Oh! these risk premiums for emerging markets!!!
These were the exact words from the management of a biotech company based in an emerging market when we were negotiating a deal with them. The company was supposed to in license the product, develop it and launch in its country as well as in other developed markets. The management had developed their own valuation model and was in the process of negotiating with our client. In their valuation model, they assumed the discount rate for the project where the product was supposed to be launched in emerging markets to be lower than that for the developed market. Can it be true?
First let us understand why an investor would demand higher return for investing in emerging markets? One does not need to be a finance expert to answer this. If you are exposed to higher risk, you would demand higher return. Emerging markets do have tremendous opportunities; however they are also exposed to various risks – social, political and economical. If you can get x% return by investing in developed markets, you would demand an extra premium for investing in these markets due to your exposure to higher risk.
However, you must be careful not to assume that all companies are exposed equally to the country risk. To see why, Imagine a company X based in an emerging market but receives 80% of its revenues from developed markets. Would you punish that company for being in the emerging market? If the company gets 80% of revenues from mature markets but all its operations are in emerging market, how would you treat it? Hence, before you demand the premium, it is important to understand the sources of revenue, manufacturing/operations and finally the risk management products that companies use to hedge the risk.
Coming back to our negotiation table, the investors demanded higher risk premium from the biotech company that was supposed to launch the product in the emerging market. The logic was simple. As the operations were in the emerging market, the project would be exposed to all country risks.
In sum, if you compare the returns/discount rates that the investor would demand from the same product that is launched in the emerging market and developed markets, the discount rates would be much higher for emerging markets than that for developed markets.