Reducing the risk

Fiona Sheridan leads the Risk Advisory Services practice for Ernst & Young which advises global companies and central government bodies on risk and assurance. She tells BM about the current global strategic business risk landscape.

Recently, we completed a research project with Oxford Analytica, which identified the Top 10 Strategic Risks to global business. An interesting finding was the similarity of the risks companies should be worried about – regardless of their sector. There is a commonality around things like regulation and compliance, global financial shock (particularly relevant at the moment), and the challenges faced in effectively capitalizing on the potential of emerging markets.

Beyond that, there are ‘bigger picture’ themes like the impact of an ageing population, increasing consumer demands combined with something we’ve termed ‘radical greening.’ The pace and extent of the “green revolution” is hard to predict but could pay dividends if consumer tastes and regulation shift quickly. When you combine this “greening” with the emerging market risks it becomes an interesting dynamic: companies are trying to leverage emerging markets to improve their supply chains and be more cost competitive, but that brings ethical and environmental challenges. With this radical greening concept popping up on this radar, it’s quite a challenge for enterprise to get right.

We’re finding organizations are beginning to talk about enterprise risk management again. When Sarbanes Oxley came on the scene, a lot of them dived into the detail to focus around financial reporting process risks. To some extent, the wider enterprise risks took a back seat, not getting the same level of attention, despite being risks that can destroy a reputation and lose competitive advantage remarkably quickly. There’s an increasing desire to think of enterprise risk management as potentially very positive rather than negative. If you can effectively understand the risk that you’re facing and be responsive to it you can take advantage of opportunities quicker than others. You will be thinking about the bigger picture, rather than thinking it’s all about avoiding bad stuff.

Regulation
Companies are starting to take things like governance and compliance more seriously. In financial services when Sarbanes Oxley came along there was obviously a lot that had to be done in terms of compliance. Companies are currently trying to increase efficiency and effectiveness in risk activities, and IT governance and process is part of that. Because of all the regulation and acquisitions that certain companies have been through there has been a “wedding cake” effect: layers and layers of risk activities built up with little connection with each other. The term being coined for streamlining this is risk convergence – there’s a real appetite to achieve this convergence in the banking and financial sector at the moment.

Progress
Things work well when an organization has a good idea of what their strategic risks are and review them annually. Strategic risk is constantly moving, but there is the tendency to think that if you’ve done it once you can leave it on the shelf for two or three years. But the environment we’re in now moves too fast. Reviewing that risk radar on a regular basis is important, and also ensuring that once you’ve identified those risks you effectively evaluate how well you respond to them.

It’s no good just identifying risks. You need to know how you’re going to respond. That means having early warning indicators and decision-making processes that explicitly balance risk and return before any decisions are made. The programs that deliver those strategic initiatives must be robustly managed and monitored. If the worst-case scenario happens and a risk materializes, you need effective scenario planning and operational response plans to mitigate any potential disaster. If all those factors are taken together and hardwired into management’s performance dashboard then you have got a more real time approach to risk management.

If you develop that strategy from the top down across the organization, then the silo effect – having all these layers upon layer – is whittled away as you focus on those risks that are the most important. A lot of organizations have had multiple pages of risk registers running for a long time, but do any of them actually make a difference to decision making? That’s the key test.

In the research work that we did, one of the top 10 strategic risks for global business was the inability to capitalize on the rise of the emerging markets. As companies are entering these markets – to look for opportunities to grow a market because traditional markets are saturated or to find competitive advantage in supply chains – they are finding problems. Such threats include currency, operational effectiveness, language and cultural issues, as well as understanding and complying with multiple regulatory environments.

Another survey we conducted on risks in emerging markets specifically demonstrated that although this is in the top 10 biggest strategic risks, 56 percent have no emerging market strategy at all. That should be a real concern for business.

Better management
Think of the cases of Mattel and GAP. Recently both companies have had issues with their emerging market supply chains, issues that have attracted negative attention. People tend to think about risk in terms of what they know and understand, but as you reach out for the first time into emerging markets you have to understand what you’re getting yourself into. Think about your due diligence processes, think about the management that you put in there, think about how you monitor that. It’s vastly important to build all of that into your investment decisions.

About Fiona Sheridan
Fiona Sheridan is Managing Partner at Risk Advisory Services. She is a chartered accountant with 14 years experience in internal audit and risk management and extensive global financial control project experience over the last 3 years. She has a particular focus on the technology and telecoms sectors.

She leads EY’s s404 response in relation to foreign registrants and has been involved in supporting and advising a number of multinational UK based companies on their s404 projects. She speaks regularly about Sarbanes-Oxley and its implications and currently leads the Ernst & Young SOX Think Tank.

She also works with companies to improve their internal audit functions and works in partnership with internal audit heads to deliver leading internal audit services across business as usual processes and also change programs and projects.

EY’s Top 10 Risks for Business
Regulatory and Compliance Risk
Global Financial Shocks
Aging Consumers and Workforce
Emerging Markets
Industry Consolidation/Transition
Energy Shocks
Execution of Strategic Transactions
Cost Inflation
Radical Greening
Consumer Demand Shifts

Company leadership must:
• Conduct an annual risk assessment that defines key risks and weights probability and impact on business drivers. Many companies undertake some form of risk assessment, but our experience suggests that too many do not do this on a frequent enough basis.
Our research suggests that one in five do not perform a risk assessment and over one third conduct a risk assessment less than once a year.

• Such a risk assessment needs to go beyond financial and regulatory risk to consider the wider environment in which your organization operates and the full extent of its operations. Less than 50 percent of respondents to our survey, Compliance to Competitive Edge: New Thinking on Internal Controls, believed that they had effective controls for M&A, IT implementation, business continuity planning, real estate construction, transaction integration and expanding into new international markets.

• Conduct scenario planning for the major risks that you identify and develop a number of operational responses – this can be a useful part of the planning cycle and help encourage innovative thinking.

• Evaluate your organization’s ability to manage the risk that you identify – in particular ensure that your risk management processes are linked to the risks that your business actually faces. The responsibility for risk must sit with the business. Do you have a ‘risk radar’? Is it current, and how will it warn you of potential risks?

• Effective monitoring and controls processes can give you both earlier warning and improved ability to respond. There can be value from much of the compliance activity demanded from regulators, but this has to be mined.

• Keep an open mind about where risks can come from. Ours is an increasingly interdependent global economy and risks that can damage your business can initiate in markets and sectors a long way from your own. High-risk mortgage lending in the US to people with limited or no creditworthiness ends up hurting the pension funds of the most cautious saver.

The Next Five
Following these top 10 threats to global business, there are some risk issues with impacts that are – though perhaps less strategic than the top 10 – nonetheless crucial in a number of sectors. Any of these could easily rise into the top 10 list in the future.

• War for Talent
• Pandemic
• Private Equity’s Rise
• Inability to Innovate
• China Setback

The War for Talent is already having a serious impact in some sectors, notably in oil & gas, which is facing a shortage of technical expertise; asset management and real estate, which are seeing talented staff poached by alternative investments; and pharma, which is facing a ‘skills crunch.’ More broadly, analysts highlighted that as growth in emerging markets takes off, companies in developed markets would no longer be able to draw on the “global pool of mobile, multi-lingual professionals possessing advanced degrees from leading universities, a growing share of whom originate from emerging markets.” In addition, one of the scientists we surveyed, a specialist in corporate innovation at the Massachusetts Institute of Technology (MIT), noted that there is a “growing regional concentration/clustering of talent – while expertise can be found in more nations than ever, within nations it is becoming more concentrated in a small number of clusters. This phenomenon is particularly true in biotech and other high-tech areas. This leads to increasing wage rates, property rental, and competition for expertise.”

The possibility of a disease Pandemic is a strategic risk that our panelists rated as significant. The potential market, economic and operational impacts of an avian flu pandemic have been much discussed, and a major outbreak would have a dramatic impact in nearly every sector. There are also more subtle potential consequences including a dramatic shift in consumer demand, which could have large competitive impacts on the pharma and biotech sectors.

The threat of Private Equity’s rise has been a serious strategic threat in sectors such as auto, where “new, non-traditional investor groups such as private equity firms are leading unplanned, hostile takeovers within the automobile industry consolidating, and forcing restructuring and creating spin-offs.” In real estate ownership, there has also been “a shift from public to private as record amounts of capital continue to flow into real estate. Companies will need to re-evaluate their global competitive positioning in light of the wave of recent M&A activity.” Several analysts also noted that private equity might crash just as quickly as it has risen – a risk alluded to in the second ‘on the radar’ risk, global financial shocks.

The threat of an Inability to Innovate is significant for business in 2008. In a number of sectors, long-standing patterns of innovation are changing dramatically. In pharma, “the productivity of pharmaceutical companies continues to decrease as disease targets become more difficult: big pharmaceutical companies are not discovering or launching new products. This will have the greatest impact as the patents for the top 10 selling drugs expire.” In asset management, “the best money managers are setting up boutiques…

The giants cannot hope to compete with the boutiques, despite the risks.” Firms in these sectors need to replace internal innovation with acquisition of innovation. Even in sectors where the impact is less extreme, innovation is becoming an increasingly crucial strategic challenge as markets mature. A consumer products panelist noted, “Most manufacturers’ largest markets are mature. Stagnation in mature markets means that companies have to innovate to find profit. However, innovation is a substantial risk as nine out of ten new products fail.”

The threat of a China Setback was the last of the ‘next five’ risks. Several analysts we polled expressed concern that China might experience volatility as it continues with an extraordinary pace of development. A growth slowdown in China could leave oil & gas companies suddenly facing a low oil price environment; a severe slowdown could add to turmoil to world markets or threaten banks or insurance companies with large China exposures; or a natural disaster in China could disrupt global supply chains. Just as firms worldwide must manage the risks arising from potential instability in the US dollar or US financial system (see risk two on the radar), China’s emergence as a major global player dictates that China’s fortunes will soon become a focus of attention even in companies without direct China exposures.

From emerging markets to surging markets – the future of global media growth
By Farokh Balsara

Emerging markets are attracting significant attention because of a surge in demand for content. With China and India accounting for one-third of humanity, these markets are the future for global media growth. Currently, some of the largest global media and entertainment companies are making less than 5 percent of their global sales from emerging markets, but the management within these companies are spending a disproportionate amount of their time dealing with these markets. It is partly a lack of both content and a handle on distribution in Europe and North America that is preventing emerging market companies from moving into developed markets. More significantly, however, the growth in their home markets is so fast that they don’t have the bandwidth to think about it.

Another important growth factor in these markets is technology. Broadband connectivity in South Korea is 98 percent, enabling the push through of huge amounts of content. In India, a global multinational company has recently conducted the world’s biggest rollout of digital cinema through satellite. This means that these companies can control exactly where movies are showing and how many times they are shown. It also means they can control piracy. And it allows them to release not just in Delhi or Mumbai, but in the smallest towns, simultaneously. This is a paradigm shift in how films are released, and it is happening in India.

At a time when technology is reshaping the global industry, emerging markets are the fastest adopters of technology. They provide an ideal test-bed where global firms can trial new technologies, before bringing them out in their home markets.

Winning in Emerging Markets
To win in these markets, companies need to localize content and be sensitive to local culture, rather than automatically dubbing and repurposing. It is possible to sell from media libraries, but this will not make you a winner in these markets. One major global media player had been in India for seven or eight years, with a mostly English offering. In 2000, they invested in 24-hour Hindi programming with local productions and quickly became the largest and most profitable channel. Firms that don’t localize their content can also run higher risks. One foreign broadcaster that was in the Indian market showed too much adult-oriented content in its programming before 11pm and the government took the channel off the air.

However, growth in demand for local content by these global players and by local companies funded by private equity firms could soon outpace the growth in supply of local production talent. This could lead to super-inflation, which should be factored into business plans. It is important to understand that even a single emerging market country has multiple markets within. Southern India is completely different from the North. To win in a national market, investors may need a very different strategy in each region. There will be differences in where the demand is, the type of content, the distribution of content, and how to take out earned revenues.

The price points in emerging markets are also often a fraction of what consumers would be charged for similar content in developed markets, often due to regulations, competition or extensive piracy. However, the huge and fast growing volumes more than make up for the low charges. As a result, a thorough assessment of the market and distribution channels is needed to appropriately price the content.

A final critical success factor is flexibility. These markets can see growth of 40 to 50 percent per annum. In such an environment, local entrepreneurs have a big advantage, and right now, a lot of local media companies are beating the global players in China and India. Multinationals will need to have flexible business plans, which do not always need to be approved by the regional office and the head office.

Farokh Balsara is the National Sector Leader for Media & Entertainment and the Markets Leader for Advisory Services at Ernst &Young, India.