As part of Gowling WLG's Special Projects Series, Paul Murphy, Managing Director of Gowling WLG's Energy Group, recently sat down with Michael Samis, Associate partner at Ernst & Young, and John Seddon, Principal at Canada Control Risks, for a discussion on country risk analysis for investment decisions and corporate strategy.

Country risk analysis - Part 2


Paul:                Hello again. My name is Paul Murphy, Managing Director, at Gowling WLG. It's my pleasure to welcome back Michael Samis, from Ernst & Young, and John Seden from Control Risks. This is the second part of our discussion on the issue of country risk. In session one we talked sort of at a high level about the issue generally and some considerations about the subject. Today we're going to focus more on the issues related to some of the analytical tools that are used in country risk and how a country risk program can be developed by companies looking to do business in overseas jurisdictions. Sort of picking up from where we left off in session one, how can companies improve the way that their assessing country risk and managing country risk?

Mike:               They can do that by developing and using a country risk management program. In essence, what that does, it better organizes the way the company is assessing and ultimately integrating country risk into the way it makes decisions, both at strategic level in making investment decisions, as well as managing a range of assets on an ongoing basis. Now the prime objectives of a country risk management program, fundamentally to control capital risk exposure when making that first investment, and then protect shareholder value once those investments have been made so protecting shareholder value on an ongoing basis.

Paul:                Looking at different stages of the investment cycle from final investment decision early on, or even maybe before that, business development strategies for particular areas of the world. Looking at some and not others then analyzing a specific opportunity and then managing that opportunity going forward, how do we see a robust country risk program assisting a company throughout all those phases of the project?

Mike:               We're really looking at country risk management program dealing with the full life cycle of the investment. Your focal points in a program like this, obviously you're starting off with the initial decision to invest and questions about how do we want to structure our capital risk exposure. That enters into questions around timeline for investments, whether you're staging investments or not. Also dealing with issues around are you going to be participating in an investment with someone else. So have a joint venture partner and also risk transfer possibly through different forms of financing. Those are the upfront considerations. Once again, once in the country and you're operating an investment, you're going to be monitoring events in the country. Trying to think about how to protect shareholder value. Developing relationships so you can protect your investment, whether it's at the local level dealing with local communities, and at the government levels, various levels of government. Then finally, your risk management program is going to have a corporate element, an aggregate element, where you're considering the impact of all the different investments you have around the world and how it comes together to impact the company. This is going to play out through looking at various risk exposures, seeing whether those exposures breach your risk budget, making sure that the investments you have are consistent, or in a line, with your overall corporate strategy and also conform to different guidelines about how you plan to invest in different types of countries. So, high risk countries you may only take on certain types of investments. Other more moderate risk countries you may invest differently. We're really looking at this as an organized activity across the life cycle of an investment and then also at the corporate level.

Paul:                You mentioned just now the idea of joint venture partners. How does a joint venture partner maybe help you to either assess the project opportunity or de-risk the project opportunity? Whether it's an international joint venture partner or maybe even a local partner that you're teaming up with.

Mike:               It's usually about how much capital you want to put into your project. For your company size you may find that a large investment, say some mining projects, require investments of 4 billion, 5 billion, 6 billion and it might be too large of an exposure for your company. You maybe wish to take on a joint venture partner to share the risk. The other aspect is if you're taking on a joint venture partner they may have relationships in country that you don't have that can help you protect the project and your investments. There's a number of reasons to go forward with a joint venture partner. Partly, it's around capital allocation and limiting certain exposure, but also there may be relationships that your partner has that you don't that can help you.

Paul:                You mentioned cash flow analysis against the classic assessment. How do you see that companies currently assess and manage country risk versus what sort of robust CRMP program might have and add value for the company?

Mike:               One of the things that John and I have commented on when we've talked to various companies about country risk, it's one of those recurring themes. How do we see people out there dealing with this? The approach that we often see, for a number of companies, is one of gathering information through various sources and country risk reports. But then all that information tends to be assimilated and then converted by some processing to some adjustment to your discount rate on your cash flows. From our perspective, that's fine, but we think you can go further. That's actually look at the cash flow effects, and through various analytical tools, understand how that creates a risk exposure for you. What we see is that it's great what we're doing now, but we can go further so we can actually generate information about risk and that can help us make better decisions about how we go forward, how we invest and how much risk do we want to take on.

Paul:                What would be a good example of by moving to this more robust analysis, something that you're picking up that might affect either your investment decision or how you manage the project, that isn't maybe being captured by traditional analytical techniques that companies are employing?

Mike:               Original techniques tend to be what we term a value effect. Country risk gets recognized through a discount rate, a little bump in the discount rate, say from 7% to 10. In the end you come up with a value for your project, or profitability index, various measures of the company attractiveness. But the issue can be that when you're comparing different opportunities around the world you may have similar values for different projects, even though they're in very different jurisdictions. Or one project might have a higher value than another but it may, on the surface, look to be a better opportunity. What we're looking to do though is try and understand characteristics of the project and how that exposes you to country risk. Putting a large amount of capital in a front, into a reasonably stable jurisdiction but for a long time, that long period of investment can add a lot of risk to your project that you may not see through using a discount rate adjustment. That can actually be riskier than putting a smaller amount of capital into a higher risk jurisdiction. It's not the case that either is better or worse but you should understand what you're getting into. Then you can discuss it and make decisions in an informed manner. If we're just limiting ourselves to discount rates we're not going to see those sorts of effects. They're not going to be discussed and the quality of the decisions you're making may not be as high as you'd like.

John:                Within this, I think what Mike is saying, there's often a focus when thinking about country risk there's a sort of downside. I think it's important to stress that with some of the model, that Mike's been describing, that also of course provides opportunity to take advantage when situations change in the country that you're involved in, that provides new opportunities, maybe to change the structure of a project or to change the way it's been operating, what have you. Similarly there can sometimes be a change in dynamics between a company's home country and where they're invested and that too can present some opportunities. With this sort of more sophisticated way of looking at all these issues, and doing so in an integrated way across the investment cycles, not only does that help you to better manage the downside of risk but take advantage of the upside.

Paul:                So, John, let's talk about a company that is looking at an opportunity in a place they've never been. Either the country or even the region. So they say, "Oh, there's opportunities in the Middle East" or "There's opportunities in South America" or "The Asian sub-continent. I want to go in but I don't know anything about that area." From a country risk perspective, what can companies do, what should they do, how do they do the country risk assessment to get up to speed to make an informed decision?

John:                Different companies will take quite varied approaches. Many will rely on a combination of home governments, and sort of trade promotional agencies, as well as wherever they're possibly looking to invest, at national and sub-national level, government agencies whose role it is to help promote investment. There are a variety of different information sources that companies can access. They will typically also go on trade missions and scouting visits and this sort of thing. All of that is potentially quite useful. Where we find companies sometimes struggle, it's often quite a wide range of stakeholders who are comfortable with operating in a new region, within a new region of the world that is, which jurisdictions are most appealing for them based on some sort of macro-level factors, combined with the opportunities that they see there for their business, as well as maybe some constraints that are there in terms of who they may be able to partner with and so on.

Paul:                Now, let's flip that around. That's from the company perspective going into a jurisdiction. If you were talking to a country that is looking to expand its foreign investment into the country, and development into the country, what can that country be thinking about, or should be thinking about, in terms of attracting foreign investment. If the companies, on the one hand are doing all of this analysis for better or for worse, then clearly the jurisdiction could be doing some things as well. What should countries be thinking about?

John:                Generally speaking, and I hope this can grow through our discussion this morning, is that companies don't like a lot of uncertainty. That uncertainty brings a risk of course. Above all else a country is looking to attract more investment should be looking to project and genuinely have a stable investment environment for whichever industries and sectors it's looking to attract. Additionally, some factors around the quality of the work force, and how communities are permitting, and someone works around bringing in expertise from abroad. There's a whole raft of issues. I'd say it's also quite crucial, bear in mind that perceptions are quite difficult to change, and so countries who have a bad reputation now, if I can be rather simplistic about it and say bad reputation, they do seem to quite struggle at changing that, at changing the perception of investors. That's particularly true when maybe they've had a history of extreme corruption, or conflict, that sort of thing. Typically so if they're in a part of the world where those issues are seen as being in debt, rightly or wrongly, it's tough to then convince foreign investors that that is a safe bet.

Paul:                Mike, we're talking about implementing a country risk management program. What impact can that have on a company's investment portfolio once you start moving in that direction?

Mike:               The impact really comes through more, I guess you can say, a more organized approach to dealing with country risks. It's going to impact the way you may think about designing your projects and how you commit capital into the region. If country risk is an issue, quite a large issue for a country, you may be thinking about how you might stage investments. You may develop a project in a manner where you're not front loading capital but actually delaying investments to see how things go. Later on in the project, if things are going well, you can commit more capital. It'll also change the way in which you think about how much capital to actually put into a particular project once you figured out the design. There may be thinking about issues around risk sharing through to alternative finance. Say through streaming or project finance and there may also be, as we talked about before, joint venture partners. How to share some of that risk. Lastly, it's obviously a portfolio impact where we're going to be dealing with how much risk we want to take on, but also thinking about the type of projects we want to get into in the particular areas in the world that you might want to invest in. A lot of this just comes from a formal approach, more detailed approach, about how we go about making decisions about where to invest.

Paul:                What kind of country risk analytics are we actually performing and at what stages are we performing those analytics?

Mike:               What we're introducing here is an approach were we're trying to convert the impact country is from a value effect into what we call a cash flow effect. The idea that country risk will have an impact on your investment cash flows and that will flow up into the value of your project and up into the company level. The way that we're going to do this is we're going to introduce something called a country risk glass model where we're actually thinking country risk in terms of every year there's potential for a country risk event to occur. Then if that event does occur there will be a cash flow effect and there will be some uncertainty around just the magnitude of that. With that type of approach, we can now use numerical techniques, like simulation, to actually model out and generate a wide range of cash flow effects on your project, across the life cycle, as well as a wide range of potential for when country risk events might occur. That's going to give us a large amount of risk information that we can use and summarize to help us make better decisions about how do we structure investments, how do we work with other entities, how does all that flow up to our corporate level.

Paul:                We hear the term "first of a kind risk" with technology or projects and things of that nature, when we factor first of a kind, whether it's the project or the country, or the region for a company, how does that factor into your CRMP analytics? I mean, sometimes frankly, you could be overly conservative about first of a kind risk depending on where it is and how it is. Other times maybe there's not enough of an appreciation of that type of thing. How do things like that factor into your model?

Mike:               Obviously moving into a new region there's going to be issues around, hey, we've been here before or we've haven't been into this particular region as an industry. That's going to have a particular impact but the strength of having an actual formalized process, a framework to work within, is that you can use that to help structure your thinking and guide you through this particular problem. Actually help you understand your exposures and how you can potentially mitigate them. It's not like, yes, every country offers particular issues and things but, generally, there's any number of high-risk countries around the world, and moderately risk countries, and countries we considered low risk and stable. We can use that, sort of the history of the industry in those other countries, to help us understand what could possibly happen if we go into new areas. For us, using this structure approach has a lot of benefits because hopefully it can help you think through the issues in a more structured way and so you're more comfortable about how do we deal with the first-in-kind type of problem.

John:                Feeding into that I think it's more that there's opportunities to use a detailed understanding of that country, or that new innovation that is there, in order to determine from a broad range of stakeholders how that may be perceived and how that project may be adversely, or positively, impact the country risk environment.

Paul:                Do you think that sometimes we have an undue bias and when we think about country risk we say, "Well, that's the developing world." If I'm going into Africa or South America or South East Asia why I need to think about country risk. But if I'm in the developed world everything's good. Then you look at something like Brexit. Or you look at Trump getting elected, and I think you can make the argument that country risk isn't just a developing world problem. It could be in almost any jurisdiction you're going into. Would you agree or disagree?

John:                Completely agree. I'd say yes, there have been a number of major headline grabbing events over the past few years, in particular, that probably drive that point home but it's by no means a new issue in developed countries. It may be somewhat self-serving working for a company called Control Risks that we say risk is everywhere, but I think if one looks at it objectively that is very true. For instance, in Canada which most people around the world would probably consider to be one of the most stable countries. And it is, certainly. But that's not to say that there aren't sometimes issues that companies come across. Particularly when considering the larger sort of capital projects with complicated issues between different levels of government, for instance, and understanding how the interplay some of those can have an impact on the project.

Paul:                When we're building these country risk management programs, what are the inputs that go into this, sort of analytically, and then how do you assess the importance of this may be data driven inputs versus call it boots on the ground? Sort of having somebody in the country that understands the country that has this sense of things, knows the right people to talk to, understands that maybe what's in the press story isn't really an accurate reflection of things. How do you balance the two of those and what different values do they create within the larger program?

John:                We say that those two elements should be integrated. You could think about in terms of top down and bottom up but that would suggest that maybe there's a disconnect there, which isn't what we would suggest one does. The different stages in making an investment decision and diligence process, varied levels of debt would probably be warranted and certainly that sort of macro-level view may be sufficient, probably would be sufficient, in the very early stages. But typically, what you referred to as boots on the ground, typically that can be quite invaluable in understanding some of the real nuances around specifics to an industry, local region, a variety of factors. Whoever it is. Media perceptions of your partners. May be perceptions of contractors who a company is working with. Positive and negative. And understanding what rumours could adversely affect an operation. That's pretty important too. Even if it is just to understand that those sort of reputational issues are there in the marketplace and may be things that need to be managed going forward.

Mike:               The other thing to remember is you can actually use qualitative and quantitative to reinforce each other. The issue with modeling is that you can build a model that you fall in love with and think this is the answer to everything. It's important to step back and have some of understanding the underlying structure of how you see country at risk playing out and its potential cash flow effects. The way you can do that is by having that behaviour reviewed by people who are experienced in country. And say, "Does this sort of behaviour actually make some sense?" The idea here is that they should be working together and complimenting each other and supporting each other.

Paul:                John, you mentioned that concept of reputation risk, which maybe is a little bit different than classic political risk, government action, those types of things, but do I want to do this project because of reputational factors to my corporate brand? How does that factor into all of this and what level importance do you see companies putting on that and do you see attitudes changing?

John:                There is a fair bit of focus on it. Perhaps not quite as much as some would think. What I was referring to a moment ago was thinking primarily local level. How a project or company might be perceived at local level and how that may positively, or negatively, impact the ability of the country to execute its project. I'm not thinking too much specifically about bad press, so to speak, but rather operational delays and this sort of thing that can result from some of these reputational issues.

Paul:                But we do see active as shareholders and NGO's especially issues like climate issues. A coal plan. Things of that nature that become targets in terms of what companies are doing or may be planning to do that then get blocked. I would think that factoring in those macro reputational issues might be important as well.

John:                They certainly are and companies that we work with often will say that it's a challenge to keep up on what they feel is a broadening array of different indicators, that they need to stay on top of, and ensure that they have adequate means to incorporate those into their models and their reporting as well.

Paul:                Let's talk about risk budgeting. What exactly is that and how does that factor into the overall corporate planning process?

John:                Risk management really should be an integral part of strategy formulation for a company project. As part of that, essentially and to put it quite simply, an organization needs to determine how much risk it's going to take and how much risk it's going to accept. By defining that, basically creating a risk budget, and understanding and communicating what the organization's risk appetite is then you can ensure that an appropriate amount of risk is taken. That, again, certain ties back to the strategy of the organization. We say that for country risk factors that the basic approach is no different to any other. In fact, country risk should be only aligned with how other risk factors are considered.

Mike:               The other thing to remember as well about risk budgeting is it's a process of how to discipline the way you allocate capital. That's a really important thing because you may see a really great investment opportunity somewhere and it's going to require a certain amount of capital investment. You're thinking what a great way to expand the company. But the question comes back is are we taking on too much? Potentially, with risk budgeting and through an enterpriser's management program, this will allow you to step back and make some choices. This can feed into yes, it's a great opportunity. We want to be there. But how do we best do it to make sure that this opportunity is aligned with the way we want the company to go?

Paul:                We've had two sessions now on this subject of country risk and I thank you for your comments, but if someone's listening to all of this and they say, "These guys sound like they know what they're talking about. I'd like to work with them more." How do each of your companies, respectively, engage on this on a daily basis with projects or with various historical clients of the firm? What are you actually doing? How are you brought into the process and are you also seeing that evolve over time?

Mike:               You go first, John.

John:                At Control Risks, we have one of the largest teams of political risk analysts in the industry who are working on a daily basis with clients across all industry sectors. They're working from major centres around the world, both in the developed world, if I may put it that way, and you were talking about risk in the developed world, as well as in some of the most interesting and high growth emerging and frontier markets. In essence, what we do is help organizations understand some of the risks that they're facing, and that can be at macro level, country risk level, as well as risk associated with some specific projects they're working on, counterparties. Then beyond just helping them understand what the risk is we help them develop frameworks to manage that and when they have issues, as problems and challenges associated with country risk factors, we help them manage those issues.

Paul:                Now, Mike.

Mike:               Ernst & Young, we have a group out of New York. A geo-political strategy group that helps businesses understand the impact of political events on their businesses. For example, Brexit and investments in England and how that may potentially impact your business going forward. On my side, I have a team here in Toronto, where we are actively modeling investments. Essentially, dynamic cash flow modeling looking at various risk exposure for investments. Particularly in the natural resource sectors where we're dealing with commodity prices, uncertainty, foreign exchange, energy uncertainty. Then on top of that we will layer on country risk and seeing how that impacts an investment. We do that at an initial stage so when you're dealing with the initial investment. Also for existing operations where you might be thinking of making another investment in that and also bringing that up to the corporate level. We tend to deal with a lot more of quantitative modeling of the these issues and generating information about risk exposure so decision makers can be comfortable in the decisions that they make around where they allocate capital.

Paul:                From a corporate perspective, I guess for both of you, to be effective you're looking both at a project level but then at more of a portfolio or industry or regional level because, as we've talked about over these last two sessions, if we're looking at risk on an individual project that has to be filtered into the company's overall risk profile and how that project fits within the larger picture for the companies. Is that fair to say?

Mike:               That's fair to say, yeah.

John:                That's exactly it.

Paul:                Wonderful. Wonderful. Listen, thank you both for your time and hopefully everyone found this to be very interesting. I know that I certainly have. But I really appreciate your time and your comments. Thank you very much.

Mike:               Thank you.

John:                Thanks, Paul.

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