Geopolitical risk in cross-border M&A: tough times ahead before and after closing

July 2024  |  SPECIAL REPORT: MERGERS & ACQUISITIONS

Financier Worldwide Magazine

July 2024 Issue

Despite three decades of globalisation and worldwide economic integration, we are witnessing a return to economic protectionism in many parts of the world. Moreover, the global landscape is increasingly unpredictable, so the management of international businesses must learn to live with a high level of uncertainty, especially for external growth initiatives through strategic cross-border acquisitions. This article will provide a short overview of how to estimate and to handle geopolitical risk in a deal, giving three perspectives from different zones – Europe, the US and Central and South America.

According to a February 2024 survey by McKinsey, most chief executives agree that M&A is vital to their companies’ growth. The report also shows that much of that growth will be cross-border and even cross-regional. In its analysis of worldwide M&A volume numbers from Dealogic, McKinsey reports that only 72 percent of all deals were domestic, while 12 percent were cross-border within a region (for example between two different countries in Europe or South America) and an additional 17 percent crossed regional borders (for example between Europe and North America).

Buying any company means placing a bet on the long-term future of the world, and clearly geopolitical risks should be part of the calculation, particularly in cross-border deals. Such political risks affect cross-border M&A in different ways, posing fire sale, economic and closing risks. In the first case, a change in the geopolitical realm may cause a seller to unload a business quickly and below market value. Alternatively, the global situation may pose an economic risk because the business plan that prompted a deal is no longer valid. And finally, there is closing risk – the possibility that the business will be blocked by political direct interference.

One source of such interference is protectionism. Most of the world’s nearly 200 sovereign nations have some combination of trade protections, be they quotas, subsidies or tariffs. While most headlines focus on superpower clashes among and between China, Europe and the US, there are many lesser-known battles and impediments occurring, making cross-border transactions challenging. It is no exaggeration to say that many countries use their economies as a weapon in a war of power. While geopolitical risk affects even entirely domestic deals, it poses its greatest risks when the buyer and seller are from two different countries. The probability of political interference during a cross-border deal depends mainly on the three factors: the size of the deal (and thus its media and political exposure), the diplomatic relationship of the countries involved, and national strategic importance of the sector of the target company.

Obviously, the geopolitical factor is much bigger for large cap deals compared to small or mid cap ones. Smaller deals can fly under the radar when it comes to media or regulatory attention. Yet the geopolitical risk can become a problem even for small cap companies in certain strategic sectors, such as defence or energy, or when deals involve critical technologies.

A primary risk in any cross-border deal will be the geopolitical relationship between the two countries involved. An obvious example will be a proposed purchase of a US company by a Chinese company, which will be affected by US-China relations, but even in the case of a France/Italy deal, for example, problems may still occur. The perfect example is the Photonis case. Ardian, the biggest private equity (PE) fund in France, invested in Photonis, a leading industrial firm in high tech optical and infrared sensors providing ‘night vision’ to the French army. At the exit, Ardian planned an estimated €500m sale to Teledyne, a US defence company. The French government imposed several measures of control in order to satisfy the strategic autonomy of Photonis. For Teledyne, the equilibrium of the deal changed and so it lowered its offer to €425m. The political pressure increased substantially, and finally Teledyne gave up the tender offer while Ardian exited to HLD, another French PE firm, for €370m, 26 percent less than initially expected.

In addition to protecting their own economies, national governments, as well as regional or global organisations, may seek ways to punish the economies of other countries, such as the sanctions we have recently seen against Iran and Russia. A common pattern may be the ‘tit for tat’ of retaliation. For example if the US government blocks a deal from a Chinese buyer, as a countermove the Chinese government will block a US deal on its territory. Such drastic measures can trigger fire sales which are usually only detrimental to the selling entity. For example, Societé Générale, one of the leading banks in France, was forced to sell its Russian subsidiary Rosbank, generating an impairment of €3.2bn for the French bank.

Trade protections and sanctions are not the only kinds of risks to consider in a cross-border deal. Any issue that causes conflict between countries can affect a cross-border deal. During the due diligence phase these will appear in various guises, including antitrust risk, customer risk, supply chain risk, cyber security risk, operational risk and reputational risk, among others. And above all, when such risks become untenable, there is closing risk.

Geopolitical risk is particularly elevated in sectors that national governments consider to be strategic, such as critical infrastructure, energy or mining. As a PE firm in a leveraged buyout, acquiring a firm in such a strategic sector is dangerous because it sharply constrains exit opportunities. Indeed, the government and other regulatory authorities can veto many potential foreign buyers, restraining the number of bidders and thus the exit price. Investments in such strategic sectors require a deep knowledge of local matters, from the cultural relationship between the citizenry and the business model, as well as compliance with the established rules. A perfect example is the acquisition by Canadian copper company First Quantum Minerals of an 80 percent stake in Panamanian Sociedad Minera Petaquilla, S.A. in 2013 to exploit one of the biggest copper mines in the region, which was being sued before the Panamanian supreme court of justice. In 2017 the contract was declared unconstitutional, as was a new contract in 2023, even with 25 violations to the constitution, which led to the cessation of activities after months of protests.

In some situations, governments or regulators intervene by putting restrictions in place to control a macroeconomic dynamic, such as currency restrictions. These can change the financial and economic environment for a deal by impacting the business model and the expected profitability of an acquired company. For example, lately international companies with acquired activities in countries like Argentina and Bolivia have faced restrictions around the purchasing of US dollars, which means that it is difficult to liquidate returns on their investments and repatriate them back to headquarters. At the accounting level, these types of restrictions might even translate into the recognition of impairment of the goodwill paid by the parent company.

So what can be done to handle geopolitical risks? Let us start with fire sale risk. To reduce the chances of a rapid, below-market sale caused by geopolitical events, a seller can work with lenders to literally buy time so that the timing of the sale is in the seller’s control.

The best way to offset the economic risk in cross-border deals is to diversify not only by geography but also by product and service. Both strategies can lower the impact of a downturn caused by a geopolitical crisis. However, although financial markets tend to respond well to geographic diversification, they tend to prefer pure players focused on a single core business.

To reduce closing risk, both parties to a cross-border transaction should anticipate reactions by regulators and the media. Furthermore, they can develop a ‘white knight’ list of all potential acquirers and run it by regulators before launching the formal sell-side process. Another way to reduce closing risk is for the buyer to set up a foreign subsidiary in the target country that can shield the buyer’s identity. This has been used several times by Chinese buyers in Europe, even if modern compliance processes are much more cautious concerning the ultimate beneficial owner.

But assuming the parties to the deal have overcome these hurdles and have made it to the deal table, what then? All geopolitical risk should be priced into the deal; hence there should be a geopolitical discount in the valuation, which could also pose a challenge. To quantify geopolitical risks which manifest in extreme scenarios, the use of traditional valuation methods puts the model into a situation where it might not respond suitably to the task, thus exposing the transaction to ‘model risk’ – the risk of error due to inadequacies in financial risk measurement and valuation models. It is helpful to use a simulation-based valuation method to fully aggregate risks, including the probability of geopolitical risks, into a model that considers ‘extreme value analysis’.

Also, geopolitical risk should be mitigated through structuring of the deal – by limiting the leverage, for example, in order to minimise the impact on the consolidated entity in case of bad outcomes. Another helpful tool is valuing and managing strategic options the buyer could have during bad times (real option valuation) such as an option to expand to other markets with less exposure to geopolitical risk, an option to contract or abandon investments, or an option to delay further investments until better information is obtained.

Such actions prove the old adage that risk and opportunity are two sides of the same coin.

 

Benjamin Forestier is a professor at Polytechnique/ESSEC/HEC, Alexandra R. Lajoux is chief knowledge officer emeritus at National Association of Corporate Directors (NACD) and Eric Vega Dominguez is director of financial and advisory at Grant Thornton Panama. Mr Forestier can be contacted by email: benjamin.forestier@polytechnique.edu. Ms Lajoux can be contacted by email: arlajoux@capitalexpertservices.com. Mr Dominguez can be contacted by email: eric.vega@pa.gt.com.

© Financier Worldwide

BY

Benjamin Forestier

Alexandra R. Lajoux

Eric Vega Dominguez

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