Country risk
Scope of the firm in emerging markets
Benefits of conglomeration
• Focus is the mantra in New York/London. Good
advice in emerging markets? Not necessarily.
The scope of the firm depends on institutional
context.
• What special in emerging markets
– Info problem in financial, product, and labor markets.
– Misguided regulation distorting markets
– Inefficient judicial systems (contracts not reliably
enforced)
Financial markets
Info problem and market failures
•
W/o access to information, investors refrain from putting money into unfamiliar
ventures. Developed markets minimize these problems thru institutional
mechanisms:
–
–
–
–
–
–
•
Reliable financial reporting
A dynamic community of analysts
An aggressive and independent financial press
SEC and other watchdog bodies
Shareholder rights are protected (securities litigation, proxy fights, and hostiles)
Venture capital firms specializes in assessing new opps.
These institutions are largely absent or inefficient in emerging markets. Implications:
–
–
–
–
–
–
Investors refrain from investing.
Large and well-established firms have superior access to capital.
Diversification has value to investors. (Also to managers)
Diversified firms can also form internal capital market (internal finance)
Investors trust diversified groups to evaluate new opportunities and to exercise an auditing
and supervisory function.
Diversified firms imitate the institution features of venture capital firms, private equity
providers, mutual funds, banks, and auditors (independence??)
Product markets
Info problems and market failures
• Cause of info problems
– Underdeveloped communications infrastructure.
– No mechanisms to corroborate claims made by sellers. (Consumer
Report in Russia?)
– Consumer protection? Product safety regulation? Truth in advertising?
• Implications:
– High cost in building credible brands in emerging markets
• But established brands wield tremendous power.
– A conglomerate with a reputation for quality products and services can
use its group name to enter new businesses, even if those businesses
are completely unrelated to its current lines.
– Groups can spread the high costs of building a reputation across
multiple lines of businesses
– Groups also have the incentive to protect brand quality.
• E.g., Samsung has used its name for a range of products ranging from TV,
microwave ovens, to computers.
Other market failures
•
Labor markets
– Problems
• Lack of educational institutions to train people
• No certification and screening
• Labor regulation that limits layoffs
– Implications
• Groups provide training programs (group specific)
• Internal labor markets
•
Regulation
– Problems ---Too much regulations
– Solution --- Groups as intermediaries between government and individual
companies. Lobbying, educating, (and bribing) politicians.
•
Contract enforcement
– Problems --- Contract not enforceable.
– Solution --- Reputation for honest dealings
•
Not every diversified group will be able to add value in the same way and no
group can hope to fill every institutional void.
Sovereign spreads
30
25
7/30/2001
1/29/2002
20
15
10
5
0
Argentina
Brazil
Colombia
Mexico
Venezuela
Hungary
Poland
Russia
Turkey
Korea
Malaysia
South
Africa
200108
200106
200104
200102
200012
200010
200008
1
200006
200004
200002
199912
199910
199908
199906
199904
199902
199812
2
199810
199808
199806
199804
199802
7
199712
199710
199708
199706
199704
199702
199612
199610
199608
199606
199604
199602
199512
9
8
Russia
6
5
4
3
World
Argentina
0
Cost of equity for average projects in emerging markets
Country
Average
monthly
return
Argentina
0.00%
10.34%
0.58
1.34
12.58%
25.88%
26%
39%
Brazil
0.83%
12.39%
0.65
1.79
5.88%
7.29%
22%
23%
Colombia
-0.67%
8.52%
0.19
0.35
6.41%
6.40%
14%
14%
Mexico
1.13%
9.59%
0.70
1.48
2.61%
2.22%
16%
16%
Venezuela
1.78%
13.27%
0.31
0.92
6.37%
13.02%
17%
24%
Hungary
1.60%
11.91%
0.56
1.48
0.62%
0.46%
15%
14%
Poland
0.55%
11.04%
0.49
1.20
0.63%
0.98%
13%
13%
Russia
3.89%
21.77%
0.51
2.46
5.81%
3.26%
26%
23%
Turkey
1.82%
19.72%
0.48
2.08
7.05%
5.20%
25%
23%
Korea
-0.04%
17.22%
0.48
1.84
1.08%
1.22%
17%
17%
Malaysia
-0.47%
13.87%
0.42
1.29
1.18%
0.94%
14%
14%
South Africa
-0.18%
8.96%
0.61
1.22
2.11%
1.92%
14%
14%
Standard
deviation of
monthly returns
Coefficient of
correlation with
world returns
Country
beta
Sovereign
spread
7/30/2001
Sovereign
spread
1/29/2002
COE
7/30/2001
COE
1/29/2002
Assumptions: Risk free rate = 5%, world market risk premium = 6%, COE = risk free rate + sovereign spread + country beta * world market risk
premium (Lessard formula)
30%
25%
C
O
E
20%
15%
10%
5%
0%
0.00%
5.00%
10.00%
Stock retrun volatility
15.00%
20.00%
25.00%
5.00%
A
v
e
r
4.00%
a
g
e
m
3.00%
o
n
t
h
2.00%
l
y
r
1.00%
e
t
u
r
n
s
0.00%
0%
5%
10%
15%
-1.00%
Cost of Equity
20%
25%
30%
Principles of Risk Management

Allocate risk to the party that controls the risk or had the greatest impact on its
outcome (effectiveness).

When possible and cost effective to do so, write a detailed contract specifying
actions, quality, and performance. Contracts work best when the risks are
identifiable, outcomes are verifiable, and contracts are enforceable.
Predictable: note the difference between risk (known distributions) and
uncertainty (unknown distributions)
Verifiable: note the role of asymmetric information.
Enforceable: note the importance of legal systems, property rights, and
enforcement mechanisms.

Allocate risks to the party that can bear them at least cost (efficiency).

When negotiation, contracting, and other transaction costs make
complete contracting unfeasible, allocate residual risk and return to
align incentives and induce optimal behavior.

If possible, allocate asymmetric, downside risks to debt holders;
allocate symmetric and upside risks to equity holders.
Why does project finance (or risk management) create value?
•
•
Modigliani and Miller’s capital structure irrelevance proposition: under
perfect capital markets, firm value should not depend on how a firm finance
its investments.
Real world capital markets are imperfect:
–
–
–
–
–
•
Taxes
Transaction costs
Costs of financial distress (bankruptcy)
Information costs (asymmetric information, managers know more than investors)
Incentive conflicts among managers, shareholders and creditors
How project finance reduces the costs of market imperfection?
– Reduce information costs by investing in tangible, transparent, and stand-alone
assets.
– Reduce incentive conflicts
• Free cash flow conflicts --- require firms to raise external funds (debt) from independent
third parties.
• Risk shifting (investing in high risk projects) --- “cash waterfall” to ensure creditors get
the cash first.
• Generally, making decision makers bear the consequence of their decision.
– Reduce financial distress
• Reduce the probability of distress -- risk contamination: independent entity
• Reduce the costs of distress -- the tangible assets. Commodity products.
– Reduce corporate taxes