If you studied corporate finance or portfolio management 20 years ago, “political risk” tended to refer to a country’s stability in government and the transparency/integrity of its capital markets.
Those considerations still matter, but the deep polarization of government in the United States and other industrialized economies has given added weight to another kind of risk.
Business managers, investors and analysts now must assess the optionality of radically different standards in law, regulation and administration based on who is in power in a given jurisdiction.
THE PROBLEM
An article in The New York Times last month made the case well, at least as it relates to environmental policy:
“Government policies have always shifted between Democratic and Republican administrations, but they have generally stayed in place and have been tightened or loosened along a spectrum, depending on the occupant of the White House.
But in the last decade, environmental rules in particular have been caught in a cycle of erase-and-replace whiplash.
“In the old days, the regulatory days of my youth, we were going back and forth between the 40-yard lines,” said Douglas Holtz-Eakin, who directed the nonpartisan Congressional Budget Office and now runs the American Action Forum, a conservative research organization. “Now, it’s back and forth between the 10-yard lines. They do it and undo it and do it and undo it.”
Economists and business executives say this new era of sharp switchbacks makes it difficult for industries to plan. If there is anything that companies like less than government regulation, it is an unstable business climate…
In the past four months, the Biden administration has strengthened or restored rules that Mr. Trump had deleted, including regulations to cut greenhouse emissions from cars and oil and gas wells; to limit the pollution of toxic coal ash; to protect the habitat of the sage grouse and other endangered species; and to tighten safety controls at chemical plants. All of these rules are likely to be weakened or rolled back once again under a new Trump administration.”
This volatility is of course not limited to the environmental arena. Federal tax and regulatory policy have always featured some oscillation between Democratic and Republican administrations, but the pendulum swings are more pronounced than ever.
For clients of my M&A firm and other private business owners, there is always sentiment in favor of lower taxes and less regulation, but the strongest sentiment may be for greater certainty.
THE DATA
Measuring political risk is big business, but it’s difficult to find metrics that drill in on volatility, as opposed to the stability and functionality of political institutions and capital markets.
The World Bank’s Worldwide Governance Indicators (WGI) project “constructs aggregate indicators of six broad dimensions of governance.” One of the six – government effectiveness – “reflects perceptions of the quality of public services, the quality of the civil service and the degree of its independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government’s commitment to such policies.”
Here is the data for the world’s 15 largest national economies at five-year intervals through 2022, the most recent year for which data is publicly available. Estimates of government effectiveness range from approximately -2.5 (weak) to 2.5 (strong). Green denotes positive movement from 2012 to 2022, red negative movement.
Over the 2012-2022 period, Canada, Australia, the United Kingdom, Germany, the United States, France, and Spain maintained positive scores but saw a decline in government effectiveness. Among countries with 2012 scores above 1.0, only Japan, South Korea, and Australia improved their positions.
Policymaking Volatility Becomes a Macroeconomic Burden
The New York Times article goes on to cite Costa Gavriilidis, a Scottish researcher who developed a U.S. Climate Policy Index after watching the United States join, leave, and rejoin the Paris climate agreement in just over five years.
“[Gavriilidis’] research shows that whenever the index shoots up to about 50 points, it creates an economic shock of such magnitude that it leads to a 1.5 percent decrease in industrial production, a 0.4 percent increase in unemployment, a 2 percent increase in commodity prices and a 0.4 percent increase in consumer prices, reflecting the fact that producers incorporate the risk of higher production costs associated with uncertain climate policy into their prices.”
This, of course, is a non-diversifiable market risk.
Non-diversifiable Market Risk Translates into Higher Required Returns
Let’s take electric vehicles as an example. Over the next few years, will the United States continue to incentivize their production and purchase? Will there be a return to support for fossil fuels? What will be the federal government’s position on domestic mining of the rare earth minerals that go into lithium-ion batteries? The answers to all three questions depend on political outcomes.
Here are the current five-year Betas for two traditional car manufacturers looking to evolve into battery-operated vehicles, and the two principal electric vehicle market entrants.
Setting aside Tesla, the spread in Beta between GM/Ford and Rivian is about .35. Considering that market-neutral beta is 1.0, that is a substantial swing. The prospect of binary political outcomes is not the only factor contributing to the marked difference in perceived volatility – and thus in required return – but it is clearly one factor dampening the valuations of the publicly traded OEMs concentrated in a new and politically contentious industry.
THE IMPACT ON PRIVATE COMPANIES
Privately owned businesses are not subject to daily public valuation, but they are subject to the same valuation methods. Public comps come into play even more directly if a company’s owner is a private equity fund or other investment company required to do quarterly “mark-to-market” valuations.
What is the impact on private investment activity in businesses affected by policy volatility? There can only be two answers. First, if the impact on required return is moderate, valuations in a given sector decline; and second, if the impact is greater, investors wait until policy direction clarifies.
Between now and the November election, in politically contentious sectors like electric vehicles, the sidelines will be a popular place.
About the Author
Andy Greenberg is CEO of Greenberg Variations Capital, a mergers & acquisitions advisory firm based in suburban Philadelphia devoted to one-off or targeted transactions. Mr. Greenberg was founder and CEO of GF Data©, the M&A data tracking service, prior to its acquisition by the Association for Corporate Growth in 2022. For more information, visit www.greenbergvariations.com.
© 2024 Private Equity Professional | May 23, 2024
