Understanding and accepting risk is an integral part of the private equity (PE) due diligence process. Traditional methods rely on sponsors and their investment banking partners to conduct conference calls with consultants, accountants and law firms to answer questions developed by the deal team to satisfy their due diligence responsibility. They also depend on checklists, like the S-1 disclaimer, to alert potential investors of asset risks. Some sponsors attempt to avoid risk entirely by retreating to U.S. markets that possess well-defined legal protections, ample liquidity and strong corporate governance. Unfortunately, none of these approaches deliver effective risk mitigation strategies that protect returns from the manifestations of social risk.
PE firms incorporate operational, reputational, geopolitical, technical, country and economic risk analysis into their due diligence process and financial models. However, it is social risk that influences the majority of contemporary risks and negatively impacts investments the most (Social Risk for Multinationals). Social risks emanate from individuals, communities, activist networks, and in extreme cases terrorist groups. Their impacts manifest in the form of work delays or stoppages from litigation, protests, unionization and in even nationalization. These activities negatively impact cash flow and ultimately, profits. Sponsors can significantly enhance their investment pipeline by incorporating the social risk analysis into their risk portfolio.
Just as all politics are local, and real estate is about location, social risk is driven by local conditions on the ground (All Risk is Local). Due to this phenomenon, geopolitical and country risk analysis are not optimal, especially in frontier markets where local laws, customs, and patronage networks influence national level decisions. Moreover, religion, tribalism and cultural nuances can vary significantly from one region to another. This requires tailored analysis for companies that have assets located in different parts of a country. Social risk assessments provide a greater level of detail than a due diligence call, checklist or geopolitical risk analysis. They pinpoint the drivers of volatility and incorporate near real-time analysis into the financial valuation. This allows sponsors to bid more aggressively on winners, avoid losers and allocate resources more judiciously.
Investment banks have an obligation to their clients to solicit the highest price available. By excluding social risk from the due diligence process, investment banks fail to optimize their financial sponsor clients’ returns from their sell-side and buy-side deals. On the sell-side, investment banks develop the roadshow materials that are used to source several potential buyers. Sponsors often excuse themselves from the first round when assessing assets outside the U.S. because they are not familiar with a country or region. Integrating social risk into the due diligence process, reveals the potential impacts of social risk to their clients’ assets, attracts potential buyers in the bidding process, and maximizes sale price.
On the buy-side, including social risk into the due diligence process creates an opportunity for investment banks to differentiate themselves from competitors. Each investment bank provides a portion of the debt required for a financial sponsor to complete their acquisition. The amount and price of debt is approved after informing an internal committee about the operational and financial risks of the asset. Integrating social risk provides committee members a more accurate picture of the risk environment. This enables the PE firm to be more aggressive and offer a larger amount of debt at a lower interest rate to the bank’s clients.
Another stakeholder in the PE acquisition process who can optimize their services and simultaneously differentiate themselves from competitors is insurance underwriters. Transactions are the opportune time for a sponsor to re-negotiate terms with insurance providers. PE firms can leverage the social risk analysis introduced during the due diligence process to more accurately price risk and lower up-front premiums. Updating insurance premiums can provide immediate savings to portfolio companies and increase their cash flow.
Instead of quick liquidity events and limited partners re-investing into new funds, sponsors have to add and maintain value for an average 5.6 years to reach their hurdle rate, according to the Bain & Company’s 2015 Global Private Equity Report. This psychological shift toward long-term investing requires a new way to assess risk, throughout the lifecycle of the investment, to protect unrealized gains. Consulting firms, especially the Big Three, provide market screens, competitor analyses, growth prospects, product placement strategies, and third-party security assessments. These offerings present market information and a potential management strategy, however, they are based on past events, fail to realize and adjust to the threats posed by social risk, and do not deliver effective risk mitigation strategies.
Identities and beliefs change over time, and relationships require continual maintenance. Unprecedented access to communication technology, especially social media, empowers individuals and groups to mobilize quickly around ideas. Disenfranchised individuals and communities negatively affected—either perceived or real—by portfolio companies’ operations now have a voice and ability to impact companies across the entire value chain. Unless portfolio companies have a proactive social risk mitigation strategy integrated into their operations, all of the other consulting assessments will fail to adequately protect the bottom line.
The implications of social risk on an investment were demonstrated in Colombia where Goldman Sachs purchased Colombia Natural Resources for ~$600 million. In 2013, the Colombian government ordered the firm to relocate residents near the mines. A few months later, women and children formed a human blockade in front of the mine, protesting on behalf of workers. As a result, the mine shut down for nine months and revenue fell from $200 million to $70 million. Maintaining production in the face of social unrest from workers, their families and communities was too challenging. Ultimately, Goldman sold its assets for $10 million and lost over $200 million. If Goldman had incorporated social risk analysis into their risk portfolio and valuation process, they could have forecasted potential challenges and developed community engagement strategies to mitigate threats and substantial losses in the face of social risk.
Today’s interconnected world creates dynamic, complex social environments that require innovative ways to identify and assess risk. Although there has been growth in Latin America, Africa and Asia Pacific through partnerships with local firms, these markets are relatively untapped and make up a small portion of the global total. Instead of looking inward at domestic markets, PE firms should take advantage of the countless investment opportunities for their seasoned management teams in international markets where there is less competition. However, to flourish in emerging and frontier markets, sponsors must navigate foreign social environments and stop applying western business models to foreign markets. By identifying and assessing social risk, PE shops can reduce the fear of entry into any international market and become authors of their own success to prosper in any business environment.