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Stepping out of the risk management comfort zone

Finance departments can use these ways to manage cross-border merger-and-acquisition risks.
Stepping out of the risk management comfort zone

As the CEO of a Colorado-based edible marijuana products manufacturer, Chuck Smith is no stranger to political risks. Despite a patchwork of legalisation among some US states, the drug is not legal on the federal level, and the threat of a raid is always present at Dixie Brands’ manufacturing facility in Denver.

“Being in this industry, we’ve lived on the tip of the spear for a long time,” Smith said. In March, Dixie Brands established a joint venture with Khiron Life Sciences, which has its main office and core operations in Colombia. The idea behind the partnership is to distribute Dixie’s cannabis-infused products through Khiron’s existing footprint in Latin America and to new markets in the region as they are legalised.

The main political risk to the deal wasn’t Colombia’s decades of internal conflict, which has eased in recent years. Rather, the main uncertainty is of a legislative nature, as some of the Latin American countries where Dixie and Khiron want to expand might delay implementation of marijuana legalisation or decide against it, which could endanger a timely return on the companies’ investments, Smith said.

A changing legislative environment is hardly unique to the cannabis industry, and is just one of the risks that can come with cross-border joint ventures or mergers and acquisitions (M&A). And political risk is not limited to emerging or frontier markets, as has been exemplified by the trade war between the US and China, the UK’s contentious impending exit from the EU, and economically motivated demonstrations that have rocked France.

“Uncertainty is the enemy to doing deals in general and certainly to risk management,” said Seth Goldblum, managing director at CBIZ CMF, the private equity advisory practice for US-based business services firm CBIZ.

However, uncertainty can be managed. Here is a look at a handful of ways in which finance departments can help mitigate political risk.

Understand the jurisdiction. The fundamental difference between same-country and cross-border deals lies in not being acclimatised to the target environment in the latter case, said Scott Brady, managing director with the global private equity and M&A practice of US-based insurance broker Marsh.

This means companies that want to buy a business in another country have extra steps to take when it comes to due diligence; they need to assess not only the target company and its corporate culture, but also the country in which it is based, both for political stability and for matters such as tax and labour issues.

Jack Clipsham, corporate finance partner with UK-based accountancy and financial adviser Kreston Reeves, recalls a client, a Malaysian company, that had been looking to set up manufacturing operations in the United Kingdom but decided to put the move on hold because of Brexit to see whether it might need a plant on the European mainland.

His client is not alone in expressing concern about the fallout from the “Leave” vote in Britain.

Airbus has said it might move operations out of Britain if the country can’t agree on an exit deal with the European Union. “Please don’t listen to the Brexiteers’ madness which asserts that, because we have huge plants here, we will not move and we will always be here,” the aircraft manufacturer’s CEO said in January. “They are wrong.”

In February, Nissan Motor Co. said it would produce its next-generation X-Trail for the European market in Japan, rather than in the United Kingdom, as had been previously planned. Although the company said it made the decision for business reasons, Nissan Europe Chairman Gianluca de Ficchy added that “the continued uncertainty around the UK's future relationship with the EU is not helping companies like ours to plan for the future.”

Meanwhile, deals in less-developed markets that do not have a history of political stability like Britain does are “infinitely more complex”, Goldblum said. Despite the uncertainties over Brexit, the UK’s stable jurisdiction with strong central banking can allow companies to forecast the general scenarios that might play out and plan for a worst-case scenario.

Acquirers should have a cross-border team to ensure they understand the nuances of risk that might not be present within the home jurisdiction, Goldblum said.

Bilateral investment treaties between nations can give an added level of security to cross-border deals, said Mairtin O’Griofa, executive director for political risks and structured credit with Aon, a professional services firm headquartered in London. Such treaties provide a legal framework if an asset is confiscated or a tax situation makes doing business in the country untenable, he said.

Have a methodical approach. Companies that are more successful with M&A take a methodical approach to doing deals so that they do not get caught up in the emotion that can go with an exciting business prospect, Goldblum said.

“You mitigate the risk by being really methodical about the diligence process,” he said. “Don’t deviate because you really want to get into XYZ market.”

Although there’s no single methodology that will fit every company, in general, companies might say they are only going to do deals of a certain size in a specific industry and with a certain type of management, Goldblum said. While a certain amount of flexibility will be required for each deal, it’s important that once a company comes up with its own M&A evaluation method that it sticks with it in general, using it as a set of guardrails, he said.

Sometimes, especially if it is a company’s first foray into an overseas market, leadership can get caught up in the romanticism of a foreign jurisdiction and the money-making potential of expanding there, Clipsham said.

But it is the CFO’s job to point out deal breakers or concerns that need to be resolved before committing. “It’s the CFO who sometimes has to be the bad guy,” he said.

Consider insurance. Traditional ways of dealing with M&A risk include paying less for a riskier asset, deferring an element of consideration to see whether a risk becomes a reality, and entering into contracts that allow companies to recover funds from sellers if an identified risk crystallises.

Insurance offers an alternative. With political risk insurance, companies can be covered against arbitrary government action, such as asset confiscation, or a change in regime. Political risk “is quantifiable, and you can put a price on it; it’s called the insurance premium”, O’Griofa said.

While it is possible to get political risk insurance against, for example, the nationalisation of assets, the more unstable the nation, the more it can cost to transfer risk from the company to the insurer, if the risk is insurable at all. Some regimes may require the use of their own domestic insurance firms, which may not inspire as much confidence as insurers in more stable jurisdictions, Brady said.

Make sure you have the human resources. Sometimes companies underestimate the amount of work involved in acquiring businesses abroad. If the CFO is already at his or her limit with running the acquiring company as it is, companies can risk damaging the existing business if the CFO takes his or her eye off the ball to pursue an acquisition, Clipsham said.

The solution, he said, may mean bringing in outside advisers or bulking up in-house staff who can help with the research.

Whether they are lawyers, accountants, human resources professionals, treasury experts, or technology professionals, make sure that advisers have deep experience in deal-making, Goldblum said.

— Matt Whittaker is a freelance journalist based in the United States. To comment on this article or to suggest an idea for another article, contact Drew Adamek, an FM magazine senior editor, at Andrew.Adamek@aicpa-cima.com.