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Risk and reward

There are profits to be made in the emerging markets, but do your homework before rushing in, says Jeremy Hurewitz, a senior consultant in the global services division of Control Risks North America. To learn more about Control Risks, visit http://www.control-risks.com.

The mood on Wall Street is doom and gloom and the newspapers are full of depressing stories about recession, scandals and falling financial indices that keep investors up at night. If you look deeper, though, you'll see that the news isn't all bad. Savvy investors have increasingly focused on emerging markets as the US economy tumbles due to a perfect storm of credit and energy crises. From the BRIC countries (Brazil, Russia, India and China) to the “Next 11” (or N-11, Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, Philippines, South Korea, Turkey and Vietnam) and on to other frontier markets that even the most intrepid investors would have recently shied away from, the rush is on to find greater yield in the markets of the developing world.

Struggling markets in developed countries are not the only factor pushing investors towards emerging markets. Expanded strategies for managing risks in these markets have also played a role. Private equity firms have increasingly found that a partnership with solution-driven practitioners of global risk management can provide greater assurances to enter markets with which they may not have as much experience.

One of the first steps that investors should take when considering an investment into an emerging market is to ask themselves if they understand the political context of the country in which they are investing. In some countries the risks are obvious: war, crime, religious fundamentalism, or often a combination of these and other factors are daunting obstacles to overcome, and quite frequently might require more risk than the investor is willing to take on.

A comprehensive risk assessment of the country, as well as the industry that is the focus of the investment, should be considered an essential part of any cross-border investment. An easy way to present this is in the form of a power-map, which presents in graphical form the key relationships and (where appropriate) conflicts which may exist between relevant politicians, regulators, and business interests and individuals. These relationships can exist through official, formal connections such as ownership or equally important informal relations – perhaps family or friendship.

Once a risk assessment has been conducted on the particular sector, transaction-specific risks should also be addressed. Prevention is the key and a range of mitigating tactics should be implemented to minimize the vulnerability of the investment to fraudulent or corrupt activities. An effective risk mitigation program incorporates the following elements:

  • Investigative due diligence on the potential acquisition or joint venture partner to establish that the partner is legitimate and does not carry with it risks which may not be acceptable
  • A screening program for business partners – agents, vendors, distributors or other intermediaries should all be screened
  • A detailed background checks of senior management positions and/or candidates who may be filling those positions
  • Corruption audits to review policies and procedures designed to identify or respond to cases of internal fraud and to help embed corporate ethics throughout an organization

    Despite the common rhetoric surrounding investing in emerging markets, many of these economies are generally stable while featuring opaque political environments that require considerable expertise to navigate. Countries like Russia, China or the wealthy kingdoms of the Middle East offer investors potentially great rewards.

    For instance, in Russia investors have witnessed an environment of rapid growth and a shifting dynamic of influence as power has been drawn back from an elite class of oligarchs towards the historical seat of power, the Kremlin. A Russian partner's connections to the central government can make or break a plan to roll up the competition and achieve scale. However, ensuring that that partner conducts business in a manner that will not run afoul of the US Department of Justice is just as important as the end goal of the investment's life cycle.

    Government connections are certainly not the only relationships that need to be carefully examined. Anyone who has done business in Russia in the last decade has stories that might make for great conversation but are not exactly best practices. One recent case provides an example and stresses the importance of conducting these reviews also for existing investments that were not subject to those checks.

    A US Fortune 500 company – which had been operating successfully in Russia for many years – became aware that one of its employees had a previously undisclosed relationship with a distributor. Further investigation revealed that there were a number of the client organization's employees who held masked interests (either directly or via family and friends) in distributors working with the company. Additionally, the industry was subject to local political interference: the public tenders that generated much of the company's sales were characterized by collusion between distributors – some of which were shell companies developed solely for the purpose of creating the appearance of a competitive tender.

    The screening program enabled the firm to uncover and deal with these issues, while avoiding expensive repercussions. However, the company also realized unexpected benefits, not least giving it a competitive advantage by helping it better understand the market in which it was operating.

    Similarly in China, connections – or guanxi – are everything, and managing those relationships is a key aspect of mitigating legal and reputational risks. While the central government in China is powerful, there is an old Chinese saying to keep in mind: “The sky is high and the emperor is far away.” Local connections, in particular in China's further-flung provinces, are therefore particularly important, for foreign investors must understand the local political landscape and how that fits into the wider context of China, where industries are rapidly consolidating and infrastructure is developing at breakneck speed.

    Unfortunately, as is often the case, substantial risks could be overlooked by investors who are lured by high returns. Recently, for instance, a private equity firm was investing in a manufacturer who had used a local company to certify that they met environmental standards. Suspecting that the company might not have been rigorous enough, the firm outsourced investigative services to quietly look into the matter. With the support of native Chinese investigators, it was uncovered that the manufacturer had contravened substantial environmental requirements that could have caused major reputational and financial – if not legal – issues for the firm.

    Investigations don't always reveal headaches and problems. Sometimes they demonstrate how the investor's concerns were unreal and how the foreign partner was not only not abusing of its employees, like an Indonesian manufacturer was recently accused of, but was exceeding local best practices.

    Doing your homework – the enhanced partner due diligence, the careful pre-employment screening and the fit-for-purpose security arrangements – is worth it. The biggest success stories in emerging markets come from the companies who have measured the risks before they entered the market, rather than after problems emerged. The globalized economy is not a place for a quick buck, but the reward is worth the risk.