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Introduction
An important and hotly debated issue in valuation is when and how country risk should be reflected in the valuation.
What is Country Risk?
Country risk arises from factors specific to the country where the asset at issue is located. Risks can differ from country to country and may affect businesses in a myriad of ways. These include economic factors, such as macroeconomic stability, the level of development of financial markets, local supply and demand conditions, and political factors such as regulatory, currency, and fiscal regimes, expropriation risks, and internal or external violent conflicts. Such country risks will have different impacts and magnitudes depending on the specific asset (for example, export projects may be less exposed to domestic market conditions than businesses focused on domestic consumers), and qualified experts often disagree about the correct method of reflecting country risk in a valuation.
How to Incorporate Country Risk in Valuation?
How country risk should be reflected depends on the valuation approach being applied. Under the market approach, it is undisputed that the choice of comparable transactions or comparable companies should consider country risk as a criterion for comparability; however, even comparables from the same country may have different exposures to risk or the valuation may incorporate different counterfactuals (for example, regarding discounts for the risk of future illegal acts). Reflecting country risk in an income approach is even less straightforward, and how to do so depends, at least in part, on the extent to which the risk of investing in an emerging market can be diversified. See Valuation > Income Approach > DCF Method > Discount Rate > Cost of Equity.
There is no single agreed-upon and systematic method to quantify the impact of country risk. Modern finance theory rests on the principle that the cost of equity should not reflect any risk that can be diversified. Therefore, while country risk includes components that are diversifiable as well as those that are non-diversifiable, only non-diversifiable country risk raises the cost of equity and hence only non-diversifiable country risk should be included in determining the appropriate discount rate to be applied in a forward-looking damages valuation. On the other hand, all country risk, diversifiable and non-diversifiable, affects the cash flows and should be reflected by a reduction to the forecasted cash flows incorporating the probability and impact of each potential risk event. This distinction matters because discount rates have a compounding effect that cash flow adjustments do not.
Incorporating Country Risk in the Cost Of Equity
The approach described above, which accounts separately for diversifiable and non-diversifiable risk, is based on the same fundamental finance models that experts typically use to value companies in developed markets, where country risk is not relevant. However, it can be difficult to implement in practice, particularly when equity markets in the emerging economy are underdeveloped, and therefore not efficient, or if sufficient information is not available to quantify the impact of country risk on a specific project’s cash flows.
Experts or practitioners often attempt to capture both systematic and non-systematic risk with a single upward adjustment to a discount rate calculated for a developed market, called a “country risk premium,” based on (though not necessarily equal to) sovereign bond market data, sometimes referred to as the sovereign spread.
Country risk premiums have been applied in the arbitral context in at least two ways:
This practice is common, but it is not based on any economic theory. It is not clear (and there is no accepted way to determine) whether the adjustment captures diversifiable risk, non-diversifiable risk, or both. Moreover, using a sovereign spread confuses the credit risk that applies to a sovereign’s debt obligations with the risk that is faced by equity investors in the particular asset being valued. Some risks may affect both investments, but not necessarily to the same degree, while others are relevant only to bond investments and not to equity investments. As a result, the use of a sovereign spread added to the discount rate to capture country-specific equity risk is overly simplistic and can produce arbitrary results.
Although sovereign spreads often represent a rough and rather inaccurate means of quantifying country risk, their use can be traced to the fact they were once the only readily available source of local financial market information, and the addition of a spread to the discount rate is computationally simple. However, a plethora of data is available today concerning local risks, and this data can be used to more accurately reflect the actual non-diversifiable country risk of a given asset or right being valued.
In principle, systematic risk is not fundamentally different for assets in developed economies and in emerging economies, and it can be measured in the same way where sufficient and reliable data exist.
International vs. Local CAPM
The International CAPM for example uses stock prices of companies listed on the emerging market local exchange(s) and estimates their betas with respect to a global market portfolio (assuming that the relevant marginal investor is globally diversified). This method, however, assumes capital markets are fully integrated, which, if not true, may overstate the diversification benefits. It also requires that the local stock market be sufficiently liquid for prices to provide timely indicators of value. A Local CAPM on the other hand uses domestic data to estimate a local-currency discount rate (which is then applied to cash flows projected in the local currency). There are few markets with sufficient data for this approach, however, and even if correctly applied, this method may overstate the correct discount rate if an international investor derives diversification benefits and the market is not fully integrated with the global markets. Moreover, like the International CAPM, it requires well developed local stock markets.
While there are challenges to estimating the appropriate systematic risk in an emerging economy, one common finding where sufficient data does exist is that the additional risk is smaller than commonly expected. The reason is that non-systematic cash flow risks have a larger impact, but the use of a single discount rate adjustment to attempt to capture all risks has masked the distinction between systematic (discount rate) and non-systematic (cash flow) risks.
Incorporating Country Risk in the Forecasted Cash Flows
Cash flows should model all the asset-specific risks, both systematic and unsystematic, including asset-specific country risk. Modeling country risks explicitly in the cash flow projections in a so-called “scenario DCF approach” deals with cash flow uncertainty explicitly by (i) asking “what if” questions about key inputs and how they could impact value, (ii) looking at the cash flows/value under future scenarios, and (iii) using probability distributions for key inputs. In other words, the projected cash flows are explicitly adjusted to account for various aspects of risk, including country risk.
Unlike their application to discount rates, sovereign bonds may contain more useful information about country risk to make cash flow adjustments. Recent research has suggested methods that could extract from sovereign spreads only the component attributable to political risk and, under the assumption that political risk affects bond and equity investments to the same degree, use it to calculate an adjustment to projected cash flows. The computations are more involved, but they also allow the impact of risks to be parsed into categories that allow tribunals to make independent decisions about what risks should be included or excluded as a matter of law.
Relationship Between the Law and the Valuation
Country risk is an area where the law and finance theory interact closely, particularly in investor-State cases, where State acts can be a source of political risk either in the form of lawful activities (for example, lawful regulation) or unlawful activities (for instance, unlawful expropriation). Questions are often raised as to which risks related to State Acts should be included in the valuation. For example, there seems to be general agreement that damages should be calculated to exclude the impact of the specific unlawful act alleged by the claimant. However, questions often arise as to whether the risk of other potentially unlawful State acts should be similarly excluded even if they do not relate to the asset or act at issues.
On the one hand, it is argued that excluding risks arising from its unlawful acts prevents a State from benefiting from actions that violate its legal obligations and is consistent with a policy objective of facilitating foreign investment. It has also been noted that, from an economic perspective, paying a discounted price for a risk that is due to a State’s own illegal conduct provides an economic windfall to the State. On the other hand, however, not doing so could provide a windfall to a claimant who purchased the investment at a discount due to the very risk that is now being excluded from the valuation.
It is noteworthy that references to market values will not resolve the question of the correct adjustment for these risks, because investors are in the position to try and anticipate what tribunals will do in providing compensation, which in turn will be reflected in what prices they may pay for assets. Hence, how a tribunal would be expected to address these issues is reflected in the price an investor is willing to pay for the asset with the effect, at the extreme, that if an investor is fully confident of receiving full compensation it will apply a discount to the valuation for the illegal acts of the State reflecting only enforcement risk. However, the more likely scenario is that the investor will apply a discount to reflect the risk that a tribunal will pay less than full compensation, a risk which is compounded by inconsistent interpretations by tribunals regarding discounting of compensation to reflect the risk of future illegal acts.
The inclusion in the valuation of only some aspects of country risk require experts to divide country risk into separate categories and to show the impact on the valuation of each aspect of country risk. This allows the tribunal to determine the asset’s value taking into consideration only the aspects of country risks that it decides are applicable based on the specifics of a given damages valuation. This can require the tribunal to make adjustments to the valuation, which makes it particularly important for valuation experts to carefully identify their instructions with respect to country risk, and to delineate clearly how the various aspects of country risk are incorporated into a valuation and would impact the outcome. Further, as a procedural matter, the tribunal would usually want to consult with the parties and/or their experts when making such adjustments.
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