A few recent developments in our markets have the topic of regulatory risk fresh on our mind, making it an opportune time to turn our attention to part four of our ongoing series on the risks of direct investing in emerging markets. We’ve coined the term “FIERCE” to summarize the main concerns we hear from U.S.-based investors interested in investing in Africa — as a reminder, these “top-of-mind” risks include Fraud, Instability, Expropriation, Regulatory, Currency and Enforcement of Contracts.
As with the other FIERCE risks, we need to think about regulatory risk in a nuanced, multi-dimensional way — however, we stress that the identification of regulatory risks need not categorically prevent us from putting capital to work in a market if we believe in the opportunity and can find ways to mitigate the risk. Rather, we need to quantitatively and qualitatively identify the implications of the existing regulatory environment and any expected, and potential unexpected, regulatory changes so that we minimize the potential for being caught off guard and are appropriately accounting for risk through the mechanisms of price and investment terms/structure.
UNPACKING “REGULATORY” RISK
When assessing the regulatory risk of emerging-market investment opportunities, we generally ask the following questions:
· How does the specific investment opportunity (i.e., Company) being considered fit within the regulatory construct in its current market? Within expansion markets?
· Who are the relevant regulators and what has been the traditional relationship between those regulators and the sector that the Company operates in? Is that relationship best characterized as contentious, collaborative, or otherwise?
· Is there longstanding regulation in place covering the sector, with buy-in from various stakeholders in the value chain? Have any members of the value chain been systematically ignored, leading to simmering resentment and potential regulatory “blind spots”?
· Has regulation caught up, or kept pace, with technological development — including in the realms of software, hardware, business model, financial, and others? If so, what are the constructs? If not, what areas are most exposed to harmful regulation and what steps can be taken to mitigate such risks?
· How does the regulatory framework in the country compare to the framework within neighboring countries and other countries around the world, and what analogs can we find in how different countries regulate the sector?
· Will the success of the Company draw additional attention from regulators, and, if so, in what way? How might regulators react? What steps is the Company taking to mitigate potential regulatory “blind spots”?
· How exposed is the regulatory paradigm to the other FIERCE risks, such as Instability, or macroeconomic changes?
· Within the sector, are there unwritten rules, normative rules, explicit or implicit exceptions to rules, or “backroom” deals that act as quasi-regulation and that might affect the Company?
· How well positioned is the management team to react to proposed, expected, and unexpected changes in regulation? How well positioned are current investors, VestedWorld, and prospective co-investors for the same?
While this seems like a long list, and perhaps has some of our readers’ imaginations running wild, we caution that these risks also apply to developed-market opportunities — especially given the level of technological and business-model innovation taking place. Examples where regulatory changes caused major headaches in a more developed market include Homejoy, DraftKings, Uber, HomeHero, and many more.
I want to reiterate, though, that we don’t believe we have a crystal ball or some heightened awareness that would have allowed us to predict the way these regulatory changes were decided. Instead, our approach is to understand the risk, make an assessment on the upper and lower bounds of the operational and financial impact, and then understand how it should affect our decision to invest and the price and terms/structure of our investment.
THE FIERCE RISK ASSESSMENT IN PRACTICE
A prime example of a change impacting the regulatory regime surrounding one of our portfolio companies was a federal policy in Nigeria restricting the import of certain preserved tomato products, and increasing the tariff on imports of other tomato products — this occurred shortly after we made our investment. Before we made the investment, however, the Nigerian government had already taken some steps toward this policy and had indicated further potential action was possible. At the meeting where our Investment Committee provided their final recommendation, we shared the following thoughts on the topic:
· “The Central Bank’s goals tend to be rooted in development, and the banning of certain imports — with an eye towards spurring domestic production — has plenty of precedent and therefore has a significant likelihood of being enacted”
· “Regulatory tailwinds to the processed-tomato import industry may entice other local processing market entrants — such competitors may be better funded, more politically connected, or possess parts of the value chain already at commercial scale (e.g., farming operations, processing operations, distribution network) — or such policies may be reversed by subsequent governments, resulting in regulatory headwinds”
· “Current (and forecasted) government regulation appears to support the growth of local tomato-processing operations (e.g., foreign-exchange ban, potential import ban of tomato paste)”
· “The Company enjoys a strong working relationship with the current government, though that could significantly change with a change in government. However, mitigating this to some degree are (1) the primacy of agriculture in the states where the Company operates; and (2) the Company’s ongoing building of goodwill with local, non-elected leaders and community members”
· “Based on our time with the entrepreneur in the operating environment, she seems to be very comfortable working with senior elected and appointed officials, and shows strong relationship building skills within the local and regional ecosystem, which modestly mitigates the risk of state and local negative regulatory changes”
· “The Company’s business plan benefits from regulatory measures undertaken by the current government: specifically, measures restricting the access to foreign currency for the use of importing certain goods, including processed-tomato products, results generally in higher domestic market prices for tomato paste, difficulty for importers in supplying the demand, and incentivizes local production of processed-tomato products. While the current policies benefit the Company, we believe that the underlying business model and economics are not contingent upon this regulatory support”
Importantly, these thoughts found their way into our financial assessment of the Company, and the discussion and negotiation on the appropriate price and terms of our investment — some beneficial, some negatively, and others neutral.
A second example of this sort of regulatory change impacting one of our portfolio companies was legislation signed into law in Kenya on bank lending and deposit interest rates. While our portfolio companies have thus far been spared the types of negative regulatory changes I linked to in my paragraph on developed-markets, nothing fully insulates us from this risk. It is more likely than not that at some point we too will be negatively impacted by some sort of regulation, no matter how much effort we (and our entrepreneurs) put into mitigating these risks.
From these examples, both in developed markets and in Kenya and Nigeria, it should be clear that regulation has earned its place in the FIERCE risk framework that we use to assess investment opportunities. But it should also be clear that these risks need not prevent investors from investing in emerging markets — and that, in fact, these risks are just as likely to apply, and be damaging, to early-stage companies operating in a familiar developed market. We caution that familiarity can be dangerous, and that the heightened perception of risk can perhaps be beneficial to investors when it appropriately translates to fund managers adopting their processes to best fit the markets where they invest.