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The boards of global companies are struggling with evolutionary changes affecting their businesses, as domestic growth prospects wane in the United States and opportunities expand in emerging-country markets. Ernst & Young predicts that 70 percent of world growth over the next few years will come from these markets, with China and India accounting for 40 percent of that growth. These markets promise access to new and underpenetrated customers with rising levels of consumption, access to low-cost labor and materials, and increasingly sophisticated research and development capabilities and capacity. However, these markets also pose unique risks that sometimes are ignored in the rush to seize an opportunity. Given the allure, management tends to overemphasize potential rewards and underestimate risks.
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As with all other risks, the board and its designated committees should follow management’s lead in identifying, managing and mitigating the risks in these markets. The challenges of these territories can present a steep learning curve. Capitalizing on the opportunities requires both the board’s understanding of the unique characteristics of the risks and its active engagement.
It is the board’s responsibility to gain sufficient insight to ensure it is in a position to provide thoughtful, meaningful counsel to management, and to exercise skepticism regarding the company’s plans. This can be done by challenging assumptions and critically assessing progress, which can be particularly difficult because these jurisdictions are vastly different, unfamiliar and subject to rapid and sometimes radical change.
While emerging-country markets are a strategic imperative for leading companies, they cannot be painted with the same brush. Some are riskier than others, and the levels of risk change over time, so that standard risk assessment templates cannot be applied.
Virtually all major boards have, or seek, someone with relevant experience and specialized expertise in each of these markets. This proficiency may be lacking, however, requiring a recalibration of the board’s approach and potentially a recomposition of its members. Current best practices suggest that the establishment of an advisory board that counsels company directors and management can help in plugging deficiencies.
Introduction to Risks
While the board’s risk oversight in emerging-country markets may not be substantially different than exercised in more developed markets, it does require additional agility and consideration of distinctively characteristic factors.
Among the more formidable risks are corruption, non-transparency of information, gaps in culture and customs, the impact of government, talent shortages and development, intellectual property protection, failure to diversify and overspending of resources.
1. Corruption Anticipating and addressing corrupt activities requires a constancy of board awareness. Corrupt politicians, bureaucrats and business leaders exist in emerging-country markets, and practices that are widely regarded as corrupt by global standards (or at least serious if not blatant conflicts of interest)can be the norm. For example, some tax collectors in Brazil customarily ask for bribes to relax inspections and assessments, to refrain from pursuing acts of tax avoidance, or to give advice through separate consulting arrangements on the legal possibilities of reducing tax obligations. Risks in China, similar to most of these markets, are exacerbated by the ubiquitous involvement of the government in business, exposing many transactions that in other jurisdictions would be purely commercial to government influence.
Even if local governments are not corrupt in their initial dealings, incentives may change after an investment is consummated and they can become predatory, even if within the law technically.
The lack of accessible or available information and cultural barriers can pose special problems. If fraud, corruption or other malfeasance is suspected, it would not be unusual to find it difficult, if not impossible, to investigate and obtain sufficient information to conclusively identify the violators and validate the violations. Local employers are often culturally impaired to provide information to investigators implicating co-workers.
Corruption is an area that requires both locally focused and expert advice. The board of any U.S. company seeking to do business in emerging-country markets needs to have a clear understanding of its duties and responsibilities under the Foreign Corrupt Practices Act and other international laws, such as the U.K.’s Bribery Act of 2010. The FCPA has a wide reach and applies to U.S. issuers, other domestic concerns (both individuals and businesses), U.S. parent companies of foreign subsidiaries, and foreign companies and individuals, including their agents. While these laws apply to the bribery of foreign government officials, they do not apply to bribery of third parties in business relationships, which is often far more pervasive and corrosive. Prosecutions, the number of fines and the size of the penalties under the FCPA have risen dramatically in recent years. As evidenced by the U.K.’s Bribery Act, the heightened focus by the regulators on corrupt activities is not confined to the United States. Regulators in some of these markets are following American and British regulators in stepping up their efforts. India introduced Lokpal Bill 2011 to establish an anticorruption watchdog. Brazil is often cited for its strong legal framework aimed at eliminating corruption, and it is used as a role model when establishing legal anticorruption frameworks elsewhere. However, its enforcement of the laws can be inconsistent and ineffective.
Not only must the board be cognizant of the resulting costs of penalties and litigation associated with corruption and bad behavior, but, perhaps more important, of the potential impact on the corporate culture and the risk to the company’s reputation, including the reputations of individual board members. In the end, the difficulties in dealing with corruption and complying with U.S. laws may result in a decision by the board to forego the opportunities identified in some of these markets.
2. Non-transparency of information The board’s oversight responsibilities in emerging-country markets can be tested even when corruption is not present because the quantity and quality of information often is opaque, if not inadequate, incorrect or nonexistent. There may be little, if any, information available on the government’s inner workings and relationships, partner profiles and reputations. Information about market attractiveness is often difficult to obtain and tends to be unreliable. Officially independent data aggregators rarely corroborate published data in these markets.
Corporate structures tend to be overly complex. In highly granular, regulated environments like China, some companies adapt by creating constellations of special-purpose but related entities, including but not limited to sales companies, finance companies, management service companies, and technology and R&D companies. Within these groups, different combinations of owners control entities, raising the risk of manipulation of transfer pricing, asset transfers and incomplete reporting of debt and revenue.
Although the landscape for local acquisitions, investments and partnering may be attractive, the results obtained from even minimum due diligence on targets can be disappointing. In mergers and acquisitions, valuations can be challenging to confirm, because even claims of asset ownership like land use rights are difficult to verify. Significant unrecorded liabilities can go unnoticed.
Audited financials of local companies, particularly if performed by regional or local attest firms, may be questionable and should be reviewed with skepticism. In these markets, the extensive underground economy that prevails to avoid paying taxes makes it almost impossible to track financial information. When due diligence is performed, workstreams need to be much more forensic and investigative than in other markets.
The levels of internal control and compliance typically do not meet international standards or investor expectations, as well. Recurring control problems tend to be weaknesses in processes, lack of remediation planning and control improvements that suffer from inconsistent attention. The end result often is a mixed quality of reporting.
Recent disclosures of improprieties in financial reporting by companies based in emerging-country markets have suggested conditions and situations that indicate highly elevated fraud risk. The Public Company Accounting Oversight Board recently published a Staff Audit Practice Alert to increase auditors’ awareness of these risks when performing external audits of companies with operations in emerging-country markets. Specifically, the alert cited reports originating from audits of companies based in China.
The non-transparency of information, which can lead to inaccuracies and poor decisions, requires board vigilance. Market opaqueness may be indicative of underperformance, differing agendas or poor behavior. Boards accustomed to very stringent reporting guidelines should understand the possibility of being unable to meet those standards and, if necessary, accept exceptions to normal practices.
3. Gaps in culture and customs The board needs to have heightened sensitivity to obvious and subtle cultural differences, both in thought and in action. Closing gaps in culture and customs requires an appreciation of the local value system, not merely a superficial adherence to etiquette rules.
These markets do not have a long history of Western business and legal practices, so surprises, misunderstandings and what is perceived to be unusual or inappropriate behaviors or responses should be expected. In China, for example, deals are based far more on relationships than on policies and procedures. Contracts are malleable, subject to change, such that negotiations are restarted immediately upon signing. Sometimes it is not just cultural differences between China and other parts of the world, but differences within the country itself.
Gaps in culture and customs involve much more than language barriers. The board needs to have not only a sense of these differences, but also an understanding of how the company adapts its normal practices to these environments.
4. Impact of government Many boards tend to underestimate the impact of government and the breadth and intensity of regulatory risk, especially when the regulator and the partner are one and the same. In emerging-country markets, this risk can be significant.
Many companies find that it is critical to build meaningful relationships with the appropriate sections or branches of the local governments, because the government may become a business partner or serve as the agent in the introduction to local companies that will become business partners. This is perceived as an essential ingredient for success.
Nevertheless, government intervention and intrusions are daunting challenges, as the laws, regulations and contracts governing an investment can be changed quickly without notification, impeding progress and significantly reducing financial viability. In China, the government’s heavy hand has intervened to nationalize strategic resources, inhibiting private investments; in Brazil, the government has raised its tax on foreign investors twice within one month, on short notice with little warning. In fact, Brazil ranks last in the World Economic Forum’s 2011–2012 Global Competitiveness Report indicators for burden of government regulation and extent and effect of taxation.
Companies need to learn to work within and across multiple and often divergent regulatory geographics and environments. In some of these markets, like India, there are many different regulations across the country’s regions and administrative districts. In China, the interpretation and rigor with which the laws are implemented can vary between cities like Beijing and Shanghai and the second- and third-tier cities.
Additionally, the regulators and bureaucrats themselves are subject to sudden, unannounced rotations, so that ensuring the relationship map with government officials is resilient to change can be an important objective requiring board oversight.
5. Talent shortages and development Success with talent in emerging-country markets in many ways is no different than anywhere else, except to a greater extent. The recruitment, training and retention of talent in these markets often represent a primary constraint to growth and the single most significant execution risk. The board needs to understand and appreciate the unique challenges associated with talent.
Local hires may have difficulty understanding corporate values, and they will need to learn Western business practices and ethics. Bilingual pools of resources are limited and, propelled by younger working populations, inexperienced. Loyalty is hard to achieve. Annual turnover of senior managers in these markets is excessive, often exceeding 40 percent. Even nominal compensation and benefits increases offered by competitors can bring about employee resignations.
Deploying bilingual nationals who have been educated in the United States can fill gaps and address critical resource challenges, but this approach can also result in significant compensation and career expectation gaps when these employees integrate into the local operations.
Success is dependent on more than language proficiency. Achieving the right balance between expatriate and local talent is among the most critical factors for sustaining growth and managing risk. Overreliance on local hires who are proficient in English but who are not locally connected or do not understand the local market and customs, well versed in the industry or possess functional expertise can lead to underperformance.
Restructuring or downsizing the operations once employees are hired also can be challenging. Local unions are very active and aggressive in frustrating layoffs. Companies in India that hire more than 100 workers, for example, require the government’s approval to initiate a layoff—and corrupt government officials often withhold this permission.
The human resources function in these markets generally is underdeveloped, making it virtually impossible to find HR professionals who are experienced in building, training and cultivating talent without significant guidance and support.
6. Intellectual property protection A primary threat is the theft of intellectual property. Successful brands and products are frequently counterfeited and sold on unprecedented scales due to the enormous size of the local markets, high price sensitivities and lack of effort and coordination among regulatory agencies. Beyond lost sales, IP theft can expose a company to reputation risk as counterfeit and potentially defective products bearing its brands flood the marketplace.
Although some of these markets are making attempts to enhance IP protection, there is no consistency in the implementation and enforcement of standards by the local authorities. In some instances, the rules may be in place but are not being effectively enforced.
IP theft requires a fundamental rethinking of strategies for IP owners and board oversight. There are absolute limits as to how long and how well IP can be protected, so the challenge is to render as much value as possible while products, designs and other advantages remain exclusive and distinct. Companies need to integrate every aspect of new product development, marketing strategies, channel management, technology, manufacturing and partnering processes to manage the value of their IP for the best outcomes.
7. Failure to diversify Another potential risk in operating in an emerging-country market is building the business contingent with a single regulator or business partner upon whom success is dependent. Although this may be unavoidable, in some cases, due to local regulations in certain industries, establishing multiple relationships often is strategically prudent. Multiple relationships with diverse purposes can be particularly useful within a territory in providing leverage with local governments and business partners if they know that withdrawal is a legitimate option.
Partner selection requires the board’s understanding of the process and the important elements of the decision making. Also critical is the oversight and care of cultivating partner relationships, as most joint ventures or partnerships end within five to 10 years. Local partners who understand the market and customs, as well as maintain good relationships with government officials, can help mitigate the risks of doing business in these markets. However, the risk profile increases with each partner selection. Disputes with partners can be protracted and costly, as in Brazil, where partner disputes taken to court might extend upwards of 10 years, due to the complexity and uniqueness of that country’s judicial system. In India, obstructive bureaucrats often become embroiled in partner disputes, resulting in notoriously slow and unseemly resolutions.
8. Overspending of resources Notwithstanding the dynamic growth prospects in emerging-country markets, experience suggests that there is a tendency to overspend in chasing opportunities. The board’s oversight of the spending of resources can serve to balance the opportunities with the risks, which is particularly critical given the volatility in these markets. The challenge is “how to do more with less.” In a recent study by the Economist Intelligence Unit, 48 percent of the companies surveyed believe that they have invested more resources in emerging-country markets than was required.
Many companies are persuaded that if they invest heavily upfront, those investments will be recouped. This is not always the case. In China, as soon as the local firms figure out how the business model works, it will be copied. Therefore, it is often important to accelerate the path to profitability and avoid overspending.
Exercise Skepticism
Emerging-country markets represent important growth opportunities with inherently unique risks. Agility in these markets is required. Investments and commitments will continue to evolve from new, exciting opportunities into business imperatives. Although the growth prospects can be seductive, board members need to understand the nature, breadth and depth of the risks, and to provide thoughtful commentary on the challenges and mitigations. The most important task for the board in overseeing risks in these markets is to exercise skepticism regarding the company’s strategy and plans by challenging the assumptions and critically assessing the progress.
Dean A. Yoost is a member of the NACD Southern California board and serves on the boards of four global companies. He is a retired partner of PricewaterhouseCoopers (PwC), for which he spent 17 years living and working in Asia and served as a member of PwC’s Global Oversight Board.