Big Risks, Big Rewards

Part Two of a Series on Investing in Developing Markets

The world’s preeminent economic leaders — heads of state and the CEOs of the most powerful global corporations — gathered in January for the annual World Economic Forum (WEF) meeting in Davos, Switzerland. One of the panels presented a new WEF/Deloitte Touche Tohmatsu study that measures the impact of globalization on corporate enterprise value. The study shows a distinct correlation between going global and successful financial performance. Despite the Asian crisis, 84 percent of the companies that ranked high for globalization have outperformed the S&P 500 over the past five years. Other studies presented at the Forum’s meeting underscored the increasing importance of globalization in corporate growth and performance and the need to shorten corporate timetables for global expansion. (See Latin American Growth Rates)

Faced with increasingly mature markets in the United States and Europe, a growing number of companies are looking for new markets in less developed countries, where booming economies coexist with troubled political systems and financial uncertainty. Guatemala is a case in point. Excavators are still uncovering bodies from mass graves in the Guatemalan countryside, where 200,000 people died in a 36-year civil war that ended only three years ago. Guatemala is reeling from charges of genocide against indigenous Indian populations, and now faces a potentially explosive border dispute with neighboring Belize. But Guatemala’s economy is growing at annual rates of close to 5 percent a year, with forecasts for even greater growth beginning in 2001. And at the close of last year, Guatemala celebrated the opening of its new electric power station, the largest in the country and the first coal-fired facility constructed in Central America. Standing next to Guatemala’s president at the December ribbon-cutting ceremony was Richard Ludwig, president of the Tampa, Florida-based Teco Power Services, which will operate and maintain the plant.

Gordon Gillette, Teco’s CFO, has guided his company through a series of investments in conflict-ridden Honduras and, more recently, Guatemala. "Our incentive to move into these markets lies in the fact that annual electricity sales growth-rates in these areas average 8 percent, compared with U.S. growth rates of 2 percent to 3 percent in high-growth states such as Florida and only 1 percent to 2 percent in low-growth states in the Midwest," he says. Teco is one of many U.S. firms that are looking to the less developed countries of Latin America for the rapid expansion now required to stay ahead in the rush toward globalization.

The rates of economic growth in less developed countries, such as Guatemala, are two to three times higher than the rates recorded in the developed world. Only 10 countries worldwide registered average annual economic growth rates of more than 7 percent from 1990 to 1998: Chile, China, Ireland, Lebanon, Lesotho, Malaysia, Singapore, Thailand, Uganda and Vietnam. With the notable exception of Ireland — Europe’s economic hot spot — all of the high-growth countries are located in less-developed regions of the world and all have been marked by serious conflict. Companies that have been willing to step into these markets often see extraordinary market growth despite unnerving bouts of political unrest and financial chaos. Although the risks are high, the companies that have been able to manage the risks and live with them are reaping some spectacular rewards.

Covering Risks

As Teco moved into Latin America, the company focused on three concerns: how to maximize the revenue stream from its Latin operations, how to structure the company’s operations from a tax perspective, and how to insure the company for the political risks associated with doing business in a volatile region. The company addressed these concerns through a coherent strategy for building its business abroad. In all cases, Teco has worked with local partners. "This is imperative in the early phase of going into a new country," Gillette notes, "because it gives you immediate entry into markets that are difficult to know and penetrate."

Wherever possible, Gillette says, "we structure projects so that they can be insured against currency and expropriation risks. We make sure that payments can be converted into U.S. dollars and our contracts require valuations in U.S. dollars." Teco obtains insurance from the U.S. government’s Overseas Private Investment Corp., which provides for the return of 90 percent of equity if currency is not convertible or expropriation occurs.

For its Latin projects, the company uses nonrecourse project financing, now offered by major banks, to protect the company’s broader assets. Under the terms of nonrecourse financing, banks cannot reach beyond the assets of the specific project if the company fails to pay its debts on the project. The World Bank Group also provides some funding for Teco’s projects. "This is an important source," Gillette says, "because local banks often cannot fund large projects. Also, with World Bank funding, there’s a level of security for the projects that private lenders cannot provide."

Teco is fully satisfied with the performance of its Latin America operations. "All of our investments have performed at least as well or better than we expected, and now contribute significantly to our growth and earnings," Gillette reports. "We have positioned ourselves to be a major player in the Central American market, and now have the opportunity to be a big part of the power supply picture for the region. We touch every Central American country at this point, and we’re considering additional investments in South America and the Caribbean."

Special Concerns

Although some Latin American nations are only just beginning to pull out of recessions touched off by the Asian crisis, the overall economic outlook for the region is overwhelmingly positive. The World Bank’s regional forecast predicts long-term average annual growth of 4.2 percent for Latin America — double the rates forecasted for the United States and Western Europe. George Mencio Jr., a partner in the Miami office of Holland & Knight LLP who specializes in international law and cross-border transactions, and Jose E. Sirven, a transactional lawyer with Holland & Knight who specializes in U.S. companies doing business in Latin America, agree that emerging markets in Latin America offer huge opportunities for U.S. companies. Some countries, however, warrant special concerns.

"We are advising clients to be very careful in Venezuela, for example, which is moving through a difficult period of constitutional revisions that may affect business," says Mencio. "Ecuador is in chaos, and in Colombia, the political climate is a problem, with guerrillas controlling significant parts of the country. From a legal perspective, Colombia is a safe country to invest in, but political and social instability make it difficult for executives to maintain a physical presence. Nonetheless, for companies with a taste for bottom feeding, there are many opportunities."

Sirven says that there are two crucial issues for U.S. finance executives who are moving into emerging markets: restrictions on the repatriation of profits and exchange controls and currency volatility. The general trend in Latin America, he notes, is to ease or eliminate restrictions on repatriation and to move toward a free market for currency exchange. He also says that one of the biggest obstacles for U.S. companies operating in Latin America stems from their approach to employment law. "In the U.S., executives are accustomed to operating in an employment-at-will environment," Sirven says. "In Latin America and in most emerging markets, employers may have hidden severance obligations that may not be readily apparent to the acquiring company. U.S. executives must complete a careful financial analysis of a local company’s obligations if they are considering partnerships or acquisitions."

Mencio cautions U.S. finance executives who are evaluating local partners or investments in regulated industries to make sure that all licenses and permits are up to date. "You do the typical due diligence that you would do anywhere, but with special attention to details that may not be obvious from a company’s books," he says. "You need local knowledge, usually obtained through a local expert with the right network, to gather detailed information about local conditions and business histories. You also need a local expert to review the details of any agreement. The local expert should carefully investigate the local company’s reputation in the industry and its debt payment history."

Sirven also warns finance executives to watch for payments in foreign transactions that may be a normal part of business transactions abroad but may violate foreign corrupt-practices laws in the United States. According to Mencio, "finance executives must be able to spot the potential for danger. Bells and whistles should go off if you are asked to make up-front payments that are not part of normal business practices in the U.S. Irregular payments and corrupt practices are not endemic abroad, but in emerging markets there is always the risk of falling into troublesome and potentially illegal transactions."

Despite the obvious drawbacks of doing business in countries where political conditions and programs can change overnight and where most people live at the edge of poverty, the huge rates of growth in these countries command the attention of corporations pursuing global development. With the right combination of business planning, financing and local intelligence, U.S. finance executives can tap these markets, often with surprisingly rewarding results.