FTI Consulting Risk Research Project

What Companies Do Right (and Wrong) in Emerging Markets

truck driving cargo falling

Executive Summary

For decades, large North American- and European-based companies have made significant investments in emerging markets, and foreign direct investment (“FDI”) inflows lately have increased in developed, developing and transitional economies. In fact, FDI flows to developing economies reached a new high in 2013 of $576 billion (the most recent year for which data are available) — almost half of the $1.46 trillion in global FDI. Given the growing interest in doing business in emerging markets, “FTI Consulting’s 2015 Risk Research Survey and Report” focuses on the risks businesses and investors face in these markets and discusses how leading companies work to mitigate them.

(For a complete explication of our survey and methodology, please view the full report.)

Our results indicate that most multinational companies have suffered significant losses in emerging markets, stung by three major categories of risk: regulatory, bribery and fraud, and reputational issues. The most damaging and costly incidents occur when two or more of these risks converge, creating a cascade of losses that become hard to contain or stem.

For example, a company could violate a regulation (either intentionally or inadvertently), then bribe an official to reduce a fine or make it go away. If the bribe becomes public, the company’s reputation will be damaged, making it more difficult to do business, thereby impairing future revenues and, perhaps, leading the enterprise to cut corners in compliance, thus fueling a vicious cycle of crime and punishment as the company blunders from one public relations disaster to another.

According to our research, organizations that have suffered most frequently and have experienced the greatest losses tend to maintain an arm’s-length relationship with their projects and subsidiaries, underinvesting in or insufficiently focusing on local managerial resources and compliance training. Conversely, enterprises that have suffered the least have one thing in common: They play by the rules and furiously guard their reputation. To do that, they make compliance a strategic priority at the highest corporate levels and provide the resources to execute on the ground. They combine a deep understanding of the political and business cultures of the environments in which they operate with a stout refusal to cut corners.

These companies develop response plans to deal with incidents before they arise, and those plans are continuously updated and communicated internally and externally. In this way, when any one of these three risks emerges, it can be isolated so as not to produce a storm of converging issues that multiply losses and impair a hard-to-restore corporate reputation.

10 key findings risk research


A Dangerous Troika of Pitfalls: Regulatory, Bribery and Fraud, Reputational

figure 1 dangerous troika

An overwhelming majority of the companies surveyed for this report — 83 percent — have suffered significant loss- making events in emerging markets since 2010.

In 99 percent of all cases that involved a loss, the cause devolved from bribery and fraud (the latter included a variety of malfeasance such as money laundering and intentional accounting misrepresentations), regulatory violations (both intentional and inadvertent) or reputational issues. The very worst incidents involved two or three of these issues occurring together or in quick succession.

Respondents cited regulatory issues as the most frequent cause of loss- generating incidents, followed by bribery and fraud and then reputational issues, as seen in Figure 1.

The specific causes of loss, ranked in Figure 2 by frequency, ranged from local regulatory change through delivery of substandard products and services. The single most common cause of loss- making incidents is changes in host country regulations.

figure 2 where losses come from

Regulatory Risk

As seen in Figure 3, the negative impacts of regulatory issues primarily include loss of revenues and reputational harm.

figure 3 the regulatory toll

Complying with regulations in developing economies is difficult. As a South American-based director of a large multinational chemical company pointed out, "The rules get changed so often, it’s hard to know what they are, let alone follow them."

One of the major causes of this uncertainty is the political instability that tends to be endemic in emerging economies. A large U.S. energy company’s representative in Eastern Europe noted that whenever a new government comes in, "it wants to change the rules."

Regulatory uncertainty can prevail in developing economies even without the drama of regime change. A particular area in which it often is difficult for companies to stay compliant in emerging economies is tax law. For example, each of Brazil’s 27 states has its own rules regarding what’s taxed and how much "and the rules change all the time," said Renato Niemeyer, Chief of Tax Legislation in Roraima State, Brazil. According to Niemeyer, this has led more than one multinational to postpone paying taxes, as "the penalties [for postponement] are relatively low, and on-time payment is expensive due to the complexity." However, when a company does pay the penalties, "corrupt officials will solicit the organization for bribes in order to lessen the penalties or to change tax legislation to benefit the company." In this way, organizations are led down a slippery slope to those two other risks of the troika: bribery and fraud and reputational damage.

Another regulatory area that is increasingly problematic — especially in the energy, mining and construction sectors — is environmental. Politicians curry favor with local populations – which bear the brunt of mining operations – by bringing actions against multinationals under a broad array of environmental regulations and difficult- to-meet environmental impact mitigation agreements.

"Latin America is growing very green in its politics," said Camilo Granada, Senior Managing Director and Latin American Head of the Strategic Communications segment at FTI Consulting. Therefore, big companies increasingly "are under strict scrutiny both from government agencies and non-governmental organizations."

What lagging companies do wrong

According to Jose Pineiro, a Madrid- based Managing Director in the Forensic & Litigation Consulting Practice at FTI Consulting, globalized companies often "overestimate their internal expertise to analyze overseas risk. And, sometimes, business agendas overstep compliance protocols."

One of the major causes of this uncertainty is the political instability that tends to be endemic in emerging economies.

Perhaps most important, many companies are unwilling to walk away from jurisdictions where compliance with regulations simply may not be possible (see Figure 4), which leading companies are willing to do. As FTI Consulting Senior Managing Director in the Forensic & Litigation Consulting segment Eduardo Sampaio said, "Companies are too hungry to make deals in hyped environments; therefore, they’re closing deals without an adequate understanding of what they’re getting into."

figure 4 just say no

What leading companies do right

In our survey, we separated the quartile with the lowest self-reported losses as a percentage of revenues (the leaders) from the quartile with the highest (the laggards). As seen in Figure 4, leading companies believe it is more important to their success to avoid doing business in places where compliance may not be possible than do laggards by a ratio of more than 5:1 and in the importance of engagement (i.e., investing in helping construct a suitable regulatory framework) by a ratio of almost 3:1. John Corbett, a company director with experience in multinational food companies and a senior advisor to FTI Consulting, said that a company always must be prepared to walk away from any venture in a country where the political system is unstable; i.e., where compliance may not be possible.

John Klick, Global Leader of FTI Consulting’s Economic Consulting segment, observed that "successful companies put a lot of effort into helping host countries establish economically rational regulatory environments — which benefit both investors and the host country over the long run — and in maintaining the stability of those regulatory environments as companies are buffeted by the inevitable winds of political change."

Companies that do well in heading off regulatory headaches also study their host country’s regulatory framework before initiating investments and projects and structure them to accommodate the prevailing regulations.

A large energy company’s Eastern European representative said his company deals with the inevitable regulatory changes in emerging markets by including a stability clause in contracts that can protect the organization from legal or fiscal changes that could negatively affect its future income. "And if new taxes threaten the economics of our project, the company re-works the governing contract to make sure we are compensated in another way," he said.

Joseph Kalt, the Ford Foundation Professor (Emeritus) of International Political Economy at the John F. Kennedy School of Government at Harvard University and a Senior Economist with FTI Consulting subsidiary Compass Lexecon, noted that "when regulations are constructed on the basis of sound economics and in concert with cultural norms of the host community, a solid foundation is created for a long-term business relationship between the investor and the host country. If either of these components is shortchanged, business risk and political risk increase exponentially."

Bribery and Fraud

In addition to loss of revenues (mentioned by more than half of respondents), companies that have been discovered engaging in fraud, or paying bribes, open themselves to a host of negative impacts. The most frequently cited consequence is reputational harm (67 percent), followed by loss of revenues (56 percent) and then prosecution (44 percent) (see Figure 5).

figure 5 paying the price

In most developed markets, paying bribes to win or facilitate business has been long understood to be bad business, and a host of international laws such as the U.S. Foreign Corrupt Practices Act ("FCPA") and the UK Bribery Act prohibit these practices. However, in many developing economies, bribery simply is a way of life. Multinational corporations often find themselves between a rock and a hard place: Refuse to pay bribes and see your business suffer or fail; pay the bribes and accept the numerous risks listed in Figure 5.

A regional audit director of a U.S.- headquartered international supplier of gases and chemicals for industrial uses noted that in China, facilitation payments are customary to keep projects on target. However, the long-established Chinese custom of gifting customers — including cash vouchers for mooncakes, a traditional treat that now, in their most elaborate and expensive forms, has become almost synonymous with graft — violates both the FCPA and the Bribery Act. And the chances of getting caught engaging in bribery skyrocket when the businessperson soliciting or receiving the bribe is politically connected.

Hewing to the straight and narrow rarely is simple. According to the Eastern European energy company’s representative, bribery is a major element of Eastern European economies. Companies must pay to win government contracts. These payments are a revenue generator for governments in general and for individual officials in particular. The problem is most acute at the lower levels of government, where poorly paid officials always are on the lookout for ways to generate extra cash.

For multinationals, the risk of becoming complicit in this sort of business is magnified when a company is working with and through local subcontractors who know no other way of doing business and often have powerful if unacknowledged political allies. "Multinationals have numerous partners," pointed out Panama-based Matias Mora, Senior Managing Director of the FTI Consulting Forensic & Litigation Consulting segment, "and the FCPA and UK Bribery laws explicitly hold companies accountable for their partners’ and customers’ actions."

Ted Unton, a former Director, Global Financial Compliance at Bemis Company, a U.S. global manufacturer of flexible packing products and pressure-sensitive materials, said his company has hired private investigators to look into alleged improprieties at partner companies and by partner executives.

Globalization, which once promised to unite the world with standardized business practices, now seems to be an engine churning out ever-multiplying risks.

What lagging companies do wrong

The key to avoiding getting ensnared in the coils of bribery and fraud is to create a culture of compliance, establishing (and sticking to) policies tailored to the local culture. And it requires careful due diligence when partnering with third parties or hiring employees to staff subsidiaries.

However, in many developing economies, bribery simply is a way of life.

Greg Hallahan, a Hong Kong-based Senior Director in FTI Consulting’s Global Risk & Investigations Practice, pointed out that companies just starting out in Asia invariably "look to drive revenues first; investment, effort and time into back office functions — such as compliance — lag." Where these companies frequently go wrong, he noted, is a consequent lack of due diligence in hiring employees and managers.

And the problems that arise from hiring the wrong people can be compounded by a lack of oversight. "Overseas management," said Hallahan, "does not always spend enough time really looking into what’s going on. For example, local managers can wine and dine headquarters executives in world-class restaurants on the Bund [Shanghai’s famous waterfront tourist area] and send them on their way," with overseas management not taking enough time to walk the factory floor to learn about the day-to-day realities of the operation.

Companies also forget, as the former president of the international energy company’s downstream subsidiary said, that the contractors the local managers engage, and the subcontractors the contractors hire, also need to be vetted and watched.

And the problems that arise from hiring the wrong people can be compounded by a lack of oversight.

Of course, that takes time and money, and not only are resources commonly insufficient, they may be poorly allocated. Too many times, Pineiro said, compliance teams are situated in a company’s home country headquarters or in a nearby, more comfortable location. But risk, he said, "comes where the money is. You have to put resources in compliance where you’re doing business."

But the biggest mistake lagging companies make is paying that first bribe.

figure 6 where size hurts

What leading companies do right

When Arvind [his first name] was engaged as Managing Director for a global leader in consumer and durable appliances to lead the company’s re-entry into the Indian market, he encountered a culture that paid "speed money" to do business and made payments to inspectors "who always would find problems in routine operations and ask for small amounts ranging from $20 to $100 to ignore them."

Arvind refused to pay even those small amounts. He went to the most senior official in the government’s Inspection department and told him the company is a "global leader that is good for India and is committed to ethical business." Arvind also assured the inspector that he had the backing of the company’s leadership.

While stopping the facilitation payments had a negative short-term impact on the company’s results, "the inspectors stopped coming," he said.

According to Arvind, the most important thing a company can do to avoid getting enmeshed in a corrupt business environment is to "get the right managers on the ground who have an impeccable track record of integrity and values and then empower them. Make sure they are senior so they can’t be held hostage by a mid-level, in-country proxy, unable to stand up to local authorities."

The type of dialogue Arvind engaged in to drive home the value of playing by the rules is accounted by leaders as the second most important factor in mitigating emerging markets risks by a ratio of nearly 7:1, as seen in Figure 7.

figure 7 keeping straight narrow

Arvind emphasized the importance of having support from the top, but it also is critical to have the right people on the ground. Leaders rate the value of that local focus more than twice as highly as do laggards. As FTI Consulting’s Hallahan said, top-down compliance training that lacks empathy for local realities generally does not work.

Unton said Bemis has "elaborate signoff systems to help local operating managers stay aware of compliance issues. The company mandates quarterly questionnaires and checkoffs." He also pointed out that while headquarters has the ultimate responsibility for compliance, "You have to have people on the ground you can trust,"" thus echoing thoughts expressed above.

Reputational Issues

As seen in Figure 8, reputational issues most often lead to loss of revenues and exclusion from markets.

figure 8 high cost impaired reputation

The list of giant companies that have had their reputation attacked in emerging markets is a long and varied one, including one of the world’s largest retailers accused of engaging in bribery in Central America and a global fast food company accused of using tainted meat in Eastern Europe. Both incidents stirred up a storm on social media.

Even companies that always play by the rules can suffer reputational damage from events beyond their control. In China, said the audit director, building new plants often requires the payment of multiple fees to partner company agents. These rich emoluments can make a company look bad to the local population.

Large corporations make inviting targets. The South American chemical company director said people in his region believe (with reinforcement by the press) that companies like his are raking in massive profits. "We don’t have a lot of defenders," he said.

What lagging companies do wrong

"When companies attempt to do business overseas, they essentially become political, as well as economic, actors," explained FTI Consulting Strategic Communications segment Senior Managing Director Jackson Dunn. "The company’s investment inevitably affects the local economy, and that has spillover effects in the political community. This places companies at reputational risk, which they frequently fail to understand or acknowledge."

This especially is true for U.S. companies in emerging markets. In Dunn’s view, these companies fail to appreciate that their host country may view them as "an extension of the U.S. government." Therefore, companies underestimate the impact local politics can have on their ability to execute. Failing to fully appreciate this can lead to a slow corporate response when incidents occur.

As was the case with regulatory and bribery and fraud issues, a lack of investment in the local market — in this case in communications capabilities — can spell trouble down the road.

Leaders rate the value of that local focus more than twice as highly as do laggards.

Of course, some companies do not play by the rules. They take the easy way. One bank official told us his firm "goes through the [compliance] motions," but he believes there is no way to "stop illegal activities from happening." Penalties levied on the bank are viewed merely as a cost of doing business. And an executive at another large multinational admitted that his company, on occasion, does make facilitation payments. Top management is "uncomfortable" about it but feels it has "no choice."

What leading companies do right

"If you comply," said Arvind, "there is no reputational risk."

This sentiment is echoed by almost all the executives of leading companies with whom FTI Consulting spoke. Playing by the rules is the best way to reduce reputational risk, as well as the two other members of the dangerous risk troika. It takes money, effort and attention, but going the extra mile — especially when it comes to tailoring policies to local conditions — can help companies safeguard their reputation.

The energy company’s Eastern European representative said that as soon as a company begins doing business in a country, "let [the government] know you will walk away if this [corruption] happens. In contracts with small contractors, specify that they are legally responsible for following anti-corruption laws."

The energy company trains all its contractors, no matter how small, in compliance. He recalled that some employees were not able to get work permits without paying someone off at the foreign embassy. "We refused," he said, "and took the case directly to the highest levels. The next day, we were granted the permits, legitimately."

"We don’t pay anyone," he insisted.

As we see in Figure 9, leaders believe by an extraordinary 10:1 ratio that maintaining a consistently good reputation is critical to mitigating reputational losses.

figure 9 good reputation priceless

Maintaining that reputation is difficult as local populations in many locations are suspicious of the motives and actions of multinationals. It takes time and what leaders define as a "long-term investment perspective" (which they rate important at more than twice the rate of laggards) to allay those suspicions. However, it can be done.

For example, the former president of the energy company subsidiary recalled how his company had to buy land for a 40-mile pipeline in Bangladesh. The area’s landowners were willing to sell the land to the company, but many farmers depended on the land for income. By kicking them off, the energy company would have been "fitted for a black hat." Instead, the company set up five offices along the pipeline route to help locals find alternatives to farming. Because the company demonstrated its concern, the locals began to accept the plan. Protests were canceled, and, later, many of the farmers ended up with new (and better) jobs with the company. Instead of feeding mistrust, the company developed a cadre of supporters that the former president believes will stand the organization in good stead in the future.

Our leaders advise that over the long haul, maintaining a good reputation includes communicating with the media in a thoughtful, strategic fashion. However, the South American chemical company director acknowledged that each statement by the company needs to be examined “a trillion times” prior to release. He knows that everything his company says will be placed under the microscope of media and public scrutiny.

How Leaders Differ from Laggards

Companies that are best at containing their incidents and limiting their losses aren’t just different from laggards in what they do; they are different from the laggards in how they think about emerging markets risk.

Public relations can be effective but never without the actions that will give it weight. Without that, public relations can contribute to the reputational damage it was meant to prevent.

As we see in Figure 10, leading companies rank almost every best practice for the mitigation of regulatory, bribery and fraud, and reputational risk higher than do laggards. This is doubly impressive (or head scratching) when one considers that laggards already have experienced more losses than leaders have. Indeed, when laggards were asked how well they thought they managed risk, companies with higher losses generally thought they managed it as well as their low-loss peers. Laggards don’t seem to know they are more exposed.

figure 10 leaders take risk seriously

It is worth noting that laggards believe running “pre-emptive publicity campaigns to counteract negative reactions” is a good strategy. Leaders do not. This spread is one of the largest differences we’ve found, along with the reluctance among leaders to do business in places where compliance may not be possible (almost 30 percent of laggards compared with 5 percent of leaders) and their insistence upon maintaining a consistently good reputation, which half the leaders consider important as opposed to only about 5 percent of laggards.

Public relations can be effective but never without the actions that will give it weight. Without that, public relations can contribute to the reputational damage it was meant to prevent.

The Benefits of Doing It Well

The benefits of getting good at managing the three risks identified in this report are manifest. The difference in rate of loss as a percentage of revenues ranges from 2.2 percent for the laggards to 0.2 percent for the leaders.

As well as being better equipped to profit from the vast opportunities present in emerging markets economies, there is a lot of money to be saved by improving the way companies manage the risks that come with operating in these geographies.

To derive actionable intelligence from the qualitative understanding of these risks is a multidisciplinary exercise," says Arun Shukla, Senior Managing Director in FTI Consulting’s Corporate Finance practice and principle inventor of the Geomarket Risk ModelTM. "It requires conversion of qualitative assessments of the geopolitical risks into quantitative scores which can be input into a model that includes traditional corporate finance adjustments to the weighted average cost of capital. This approach lets you improve the risk/return profile of an overall portfolio.

And, clearly, it does not pay to be a laggard.

© Copyright 2015. The views expressed in this article are those of the authors and not necessarily those of FTI Consulting, Inc., or its other professionals.
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