M&A Vocabulary – Expert Insights: “Country Risk: The Brazil Example”

When companies invest in emerging or developing countries, they hope for higher returns, as they are also exposed to additional political and economic risks. Therefore, for intended investments in emerging markets like Brazil, the potential impact of inherent macroeconomic country-specific risk factors must always be included in the valuation calculus.

There is no uniform definition of so-called country risk; this term encompasses a multitude of risks from the economic, social, and political environment of a country. This can lead to both potentially favorable and adverse consequences for investments in the respective country.

Practical Examples of Country Risks

The following practical examples can be cited for country risks in Brazil:

1. Exchange rate development: Volatility of the local currency and its significant depreciation over the last two years
2. Interest rate development: Re-increase of the (quasi) risk-free base interest rate from 2% to 10.75% within one year
3. Inflation development: Re-increase of the inflation rate to 10% after moderate years at around 4%
4. High volatility in financial markets: Volatility of foreign direct investments
5. Political and institutional instability: Increased polarization
6. Infrastructure deficits: Structurally weak regions
7. Unpredictability of tax and financial policy: Complex tax system and rampant bureaucracy (so-called Custo Brasil)
8. Social inequality: High wealth and income disparities

Practical Challenges in Business Valuation

How can country risk be considered in Business Valuation?

Since the respective likelihood of occurrence and potential impact of the manifold risks on a company’s financial surpluses are difficult to estimate, the inclusion of (derivative) country risks in financial planning is complex in practice and problematic in detail. Due to easier handling and transparency, country risks are therefore often considered in valuation practice by adjusting or increasing the cost of capital.
Depending on the availability of data (such as ratings and government bond yields of the respective countries) and the valuation occasion, different methods can be used to derive country risk premiums. The following methods have proven effective in practice for an initial, simplified indication:

Bond Default Spread:

• Frequent recourse to default spreads of government bonds of the corresponding country
• With suitable market data: Yield comparison with a (default-)risk-free bond with an identical remaining maturity in the same currency (leading currency USD or EUR)
• Without suitable market data: Using a specific country rating of comparable countries and deriving a “typical” default spread
• As a first indication, publicly available data can be used; for example, 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%
  c) Country Risk Premium: 2.91%

Credit Default Swap (CDS) Spread:

CDS spreads can potentially lead to more precise results than (bond) default spreads. However, these are subject to comparatively high fluctuations over time due to possible shifts in investor risk aversion.

Examples of CDS Spread for Brazil as of January 2022 (Source: Prof. Damodaran, Stern School NYU):
a) CDS Spread (over US Spread): 2.72%
b) Country Risk Premium (CDS): 3.16%

In addition to these pragmatic approaches, there are other methods, such as estimating the country risk premium through the relative market volatility of stock prices in the countries concerned using mathematical-statistical models or directly estimating expected cash flows using (Monte Carlo) simulation models.

Due to the lack of suitable capital market models, further analyses are always necessary to derive a country risk premium. These should include both historical and future-oriented aspects and must always be determined based on the underlying, company-specific characteristics.

Risk Adjustment of the Cost of Capital

The estimated Country Risk Premium (CRP) can be integrated into the standard formula for determining the cost of equity. The cost of debt must then also be adjusted accordingly for country risk.
In addition, the inflation differential should be included in the calculation of the cost of capital to account for local inflation expectations.

Conclusion

Since emerging and developing countries generally exhibit higher country risks than established industrialized nations, country risk premiums should always be considered when valuing companies in these countries.

Depending on the availability of data and the valuation occasion, country risk premiums can be determined based on different methods. The valuer should generally use several methods and always assess the amount of the applicable country risk premium in an overall view.

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