European private equity and international expansion risks

European private equity and international expansion risks

Charlotte Wales Blog, Private Equity

When European private equity firms are considering investing in companies that have ambitions to expand internationally, associated ESG risks must be focused on more sharply as part of this strategy, particularly when the targeted markets are in the Middle East, Africa and Indian regions.

Investment in some of these less well-regulated markets and industries comes with far greater operational risk than a similar company in a highly regulated environment. ESG audit and governance is therefore ever more critical. In some of these regions, significant payment delays to suppliers, and in some cases payment default without cause is seen as part of doing business in that region. In such circumstances, available legal avenues for redress can be few and far between without causing potentially terminal, long term effects to your business in that region; resolution is often best pursued through social/political negotiations at the highest levels through trusted intermediaries. While this may seem to be a breach of a general code of western business conduct, it needs to be considered more as part of the ways of working in these regions and is manageable when thoroughly understood as part of a long term international strategy.

The key take away here is that risks associated with portfolio companies expanding into international markets, particularly developing markets, must be mapped out in advance by private equity firms, and the purpose and impact of such risks fully understood and financial impact scenarios built into any models for profitability and the investment cycle.

Due to the intricacies of local networks, strike programmes and the temptation to take advantage wherever contractually possible must be avoided, at least until strong partnerships have been built and developed with influential local contacts. Any public show of inappropriate strength during early engagement will alienate potential partners limiting both scope and potential profitability.

With the above in-mind, two key elements of risk to consider are:

  • Poor/protracted sales traction due to cultural implications of the complex buyer and seller interconnected networks.
  • Financial and contract risk due to implications of local jurisdiction legal enforcement and compensation mechanisms.

The keys to achieving successful long-term business development in emerging markets can be summarised as follows:

  • Commit to a long-term business plan (ten years +) that drives economic benefit both in the region and for the portfolio company.
  • Recruit senior managers (ideally native speakers) who have worked extensively in the region; direct cultural experience and pre-existing relationships means everything in building a successful long-term business.
  • Start the business planning process by identifying high-quality local agents that you can work with to build the networks relevant to the portfolio company. Ideally, this should happen 12 months in advance of committing to any sales forecasts.
  • Build local delivery teams, ideally employing a number of local people, but be aware of any potential for social divisions (either class or tribal), which may cause serious rifts within the workforce. Seek expert local advice if you think this is a possibility.
  • Plan for a higher than usual % of sales to be written off as bad debt in the early years as the portfolio company demonstrates, through consistent action, that it is committed to building long-term (ten years +) relationships in the markets.

The first step is to identify all potential issues, not just those that actually exist. In many cases, this requires a full supply chain audit back to source. In recent years, there have been multiple instances where this process was carried out only with direct suppliers to the organisation and with devastating consequences: for example, horse meat entering the food chain in Europe; child labour in clothing manufacturing worldwide; and catastrophic technical failure in oil production in the US. A thorough forensic audit and in-depth research is critical to understanding the risks hidden under layers of suppliers, which could ultimately affect the investment portfolio. This is most apparent in the production and manufacturing sectors, but should not be underestimated or ignored in companies operating in other industries. Any business can be at risk of hidden ESG issues, from an organisation that buys cleaning services only then to be denounced in the media as a supporter of modern slavery, to the financial markets and sub-prime mortgage debacle.

The impact of light-touch audits or conducting the process as a box-ticking exercise undermines the genuine identification of business risk and the actionable intelligence that can come from that. Most issues can be mitigated, but only if they are uncovered in time and appropriately elevated. A lack of true engagement with the portfolio company and its employees and suppliers throughout the ESG process creates a false sense of security, which is more dangerous than no audit at all.

This article by Charlotte Wales was first published in PEI’s book Value Creation Through Responsible Investment.