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How to better evaluate geopolitical risk

How to better evaluate geopolitical risk
How to better evaluate geopolitical risk

Global Business and commerce have certainly faced a tumultuous 2022. Corporate risk management was tested with seismic geopolitical, inflation, currency, and operations risks, which put business resilience testing right at the top of the agenda. 

M&As constitute one of the most important corporate investments that aid firms in creating value and achieving growth. However, during periods of high risk, especially geopolitical risk, many investments are frozen due to a perceived rise in uncertainty. And the most commonly used method to manage periods of geopolitical risk is simply to avoid investments in such periods. 

Times like this create a risk-off environment where pioneering or riskier investment strategy is put on hold and replaced with a conservative outlook on business strategy, development, and execution. 

Identify the causes of investment conservatism

This shift in strategy tends to happen for two main reasons:

  1. The actual business operations have been affected by the risk, which means firms have to take a proactive step in hedging any immediate losses.
  2. Due to the perceived knock-on effects said risk has on a business. 

These perceived risks may not be realised, but the anticipation of a risk unravelling and hitting a business is enough to change wholesale the trajectory of entire companies for many years to come. 

In essence, it is a lack of knowledge that causes the second reaction to take place in businesses across the world. A herd mentality mixed with headline risk and an almost automatic fight or flight response takes hold of the C-suite. 

Ask why instead of how

It is our assertion that if corporate leaders better understood the fundamentals of why the world is being challenged the way that it is, as opposed to just understanding How it is being challenged, then business strategy decisions like M&A would be made with more confidence and thus with better results. 

This lack of understanding of the ‘why’ became the catalyst for creating Pareto Economics and is a mission we have dedicated ourselves to. 

Differentiate geopolitical risk and political risk

A geopolitical risk is a business risk arising from an interaction between one country and another or several countries. This includes risks arising from war, sanctions, etc. 

Political risk is a business risk that arises from the actions of a government or a people within a country. This includes risks like civil war, labour problems, strikes, and expropriation, among others.

Be very specific

Secondly, when discussing the impact of geopolitics on M&A, it is very important to temper every general assumption and statement with an understanding that there are always exceptions and that everything depends on the specifics/nuance. Overarching claims about the impacts of geopolitics are unhelpful as firms do not exist in the “general” but rather operate in the often harsh specific.

It is known that geopolitical risk can heighten the perception of disastrous outcomes, lower consumer confidence, and make investment less attractive. These tend to emerge especially if the geopolitical risk is new or relatively new to a country/region or if the region/country which is the source of geopolitical risk is systemically important to global supply chains.

Look for the long-term game

Geopolitical risk is an essential component of firm systematic risk and can influence equity volatility and valuation. Timing is important to consider, especially with this point. When an important geopolitical risk, like war, for example, becomes present, there will be an almost natural but temporary corresponding reaction to stock/bond markets and commodity markets. These tend to be temporary as markets regain losses or lose temporary gains, which is dependent on the type of risk and the predicted longevity of the risk.

Business leaders need to properly assess the short-term liquidity/valuations risk of their business and not display short-term reactions that have the potential to do more harm than good. 

How to take advantage of M&A opportunities during geopolitical tension

Conversely, M&A opportunities can, in some cases, also increase during the arc of a geopolitical confrontation. 

  • Domestic industry: What has become clear with heavily sanctioned countries is that the main winner becomes a domestic industry. Without competition for goods and services from abroad, domestic champions in many industries succeed disproportionally compared to foreign companies being allowed to penetrate the market. 
  • Expansion of other commercial alliances: Moreover, as we saw in the aftermath of Russia’s invasion, many systemically important products like payment processing were replaced with domestic and other foreign providers. Domestic providers replaced the likes of VISA and MasterCard by the likes of MIR facilitated by Chinese support in the form of China Union Pay.

This level of decoupling can present windfall opportunities for domestic producers/service providers and other regional alternatives who can be poised and ready to take advantage of tectonic geopolitical shifts. 

  • Currency devaluation: M&A can also become cheaper due to currency devaluations, potentially favourable borrowing terms from banks, and useful tax incentives to invest in geopolitically turbulent countries/regions.  

The Great Convergence 

Fundamentally, it is important to understand that the globe and everything in it experience what we call in geopolitics “the great convergence,” which sees phenomena connected with Globalization, Geopolitics, Transformative Technology, and Societal Change (the global 4) converge in its impacts on people and business. The great convergence and its effects are the least understood development in world affairs today.

This article will be the beginning of many that will delve deep into these concepts to help M&A practitioners in legal, business strategy, treasury, risk, or operations.

For successful M&A to exist, all key functions of not only the transaction but post-transaction integration need to be aligned and to have a better understanding of the non-financial risks and opportunities that will inevitably arise when leveraging geopolitical factors in M&A, especially in cross-border M&A.

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