M&A Vocabulary - Experts explain: Country risk based on the example of Brazil

published on 6 April 2022 | reading time approx. 3 minutes

In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner present an important term from the specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give or refresh a basic understanding of a term and provide some useful tips from our consultancy practice.

When companies invest in emerging and developing economies, they hope to achieve higher returns because they are exposed to additional political and economic risks at the same time. Therefore, when contemplating investing in emerging economies such as Brazil, it is important to consider in the investment calculation also the potential impact coming from immanent macroeconomic country-specific risk factors.

There is no uniform definition of the so-called country risk; this term encompasses a large number of risks arising from the economic, social and political environment of a country. This can have not only potentially favourable but also adverse consequences for investments in the respective country.

Practical examples of country risks

The practical examples for country risks in Brazil can be as follows:

Exchange rate development: Volatility of the local currency and its significant depreciation over the last two years
Interest rate development: The (quasi) risk-free base interest rate rises again from 2 per cent to 10.75 per cent within one year
Inflation trend: The inflation rate rises again to 10 per cent after moderate years when it was around 4 per cent
High volatility on financial markets: Volatility in FDIs
Political and institutional instability: Increased polarisation
Infrastructure deficits: Structurally weak regions
Unpredictability of fiscal and financial policy: Complex tax system and excessive bureaucracy (the so-called Custo Brasil)
Social inequality: Large wealth and income disparities

Practical challenges in business valuation

How can a country risk be considered in business valuation?

As it is difficult to estimate the probability of occurrence and the impact of the various risks on the financial surpluses of a company, the inclusion of (derivative) country risks in the planning calculation is time-consuming in practice and problematic in the individual case. In valuation, country risks are therefore often taken into account by adjusting or increasing the cost of capital, as this is easier to do and more transparent.

Depending on the availability of data (such as ratings and yields on government bonds of the respective countries) and the reason for making the valuation, different methods can be used to derive country risk premiums. As an initial, simplified indication, the following methods have proven to be effective in practice:

Bond Default Spread:

Frequent recourse to default spreads on government bonds of the respective country
If suitable market data are available: Yield comparison involving a (default-)risk-free bond with identical residual maturity in the same currency (USD or EUR as base currency)
If suitable market data are not available: Using a specific country rating of comparable countries and deriving a "typical" default spread
As a first indication, publicly available data can be used, e.g. country default spreads for Brazil as of January 2022 (source: Prof. Damodaran, Stern School NYU):

a) Moody’s Sovereign Rating: Ba2
b) Adj. Default Spread: 2.56 per cent
c) Country Risk Premium: 2.91 per cent

Credit Default Swap (CDS)-Spread:

CDS spreads can possibly lead to more precise results than (bond) default spreads. However, they are subject to comparatively high fluctuations over time due to possible changes in investors' risk aversion.

Examples of CDS spreads for Brazil as of January 2022 (Source: Prof. Damodaran, Stern School NYU):

a) CDS-Spread (for US Spread): 2.72 per cent
b) Country Risk Premium (CDS): 3.16 per cent

In addition to these pragmatic approaches, there are also other methods, such as estimation of the country risk premium based on the relative market volatility of share prices in the respective countries using mathematical-statistical models, or direct estimation of expected cash flows using (Monte Carlo) simulation models.

As there are no suitable capital market models, it is always necessary to perform further analyses to derive a country risk premium. These should include both past-oriented and forward-looking aspects and should always be determined based on the underlying, company-specific characteristics.

Cost of capital risk adjustment

The estimated country risk premium (CRP) can be integrated into the standard formula for calculating the cost of equity. Also borrowing costs should then be adjusted for the country risk.

In addition, the inflation differential should be included in the calculation of the cost of capital in order to consider inflation expectations at the local level.

Conclusion

Since emerging and developing economies generally have higher country risks than prosperous industrialised countries, country risk premiums should always be taken into account when valuing companies in these countries.

Depending on the availability of data and the reason for making the valuation, country risk premiums can be determined on the basis of different methods. As a rule, the valuer should use several methods and always see the big picture when assessing the amount of the country risk premium to be applied.