Country Risk and IRR
Ok, following thought: in an LBO my final output to assign if the investment makes sense, i.e. offers attractive returns based on the capital structure and projected cash flows, is IRR (or MOIC). But both measures fail to incorporate the riskiness of said investment to some degree, no?
To illustrate: two companies have exactly the same fundamentals, one in the US, one in, lets say, Uganda. Obviously for the Uganda asset, risk will be factored in in purchase price. But this cancels out with lower exit projections as well.
So ultimately, both might give 25% IRR. Now this is an extreme example, and everyone than logically would choose the US investment. Nevertheless, in real world (e.g., Western vs. Eastern Europe), no one really seems to think about "risk-adjusting" returns in LBOs. Obviously, you would work with scenarios to potentially capture those things but I feel this to be quite hard to quantify. Any best-practices?
Based on the most helpful WSO content, it's true that traditional IRR calculations in LBO scenarios often don't explicitly factor in the geographical or country-specific risks, which can significantly impact the risk-return profile of an investment. Here are some best practices and considerations for incorporating country risk into LBO analysis:
Risk-Adjusted Discount Rate: One common method to account for higher risk in certain countries is to use a higher discount rate when calculating the Net Present Value (NPV) or IRR. This adjusts the expected returns to reflect the increased risk. For countries with higher political, economic, or currency risks, a higher discount rate can be used.
Scenario Analysis: Conducting a robust scenario analysis can help in understanding how different risk factors could impact the investment returns. This includes best-case, base-case, and worst-case scenarios, factoring in potential political changes, economic downturns, or currency devaluations.
Country Risk Premiums: Adding a country risk premium to the cost of capital is another approach. This involves adjusting the Weighted Average Cost of Capital (WACC) used in the LBO model by adding a premium specific to the country’s risk. The premium can be derived from several sources, including global financial institutions or risk assessment agencies.
Comparative Analysis: When evaluating investments in different regions, a comparative analysis can be insightful. This involves not just looking at the projected IRR but also at the qualitative factors such as market stability, governance standards, legal protections for investors, and historical performance of similar investments in those regions.
Hedging Strategies: For financial risks like currency fluctuations, consider using hedging instruments such as futures, options, or swaps. While this might increase the upfront cost, it provides a buffer against potential losses due to adverse movements in exchange rates or interest rates.
Exit Strategy Considerations: The exit strategy should also reflect the country risk. In higher-risk countries, it might be prudent to plan for multiple exit strategies or anticipate a longer holding period to manage risks better.
Local Expertise: Leveraging local expertise and partnerships can provide better insights into the market dynamics and help in navigating the local regulatory and business environment effectively.
By integrating these practices into your LBO analysis, you can better quantify and manage the risks associated with investments in different geographical regions. This holistic approach not only enhances the decision-making process but also aligns the expected returns with the associated risks.
Sources: The Asymmetric Risk Profile: Preparing for the Hedge Fund Interview, LBO Returns - Increasing Leverage Doesn't Increase Returns?, Corp Dev LBO returns question: Levered and Unlevered IRR, The Asymmetric Risk Profile: Preparing for the Hedge Fund Interview, Specialty Lending (GS/TPG) - Any insights?
Deeply theoretical question, but let's try to work it out for a hypothetical country. When valuing a company in an emerging market (where you are comfortable with the risk of asset expropriation and confident that you can actually repatriate your investment profits), it's best to start by analyzing the historic and projected macroeconomic environment, considering factors like economic growth, inflation rates, and FX curves. If the macro is poor, there is nothing more to do, right? Conversely, if the macro forecast looks promising, the next step is to perform a valuation analysis of the investment target. However, there's a complication: the company's cash flows are in a risky currency that doesn't match the currency of the investment fund. To address this, two simple rules are generally followed: ignore real rates and the currency of the fund. Instead, consider all valuation metrics and model operating cash flows in nominal terms in the local currency, ensuring any significant debt is also in the local currency to avoid currency mismatch. The final step involves calculating the investment return in the local currency, which can then be translated into the currency of the fund.
For instance, if investing from a dollar-denominated fund, converting the local currency return to a dollar return involves translating the initial equity investment into dollars using the FX rate at the transaction closing date, then converting dividend payments and exit proceeds using applicable FX forward rates (and you should expect that the FX forward rate for Year 5 to be higher than that in Year 3 in most cases). Additionally, the dollar return can be adjusted for sovereign risk by subtracting the cost of a 5-year credit default swap (CDS) for the deal's geography. This is a huge adjustment that you might be missing in your thinking. By the way, this sovereign risk can also be hedged explicitly by buying protection in the form of a 5-year CDS at the time of transaction closing. Holding the CDS until exit isn't mandatory; if political or macro factors lead to adverse conditions in the country, selling the CDS at a higher value can yield a profit, mitigating losses.
Uganda is an interesting example, as investors are likely to penalize both the entry multiple and the exit multiple (as no developed ECM markets, small universe of buyers at exit and thus more limited investment monetization options). Also, is there even a liquid CDS for Uganda? And how much would investors get paid if they hold straight-up dollar-denominated government debt (I would expect serious double digits). All good questions to ask.
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