AS CROSS-BORDER partnerships and investments become increasingly important for major corporations combating slow growth and depleted resources in their traditional markets, so too has the need to manage country risk in emerging markets. Many of the largest U.S. and European companies already receive 20 to 40% of their sales from joint ventures with foreign partners, a figure that is likely to rise. Royal Dutch Shell, Vodafone, and General Motors have significant portions of their portfolios committed to joint ventures in emerging markets.
However, these international conglomerates are not the only players in the space. Even small to midsize companies are creating joint ventures outside of their core geographies. Just recently, Vice Media announced that it will pursue an aggressive international growth strategy involving joint ventures in the Middle East and Asia. We would be remiss if we did not remind Vice Media, and even those international corporations experienced in emerging market dealmaking, that these types of partnerships, which are formed to access natural resources, low-cost manufacturing or, in Vice Media’s case, new customers, come with a unique set of country risks that must be managed carefully to ensure growth and protect existing income streams.
Most of these country risks relate to the relationship between the company and the host government, and they exist whether or not the government holds equity directly or through a state-owned enterprise (Exhibit 1). These risks stem from misalignments in shareholder interests, exacerbated by differences in the length of the political and business cycles; the often capital-intensive, highly visible, and inextricable nature of foreign-asset development; and information asymmetries between the parties. Recently, Water Street Partners conducted interviews with over 80 executives in the mining and other industries to discuss joint venture asset development in emerging markets. While most interviewees conceded that companies excel at their core operations, managing relationships with foreign governments was commonly cited as a critical weakness.
But without managing country risk appropriately, these risks may manifest in the form of host governments renegotiating, restructuring, or reneging on their prior commitments, seeking to extract more value from the foreign investor or a willing substitute.
Material disputes between governments and their investors are far more common than one might think, and the implications range from minor penalties or assessments, to outright nationalization. In 2012, Rio Tinto and the Mongolian government were publicly debating a tax payment made by the diversified miner for its Oyu Tolgoi copper and gold mine joint venture. Rio Tinto claimed that the payment was an advance payment, but the government claimed it was a payment in arrears, leaving a large, unpaid balance in contention. In Guinea that same year, the government updated its mining code, permitting itself to claim a free 15% carry stake in mining projects that could theoretically apply retroactively. In Argentina the government went further when it nationalized the country’s main oil company, YPF, causing Spanish oil company Repsol to claim a $10.5 billion loss on its majority stake equity investment.
Clearly, these risks are real and can be crippling. To combat them, companies typically perform extensive due diligence on the counterparty, vendors, customers, and host government before doing the deal, and obtain political risk insurance to protect themselves after closing the deal.
SIX PRACTICES FOR MANAGING COUNTRY RISK
Water Street advises corporations to use diplomacy and defense to level the playing field in partnerships with host governments. Corporations, like countries, should adhere to a set of diplomatic principles when managing their government relationships. These include becoming well-versed in the current wants, needs, and concerns of the foreign government. This is an obvious, but often poorly executed step. Major corporations might also employ a number of defensive moves to complement their diplomatic ones, using leverage to defend and advance their position. Of utmost importance is to craft a fair deal and communicate its workings to all key constituencies, but beyond that, there are a number of other less obvious tactics.
To illustrate these less obvious tactics, we developed six practices – some involving diplomacy, some involving defense – that companies can use to level the playing field when negotiating with host governments and manage country risk. In Flipping the Script, A Different Way to Manage Country Risk in Emerging Markets, we go in depth into these six practices by providing case examples and implications for each of the specific applications.
To ensure growth, large corporations will need to continue to access customers and resources across the globe. To do so economically will require a clear view of country risk, and a set of techniques to manage it. Success in the “Asian Century” will depend on more than just a great product and political risk insurance – it will require proficiency with both diplomacy and defense to level the playing field.