Navigating Operational Due Diligence in Emerging Markets
August 03, 2016
By Claudia Osmar
Emerging markets, such as those in Latin America, can be highly profitable. The costs are low and the markets are eager to attract foreign investment. However, they also involve certain risks, ranging from potential political problems to simple differences in business culture.
In developed markets, investors often limit the scope of operational due diligence to traditional financial and tax issues. This approach may fall short to uncover important information in an emerging market.
In emerging markets, the most difficult areas to navigate generally relate to the political environment, lack of transparency, bureaucracy and corruption. The traditional approach to operational due diligence is not enough to respond to the unique and specific challenges that exist. Sophisticated investors utilize a more integrated due diligence approach focusing on areas beyond traditional financial information.
KEY FACTORS TO CONSIDER DURING EMERGING MARKETS OPERATIONAL DUE DILIGENCE
A local team is crucial
In places where the line between businesses and government interests is sometimes blurry, understanding the culture of the emerging market and establishing a presence in the local market is a fundamental part of the process.
Local teams are a key factor to success as they will have relationships and connections that enable them to understand and navigate the country’s regulatory environment.
Higher importance should be placed on the reputation of the local company and its management. Getting to know the people is as relevant as a good track record and reputational due diligence should be part of the process.
Lack of transparency
One of the most important reasons for investors breaking off deals is a lack of transparency.
In emerging markets, many businesses are family owned and companies might have a poor track record or lack of audited information. Often the quality of information is questionable (accessibility and accuracy) and it must be supplemented with on-the-ground work and interviews. It is not unusual to find multiple sets of books.
Investors might engage auditors and/or consultants with experience in the local market to perform financial due diligence on site and/or gather independent information to validate the financial information provided by the company. Records might need to be converted into U.S. GAAP or International Financial Reporting Standards (“IFRS”) to allow comparability and analyze the impact on future consolidations.
Businesses’ and governments’ interests
Investors should understand the relationship between the company and the state as companies are frequently supported or influenced by the state. Conflict of interest is a common issue in emerging markets and the instability that would be caused by a change in the relationship with the state is a risk that should not be underestimated.
Personal relationships with these governments are key for some businesses and more often than not cannot be passed on to a new owner.
Unstable regulatory environment
Regulations in emerging markets can be complex and unstable. Often, emerging markets’ legal systems move too slowly for enforcement which increases the risk of corruption and bribery. Adequate investor protection is often missed.
Other areas of concern are future regulatory requirements in which emerging markets are highly uncertain and volatile. It is important to work closely with a trustworthy local law firm throughout the process.
Political stability and elections are other factors investors should consider. Elections are a key indicator to project the political stability or trajectory of a jurisdiction. For example, Argentina had an election during 2015 and the new government has already shown a favorable change towards foreign investments in comparison to the previous government who was in power for 12 years and made foreign investments very difficult.
Investors need to be able to examine the financial viability of an investment in an emerging market. They will need to apply an integrated approach to ensure an appropriate risk assessment that will allow them to develop a strategy aligned with the emerging market reality.
Asset Management Intelligence - Q3 2016