Hide Or Seek: Tales Of Risks and Opportunities In Emerging MarketsDr. Harry G. Broadman
By Harry Broadman
(Forbes) – As corporates, banks, institutional investors, and private equity funds scour the globe for new investment opportunities with high returns, inevitably emerging markets come into play. No big surprise here since their average growth rates in real terms have been multiples of those of advanced countries for the past two decades, and due to secular changes in the structure of the world economy, are destined to continue to do so for the foreseeable future.
But the nagging issue, which almost always wins the day, is that despite the sizeable potential returns seemingly presented by these fast growing markets, the perceived high risks of doing business in them undercut the prospects for actual consummation of investment deals.
The consequence is that investors—especially corporates based in the advanced countries—pass over sound opportunities in some of the most promising emerging markets, where risk-adjusted rates of return, in fact, are—or can be made to be–truly sizeable. Not only is “money left on the table”, but in doing so they surrender competitive first-mover advantage to rivals, perhaps most notably world-class multinationals emanating from the emerging markets themselves, who, in time, could well undercut advanced country firms’ market positions on their own “home turf”.
To be sure, accurately assessing the opportunity-risk tradeoffs of investing in emerging markets is, by the very nature of these markets, a tricky enterprise. But in many cases—though not all—the perceived risks are either understated or overstated, and the same goes for the perceived returns.
Two examples illustrate the point.
First, take China. Many investors and corporate executives believe they can—indeed they must—do business there given its market size and seemingly rapid growth rate. From my experience, however, having worked in the field for more than two decades across the country–from the more advanced provinces in the Southern and Eastern Coasts to the interior and Western provinces, which are generally far less developed–the overall on-the-ground investment environment in China is far more nuanced and complex than most investors—whether from advanced countries or other emerging markets, including those in Asia–appreciate.
China’s property rights remain “fuzzy”; inter-provincial barriers to trade, investment and labor mobility are often still appreciable; the state’s ownership and/or control of key enterprises in the corporate and banking sectors continues to be omnipresent—though much more informal and less explicit than was the case several decades ago giving the appearance of a thriving, indeed almost dominant, private sector; and policy and regulatory changes still occur in an unanticipated and irregular fashion (a diplomatic turn of a phrase for “corruption”).
But the real soft underbelly of the Chinese economy that many investors still seem to turn a blind eye toward is the relationship between the dominant state-owned banks and the “backbone” state-owned enterprises (SOEs). It is only a bit of an exaggeration to say that the main banks pretend to “lend” money to the SOEs while the SOEs pretend to pay back the “loans” to the banks. One need only look at China’s officialtime series data on the proportion of “non-performing” loans over the past two decades or more.
Mind you, I am not singling out China here: the country is hardly unique among emerging markets in possessing these attributes. Indeed, the Chinese leadership has made truly significant reform progress since the beginning of its Open Door Policy in 1978. But, China, today, is a classic case of a market where the investment risks generally are underestimated while the opportunities are overstated.
This also doesn’t mean that one cannot do business very successfully in places like China (a few lessons are suggested below). But it does call for a recalibration of strategy for investing in China, which one might call the “China 2.0 Strategy”.
Perhaps the best counterexample at the other extreme to China, is a growing group of countries in sub-Saharan Africa. (Needless to say, unlike China this is a continent comprised of 47 (using the UN typology) individual states, among which there is significant heterogeneity.) Illustrative representatives of this group would include Ghana, Rwanda, South Africa, Nigeria, Ethiopia, Botswana, Zambia, Namibia, Cote d’Ivoire, Uganda, Kenya, Mauritius, Tanzania, Mozambique, and Senegal.
Most corporates, banks, private equity funds, pensions and sovereign wealth funds with whom I talk to in developed countries–as well as in a number of emerging markets–lack almost any semblance of accurate information about market, institutional and political conditions on the African continent.
They don’t know, for example, that about one-half of the population in sub-Saharan Africa lives in countries where GDP growth, adjusted for inflation, has averaged more than 5 percent per year over the last two decades. They also don’t know that there is a burgeoning African consumer class, and more importantly, a growing cadre of African consumers who demonstrateincreasingly sophisticated purchasing decision-making behavior, which at its core, is not terribly unreminiscent of that observed in advanced countries. And I’m not referring to South Africa alone–by any means. To put it bluntly, a large number of investors—including some who are considered to be sophisticated–—simply don’t believe there are—or even could be–any realistic investment opportunities in Africa.
At the same time, African markets are seen as utterly fraught with excessive risk. There are, of course, appreciable risks of doing business in Africa, just as there are in most emerging markets, whether Latin America, the Middle East, the former Soviet Union, Central and Eastern Europe, India and South Asia, and East Asia, of course, including China. Indeed, many African countries share much of the risk attributes of China described above.
The key question, however, is: are the risks in Africa accurately—or at least reasonably–perceived? I was absolutely stunned four years ago when a very senior executive of a Fortune 10 US-based global company told me he would never contemplate his company investing in Uganda because that was where Idi Amin was from and he’d be afraid of being cannibalized! I’m serious.
Suffice it to say, that remark was an outlier. But it says gobs about what otherwise sophisticated people think about the continent: The perceived risks of investing in Africa are grossly overstated, while the opportunities are understated.
Three examples are instructive. First, during the recent global financial crisis, despite the worry that it would be countries in Africa, more than any other region of the world that would put in place price controls and protectionist policies in the hopes of sheltering the population from economic shocks, many African policy makers, veterans of hard-won economic reforms over the past few decades, were actually part of the few exceptions around the world to refrain from such self-defeating policy actions. Other emerging markets—Brazil, India, Turkey and Russia, for example—as well as a number of advanced country markets actually pursued such initiatives to their detriment.
Second, like some other emerging markets driven either by the necessity to fill cross-sectoral economic development deficits or unburdened by costly, if not obsolete, technologies and manufacturing or service delivery practices, some African countries are truly leapfrogging ways advanced countries are doing business. Mobile money, which was first invented in Kenya, is only now making its way to the US, for example. As I noted in an earlier column, places like Africa are turning the traditional “product life cycle” model of global innovation on its head.
Finally, while still much more progress is needed on the African continent in terms of orderly changes of government through democratic processes and reducing civil strife and cross-border disturbances, the significant positive trend in both of these areas over the past decade and a half are simply undeniable.
So, how might one accurately assess the risks and opportunities in emerging markets?
It has become more than trite to say that one part of the solution is “to know” your customers, suppliers, distributors, JV partners, and other stakeholders, including the particular government with which you’re dealing. But where this task often fails—and generally miserably—is the actual process undertaken to achieve this goal. Recent experience suggests the best way to do this is to carry out tailored due diligence, simultaneously employing a variety of interdisciplinary lenses and techniques, not just assessing legal and financial risks but especially reputational risk, and most critically by using independent, verifiable sources.
I frequently see companies rely on self-proclaimed experts or (the many) people who claim to “know very important people” in the local economies, only to discover that these people themselves are of questionable integrity and judgement. The ability to perform world-class due diligence comes from having done it repeatedly throughout challenging parts of the world so there is the capacity to recognize similar problems–or actually uncover concealed bona fide opportunities–when they crop up, and information is collected and interpreted by parties who are truly independent to the transaction and are mutually trusted by all sides.
Such due diligence can be applied in a number of ways by investors to effectively mitigate risks and maximize opportunities in emerging markets.
One approach is to establish business-to-business (B2B) cross-sectoral (horizontal) alliances that exploit economies of scale and scope. For example, an electric power company might establish a B2B agreement with an informatics/communications company, and a health care system provider in a particular geography, say in Southeast Asia. This brings under one tent a variety of stakeholders within one country from different vantage points. Because the project simultaneously addresses cross-sectoral development deficits, the government, workers, consumers and other civil society groups—let alone ancillary industries—should have a keen interest in it being successful. From the investors’ perspectives, if the B2B performs well, the three companies, who now have a track record of co-investing, could replicate the relationship elsewhere in Southeast Asia or in another region.
Business-to-government agreements or public-private partnerships (PPPs) are another avenue. A world-class international engineering and construction company a few years ago signed a 15-year master service agreement with West African government to become the anchor investor and provide management and technical support to the government as it develops a national infrastructure master plan.
Similarly, a major beverage firm formed a PPP with three East African governments that provides wholly new market outlets for local fruit farmers to sell juice to the beverage company’s supply chain (substituting for the company’s much more costly juice imports), fosters intra-regional trade that otherwise did not exist, and creates broad economic multiplier effects by raising disposable incomes and creating new jobs across the three local populations. Such a “win-win” approach not only helps to inoculate the project from risk of intervention from vested interests because it addresses the governments’ economic development objectives, but it also expands the firm’s bottom line.
Indeed, it illustrates an innovation in business strategy in emerging markets where the traditional pursuit of Corporate Social Responsibility (CSR) objectives actually can fulfill mainstream corporate commercial goals of higher profits and reduce exposure to risk, especially corruption risk. (This is a topic I will address in a future column.)
The bottom line is that there are proactive actions that investors can—and should–undertake to gain far better insight into the actual on-the-ground risks and opportunities in emerging markets, rather than be guided by inaccurate information or worse, misperceptions.