The “FIERCE” Risks of Investing in Emerging Markets: Instability
In our last post, my colleague Jeff Stine covered the Fraud element of the FIERCE risks framework that we use to think about our investments into early-stage companies in emerging markets. In this post, we’ll highlight how the risk of instability (the ‘I’ in FIERCE) impacts our investment decisions.
We have conversations with entrepreneurs and VestedAngels daily. Entrepreneurs are optimistic about the businesses they are building, passionate about the problem they’re solving and frustrated about the lack of capital available to fuel their growth. VestedAngels are cautious and ask us questions that can be summarized as “I do not know much about these markets but I know there are opportunities to create and capture value.” Further summarized, these investors are worried about the risks of doing business in a foreign land. In addition to fraud, instability is frequently a major concern.
Instability can be broadly defined as risks that create uncertainty and unpredictability, and make situations more volatile and subject to erratic changes. Instability can be caused by politics, economics, conflicts or societal issues. These risks are a nightmare for investors because it’s sometimes difficult to anticipate and plan for them accordingly.
- Political stability is influenced by the individual serving as the country’s leader, the ruling party, the role of and adherence to the rule of law, power dynamics among various ethnic/religious groups within the country, and regional and international relations, among other things.
- Economic stability is influenced by a host of factors, including the country’s fiscal condition, prevailing interest rates and banking sector, level of investment (both domestic and foreign), commodity prices, wages, infrastructure and labor markets.
- Conflicts may result from coups, electoral fraud, internal uprisings, civil wars, regional conflict or terrorism.
- Societal stability is affected by health emergencies, food security, humanitarian crisis, growing wealth disparity and inequality, levels of education, high unemployment, lack of social services and the dynamics between various ethnic/religious groups.
The perceptions that investors have about instability in developing countries are not without basis. Many developing countries, particularly in sub-Saharan Africa, have experienced every imaginable type of instability: Pierre Nkurunziza’s attempt to alter term limits in Burundi to allow him to run for a third term as President; the banking bill in Kenya that caps banks’ commercial lending prices; military coups that were prevalent throughout much of the 60s, 70s and 80s; and seemingly ongoing humanitarian crises across the African continent. Mainstream news media also provides regular reminders of the events that affect stability, so it’s not surprising that most investors feel that these markets are unstable.
However, as a whole, we’ve found that developing markets are becoming more stable, and, as they become so, provide a uniquely attractive investment climate for those willing to invest during this period.
A study released by Freedom House recently showed that while only 30% of countries in sub-Saharan Africa were “free” or “partly free” in 1973, today that number stands at 61%.
Due to an increasing need to access the international financial markets (international sovereign bonds outstanding increased from less than $1B in 2008 to over $18B in 2014) and attract foreign investors, central bank administrators, finance ministers and other government officials across the continent are implementing sound fiscal policies and measures to assure and protect foreign investors. Coups are generally a thing of the past — in part because the African Union has refused to recognize leaders who come to power through coups. And while humanitarian crisis are still regular occurrences, significant strides have been made in combatting many diseases and societal issues that plague many countries around the continent.
There are countless other examples of how common perceptions held by investors in the developed world are not in line with the reality on the ground in developing countries.
So, how do we think about instability as it relates to our investment decisions?
First and foremost, the risk of instability is beyond our control — we cannot influence the political, economic, security or societal stability in the countries where we invest. Therefore, we need to be acutely attuned to these dynamics in the countries where we invest.
We spend a significant amount of our time understanding the history, trends and current situation in each of the countries where we invest. We ask the following questions (among others):
- What is the overall political climate in the country: is there a history of democratic elections and have there been successful transitions of power?
- What are the major policy platforms of the primary political parties in the country in question?
- How will the current policy platform affect our investment, and how might a change in ruling political party affect our investment?
- Are there specific policies in place that benefit (or disadvantage) the potential investment, and how might the investment opportunity change if the policy is reversed?
- What quasi-governmental or non-governmental bodies are stakeholders in the business, and how might their policies (or a change in such) affect the investment?
Example: *Current company in due diligence* — Despite the macroeconomic headwinds currently prevailing in Nigeria, we remain very excited about the potential opportunities in this country. While political turmoil plagued the country throughout the 70s, 80s and 90s, Nigeria has now had a series of relatively smooth elections, and their last presidential election was the first time that an opposition candidate won. This indicates that the politicians are beginning to respect the electoral process as the means for political change. The policies of Muhammadu Buhari and his All Progressives Congress party represent a change in the status quo and may unearth opportunities for entrepreneurs to build new businesses. As part of our potential investment, we will seek to assess the proposed ban of certain imported consumer goods, the effects on the business and the ongoing viability of the business if such policies were reversed.
- How is the investment opportunity affected by domestic and regional macroeconomic trends?
- How exposed is the business to domestic economic stability, and are there any natural hedges inherent in the business model?
- If economic stability is in question, what opportunities might this provide for the investment being evaluated?
Example: Beacon Power Services — The worldwide decrease in the price of oil has impacted Nigeria’s economy significantly, with spillover effects on many of the country’s businesses, both large and small. An in-depth review of Beacon Power Services’ exposure resulted in a view that the risk was mitigated by the natural hedge provided by the company’s business model — cost rationalization by Nigerian businesses would likely result in an increased demand for the services provided by Beacon Power Services, since energy prices are often one of the top three cost line items for a Nigerian business. We also believed that the Company would be able to continue to thrive in spite of any potential devaluation to the Nigerian currency because our model used an exchange rate ratio that was even lower than the black market rate and we projected further depreciation in the currency over the life of our investment. To date, our views have held up, with the Company receiving a significant increase in inbound requests for services and the currency depreciating after the Central Bank of Nigeria allowed the currency to float.
- How likely is conflict or the threat of conflict to affect the market of the potential investment?
- How does the reality of the threat “on the ground” differ from that of the news coverage, and does it matter?
- Will the businesses assets or operations be located in an area where terrorism or other threats are credible?
Example: Beacon Power Services — Both Boko Haram and the Niger Delta Avengers have been featured prominently in the 24-hour news cycle over the past year (and more). Our assessment of our investment into Beacon Power Services led us to believe that the risk of the activities of Boko Haram affecting Beacon Power Services was low — including the potential spillover effects of reduced tourism and increased governmental intervention. The Niger Delta Avengers announced their existence as we were closing our investment in Beacon Power Services; unlike the threat of Boko Haram, the Niger Delta Avengers directly affect the market Beacon Power Services operates in. However, we felt that a further decrease in the reliability of electricity provided by independent power providers and state-run power producers would potentially result in larger companies seeking to do business with Beacon Power Services — this view has also proven to be true, as Beacon Power Services is working closely with major Nigerian banks to provide comprehensive power solutions to those businesses.
- What role will the company play in the labor market, and what is the company’s plan to manage its human capital?
- What is the company doing to support the stability of its stakeholders, and how might the company do more?
- Will the company be viewed adversely by any stakeholder group due to its business model, business purpose or labor practices?
- If successful, how might the company support further social stability in the areas where it operates?
Example: MoringaConnect — As a producer of premium, organic goods, MoringaConnect is exposed at many levels to the stability of its various stakeholders — the farmers whom grow the moringa, the communities where the moringa is farmed, the employees who help to process its products, etc. As organic, premium goods command higher prices in the market, we understood any risk to achieving this certification would have significant impact on our investment. For this and other reasons, we assessed the social stability risk as high in our investment into MoringaConnect — it therefore became critical that we understood how the company would manage its relationships with its outgrower farmers, what additional services it would provide to those farmers and how much it would pay the farmers for the moringa leaves and moringa seeds that make its core products. A system of community-enforced procedures, codified by contracts but largely enforced based on reputation and mutual benefits, led us to believe the social stability risk was mitigated to a manageable level.
Despite the risks (perceived and real) in emerging markets, the fundamental needs of businesses exist and, where the pain is great enough, there are entrepreneurs solving these problems. This is one of the main lessons we are learning about entrepreneurs in developing countries: the obstacles that exist in these markets are matched by the local understanding and the tenacity of the entrepreneurs that have chosen to build scalable businesses to solve local problems. We’ve seen this in each of the companies we’ve invested in. It’s why we provide them with capital and why you should too.
 IMF Regional Economic Outlook: Sub-Saharan Africa