By Ernst & Young
Global companies are seeing more and more opportunities in rapid-growth markets including the BRIC countries and even less familiar ones like Indonesia, Thailand, Mexico and Ukraine. While potential rewards of investment are undeniable, so are risks and the likelihood that budget overruns might temper future growth prospects.
More than a few companies, however, risk profitability by underestimating the costs and time involved in entering rapid-growth markets according to a recent Ernst & Young report, based on a survey of 921 chief financial officers (CFOs) around the world as well as in-depth interviews with finance leaders from developed and emerging markets.
Our study suggests that CFOs should not assume that rapid-growth markets are also low-cost ones. Among the survey respondents, more than one-third (36 percent) said the overall costs of investing in these markets were higher than expected and nearly half (43 percent) said the investment took more time than anticipated.
``What lies beneath? ― the hidden costs of entering rapid-growth markets,’’ a 54-page publication containing the key findings of the research, examines the ``hidden costs’’ of rapid-growth market entry with a special focus on the CFO’s role throughout the process.
Of the many and varied costs of market entry, there are six that Ernst & Young identified as areas of particular concern for CFOs. In order of the reported likelihood to overspend, they are financing costs; mode of entry costs; operational costs; regulatory costs; human capital costs; and political costs.
● Financing costs: rising inflation and currency fluctuations are becoming key concerns for foreign investors.
Surging capital flows into rapid-growth markets are stoking inflation and pushing up currency values. Although policy-makers in these markets are trying to cool their economies by tightening monetary policy, the potential for currency risk remains a key source of unexpected cost for foreign investors. International policy is creating another source of currency risk. Growing pressure on the Chinese Government to further revalue the yuan and allow it to appreciate more quickly could raise costs substantially for exporters and alter the rationale for investment in China.
● Mode of entry costs: choosing the right mode of investment is considered the most critical decision, with valuation a key challenge.
When asked to advise their peers on where to pay most attention in relation to investing in rapid-growth markets, respondents point to the mode of entry as the most critical decision that must be made ― even more so than the investment destination. It also pays to take a long-term view.
Over time, given increased liberalization in many markets, the mode of investment may need to change. Companies planning an investment should consider whether this will be possible and what the implications will be. When acquiring companies in these markets, survey respondents consider valuation to be the key challenge they face. Although the situation varies from market to market, investors may find it difficult to extract accurate data on which to base a valuation.
Another common problem is that disclosure levels may be poor, either because of regulatory shortcomings or a lack of cooperation from the seller. These challenges highlight the importance of obtaining data from multiple sources and using a combination of valuation methods to improve accuracy.
● Operational costs: those related to R&D and finance function integration are the main operational concerns.
Anything that increases the cost of production is a critical concern for CFOs, in markets that rely on very high volumes and very low margins to make profit. The highest unanticipated costs relate to R&D investment which, particularly for high-performing companies, is on the rise.
The increasing importance of rapid-growth markets is encouraging a growing number of companies to set up R&D centers in these economies to serve populations with fast-rising per capita incomes. Another key area of overspend relates to the integration and harmonization of reporting frameworks, IT systems and local finance talent to meet global reporting obligations.
● Regulatory costs: evolving regulatory systems and high levels of bureaucracy are the main areas of unbudgeted costs.
Obtaining the right licenses and permits is a particular challenge for survey respondents. As regulatory systems evolve, these costs may be streamlined but other compliance costs will rise as regulations becomes more demanding. Foreign investors should ensure that they ``future-proof’’ their investments by anticipating future regulatory changes and building that into their overall business case.
● Human capital costs: attrition levels are the main reason for human capital overspending.
Rapid economic growth and rising demand for a finite pool of skilled workers are pushing up wages and creating high levels of employee turnover in many rapid-growth markets.
To counter this problem, foreign investors need to build a brand as an employer of choice, ensure that they build strong relationships with local communities and pay close attention to training and compensation policies.
● Political costs: fear of expropriation has been replaced by bribery and corruption.
The upheaval in the Middle East and North Africa in early 2011 brought political risk back to the top of the agenda. Political risk management forms a critical part of the pre-entry planning but should also stay on the radar throughout the life cycle of the investment. Although some political risks, such as expropriation, have diminished, others, such as bribery and corruption, remain a key concern.
While acknowledging that local competitors and partners may be used to bribery as part of the normal course of doing business, zero tolerance is argued as critical by those CFOs interviewed, and a key consideration when determining investment destination.
CFOs, according to the survey, tend to play a slightly more active role at the pre-entry stage of investment than at the post-entry stage. While 29 percent of respondents said they play a leading role at the pre-entry stage, only 20 percent said they do so during post-execution.
However, the leading CFOs interviewed stressed the need for involvement at all stages of the process to safeguard the promise of investment and sustain growth in markets where change is rapid. While it may not be practical for the CFO to stay close to every investment in a global portfolio, the ability to delegate and secure the right balance of local and group finance expertise is critical.
CFOs now have to strike the right balance between accelerating investment in the rapid-growth markets, while monitoring and controlling the pace and method of investment. They should develop the investment plans with the right on-the-ground talent to support these plans, with ongoing involvement and oversight of the entire investment process for as long as necessary.
This article was contributed by Ernst & Young Korea.