The Consequences of Misreading Global Risks

Bob Gross

Thursday, October 29, 2015

Pick whatever source of news you like, and you’ll soon see or hear about something that is causing a problem in one area of the globe or another. Sometimes these are natural disasters that have and always will happen randomly, but many others are economic surprises caused by people, sometimes well-intentioned but sometimes not. These events can cause a change in the riskiness of doing business, and changes in the assessment of risk can substantially impact a firm’s value.

As companies venture forth and expand globally, especially in the early stages of cross-border expansion, there is often a tendency to miss or misread the incremental risks they might be taking on. To be fair, the riskiness of the overall firm may not move much with a modest step overseas. But over time, as companies continue to creep further and further into the process of globalization, the consequences can become material. In my experience, many companies find themselves with 20 to 30 percent of their overall business overseas before they know it, and that’s enough to move the ‘risk needle’ quite a bit.

How does this happen? All too often, I see companies project their domestic thinking onto international expansion opportunities. For example, they look at an expansion into India as being similar to an expansion into Indiana. They get enamored (almost romanced) by the growth possibilities but tend to forget the incremental risks relating to operating challenges, currencies and dealing with people in a distant, sovereign nation. As a result, there is a tendency to overpay or over-invest, which has the effect of diluting future real financial returns.

I won’t go into any real depth here about how the added risk can impact the firm’s value, but let me at least briefly summarize the issues to jog your memory of past finance classes. Here’s how this ‘waterfalls’:

  1. The investor market will always find out about your added risks, and will adjust their required return to compensate for it, so…
  2. Their required return becomes your overall cost of capital, which means…
  3. Your overall cost of capital needs to reflect a blend of the risks of your domestic and international business units, so you better….
  4. Evaluate your expansion decisions with country-specific risks in mind.

This is a topic of some importance in our Global Finance course at Lake Forest Graduate School of Management (LFGSM) as we learn how to (1) identify and (2) measure the impacts of added risk. Companies that are implementing plans that strategically place assets around the globe need to be aware of what they are getting into, and reflect those realities in their investment decision processes.

Finding the information to do that isn’t easy, but it is worth the effort. At the very minimum, the added financial risk should be a front-end topic of discussion for a couple of good reasons:

  • First, there may be clear opportunities for mitigating the currency-related and other non-currency risks using a number of different techniques. It is infinitely easier to employ, for example, strategically designed natural hedges concurrently with the expansion implementation rather than to try to create them after the fact.
  • Second, quantifying the added risks in the investment or acquisition modeling used by the company will result in more realistic investment return estimates and project/acquisition pricing. This helps set reasonable expectations in advance that might be exceeded, rather than trying to explain away a ‘surprising’ shortfall after the fact. The latter is almost always received poorly.

The misreading of cross-border risks might explain a lot of the disappointments you’ll see mentioned in the news. Articles citing project delays, cost overruns and unmet profitability targets are often portrayed as unavoidable surprises. However, they are frequently the result of financial expectations that are set without a full reflection of the new layers of risk that accompany global expansion. Knowing that these added risks exist (and then doing something about them) are mission-critical elements of global financial management.

 

bobgrossfinalBob Gross teaches Financial Management and Global Finance at Lake Forest Graduate School of Management. Bob is also the Co-Founder and Senior Managing Director of Prairie Capital Advisors, Inc. Prairie is an employee-owned company that provides investment banking, ESOP advisory and valuation services to support the growth and ownership transition strategies of middle-market companies. Bob has a passion for staff development, and he speaks to audiences on a wide variety of corporate finance topics, including valuation, mergers and acquisitions, ESOPs, ownership transition, securities design, and synthetic equity. LinkedIn

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