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Kellogg’s Corner : Assessing project risks

Kellogg’s Corner : Assessing project risks
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First Published: Mon, Feb 26 2007. 12 23 AM IST
Updated: Mon, Feb 26 2007. 12 23 AM IST
Valuing an international project requires an accurate assessment of risk. Yet risk assessment, especially in emerging markets, is not a definitive science. In fact, it may never be. The “scientific” approach considers a net-present value calculation based on the assessment of various possible outcomes. While market prices for inputs and output might be reasonably forecasted, many other relevant sources of risk, from exchange rate fluctuations to non-market problems that can arise, are very difficult to predict in quantitative terms.
Consider a project in an emerging market, where the legal system is typically less consistent and transparent, and the political system is less stable. A weak legal system means that contracts might not be enforced. This raises dynamic incentive problems where one party may “hold up” the other after specific investments are made. More generally, a weak contract environment creates uncertainty—increasing risk—because all issues may be renegotiated as circumstances change. Weak legal systems further mean that minority equity interests may not be protected, and property rights to land, machines, or profit streams may be more easily undermined by partners or third parties, including the government. While outright expropriation by governments is less common these days, “creeping expropriation” through increased profit taxes or tariffs on necessary inputs is quite common. Indeed, agreements for tax holidays or other preferential treatment from the government may not last, especially if the personalities in power change.
How do we scientifically assess these non-market risks? Integrating these risks into a net-present value calculation is difficult, largely because the probabilities of various non-market disruptions are not well known from country to country or time to time. As a default, one simple solution is to add the risk premium on sovereign debt to the required internal rate of return. This makes sense if the risks your project faces are similar to the risks faced by government debt. But that condition is unlikely to hold, largely because any individual project—from mining to manufacturing, from selling locally to processing for international trade—face different issues.
Given these important uncertainties, project valuations must be viewed with some scepticism by managers. While useful tools, one must recognize that the estimation error may be exceptionally large. But it’s not all bad news, because the important part of value lies not in the valuation, but in the structure. The savvy manager knows that projects can be designed to both increase value and limit uncertainty. Indeed, there are many strategies that can make projects robust to market and non-market risks. Two key ideas for projects in emerging markets can be summarized as follows.
First, use local partners and consultants. They can provide useful information regarding local regulations and cultural norms. Better, the right partner—a powerful one—can provide political leverage that will be useful in case of local disputes. Local eyes, ears, and leverage, all matter. There’s a difficulty of course: the more powerful your local partners, the more certain you need to be that they will work for your interests—not against them. Can you trust your partners? This question leads to a second set of considerations.
At the core of increasing value and reducing risk is the issue of incentive alignment. You must identify all parties that are important to the project’s success, assess their natural incentives to participate, and then structure the project to bring all the important parties on board. If a contract can’t be enforced, why would this person continue to help you? Relationships must be structured so that each party sees gains ahead that are sufficient incentives against unhelpful behaviour today. Reputation and trust come naturally when you and your partner have common stakes in the future. This means that you pay after services are performed. This means that local partners have a stake in future profits. This means that weak legal systems no longer matter so much.
To put the strategy simply, “if it’s not fair, it’s not sustainable”—a mantra of the International Finance Corporation. As others might say, “don’t overreach”. A good project gives a piece of the pie to all critical players, typically including the government in poorer countries. Yes, you can use expensive lawyers to out-negotiate the naïve partner, garnering yourself higher apparent rates of return. Yes, you can pay a bribe to secure a project. But these kinds of strategies are often recipes for long-run disaster—and bribing is illegal. Once the local partner or government realizes it got a bad deal, the deal is dead and the real trouble begins. When local political personalities change, a bribe to the ex-bureaucrat or politician will be worse than worthless—it will be a serious liability. Align incentives over the life of your project and the risks will be slight. A good structure makes the expected return higher and the variance lower, creating valuations you can trust. Good structure is good value.
Benjamin F. Jones Assistant Professor of Management and Strategy
(This column will carry contributions from Kellogg School’s faculty, staff, students and alumni, and will strive to be relevant and meaningful for those living and doing business in South Asia. ­Every fortnight you will read about innovations in management across various business categories that can make an individual, a team or an organization, a global leader.)
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First Published: Mon, Feb 26 2007. 12 23 AM IST
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