Budgeting for risk in emerging markets

With risk often comes reward, which is true of any market. But in emerging markets the risks and rewards seem greater, resulting in GPs entering Africa, Latin America and much of Asia to undergo relatively complex cost/benefit analyses when conducting due diligence. 

That doesn’t come cheap. And because every country or market is different, and every deal also different, how do firms work out how much due diligence is needed and if the deal is worth doing at all?

AVOIDING ‘DEALBREAKERS’

“We set up a phased approach to due diligence, which means we are not committing right upfront from day one a significant amount of costs. We stage it in a way that allows us to flush out the ‘dealbreaker’ issues early without the expenditure of too much cost and progress through the stages as we go along,” says Fash Sawyerr, director of business and strategy at emerging markets focused firm Actis.

Fash Sawyerr

There are certain core elements to Actis’ early stage diligence process, elaborates Sawyerr. The firm will critically examine the investment thesis of a deal, which involves being really crisp on the three to five critical sources of identified value in the deal, and then focusing on what really matters to deliver a 3x return before diving deeper. The firm often then assesses the likelihood of “dealbreaker scenarios”. 

To test the investment thesis Actis investigates the target company against themes Actis has developed over many deals. These are factors that, more than likely, will result in a good investment rather than a bad investment which Actis has seen over time. 

Dealbreaker scenarios are Actis’ assumptions that would bust the model. What would you have to believe for this business to not produce a return? That could be anything from losing the biggest customer, to major operational issue in a distribution centre, to huge multinational competitors that come in to your market and so on, says Sawyerr. 

Once the dealbreakers have been established Actis goes through a subjective assessment of whether each scenario has a 20 percent probability outcome, or a 1 percent probability outcome, before green lighting further due diligence.

BOOTS ON THE GROUND

But this early commercial due diligence needs to work in tandem with other due diligence work streams, such as regulatory, political or legal matters. Here Actis’ has a considerable advantage as it has been working in emerging markets for decades. 

“We have local teams on the ground that know the market well, so we tend to have our finger on the pulse of political issues and country risks, currency issues etc,” says Sawyerr.

“But periodically we commission specialists to refresh our fact base, and if we are contemplating a deal in a market we haven’t done an investment in the past, or it’s been a while since we have done one, then we would engage a political risk/country risk specialist to help flag up and give us perspectives on the regions,” he adds.

Zachary Latif, managing director of Africa-focused TLG Capital, agrees that having local connections is crucial, especially for differentiating emerging markets.

“A lot of firms tend to group emerging markets together, but they are not the same. How would you go in to one that is very underdeveloped in its regulatory regime and with very different legal and political processes to a relatively more developed market by emerging market standards?”

But what about firms that don’t have the local connections or country specific resources to get to that level of comfort? 

Peter Turecek, senior managing director at advisory firm Kroll, says: “There are plenty of firms out there who do lite-level screening due diligence, primarily desktop research from somewhere else in the world that provides a snapshot of some available information. This is great if you are screening 150 deals you are considering that year. But when actually pulling the trigger on deals that you are seriously pursuing, it’s just an insufficient level of due diligence, because it is not going to give you the insight that is going to keep you safe – both legally and from a business perspective.”

Turecek adds that going from the desktop screening to a boots on the ground level is a significant step, so cost increases should be expected. That’s because “you need people who have local on-the-ground knowledge, contacts and a network of resources to get that clear picture. As a result, the value of the information is also exponential,” he adds.

But just how much is too much? It all depends on the size of the firm, and the size of the deal says Turecek. “There have been deals where I have told the client that a certain level of due diligence was insufficient for the nature/risk profile of a deal and we won’t take on that assignment because I know I can’t give them an appropriate level of work. In consulting with the client, I seek to protect them, as well as Kroll.”

WHAT’S THE COST?

Once a firm has decided it will take the plunge and delve deeper into the deal, how much should they expect to pay for this level of due diligence?

“It’s not unheard of for us to spend upwards of $1.5 to $2 million across all the due diligence streams for an investment that might be a $100 million equity investment. So we could easily spend 1 or 2 percent of the equity investment on due diligence provided we think there is a really attractive return opportunity for us,” says Sawyerr.

But despite this large cost burden Turecek says most of the due diligence in emerging markets is just an extension of what a firm would do in a developed market. This includes reviewing what public data (relevant to a target) is available – of course less information in this area can be found in emerging markets – or, for example, getting comfortable with the target’s management board and company as a whole. 

 “A lot of the true due diligence work you have to do in the emerging markets is finding out who are these people? Do they really have the connections they claim they do? Are those connections the right connections to get the job done in that market and are those connections likely to cause the client to run afoul of regulations in countries they are operating out of?” says Turecek.

Accordingly, firms looking at deals in emerging markets for the first time would be wise in following the footsteps of the established players and make local connections. Of course perhaps easier said than done when millions of dollars are often at stake.