticipated expenses and fluctuating currencies—are often invisible to a

company entering the market for the first time. But they can easily turn a promising

venture into a losing proposition if they aren’t dealt with quickly and effectively.

In India, my team was enlisted to help a large financial services firm build an

agricultural extension services practice in the state of Andhra Pradesh. Our team

came equipped with a diverse array of skills, and our expertise was sought in

developing a feasible operational model. In support of this, we also had to develop

financial models and accounting procedures. Both were measures whose importance

was underestimated by management.

From the beginning of the project, we experienced some big, unexpected hurdles.

For example, we determined at the front end of the project that marketing would be

a large component of the firm’s success and that the materials and labor needed for

this activity could be obtained for a low cost. However, we didn’t realize some of

the hidden expenses that the company would face on the marketing side, such as an

expensive, informal “registration fee” required for participation in an important

government-sponsored forum. Despite the name, this fee was more of an off-the-

record transaction, arbitrarily determined by government officials, with the only

basis for the amount being the client’s ability and willingness to pay. We refused to

pay this fee, since doing so could be a violation of the Foreign Corrupt Practices Act,

and instead worked to find other ways to spread awareness of our client’s service.

In addition, to make its business model viable, this socially minded firm planned to

rely on government contracts to help it reach impoverished farmers. But because so

much of the government’s funding ebbed and flowed from year to year–either due

to economic or legislative issues, or bureaucratic corruption–the company was

unable to determine whether national or local officials would ever be able to fund

the project, or whether other funding vehicles should be pursued.

Further, by its very nature, agricultural extension work is a relatively low-margin

business. Thus, when the rupee appreciated or depreciated sharply against the U.S.

dollar, the effects on the company’s balance sheet and income statements were

immediate and substantial. Depending on the magnitude of these swings, the

company’s entire investment in the country could be called into question.

As is typical of many businesses pursuing international diversification, my client

overcame some of these issues, but on less favorable terms than it had anticipated.

Because of the potential corruption issues in dealing with government-sponsored

marketing forums, it had to market independently, in a manner that was more

expensive and had less reach. Since local government agencies and small businesses

in India were unreliable, it had to seek partnerships with larger, international

corporations, which had significantly more bargaining clout. And as India’s currency

fluctuated wildly, the company had to keep most of its profits in India through

reinvestment, even when there was a lack of attractive projects to justify this action.

FORMIDABLE RISKS

As countless other companies have learned the hard way in recent years, while

investing in the emerging world can be very rewarding, it carries formidable risks as

well. These risks, which often slide by without notice in the rush to seize an

opportunity, can undermine an otherwise sound operation.

The following are some of the biggest threats to anticipate when entering an

unfamiliar, developing market:

Corruption. Emerging economies, more so than those in the developed world, are

often saddled with corrupt politicians, bureaucrats and businesspeople. The E7

nations—China, India, Brazil, Russia, Indonesia, Mexico and Turkey, considered

the primary sources of the world’s economic growth through 2050—are among the

poorest performers on Transparency International’s Corruption Perception Index,

which measures public sector corruption. With a score of 3.3 out of 10 (where a

score of 10 is “highly clean” and 0 is “highly corrupt”), India ranked 87th out of 178

countries in the 2010 index. Often, corruption is the legacy of previous governments

that, while no longer in power, continue to have an influence through people or

policies that remain in place. And even when a new government has cleaned house

and old institutions and bureaucrats are gone, social norms may continue to keep

corruption alive and slow the progress of economic liberalization. For instance,

Russia has long suffered from quasi-legal forms of bribery. This practice seems to

be a remnant of the country’s former communist rule.

Moreover, even if local governments are not corrupt in initial dealings, their

incentives may change after a foreign firm commits to making an investment. A

government that was initially cooperative and willing to provide assistance may

impose onerous taxes or restrictions once the host company is heavily invested and

doesn’t have the option of a quick withdrawal.

Operating within this business climate, we even found that the farmers with whom

we were interacting were initially unwilling to trust us and were highly skeptical of

our motives. From their perspective, we were working with the government and

regarded simply as one more intermediary that would prevent funding from getting

to its intended targets.

Any U.S. company seeking to do business in a foreign country needs to have a clear

understanding of its responsibilities under the FCPA and other international laws,

such as the United Kingdom’s Bribery Act 2010. The FCPA’s anti-bribery

provisions make it illegal to offer or provide money or anything of value to officials

of foreign governments or foreign political parties with the intent to obtain or retain

business. The provisions apply to U.S. issuers, other domestic concerns (individuals

and businesses), U.S. parent companies of foreign subsidiaries, and foreign

companies and individuals, including agents.

To protect against charges of corruption, companies need to keep books, records and

accounts that accurately reflect their transactions and disposition of assets. In

addition, companies need to devise and maintain internal accounting controls aimed

at preventing and detecting FCPA violations. They also must have clear policies and

procedures that explain how business is to be conducted as well as ongoing training

for employees and business partners.

Lack of transparency. Even when corruption per se is not present, there often is very

little transparency into the inner workings of government and business. Granted,

improving the visibility of financial reporting in the U.S. and other developed

nations is still a work in progress. But, in many emerging markets, the commitment

to improving transparency lags far behind the norm.

As a result, major Western corporations have been hesitant to invest substantially in

emerging economies, realizing that market opaqueness often can be a smokescreen

for shady behavior. In their home countries, large multinationals have very stringent

reporting guidelines, and they may be fearful of being unable to meet these standards

when working in new countries if transparency is minimal.

Lack of transparency proved to be a major obstacle during our engagement. Not only

did we have little insight into the decision-making process of the government

agencies that would be granting us contracts (making financial planning

extraordinarily difficult and imprecise), but it was even a struggle to get financial

and operational information from potential corporate partners who would have

benefitted from such communication. A culture of distrust permeated every

company with which we interacted.

Currency fluctuations. As was true for the Indian project I worked on, investments

in emerging markets can be undercut by currency fluctuations. Though many

economists have argued in favor of fixed exchange rates for emerging economies as

a way to combat this problem, most countries have avoided this approach, according

to the Bank of Canada.

Studies show that emerging nations are particularly susceptible to sharp

appreciations or depreciations in currency values. In industries in which margins are

low, a currency shift can turn a gain into a catastrophic and inexplicable loss

overnight. Even if these swings later reverse themselves, shareholders, especially in

the U.S., are more concerned with short-term gains, and these gains can be

compromised through unpredictable currency changes.

STEPS TO REDUCE RISK

Despite these substantial challenges, firms considering investments in the emerging

world have some concrete steps they can take to reduce risks and improve their odds

of success. They include:

Conducting due diligence. Performing due diligence is a critical first step to diffuse

some of the risks that come with doing business in an emerging nation. However, to

be successful, the measures used need to be different from the “cookie cutter”-type

of due diligence used in acquiring a domestic firm or starting an operation within a

home country.

While conducting due diligence in an established, domestic industry involves

evaluating comparable firms with a robust set of assumptions, companies looking to

invest in emerging markets usually don’t have access to this type of information.

Invariably, a firm’s research into an emerging market will focus largely on the

relationships between government and business in that host nation, as well as in

bordering nations.

Western economies have had persistent success, in part, because of the symbiotic

relationship between government and business. But this assumption may not hold

true in emerging economies. Indeed, in many cases, there are tangible costs

associated with government-related inefficiencies. Such expenses are relatively easy

to calculate and should be incorporated into investment decisions. For instance, if

the government has a history of imposing undue amounts of red tape that could lead

to delays in operating a factory or in exporting goods, this cost can be anticipated

and quantified.

Somewhat more challenging to foresee are the costs stemming from long-term

damage to reputation or overt corruption, such as bribery. For obvious reasons, there

typically isn’t accurate data about how substantial these costs can be. At best,

estimates will be imprecise. Consequently, companies considering investments in

countries where these are thought to be typical practices should adjust discount and

hurdle rates upward to reflect unforeseen risks.

Improving transparency. In addition to using targeted due diligence, firms must

seek to overcome transparency shortcomings that can adversely affect their

operations. Because many governments with developing economies don’t require

significant transparency as part of corporate governance, the investing companies

must be proactive and seek their own remedies.

Identification and education of all interested stakeholders is a necessary precondition

for improving transparency. These efforts must include government officials,

employees and customers, among other groups. Their interests must be heard and

understood in developing rigorous corporate governance codes.

Internal controls, especially, must be enumerated and tested to a greater extent than

they are in developed countries. That’s because there may not be the same economic

incentives favoring transparency and integrity that are present in other places, and

the disincentives for fraudulent behavior, such as enforcement and penalties, also

may be missing.

Internal controls should focus especially on transactions in which cash may change

hands or in which a party has the potential for unjust enrichment or fraud, such as

contracting with chronically underpaid government or business officials. While

internal controls in the U.S. often focus on mitigating honest errors or

miscalculations, companies investing in the emerging world may need to focus on

rooting out deliberate falsehoods.

Moreover, if government agencies are not in a position to guarantee transparency,

engaging other multinational corporations as suppliers or customers will impose

another layer of discipline and security. And making a decision to work only with

partners that demand transparency in their own operations puts pressure on other

potential suppliers who otherwise might take advantage of loopholes and lax

controls to curtail such behavior.

Keep in mind that a company will not have to make the same costly provisions for

potential fraud-related losses if it can show it had adequate procedures in place to

prevent such crimes. Those procedures include having a systematic program of

education and training, risk assessment, due diligence, and monitoring and review,

among other measures.

If a company can achieve total visibility into all the operations that affect it, and

impose the type of stringent corporate governance guidelines that have served

developed economies so well, the risks posed by in-country fraud and corruption

drop considerably.

Diversifying investments. Diversification can be an effective tool for mitigating the

risks associated with emerging markets. While due diligence is often prohibitively

expensive and inexact, diversifying across multiple countries can hedge some of

these risks. An adverse government action or widespread labor problems in one

country can be devastating if that country houses the firm’s only emerging market

investment. But if investments are spread across a number of countries, with their

own distinct governments, cultures and business climates, problems caused in one

location are less likely to jeopardize the whole enterprise.

Naturally, all companies are subject to capital constraints to some extent and, as

such, it’s reasonable to pursue less expensive, more tentative forms of foreign

investment. For instance, while foreign direct investment often represents an

irreversible commitment, joint ventures with local firms or other multinational

corporations often may require more modest investments and can be divested

without serious legal consequences. In fact, such arrangements can sometimes allow

two companies with complementary skills or assets to work together to minimize

each firm’s exposure, both operationally and financially. Teaming up can make

international investment less risky and, thus, more appealing to decision makers.

Further, diversifying investments offers the company leverage in dealing with each

individual government: Governments are more likely to make concessions or

accommodations to foreign firms if they know that withdrawal is a legitimate option.

Such diversification, in addition to shielding against operational failures, also can

serve as a hedge against the unpredictable currency fluctuations that typify emerging

markets.

CONCLUSION

Despite their risks, emerging markets offer demonstrated returns that are

significantly higher than those of most developed economies. Though issues of

corruption and uncertainty have impeded progress, emerging markets in general

have excelled in recent years.

Certainly, if the past two decades are any indication of what’s to come, investment

in the emerging world will continue to evolve from its current status as a novel and

exciting opportunity into a virtual prerequisite for enduring growth. But success will

depend on acknowledging, anticipating and mitigating the many risks inherent in

such investments. This requires both research and resourcefulness, since emerging-

market risks can be difficult to pinpoint and vary widely by country.

The take-away from our team’s experience in India: No stone can be left unturned

in the effort to find markets that are both promising and secure.