Scope of the firm in emerging marketsBenefits of conglomeration • Focus is the mantra in New York/London. Good advice in emerging markets? Not necessarily. The scope of the firm depends on institutional context. • What special in emerging markets • Info problem in financial, product, and labor markets. • Misguided regulation distorting markets • Inefficient judicial systems (contracts not reliably enforced)
Financial marketsInfo problem and market failures • W/o access to information, investors refrain from putting money into unfamiliar ventures. Developed markets minimize these problems thru institutional mechanisms: • Reliable financial reporting • A dynamic community of analysts • An aggressive and independent financial press • SEC and other watchdog bodies • Shareholder rights are protected (securities litigation, proxy fights, and hostiles) • Venture capital firms specializes in assessing new opps. • These institutions are largely absent or inefficient in emerging markets. Implications: • Investors refrain from investing. • Large and well-established firms have superior access to capital. • Diversification has value to investors. (Also to managers) • Diversified firms can also form internal capital market (internal finance) • Investors trust diversified groups to evaluate new opportunities and to exercise an auditing and supervisory function. • Diversified firms imitate the institution features of venture capital firms, private equity providers, mutual funds, banks, and auditors (independence??)
Product marketsInfo problems and market failures • Cause of info problems • Underdeveloped communications infrastructure. • No mechanisms to corroborate claims made by sellers. (Consumer Report in Russia?) • Consumer protection? Product safety regulation? Truth in advertising? • Implications: • High cost in building credible brands in emerging markets • But established brands wield tremendous power. • A conglomerate with a reputation for quality products and services can use its group name to enter new businesses, even if those businesses are completely unrelated to its current lines. • Groups can spread the high costs of building a reputation across multiple lines of businesses • Groups also have the incentive to protect brand quality. • E.g., Samsung has used its name for a range of products ranging from TV, microwave ovens, to computers.
Other market failures • Labor markets • Problems • Lack of educational institutions to train people • No certification and screening • Labor regulation that limits layoffs • Implications • Groups provide training programs (group specific) • Internal labor markets • Regulation • Problems ---Too much regulations • Solution --- Groups as intermediaries between government and individual companies. Lobbying, educating, (and bribing) politicians. • Contract enforcement • Problems --- Contract not enforceable. • Solution --- Reputation for honest dealings • Not every diversified group will be able to add value in the same way and no group can hope to fill every institutional void.
Principles of Risk Management • Allocate risk to the party that controls the risk or had the greatest impact on its outcome (effectiveness). • When possible and cost effective to do so, write a detailed contract specifying actions, quality, and performance. Contracts work best when the risks are identifiable, outcomes are verifiable, and contracts are enforceable. Predictable: note the difference between risk (known distributions) and uncertainty (unknown distributions) Verifiable: note the role of asymmetric information. Enforceable: note the importance of legal systems, property rights, and enforcement mechanisms. • Allocate risks to the party that can bear them at least cost (efficiency). • When negotiation, contracting, and other transaction costs make complete contracting unfeasible, allocate residual risk and return to align incentives and induce optimal behavior. • If possible, allocate asymmetric, downside risks to debt holders; allocate symmetric and upside risks to equity holders.
Why does project finance (or risk management) create value? • Modigliani and Miller’s capital structure irrelevance proposition: under perfect capital markets, firm value should not depend on how a firm finance its investments. • Real world capital markets are imperfect: • Taxes • Transaction costs • Costs of financial distress (bankruptcy) • Information costs (asymmetric information, managers know more than investors) • Incentive conflicts among managers, shareholders and creditors • How project finance reduces the costs of market imperfection? • Reduce information costs by investing in tangible, transparent, and stand-alone assets. • Reduce incentive conflicts • Free cash flow conflicts --- require firms to raise external funds (debt) from independent third parties. • Risk shifting (investing in high risk projects) --- “cash waterfall” to ensure creditors get the cash first. • Generally, making decision makers bear the consequence of their decision. • Reduce financial distress • Reduce the probability of distress -- risk contamination: independent entity • Reduce the costs of distress -- the tangible assets. Commodity products. • Reduce corporate taxes