A Capital Lesson from Egypt

The political turmoil in Egypt is a reminder that the cost of capital in emerging markets has to be regularly reassessed.

In a very real illustration of risk outweighing reward, investors knocked a few billion dollars off the market value of Apache Corp. as the turmoil in Egypt intensified. That’s because the Egyptian market represents about 15% of the oil and gas producer’s value, estimates one equity analyst, and 22% of Apache’s production this year. Perhaps investors thought their money could get the same return for less risk elsewhere, as Apache’s stock dropped 6% in two days of trading last week.

U.S. corporations may begin to feel the same way. The Egypt situation, however, contains a broader message for finance: even as hot money flows into emerging markets, estimating the cost of capital in less-developed countries to a certain degree of accuracy is still very important.

“Because of the greater globalization of business and integration of markets the past few years, you could make an argument that there are fewer risks across borders,” says Jim Harrington, a vice president at valuation firm Duff & Phelps. But while many international companies have diversified operations globally to the point of lowering the volatility of their portfolios, and thereby possibly lowering the overall required rate of return, they have not lowered the risk premiums attached to individual emerging markets to zero.

Many CFOs would rather avoid the task. Estimating the value or potential value of a business in emerging markets is difficult. Just keeping up with what’s happening around the globe can be taxing. “Many companies looked at years of stability in emerging markets,” says Roger Grabowski, a managing director at Duff & Phelps. “All of a sudden now we have two things going on: rapid change in economic conditions and political instability in some markets. The combination of these makes it necessary for companies to revisit their assessment of political risk in all of the countries in which they’re investing.”

Political risk, says Grabowski, is how settled a given market is in terms of its history of legal and economic stability and the history of its legal system in protecting owner rights. While companies buy political risk insurance to protect assets and contracts, it won’t cover every contingency, and the term of coverage might not be long enough. “Buying a company, expanding a plant, adding new product lines — capital expenditures are not like buying stock, where two days later you can flip it if things don’t work,” he says. “The real issue in emerging markets is that you’re committing money for long-term investments, but the risk mitigation — like currency hedging — is available only for the short term.”

Another problem is that there is no consensus on how to measure the risks in emerging markets. There are global and country-specific capital asset pricing models, as well as yield-spread models and country credit-rating models, but all cost-of-capital models have good and bad parts. “One of the problems we see is that CFOs adopt one model that may not be appropriate for the circumstances in a specific country or for a specific investment,” says Grabrowski.

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