Figure 2.4 The selected countries are summarized, along with a heat map of the relevant statistics.
The most noticeable feature of Figure 2.4 is that there are some affluent geographies on the list, such as Singapore and Hong Kong. Even though the HDI is heavily weighted, there are still four other factors that favor developed countries. For this reason, it is necessary to take a closer look at the heat map that shows how the rankings were created. It is clear that there are trade-offs with each country that was selected. For instance, the first choice is Rwanda, a country that is very favorable because of a high development need based on HDI and acceptable scores on investment protection and contract enforcement. Insolvency and ease of starting a business are not very good, but the other factors still outweigh the low scores.
The trade-offs are evident when Singapore is examined. It has the lowest HDI score of the top 15 countries shown, but makes it to the top 15 because of very high scores for contract enforcement and investor protections. It also has high scores for the ease of starting a business and insolvency mitigation.
Investors can customize the weightings depending on the focus of their investment strategy. For instance, a debt investor may put more emphasis on insolvency protection and contract enforcement given the first lien position of debt on the assets of a company. Change the scenario selector on the sheet to Global Impact – Debt. When this is done, the results change and Ethiopia takes the top spot, primarily because of a more favorable insolvency mitigation score, which is important for debt investing.
Keep in mind that this is only a method to start building a framework for geographic suitability and that each country should be examined in detail. For instance, Ethiopia as the top choice for Global Impact – Debt has a high need for development and a good insolvency mitigation score, but compared to the mean investor protection score amongst the top 25 (6.256), its investor protection score of 1.6 is very low. Depending on the risk appetite of the investor, this combination may not be suitable. Individual analysis is always required. Also, the data sets chosen here are not exhaustive or completely indicative of a perfect investment environment. Local due diligence should always be undertaken to vet country risk.
Finally, impact investing does not have to only be done in emerging markets. There are many companies that are domiciled in developed countries that have focuses abroad or, as mentioned in Chapter 1 earlier, even in areas domestically that demonstrate need. However, investors in companies that are domiciled in developed markets and do business in emerging and frontier markets should still do a country risk analysis of the primary operational regions. Indirect risks can disrupt cash flow and quickly put stress on the viability of the company as a whole.
Country Economic Analysis
Although the previous analysis on country suitability included many investment related characteristics, economic indicators were notably missing. There are many economic indicators one could look to but two important ones that capture multiple subrisks are business cycle and foreign exchange. Even if a country is suitable for investment, the timing might not be right because of these two factors.
Business Cycle
History has shown economists and businesses that there is a relatively standard pattern in the economy that creates a business cycle. Economies move through periods of growth, contraction, and back to growth. The time of each point in the cycle can vary widely, but this pattern is evident. Figure 2.5 depicts the standard business cycle.
Figure 2.5 The standard business cycle is important for investors to understand.
Countries can exhibit their own unique business cycles or be correlated to other countries that may influence their economies. For this reason, an investor should always gather economic data on the country in mind to understand the business cycle. Sector specific investors must think about their sectors vis-à-vis the business cycles and their expected evolutions. For example, a housing project company may look attractive during the growth phase shown in Figure 2.5 since the economy will be getting better, discretionary spending will be higher, and credit will be loosening. However, during a recession phase credit might tighten up, making mortgages difficult to obtain and consumers focus on savings.
Timing investment with the business cycle can be important given the holding time of many impact investments. Most equity impact investors hold on to their investments for five to seven years, if not longer. Debt investors average from one to three years for their investment horizons. The business cycle at investment and exit can have profound impacts.
An ideal situation would be to identify the early part of the growth phase for an economy. This can be difficult, as statistics that are being shown will be based on the recession phase. However, these statistics are where opportunity can exist. Businesses will generally be down and business valuations may have decreased. Investing at this stage could lead to a low entry price and future increase in performance. For debt investors, it would also be an opportune time, as sales will increase that should cover all or some debt service.
The contrary situation would be investing during a contracting phase. In this situation, the business valuations could still be very high, as they would be reporting data from the expansionary phase. Soon after investment, the economy could begin to shrink, sales could decrease, and credit could tighten. The combination of decreased sales and tighter credit can put a substantial amount of stress on an early stage company. If the company is unable to generate or obtain working capital, it will need more cash from equity or debt investors. Investors in these situations may find themselves funding the company until a growth phase begins.
Debt investors need to pay special attention to the inflationary aspect of the business cycle. If debt investors offer a fixed-rate product, they could introduce the concept of basis risk, defined as a risk caused by a mismatch between fixed and floating interest rates. For instance, if the investor is a local debt fund that pays its investors a floating rate return, but offers fixed rate debt to investees, there could be a mismatch, depending on how the business cycle evolves. If debt was issued to an investee at the bottom of a recession, when interest rates might be very low in order to spur growth, and then the growth phase proceeds quickly where rates start rising, the debt fund will incur margin compression. The yield from the investee will be fixed low and the amount the debt fund must pay its investors will increase. Most funds would invest in hedges, but these can be expensive.
Foreign Exchange Risk
Whether globally or locally based, investors often have to contend with foreign exchange (forex) risk. This is the risk that movements in currency exchange rates may impact the investor directly through a conversion into or out of a currency different than the one the investor is funded in, or indirectly through the invested company's operational exposure to foreign exchange.
Direct forex risk can occur at multiple points in an investors' investment horizon. For equity investors, it can occur at the time of investment and at the time of exit. For debt investors, it can occur at the time of investment, during interest payments, and during principal amortization. Debt investors typically hedge against forex risks, but equity investors have a difficult time. The difficulty for equity investors to hedge foreign exchange risk is caused by the fact that they do not know the duration or how much to hedge against. Equity investors may have to hold their investment for many years until exit, making long-term hedging extremely costly. Also, since an exit amount can vary wildly from investment to investment, the exact amount to hedge for exit is difficult to pinpoint. An equity investor can easily be over or under hedged.
If an equity investor does choose to take on direct currency risk and invest in a currency that is different from its funded currency, then she should research the foreign currency volatility and how future movements might affect returns. To understand this better the following two points of direct forex risk for an equity investor should be analyzed in detail: investment and exit.
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