For decades, large U.S. and European companies have invested in emerging markets, and the Great Recession of 2008, which brought growth in developed economies to a shuddering halt, further encouraged companies and their CFOs to look for greater returns on invested capital in less developed markets.
Indeed, according to the United Nations Global Investment Trends Monitor, foreign direct investment (FDI) in developing economies reached a new high in 2013 of $759 billion, more than half of the $1.46 trillion in global FDI.
Doing business in these emerging markets – where bribery and corruption are endemic, regimes and regulations may change suddenly and unpredictably, and language, distance and cultural differences often make it hard for companies based in Boston, Berlin, or Brussels to know what’s going on – means assuming more risk.
Consequently, FTI Consulting, a global business advisory firm, conducted research in November and December of 2014 to explore the experiences in emerging markets countries of large (at least $1 billion in annual revenues) North American and European-based multinationals since 2010. In all, senior executives with responsibilities for risk management and compliance at 150 companies responded to our survey. We found that over that period 83% of responding companies had suffered significant losses in emerging markets, with the average cost per incident estimated at $325 million and the average cost per company over the last five years $1.38 billion. The average loss per year was $260 million, or 0.7% of annual revenue.
Almost all these losses (99%) derived from three categories of risk: regulatory (44%), bribery and fraud (31%), and reputational issues (25%). We found that the most costly incidents occur when two or more of these risks converge, creating a cascade of losses that become increasingly hard to contain or stem. Sixty percent of those incidents that generated the highest losses involved more than one type of hazard, 35% involved two, and 25% involved all three.
For instance, a company could violate a regulation (either intentionally, due to hard-to-follow or rapidly changing rules, or because of weak compliance policies). It might then bribe an official to reduce a fine or make it go away.
Then, if the bribe becomes public, the company’s reputation will be damaged, making it more difficult to do business, impairing future revenues. That could cause the company to reduce its investment in compliance training and cut more corners, fueling a vicious cycle of crime and punishment as the company blunders from one disaster to another while its losses mount.
Unfortunately, some companies see these losses as an inevitable cost of doing business in these jurisdictions. They say they’re too large to vet all their employees or vendors, or operate in too many countries to track regulatory changes. They say social media makes it impossible to control their story, and that green activists (especially in South America) will never be satisfied no matter what they do.
This attitude would be a mistake. Worse, it ignores the fact that some companies succeed in managing their risks – and limiting their losses – far better than others.
Leaders Differ from Laggards
We define leaders as companies whose self-reported losses in emerging economies were in the lowest quartile, averaging 0.2% of revenue; laggards were in the highest quartile, with a loss rate averaging 2.2%,
We found that companies that are best at containing their incidents (not allowing risks to converge) and limiting their losses aren’t just different from laggards in what they do; they are different from them in how they think.
We also found that leading companies rank almost every best practice for the mitigation of regulatory, bribery and fraud, and reputational risk higher than do laggards. (Click on image to see a larger version.) This is a bit of a head scratcher when one considers that laggards already have experienced more losses than leaders but still don’t rate these precautions as highly. Indeed, when asked how well they thought they managed risk, companies with higher losses generally thought they managed risk about as well as their low-loss peers. In other words, laggards don’t get it.
Laggards also believe running “pre-emptive publicity campaigns to counteract negative reactions” is a good strategy. They apparently believe that PR has magic powers.
Leaders do not. They believe in action, such as conducting a continuous dialogue with local staff on compliance issues (65% of leaders do this as opposed to only 10% of laggards). This spread is one of the largest differences we found, along with leaders being reluctant to do business in places where compliance may not be possible (almost 30% compared with 5%) and maintaining a consistently good reputation, which 50% of leaders consider important as opposed to only about 5% of laggards.
The best companies protect themselves in three important ways:
- They maintain a consistently good reputation over the long haul. They do so by playing by the rules and letting the leadership of the country in which they are operating know it. They conduct due diligence on partners that can ruin their reputation as well as their balance sheet. And they maintain their reputation by working with and through the media.
- They take care to understand and accommodate the regulatory environment. They examine the regulatory framework of the country in which they are considering investing before they make their investment, understanding that they are making a long-term commitment to the country and its people. And if that regulatory framework is constructed so as to make compliance impossible, leading companies are willing to walk away.
- They engage with the local culture. Leaders have employees and managers on the ground that they can trust in the countries in which they do business. These employees are often native-born managers who have served elsewhere in the company and have absorbed a culture of ethical business practice. And top management impresses upon middle management that the company is committed to rigorous, unbending compliance.
Finally, CFOs should always view risk in terms of aggregate return. This is how the performance of their company’s entire portfolio of investments in emerging economies can be improved rather than focusing on a single local market or jurisdiction.
The very fact that there are leaders and laggards when it comes to managing risk, improving profitability, and reducing losses in emerging markets should tell CFOs that the cost of doing business-as-usual is always too high.
Arun Shukla is a senior managing director in the corporate finance practice of the FTI Consulting Corporate Finance practice.. Andrew Klemm is a senior consultant in the same practice at the consulting firm.