Most of the businesses we have valued in emerging markets and underdeveloped countries are private, sometimes family-owned. In regions like Asia and Latin America this is a consequence of culture and economic history, but also due to the low level of their capital market development. This kind of scenario poses novel challenges for valuation. In this article, we analyze how to approach three of these challenges: the quality of corporate governance, cross-holdings, and cross-subsidization between companies.
There are incentive mechanisms and an explainable rationale behind the structure of family-owned and private businesses that are controlled by closed small groups. It is not in the scope of this article to analyze them. But, it is interesting to look deeper into some of the implications this has in order to perform valuations. For instance, good corporate governance often means that difficult, but necessary, changes must be implemented. But, in these types of business structures, in which, many times, familiar and personal interests and relations outweigh the business interests makes change very unlikely to happen. If you are valuing a public- traded company in an advanced economy, you could assume that any management team of a non-performing company would have been replaced if it hadn´t succeeded changing the company’s course in a timely manner. This is not something you should assume when valuing private businesses in certain emerging or developing countries, especially family businesses, because achieving harmony within the family or ownership group is sometimes achieved at the expense of a sub-optimal management of the business. The value you come up with should reflect this. One way is to project cash flows which reflect that the business is not achieving the overall market growth potential. Or, an adjustment in value could be considered to account for lesser efficiency or productivity due to poor corporate governance.
In business conglomerates, it is important to identify business cross-holdings and reflect their impact on the value. Again, there is a well thought decision behind such ownership structures. For instance, a company that would otherwise be considered unworthy of credit can take on loans because of the implicit assumption or explicit guarantee that the whole conglomerate will honor the company´s obligations if the individual company loses the ability to do so. When valuing a business, what matters is the intrinsic value of that business. Cross-holdings blur the picture because they generate/destroy value aside from the intrinsic value. In this case, it is important to differentiate and calculate future cash flows from the business and from cross-holdings separately, and to use a discount rate that reflects the conglomerate´s capital structure and indebtedness. This information becomes very useful, for example, for an investor interested in acquiring stock in a company. It will show the investor to what extent he/she is really buying a participation in the company and to what extent he/she could be exposing (him) herself to a different portfolio he/she might not even be interested in.
Cross-subsidies within a conglomerate often mean that the whole is less valuable than the sum of its parts, and sometimes, that a portion of the business portfolio is destroying value and should be shut down. When this is confronted during a valuation, it is important to identify who is subsidizing whom, by how much, by what means, and its effect on the value of the companies and the conglomerate.
The less developed an economy and its capital markets are, the more important it becomes to have access to local expertise to choose the right approach to undertake a valuation.