What lies beneath: The hidden costs of entering rapid-growth markets


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This report is the latest in Ernst & Young's The Master CFO Series and provides insight on the CFO's role in relation to rapid-growth market entry, and the true costs of entry. It is based on a survey conducted with 921 CFOs from around the world, conducted by the Economist Intelligence Unit.

The Master CFO Series is a collection of studies from Ernst & Young which provide insight on events and experiences that CFOs encounter as part of their role.

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What lies beneath: The hidden costs of entering rapid-growth markets

  1. 1. The Master CFO SeriesVolume 2What liesbeneath?The hidden costs of enteringrapid-growth markets
  2. 2. The CFO’s roleWe believe these six segments represent The Master CFO Seriesthe breadth of the CFO’s remit. The leading What lies beneath?CFOs we work with typically have some The hidden costs of entering rapid-growth marketsinvolvement in each of these six — eitherdirectly or through their team. Whilethe weighting of that involvement willdepend on the maturity and ambition ofthe individual, the sector and scale of thefinance function, and economic stability,they are all critical to effective leadership. rnal T the exte Trus ting E N to ce the ion la nu at tp E m ic rke X be un ma M E m rs P Representing m C Ensuring business Co the organization’s O decisions are UT progress on grounded EL strategic goals in sound financial to external criteria ION gy stakeholders DEV rate 6 1 ment of business st Providing insight Developing and Providing insight defining the The CFO’s and analysis to overall strategy 5 2 support CEO and for your organization role other senior managers elop 4 3 Dev Funding, enabling Leading key and executing initiatives in finance strategy set that support overall by CEO strategic goals Fu nd er g in rd or o ga in niz se ati ou ona l str urh ategy g yo Gettin EN ABLEMENT
  3. 3. In this report Executive summary: What lies beneath? 4 The good news story of the global economy 8 The role of the CFO 12 The hidden costs of investing: 16 Financing costs 18 Mode of entry costs 22 Operational costs 28 Regulatory costs 34 Human capital costs 37 Political costs 42 Ten lessons for CFOs 48 Respondent demographics 50 Other titles and contact information 51What lies beneath? The hidden costs of entering rapid-growth markets 1
  4. 4. The hidden costs of investing Financing costsThis report is the latest in Ernst & Young’s The Master CFO Series andrelates to the CFO’s role in relation to rapid-growth market entry, and thetrue costs of doing so. It is based on a survey of 921 CFOs from aroundthe world, conducted with the Economist Intelligence Unit, as well as aprogram of in-depth interviews with leading CFOs and senior executives.The Master CFO Series is a collection of studies from The CFOs and executives with whom we conductedErnst & Young which provide insight on events and the in-depth interviews include:experiences that CFOs encounter as part of their • Stefan Asenkerschbaumer, Chief Financial Officer,role. The series is a part of our CFO program, which Robert Boschlooks at aspects of personal interest to CFOs, andfuture finance leaders, as they develop themselves • Ron Bell, Chief Operating Officer, Actisand their teams, and learn from others in their • Peter Bracke, Vice-President and Chief Financialcommunity. For further information on other titles, Officer, Honeywell Transportation Systemsplease see the back of this report. • Mikael Bratt, Senior Vice-President and Chief Financial Officer, Volvo Group • Paul Brooks, Chief Financial Officer, Experian 2 What lies beneath? The hidden costs of entering rapid-growth markets
  5. 5. • Robin Freestone, Chief Financial Officer, Pearson• Deirdre Mahlan, Chief Financial Officer, Diageo• Pinak Maitra, Chief Financial Officer, Kipco Group• Pavel Mitrofanov, Deputy Chief Executive Officer and Chief Financial Officer, Metalloinvest• Paul O’Flaherty, Finance Director, Eskom Holdings• Frédéric Puistienne, Chief Financial Officer, AdisseoOur thanks to all who participated and shared theirexperiences. What lies beneath? The hidden costs of entering rapid-growth markets 3
  6. 6. Executive summary: What lies beneath?The opportunities in rapid-growth markets are undeniable. So are the potential risks and the likelihood thatbudget overruns can temper growth prospects. Over one-third of CFOs underestimate the costs, and4 out of 10 the time, involved in entering markets where even the smallest miscalculation can erodeprofitability. Where others see primarily opportunity, the CFO must be able to spot complexity — the costsboth manifest and hidden. This requires ongoing scrutiny, and not just an initial investment evaluation.The choice of investment destination is becoming More than one-third of companies underestimatemore diverse the costs of investing in rapid-growth marketsThe increasing importance of rapid-growth markets to their future Companies should not assume that rapid-growth markets are alsoprospects is encouraging multinationals to look beyond the low-cost ones. Among our survey respondents, more thanfirst-tier rapid-growth markets, such as the BRIC countries, into one-third say that the overall costs of investing in rapid-growthless familiar economies. Although countries such as China and markets were higher than they expected. Time overruns are anIndia will remain vital destinations for investment, finance leaders even bigger problem, with 43% saying that the investment tooksurveyed for this report say that their companies are also looking more time than they had anticipated. Unexpected costs infurther afield, to countries including Indonesia, Thailand, Mexico rapid-growth markets can be a serious issue. With low per capitaand Ukraine. incomes requiring investors to adopt a high-volume but low-margin business model, even small increases in costs canThe CFO must retain oversight at every stage of the erode profitability.investment Of the many and varied costs of market entry, there are six weThe CFOs surveyed tend to play a more active role at the pre- have identified as areas of particular concern for CFOs. In order ofentry stage of investment than at the post-entry stage. In order to the reported likelihood to overspend, they are:safeguard the promise of investment and sustain growth inmarkets where the pace of change is rapid, the leading CFOs 1. Financing costs – rising inflation and currency fluctuationsinterviewed stress the need for involvement at all stages of the 2. Mode of entry costs – choosing the right partner and accuracyprocess. Given that it may not be practical for the CFO to stay of valuationsclose to every investment in a global portfolio, the ability to 3. Operational costs – R&D costs and finance function integrationdelegate and secure the right balance of local and group financeexpertise is critical. 4. Regulatory costs – evolving regulatory systems and high levels of bureaucracy 5. Human capital costs – shortage of the right talent and high levels of attrition 6. Political costs – Government instability and dealing with bribery and corruption4 What lies beneath? The hidden costs of entering rapid-growth markets
  7. 7. 1. Financing costs: rising inflation and currency When acquiring companies in these markets, survey respondentsfluctuations are becoming key concerns for consider valuation to be the key challenge they face. Although the situation varies from market to market, investors may find itforeign investors difficult to extract accurate data on which to base a valuation.Surging capital flows into rapid-growth markets are stoking Another common problem is that disclosure levels may be poor,inflation and pushing up currency values. Although policy-makers either because of regulatory shortcomings or a lack ofin these markets are trying to cool their economies by tightening cooperation from the seller. These challenges highlight themonetary policy, the potential for currency risk remains a key importance of obtaining data from multiple sources and using asource of unexpected cost for foreign investors. International combination of valuation methods to improve accuracy.policy is creating another source of currency risk. Growingpressure on the Chinese Government to further revalue the 3. Operational costs: those related to R&D andrenminbi and allow it to appreciate more quickly could raise finance function integration are the maincosts substantially for exporters and alter the rationale for operational concernsinvestment in China. Anything that increases the cost of production is a critical concern2. Mode of entry costs: choosing the right mode of for CFOs, in markets that rely on very high volumes and very lowinvestment is considered the most critical decision, margins to make profit. The highest unanticipated costs relate to R&D investment which, particularly for high-performingwith valuation a key challenge companies,1 is on the rise. The increasing importance of rapid-When asked to advise their peers on where to pay most attention growth markets is encouraging a growing number of companiesin relation to investing in rapid-growth markets, respondents point to set up R&D centers in these economies to serve populationsto the mode of entry as the most critical decision that must be with fast-rising per capita incomes. Another key area ofmade. Even more so than the investment destination. It also pays overspend relates to the integration and harmonization ofto take a long-term view. Over time, given increased liberalization reporting frameworks, IT systems and local finance talent to meetin many markets, the mode of investment may need to change. global reporting obligations.Companies planning an investment should consider whether thiswill be possible and what the implications will be.1 hose companies with EBITDA growth of above 11% over the last 12 months. T What lies beneath? The hidden costs of entering rapid-growth markets 5
  8. 8. Executive summary: What lies beneath? (continued)4. Regulatory costs: evolving regulatory systems 6. Political costs: fear of expropriation has beenand high levels of bureaucracy are the main areas of replaced by bribery and corruptionunbudgeted cost The upheaval in the Middle East and North Africa in early 2011Obtaining the right licenses and permits is a particular challenge brought political risk back to the top of the agenda. Political riskfor survey respondents. As regulatory systems evolve, these costs management forms a critical part of the pre-entry planning butmay be streamlined but other compliance costs will rise as should also stay on the radar throughout the life cycle of theregulation becomes more demanding. Foreign investors should investment. Although some political risks, such as expropriation,ensure that they “future-proof” their investments by anticipating have diminished, others, such as bribery and corruption, remain afuture regulatory change and building that into their overall key concern. While acknowledging that local competitors andbusiness case. partners may be used to bribery as part of the normal course of doing business, zero tolerance is argued as critical by those CFOs5. Human capital costs: attrition levels are the main interviewed, and a key consideration when determiningreason for human capital overspend investment destination.Rapid economic growth and rising demand for a finite pool ofskilled workers are pushing up wages and creating high levels ofemployee turnover in many rapid-growth markets. To counter thisproblem, foreign investors need to build a brand as employer ofchoice, ensure that they build strong relationships with localcommunities and pay close attention to training andcompensation policies.6 What lies beneath? The hidden costs of entering rapid-growth markets
  9. 9. What lies beneath? The hidden costs of entering rapid-growth markets 7
  10. 10. The good news story of the global economy8 What lies beneath? The hidden costs of entering rapid-growth markets
  11. 11. “t’s something that’s on the radar of every board I and investor. As a company, you want to be seen to be investing in those markets.” —Paul Brooks, CFO, ExperianExpansion into rapid-growth markets has become High exposure to rapid-growth markets is proving a welcomesomething of a mantra for growth-hungry CEOs. boost to the performance of many multinationals. According to a recent research report from Thomson Reuters, SP 500If a company does not have a rapid-growth market companies that generate more than half of their revenues fromstrategy, investors will want to know why. overseas markets will see average growth of 10%, comparedWith rising per capita incomes, favorable demographics and large with 6% for those companies with more than half of theirpopulations, rapid-growth markets have significant momentum revenues from the US.3 A number of companies already derivebehind them. Most have come through the financial crisis with more than 50% of their revenues from rapid-growth markets.very little long-term damage and remain on impressive growth The huge growth potential of rapid-growth markets is encouragingtrajectories. According to the latest Global Economic Outlook a massive reallocation of capital and resources among the world’sfrom the International Monetary Fund (IMF),2 emerging multinationals. In 2010, emerging and transition economieseconomies as a whole will grow by 6.5% annually in both 2011 attracted more than 50% of the world’s inflows of foreign directand 2012. This compares with 2.4% in 2011 and 2.6% in 2012 for investment for the first time. It was also the busiest year onadvanced economies. record for emerging market transactions. According toFor CEOs on the hunt for long-term growth, the statistics coming mergermarket, there were 2,763 deals worth US$557.2 billion inout of rapid-growth markets make for compelling reading, these economies over the course of the year, which accounted forparticularly in a context of sluggish growth in developed markets. 26.7% of the global total.4Already, middle class consumers in the largest rapid-growth A number of those we interviewed for this study stressed themarkets comprise two billion people who collectively spend pressure on CEOs and CFOs to have a growth story forUS$6.9 trillion annually. In 2010, China overtook the US to shareholders around their plans to capture the potential offeredbecome the world’s largest car market. It is also the world’s third by rapid-growth market investment. “There’s a real pressure onlargest market for pharmaceuticals (after the US and Japan) and business to invest in markets such as Brazil, India and China,”will become the second largest market for consumer goods by says Paul Brooks, CFO of Experian, a global information services2015. And, despite having a per capita income of just US$4,300, company. “It’s something that’s on the radar of every board andChina is now the world’s second largest market for luxury goods investor. As a company, you want to be seen to be investing inafter the US, with annual sales of US$17 billion. those markets.”2 ttp://www.imf.org/external/pubs/ft/weo/2011/01/index.htm h3 ttp://blogs.reuters.com/india-expertzone/2010/10/19/us-top-lines-set-to-track-overseas-exposure/ h4 ttp://www.mergermarket.com/pdf/Press-Release-for-Financial-Advisers-Year-End-2010.pdf h What lies beneath? The hidden costs of entering rapid-growth markets 9
  12. 12. The good news story of the global economy (continued)The choice of investment destination is becoming Chart 1: In which of the following rapid-growth markets doesmore diverse your organization have significant investments, or is planning to invest significantly in the next two years?The increasing importance of rapid-growth markets to their 23future prospects is encouraging multinationals to look beyond China 20the first-tier rapid-growth markets, such as the BRIC countries India 24of Brazil, Russia, India and China, into less familiar economies. 10 17 MexicoAlthough countries such as China and India will remain vital 17 6destinations for investment, finance leaders surveyed for this Indonesia 14report say that their companies are also looking further afield, Brazil 8to countries including Indonesia, Thailand, Mexico and Ukraine 12 5 Thailand(see chart 1). 12 16 Poland 11 9 Romania 11 9 Russia 10 4 Ukraine 10 8 United Arab Emirates 9 5 Turkey 9 5 Colombia 8 4 Vietnam 8 7 South Africa 8 5 Egypt 7 3 Kazakhstan 7 3 Nigeria 6 4 South Korea 6 Current 3Shown: percentage of respondents Argentina Planned 510 What lies beneath? The hidden costs of entering rapid-growth markets
  13. 13. What lies beneath? The hidden costs of entering rapid-growth markets 11
  14. 14. The role of the CFO12 What lies beneath? The hidden costs of entering rapid-growth markets
  15. 15. “ make sure that the local business leaders are all thinking I about the long-term as well as near-term growth. There’s a real danger of throwing money at emerging markets and wanting to invest in everything.” —Deirdre Mahlan, CFO, DiageoThe CFO is uniquely tasked with finding a “My primary role is to make sure that the business considers alldelicate balance between the accelerator and the aspects of the investment,” says Deirdre Mahlan, CFO of Diageo, a consumer drinks business headquartered in the UK. “As well asbrake. Their role is to develop and enable being part of the initial decision over whether or not we shouldthe growth plans of the business, while also enter a market, I also make sure that the local business leadersensuring that these plans are grounded in sound are all thinking about the long-term as well as near-term growth.financial criteria. There’s a real danger of throwing money at emerging markets and wanting to invest in everything.”In our previous study, The DNA of the CFO,5 we described the CFOas having a “unique optic” — a particularly broad perspective over This balancing act is further complicated when managing athe entire business. This makes them uniquely positioned to drive, global investment portfolio. The skills and judgment required inenable and evaluate rapid-growth market investments. At the rapid-growth market entry is different to those deployed inpre-entry stage, the CFO can work closely with the CEO to mature markets. “In developed countries, the focus of thedetermine how and where to invest. They can provide vital input CFO has been on cost reduction,” says Christian Mertin ofto building a rationale and appropriate structure for the Ernst Young’s Advisory practice in India. “In markets like India,investment, and in funding and enabling its execution. Once the on the other hand, the challenge is how to manage growth thatinvestment has been made, the CFO continues to play an active might be in excess of 20% a year. That requires a different set ofrole in monitoring performance, identifying and assessing risks skills entirely and means that CFOs need to think carefully aboutand ensuring that the investment is sustainable. the team they build around them to deal with that growth.”Yet, in the same report, we also described them as being theobjective “conscience” of the business. So while they aresingularly placed to play an active role in rapid-growth marketentry, they also have a responsibility to temper the push to be inthese markets at any cost.5 he DNA of the CFO: A study of what makes a chief financial officer, Ernst Young, 2010. T What lies beneath? The hidden costs of entering rapid-growth markets 13
  16. 16. The role of the CFO (continued)CFOs tend to be more active at the pre-entry stage The influence of the CFO is clearly felt at all stages of the process.of investment However, their involvement does tend to diminish toward the post-execution stage. While 29% say that they play a leading roleThe CFOs we surveyed vary in the extent of their involvement in at the pre-entry stage, only 20% say that they do so duringrapid-growth market investments. Around one-third say that they post-execution (see chart 3).are in charge of all key aspects of market entry strategy, whichunsurprisingly rises to nearly two-thirds for Group CFO Chart 3: At what stage(s) do you play a role in yourrespondents. A slightly higher proportion of 40% say that they organization’s strategy for entering rapid-growth markets?primarily provide a supporting and advisory role. One quarter of 29 20 1 At the pre-entry strategyrespondents play a more traditional finance role, and only get and design stage 46 4involved in the more technical aspects of the investment, At the execution stage 25 29 1 (e.g., implementing transactions)such as due diligence and valuation (see chart 2). 41 4 At post-execution stage 20 28 2Chart 2: How would you describe your role in relation to (e.g., post-merger integration) 42 8entering rapid-growth markets? Leading role 1 2 3 4 Minimal role 5 Supporting CEO/board on overall 40 market entry strategy in an advisory role 27 One reasonable explanation for this is that the majority of CFOs In charge of all key aspects of 33 market entry strategy are most actively involved in the earlier stages when their 60 advisory and analytical input is required to bring discipline to theProviding mainly specialist finance support 27 (e.g., due diligence, valuation) 13 evaluation of the investment opportunity. They then delegate to team members during the execution and integration stages, All CFO respondents Group CFO/FD respondents only retaining an oversight role. While good delegation is an essential capability for today’s CFO, a number of the leading CFOs we interviewed stressed the need for CFOs to play an active role at every stage in the investment.14 What lies beneath? The hidden costs of entering rapid-growth markets
  17. 17. “ hen you enter these growth markets, the opportunity W is an obvious fact, so don’t spend time analyzing that. Instead, focus your attention on the execution because that is where the challenges lie.” —Pinak Maitra, CFO, Kipco Group“The CFO needs to be involved right from the concept stage As investors chase a limited supply of targets in a market wherethrough to finalization,” says Paul O’Flaherty, CFO of Eskom they need presence to fulfill their growth ambitions, there may beHoldings, a utilities company based in South Africa. “Yes, you can increased pressure on the CFO to be actively involved in thedelegate but you need to have the dashboards in place so that as integration stage of the investment. Where investors areyou move along the investment process you are constantly back competing on price to acquire assets, and the gap betweenchecking to make sure you are getting the return you expected.” valuation and price widens, there will be more of a need toPinak Maitra, CFO of Kipco Group, a diversified holding company integrate these assets as quickly and effectively as possible tobased in Kuwait, goes further, “When you enter these growth remain competitive.markets, the opportunity is an obvious fact, so don’t spend timeanalyzing that. Instead, focus your attention on the executionbecause that is where the challenges lie.” What lies beneath? The hidden costs of entering rapid-growth markets 15
  18. 18. The hidden costs of investing Financing costs Mode of entry costs Operational costs The hidden costs of investing Regulatory costs Human capital costs Political costs16 What lies beneath? The hidden costs of entering rapid-growth markets
  19. 19. “ verything took much longer than we expected.” E —Paul Brooks, CFO, ExperianThe potential rewards of investment in rapid- The hidden costs and risks facing companies that invest ingrowth markets are undeniable. So too are the rapid-growth markets are many and varied. From our research, we have identified six in particular that are likelycosts – both manifest and hidden. Among our to cause problems for investors (see chart 5).survey respondents, 36% say that the overallcost incurred in their recent investments in Chart 5: Thinking about recent investments that you have made in your main rapid-growth markets, how would yourapid-growth markets was higher than expected assess the overall level of cost incurred in the following areas?(see chart 4). A bigger problem than costhowever, is time, with more than 4 out of 10 Financing issues 38 12 50reporting that they spent more time than 36 13 Market entry processanticipated. 51 36 14 Operational issues“Everything took much longer than we expected,” says 50Mr. Brooks, of Experian. “The sheer bureaucracy meant that Regulatory issues 30 18 52the licensing process alone involved multiple government 28 13agencies, then there would be a change in the individual Human capital issues 59handling it and everything would be set back again.” 27 18 Political issues 55Chart 4: Thinking about recent investments that you havemade in your main rapid-growth markets, how would you Higher than expected As expected Lower than expectedassess the overall level of cost incurred in the following areas? Overall time spent 43 7 on the investment 50 36 4Overall cost of the investment 60 Higher than expected As expected Lower than expected What lies beneath? The hidden costs of entering rapid-growth markets 17
  20. 20. The hidden costs of investingThe hidden costs of investingFinancing costs costsFinancingAccording to survey respondents, financing Over the past decade, the economic and financialissues are the aspect of investment in rapid- environment in most rapid-growth markets has become much more stable. Risks such as currency crisis or sovereign debtgrowth markets where costs are most likely default have faded and one could argue that these are nowto overrun, with 38% saying that they were more of a concern in some developed markets. Bankinghigher than expected. As the core competency systems have become more mature and there are now majorfor the CFO, it is perhaps not surprising that financial centers in Shanghai, Mumbai and Singapore.these issues are front of mind. But the fact that Countries like South Africa have also emerged as financialmore than one-third say that the costs were hubs, offering a range of capital markets services of a similar quality to those found in developed markets.higher than expected does suggest that manycompanies are experiencing real challenges to Inflationary and currency volatility is themaking their investment a success. One reason main concernwhy these costs may be so high is that CFOs Further volatility, however, cannot be ruled out. Low interestand their teams may tend to focus on aspects of rates in developed markets and the quantitative easingthe investment where they expect to encounter program in the US have led investors to turn their attention toproblems, such as political risk, and assume that rapid-growth markets in search of yield. According to thethe financing issues will be less challenging. Institute of International Finance,6 net capital flows into emerging markets were estimated at US$908 billion in 2010, which is 50% higher than in 2009.6 Source: IIF Research note entitled Capital Flows to Emerging Market Economies18 What lies beneath? The hidden costs of entering rapid-growth markets
  21. 21. Financing costsThis surge of capital is pushing up currency values and stoking When making an initial investment in rapid-growth markets,inflation, which is already rising as a result of surging food and companies will typically obtain finance in their domesticcommodity prices. This volatile situation is clearly one that market, rather than raising capital locally in the local currency.worries multinational investors. “If you combine an “In equity and bank markets, the rapid-growth markets storyenvironment of very high inflation, with potentially higher is a strong one and investors are happy to buy into it,” saysfreight costs to export your products to developed markets, Mr. Middleton. “Then, as the business matures and the localthen I think that’s a key concern for companies when investing currency earnings develop, there is a natural hedge inin emerging markets,” says Peter Bracke, Vice-President and starting to raise more and more finance in the local marketCFO of Honeywell Transportation Systems. and local currency.”High interest rates imposed by central banks trying to cool On the surface, raising finance in rapid-growth markets canoverheating economies can increase the cost of capital in appear expensive because interest rates are often high.some rapid-growth markets. But this is also encouraging an But there are other factors to be taken into account,unprecedented carry trade, with financial investors in such as incentives for local investment that offer a reduceddeveloped markets borrowing in low-yielding currencies, such interest rate. “It often makes sense to mix the fund-raising inas dollars or euros, and investing them in high-yielding assets terms of local and international resources,” says Rogerio Villa,in rapid growth markets. The concern is that surging debt Transaction Advisory Services Leader for Brazil atissuance and rising interest rates in key developed world Ernst Young. “In Brazil, for example, you might get aeconomies, such as the US, could reduce the availability of cheaper interest rate when acquiring certain types offunds for rapid-growth markets that rely heavily on external machinery or equipment, but you’d pay a higher rate forfinancing. “A sudden withdrawal of these capital flows from working capital. So you might try to raise funds locally forrapid-growth markets could have a devastating economic infrastructure, but overseas for working capital.”impact,” says Dougald Middleton, Leader of the Capital andDebt Advisory Group at Ernst Young. What lies beneath? The hidden costs of entering rapid-growth markets 19
  22. 22. The hidden costs of investingFinancing costs (continued)Among the survey respondents, currency fluctuations are Some companies also apply “natural” hedges to theirseen as the key source of unexpected cost associated with currency risk exposure by ensuring that they earn revenuesfinance (see chart 6). Foreign exchange risk management and incur expenses in the same local currency. If revenueshas always been a key area of responsibility for the finance decline because of shifts in currency values, some of thefunction, but in a context of deepening rapid-growth market losses can be offset by a reduction in costs. “You can try toinvestments and ongoing volatility, this has become even hedge your risk by ensuring that you have both assets on themore pressing. A growing number of multinationals are ground and liabilities, in the form of debt, in the same localmaking use of currency hedging through instruments such as currency,” says Robin Freestone, CFO of Pearson, a publishingoptions and forwards to help them manage some of the risk. and education company headquartered in the UK. “If there is any political risk that causes a fall in currency, then, with yourChart 6: Which of the following factors relating to financial assets and liabilities matched, you have a natural hedgeissues in your organization’s rapid-growth markets have between the two.”proved to be more costly or time-consuming than originallyanticipated? (Select up to three) For companies that invest in China, the potential further revaluation of the renminbi is another key source of currency 38 Currency risk risk. With international pressure mounting on the Chinese to 34 allow the remninbi to appreciate more quickly, the prospect ofCredit ratings of suppliers or customers a rising renminbi is becoming more likely. “Currency risk Levels of bad debts of potential 32 resulting from a rising Chinese currency is something that we customers, suppliers or distributors watch very carefully,” says Frédéric Puistienne, CFO of 32 Access to capital markets Adisseo, a manufacturer of animal nutritional additives and a 31 subsidiary of the Bluestar Group, a Chinese chemicals Quality of the banking system company. “It is certainly possible that we will see the currency Trade finance/credit 30 valued more highly than it was in the past.” (either offered or received) 27 Cost of borrowing 23 Ability to repatriate invested funds 11 Tax rates20 What lies beneath? The hidden costs of entering rapid-growth markets
  23. 23. Financing costsThe repatriation of cash from investments in some rapid- The importance of credit ratings to the smooth running of thegrowth markets is also a source of concern for some CFOs. economy is encouraging some governments in rapid-growthA number of countries, including China, India and Brazil, have markets to provide incentives for local companies to obtainstrict regulations governing the repatriation of funds by ratings. In India, for example, the Government has introducedmultinationals. “Seeking government approval to repatriate a Credit Rating Subsidy Scheme that pays for up to 75% of themoney could be an issue,” says Mr. Puistienne. fee charged by the rating agency.Lack of reliable ratings data complicatescredit risk assessmentCredit risk is another key source of financing risk formultinationals (see chart 6). A common problem is that creditratings for suppliers or customers can be difficult to obtain— either because suppliers have not obtained the ratings orbecause the ratings system is insufficiently developed. Insome rapid-growth markets, credit bureaux have only been inoperation for a short period of time. Mr. Brooks has first-handknowledge of this issue in his role as CFO of Experian, a creditrating agency. In 2010, his company was awarded a fulllicense to operate a credit bureau in India. “Setting up a creditbureau from scratch is always difficult but in India you haveparticular challenges,” he explains. “For example, until fairlyrecently there was no unique personal identifier, like a socialsecurity number, and no real address structure or zip codes.” What lies beneath? The hidden costs of entering rapid-growth markets 21
  24. 24. The hidden costs of investing hidden costs of investingMode of entry costsFinancing costsCareful planning is a crucial factor in the future Chart 7: If you were to advise another CFO aboutsuccess of any investment. In rapid-growth investing in rapid-growth markets, to which of the following stages of the investment would you suggest that they paymarkets, the pre-entry phase is especially critical. most attention?In addition to playing a vital role in selecting the 23destination for the investment, the CFO also Selecting the mode of market entryneeds to collaborate with other members of the 20 Selecting the destination for the investmentsenior executive team to determine the mode of 15entry and long-term strategic goals. “It’s essential Initial gathering of market data and analysisto sit down with the board and management to Due diligence on local partners 13have a detailed discussion about the strategic 11goals of the investment,” says Mikael Bratt, Due diligence on the businessCFO of Volvo Group, a car manufacturer Integration plans 10headquartered in Sweden. “It’s always important 5 Assessment of local management teamto have a long-term vision of how the investmentwill evolve over time.” Post-deal execution 3When asked to advise their peers on where to pay mostattention in relation to investing in rapid-growth markets, Often, the mode of entry will be determined in part by localrespondents point to the mode of entry as the most critical regulations. In India, for example, there is a long standing bandecision that must be made. This is considered even more on overseas multi-brand supermarket chains setting up retailimportant than the destination for the investment itself stores. Single-brand retailers, such as Nike, Starbucks or(see chart 7). Mothercare, can own a 51% stake in their Indian stores, but supermarket chains such as Wal-mart or Carrefour can onlyDespite the importance of the market entry process, this sell to wholesale customers, again via a joint venture with acontinues to be an aspect of investment in rapid-growth local company.markets that causes problems. Among our surveyrespondents, 36% say that the costs of market entry werehigher than expected (see chart 5).22 What lies beneath? The hidden costs of entering rapid-growth markets
  25. 25. “t’s always important to have a long-term vision I of how the investment will evolve over time.” —Mikael Bratt, CFO, Volvo Group Financing costsThese regulatory constraints can force companies to be “Often, part of the long-term plan is an evolution from onecreative about their entry strategy in rapid-growth markets. initial market entry method to another,” says Ms. Mahlan ofConsider the example of Pearson, the publishing and Diageo. “It’s important to understand the implications of that.education company, which wanted to ramp up its exposure to In some markets, when you attempt to shift the relationships Mode of entry costsChina. Because foreign investors are restricted in owning more that you’ve built, your initial distribution network becomesthan 50% of a publishing company, Pearson has entered the destabilized when you then say you’re going to go off and domarket via an adjacent route. In addition to a joint venture this on your own.”with a local publishing company, it has acquired companiesthat teach English as a foreign language, where there are no Choosing a partner is about more than thesuch limits on foreign ownership. It can then use these schools numbersas a distribution channel for its English educational In cases where multinationals need to work alongside a localpublications. “You’ve got to go in with a strategy that works company, the selection of partner is absolutely critical. “It isfor you in a particular market,” says CFO, Mr. Freestone. very important in these markets to find out who you’re going“Because there are Chinese regulations on the percentage of to bed with,” says Mr. Maitra. “You have to spend an enormousa publishing company we can own, we decided to take a amount of time evaluating potential partners and getting todifferent route.” know them. In emerging markets or fast-growing markets, theCompanies must also bear in mind that their initial mode of difference between success and failure is the partner.”entry may need to change at some point in the future, and Arpinder Singh, Leader of Ernst Young’s Fraud Investigationthis can add significantly to the overall costs of the and Dispute Services in India, advises companies to conductinvestment. Over time, ongoing market liberalization in what he calls “integrity due diligence” before committing to arapid-growth markets may broaden the available choices for joint venture with a local company. “You have to get under themarket entry. Over the past decade, for example, the Indian skin of a potential partner because if you go by official recordsGovernment has made a number of changes to the rules alone, you won’t find out very much,” he says. “You need togoverning foreign investment in the telecommunications know what the partner’s customers think, whether regulatorssector. Equally, a company may find that it outgrows its initial have any concerns, and whether the company has a goodmode of entry and needs to adopt a different approach. Either credit history and is ethical in its dealings.”way, the implications of a changing investment strategy needto be carefully considered. What lies beneath? The hidden costs of entering rapid-growth markets 23
  26. 26. The hidden costs of investingMode of entry costs (continued)For many companies interviewed for this report, attitudes to When multinationals form joint ventures in rapid-growthbribery and corruption form an important part of this due markets, there is a good chance that it will be with a familydiligence phase. This is particularly important for companies business. Some estimates put the percentage of grossheadquartered in countries with legislation preventing bribery domestic product accounted for by family-run companies inof foreign officials, such as the US and UK. “We spend a lot of rapid-growth markets as high as 70%. The governance of atime looking at how a potential target conducts business and family business, in which personal and professional affairs areperforming commercial due diligence on how are they getting closely intertwined, can sometimes be quite different fromcontracts,” says Mr. Freestone. “Particularly when you’re that of a listed multinational. “When you work with a familydealing with governments, you need to be absolutely clear business, you need to understand the family tree and work outthat the way you’re getting the business is not something that who are the real decision-makers,” says Harriet Mossop,you’re going to be ashamed of later.” Leader of Ernst Young’s Financial Accounting Advisory Services in India. “Often, the power is concentrated in theThe impact of teaming up with a local partner on existing hands of a senior family member, so it’s important that seniorcommercial relationships also needs to be considered. “If you executives from the multinational know who that individual isgo with a local company that is part of a bigger group, and and have access to them.”that group competes with some of your customers, it cancreate a bad reaction and potentially exclude you from doingbusiness with them,” says Mr. Bracke of HoneywellTransportation Systems.24 What lies beneath? The hidden costs of entering rapid-growth markets
  27. 27. Financing costsAccuracy of valuation data and seller disclosure Chart 8: Which of the following issues relating to marketare the biggest hurdles for acquirers entry plans proved more difficult or costly than originally anticipated? (Select up to three)It is easy to see the appeal of the MA route to entering Mode of entry costs 45rapid-growth markets. When regulations permit such an Valuing potential acquisitionsapproach, acquisitions give investors greater control than a 44 Identifying reliable business partnersjoint venture, and also provide quick access to market share,skills and existing distribution channels. Valuation of market opportunities 36As with partnerships and joint ventures, a cultural fit between 33 Strategy developmentacquirer and target is an important determinant of success.If the two companies to be merged share similar values, the Short- to medium-term costs 32integration process becomes much more straightforward. 31“When I look back at acquisitions that haven’t worked for us, Identifying MA targetsoften it’s about the culture, where the fit just wasn’t right,” 21 Due diligencesays Mr. Freestone. “Those cultural considerations, whetherit’s ethics or just attitude to customers, become quite None of the above 1important in emerging market acquisitions.” Other, please specify 0Compared with developed market transactions, the valuation A key barrier to effective valuation in rapid-growth markets isprocess in rapid-growth markets can be fraught with risks. a lack of reliable data. Although the maturity of capitalIndeed, survey respondents see valuation as the aspect of markets varies widely from market to market, they can oftenmarket entry where costs or difficulties are most likely to be be illiquid and shallow compared with developed markets. Thisgreater than anticipated (see chart 8). means that there are few comparable transactions on which to base a valuation. In valuations based on discounted cash flows, calculating a discount rate can also be challenging because different assessments of risk can lead to very different valuations. What lies beneath? The hidden costs of entering rapid-growth markets 25
  28. 28. The hidden costs of investingMode of entry costs (continued)At the same time, disclosure requirements may be less One possible reason for these challenges is that accountingrigorous, which can make financial data less reliable. Among standards in some rapid-growth markets may place lessthe survey respondents, poor disclosure of material emphasis on disclosure. In Brazil, for example, there was untilinformation is seen as the biggest challenge when valuing recently no requirement for non-listed companies to beassets (see chart 9). audited, which makes it more difficult for foreign investors to have confidence about reported financial statements.Chart 9: When valuing assets in rapid-growth markets, “It’s very common in rapid-growth markets to find a situationplease select those factors that are most likely to cause where you don’t have audited financial statements and wheredifficulties for potential investors? (Select up to three) the governance requirements are very different from Poor disclosure of material information 35 developed markets,” says Mr. Villa. “Companies planning an acquisition therefore need to work closely with advisors to 33 Lack of adequate profit/cash flow forecasts obtain and ensure the reliability of financial information.” 32 These challenges with valuation highlight the importance of Lack of empirical data on similar deals obtaining data from multiple sources and not relying 31 Complexity of determining cost of capital exclusively on information provided by the seller. “You need 30 to look at different scenarios and not just take figures Selection of valuation methodology presented by your potential targets at face value,” says Impact of inflation/exchange rates 28 Stefan Asenkerschbaumer, CFO of Robert Bosch. “It’s also on business planning important to establish clear boundaries and be prepared 27 Inadequate due diligence to cancel the project if you are not comfortable with the data 27 that you receive.” Difficulties in assessing tax risks 13Unreliability of historical financial information 6 Difficulty in using valuation multiples26 What lies beneath? The hidden costs of entering rapid-growth markets
  29. 29. “ e’ve seen multiples in China, India and Brazil get really W quite high on the back of expected growth for a long period into the future, so I think there is definitely a danger of overpaying for assets.” —Robin Freestone, CFO, Pearson Financing costsUsing a combination of valuation methods can also help to Yet at the same time, companies may not have a choice but topaper over some of the cracks in available data. A common pay a premium. With shareholders expecting them to invest inmethod is to combine discounted cash flows with probability- rapid-growth markets, and with growing competition forweighted scenarios that measure the risk a company investment, acquirers are increasingly competing on price. Mode of entry costspotentially faces. “We look very closely at the sensitivities to “The fact that valuations are so high means that there is moresales in emerging markets,” says Mr. Freestone of Pearson. pressure to integrate assets quickly in order to remain“These markets remain volatile and so it’s difficult to be sure competitive,” says Alexis Karklins Marchay, Capitalabout just how sustainable their growth will be. This means Transformation Leader for EMEIA7 at Ernst Young. “Thisthat we always question the top-line forecast in our model and may mean that, in future, CFOs will need to be more hands onsubject it to fairly rigorous tests.” with the integration stage of the investment than previously.”Overpaying may be the only option The risk of paying too highly for rapid-growth market assets has encouraged private equity firm Actis, which specializes inAt a time of unprecedented enthusiasm for rapid-growth rapid-growth markets, to focus on proprietary sourcing,markets when there are large amounts of money chasing a control investments, complex cross-border investments and alimited supply of targets, there is also a danger of overpaying buy-and-build strategy to its acquisitions. Buy-and-buildsfor assets. “There are risks in any assumption of sustained involve buying smaller companies in fragmented industrieseconomic growth and the ability of an acquirer to capture led by leading-class management teams, and then combiningmarket share,” says Mr. Freestone. “We’ve seen multiples in them with other bolt-on acquisitions. “Working with sellers ofChina, India and Brazil get really quite high on the back of smaller enterprises and putting them together into largerexpected growth for a long period into the future, so I think platforms is one way of getting an attractive entry valuationthere is definitely a danger of overpaying for assets.” and putting capital to work at lower multiples,” saysPavel Mitrofanov, Deputy Chief Executive Officer and CFO of Chief Operating Officer, Ron Bell.Metalloinvest, urges potential investors to take a long-termview and look across the entire cycle before agreeing a price.“You really need to take the mid-cycle view and apply verystrict parameters and assumptions when you take a look atthe valuation of your investment target,” he says.7 urope, Middle East, India, Africa E What lies beneath? The hidden costs of entering rapid-growth markets 27
  30. 30. The hidden costs of investingOperational costsIn The DNA of the CFO,8 a key theme that Chart 10: When merging or integrating rapid-growth marketemerged was the increasing trend for CFOs investments with your own organization, which of the following aspects do you typically find most challenging?to take on operational responsibilities. In the (Select two)context of rapid-growth market investments,this becomes even more critical because of the Operational improvements (e.g., IT, logistics) 28potential for unexpected costs and risk. Among Quality and experience 28our survey respondents, 36% say that the costs of local management and workforce 24associated with operational issues were higher Customer retention and acquisitionthan expected (see chart 5 on page 17). They 24 Reorganizing senior leadershipalso consider operational improvements to be 22the most costly aspect of merging or integrating Tax compliance and reportingrapid-growth investments (see chart 10). Integrating products and brands 20 19 Cultural alignment 14 Language barriers 9 Financial reporting Developing metrics to track integration process 48 he DNA of the CFO: A study of what makes a chief financial officer, T Ernst Young, 2010.28 What lies beneath? The hidden costs of entering rapid-growth markets
  31. 31. Financing costsUnexpected operational costs are particularly important in Chart 11: Which of the following factors relating torapid-growth markets because companies typically operate on operational issues in your organization’s rapid-growtha model that relies on high volumes but very low margins. markets have proved to be more costly or time-consumingAnything that increases the cost of production can erode than originally expected? (Select up to three) Mode of entry coststhese margins, threatening overall profitability. “In countries 35like India, which have large populations, everyone competes Supporting innovation and RDon price and volume in order to increase their market reach,” 34 Infrastructuresays Mr. Arpinder Singh. “This means that you need acompletely different business model, in such high growth 33 Cost of production or servicesmarkets, that relies on low cost and thin profit margins but 31 Operational costsmassive volumes.” Sales and marketing 31The innovation agenda is driving cost Distribution 23Asked about the operational issues in rapid-growth markets Sourcingthat were most likely to lead to higher than expected costs, 21 Corporate social responsibilityrespondents point to supporting innovation and RD as theleading factor (see chart 11). Almost three-quarters of 19 Import barriersrespondents say that they plan to increase spending on RD Dealing with local stakeholders 17relating to development of new products for rapid-growth (e.g., NGOs, media)markets in the next 12 months (see chart 12 overleaf). This 15increase is largely driven by respondents from high- Export barriersperforming companies, which correlates with similar findings 1 None of the abovefrom our Competing for growth9 study, in which product andservice innovation emerged as a key competitive differentiatorfor high-growth companies.9 ompeting for growth: How business is growing beyond boundaries, C Ernst Young, 2011. What lies beneath? The hidden costs of entering rapid-growth markets 29