Picking Winners and Losers: The Fine Art of Conducting Due Diligence in Frontier Markets

I’ve been looking forward to writing about this subject for a long time now. For me due diligence is one of the most exciting and critical parts of a business deal, but one that is massively overlooked when it comes to looking for practical advice.  Hopefully I can help to redress this issue below….

In this article I’m focusing on the pitfalls of buying an equity stake or outright ownership in a frontier market located medium sized business. What follows is based primarily on my first hand experiences, but I have also spoken to a number of business people and bankers operating in frontier markets to get their views.

Conducting due diligence is essential when buying any business, but if you are working in an unfamiliar frontier market then it is absolutely vital to ask the right questions in order to ensure you are getting the best possible value for your money and avoid getting sold a dud.

Frontier markets also raise a whole load of other interesting issues like lack of legal redress, government interference and currency depreciations. But this is what also makes these countries so challenging, fascinating and exciting. If we didn’t want to take any risks with our investments we could place our money in established blue chip stock and treasury bills in developed markets, a stark contrast to the superior returns offer by frontier markets.

Risky Business

Whether you are thinking of buying a business, investing in a greenfield project, or partnering with a local firm in a frontier market, it goes without saying that research on the company and the macro-economic environment are vital steps to make before making an investment.

But as we know frontier markets suffer from a paucity of reliable corporate information. Comprehensive company reports, financial data and expert analysis that are taken for granted in Europe or North America will be much harder to source in emerging economies and often missing altogether.

So very often you have to get the information yourself and these are the key questions you should ask yourself when buying a company in a frontier market:

Can you verify their track record?

While accounts don’t tell the entire story, they are important. Accounts in frontier markets may be drawn up to local standards, which may not bear much resemblance to international financial reporting standards (IFRS). So you face the choice of learning to interpret these local accounts, (which can be tricky) or converting them to IFRS (which can be costly).

If you are lucky the company may well have already made this step, so you can compare and analyse their profit, cash flow and lots of other financial metrics with much greater ease and confidence. The next step would be to benchmark the target company’s performance with its peers. But bear in mind a profit margin which looks healthy in your home or a neighbouring country, might in fact be highly average or below par in a frontier market.

Is the track record to the work of the current core management team (or did they just leave to start a rival venture?).

Accounts just give you a company’s history and as we all know this only a partly reliable guide to its future. Now you have to turn psychologist and determine whether the management team has what it takes to make the company grow sustainably and maintain profit into the future. Even if this is true, are they incentivised to work for you?

Another problem is if a management team is so well embedded they have absolute devotion to the firm, but view any ownership changes and reforms as interference from outsiders and/or foreigners. This can torpedo your venture before you have even started.

Don’t Rock the Boat? Team Stability

The deal looks like a winner, but will you coming on board lead to departures and uncertainty, as the current management see an ideal time to jump ship to a competitor or start their own firm? For course you can look to bring in your own management.

If you have got this far in business, you will undoubtedly have a strong network of contacts and colleagues in the industry that you know will do a great job, so why not move one or more of them into a new position running the new venture. While it is always positive to hire people you trust and know, do think first about whether this kind of move will leave the company shorn of local knowledge and expertise.

Any existing or locally hired management will most likely have the local contacts and knowledge required to run the business. People who have been working a long time in the firm could even have the power to ruin the venture, putting off suppliers, administrators and others important to the business should you cross them or try and fire them, leaving you the legal owner, but with no real control. This is often difficult to comprehend until you spend time working in a frontier markets where personal connections trump professional experience.

Good Management is hard to find and easy to lose, or lose control of.

Is there sufficient deal flow?

A company might have done well so far, but do they have sufficient deal flow or sales potential, or is the market saturating, either through competition or slowing growth. While Frontier Markets have seen healthy growth in recent years, it remains unpredictable and patchy.

When judging whether there will be sufficient deal flow it is important to understand how are returns made in the market?

You know a supermarket makes money by selling food, mines sell minerals and metals, builders sell houses and shops, but you need to get under the skin of what makes a particular industry or company make a lot of money in this particular locale.

For example Indian owned mobile phone operators Bharti Airtel made a big success of African markets, partly through good timing, but also by understanding and adapting to that market. So ask yourself is the company you are buying or starting anew well adapted to make strong sales in that particular country or region.

Are there exits?

In large markets like India or Indonesia, you will have access to a fair sized stock market and a large range of buyers. But what about buying a company in Armenia or Costa Rica, you might find a company offering fantastic value and great potential returns, but five years down the line you may face major problems selling it thanks to a paucity of buyers, due to the difficulties of attracting investors to a small marginal market and little hope of a decent local stock exchange flotation.

Are contracts enforceable?

This is a massively underrated issue: in the West we assume that although going to court is expensive and to be avoided, it will generally lead to equitable judgement, and therefore we feel the reassurance of signing business contracts.

But in many jurisdictions, the contracts are unenforceable and courts not worth the hassle, you have to look beyond legal contracts and think about the relationships with the management and staff of a company and whether they will be adequate in protecting your interests.

That’s not to say you shouldn’t take legal contracts seriously, have the contracts drawn up in English or New York law by a lawyer familiar with the geography and sector you are working in. Just don’t place all your faith in the lawyers’ carefully chosen words.

Political and Economic Collapse? Macro and Political Risks.

Many would argue that this is the biggest problem a Frontier Market investor faces, the unpredictability of politics in many parts of the world. Even seemingly stable places like Ukraine can suddenly face an unprecedented and unforeseen political crisis. While others like the Central African Republic or Sudan seem on a constant treadmill, of war, conflict and instability.

Even the best run company in the world cannot usually maintain strong performance in a war zone, but it is possible to predict which countries will face conflict and to take a measured approach to risk, an unstable country beset with violence may see those issues primarily effect one region, or that they do not damage fundamental business interests. Thailand has seen waves of protests and coups in recent years, these have certainly damaged the country’s economic record, but they haven’t ruined it either.

More controversially there is an argument that instability can drive away competition creating opportunities for the companies brave enough to remain and ride out the storm.

Casinos, Crooks and Criminals: Red Flags

It is fairly obvious advice to avoid anyone with criminal associations, but assuming they don’t advertise them and you can’t find anything from media reports or desktop research you need to trust your judgement of character. But watch for classic red flags such as links with nightclubs, casinos and property speculation, all industries notorious for connections with organised crime and money laundering.

If your suspicions are raised or you get a feeling something isn’t right, you can hire a corporate investigator that can look into the matter. But to be honest, if you have got the point where you are going to seriously investigate a potential business partner, then the deal is probably not a great idea.

1st Hand Case Study: Buying 25% of a Bank in Eastern Europe

This is a brief account of the due diligence process preceding the purchase of a stake in small bank in the former Soviet Union, based on my direct experience.

The chance to buy a stake in a bank located in Eastern Europe arose thanks to a sponsor looking to sell in order to divert funds back to their core business. Once initial contact was made a week long on-site due diligence study was conducted in order understand the ins and outs of the business.

Although it represented a modest sized deal in a limited market, the bank had good growth prospects, a decent financial history and strong management, ranging from locals with 20+ years’ experience of the market, along with others who had a blend of local and international experience, working in both neighbouring countries and the United States creating a well balanced team.

The bank had a good mix of SME, corporate and mortgage business, with slight over conservatism in terms of capital base. Arguably they were not utilising their capital to its full potential, but given the small size and relative fragility of the country’s financial system, this strategy was understandable. A major plus was the fact the bank faced little local competition.

Expense wise there was concern around the relatively large number of flashy German cars purchased by the Bank, but these vehicles are a crucial part of the image for businessmen in this part of the world. The main negatives around the purchase was the lack of a decent exit strategy, while selling the stake was envisaged in 5 – 7 years, the size of the Bank even with strong growth would not be large enough to exit via an IPO in a liquid market, leaving with us with the prospect of a sale to a private buyer, or possibly a strategic international buyer, but these options were limited by the bank’s remote location and relatively specialist sector (financial institutions).

End Game

A search of local and international press as well as discussions with the banks’ counterparties and competitors uncovered no red flags or negative reports. The Bank’s accounts were converted into IFRS and an international “big ten” auditor was hired for future audits. The successful due diligence process was followed by protracted negotiations over pricing and terms, but the realisation that the company was honest, had a strong ability to continue producing a healthy balance sheet and growth allied to a talented and stable management team meant the deal was successfully completed.