Customs Street Advisors is a full service investor relations firm based in Lagos, Nigeria.

Growing up in frontier markets

This week in Alrroya, the United Arab Emirates business and finance daily, I discuss the demands by international fund managers on public companies in frontier markets like Nigeria to improve their corporate governance and risk management processes.

Frontier markets like Ghana, Kenya and Nigeria are being forced to grow up. Their indulgent childhood is fast coming to an end. Global investors have lost their patience and expect companies in these fringe economies to begin to act like adults. That means that they will be held to the same accountability and responsibility standards as their developed market peers. Companies in these emerging emerging markets can no longer serve as capricious extensions of the personal piggy banks of the founders or government. This should come as no surprise. To a keen observer, it was only a matter of time before the petting ended.

Michael Hartnett, chief global equity strategist at Bank of America Merrill Lynch, defines frontier markets as ‘developing economies with undercapitalized equity markets that are relatively new, thinly traded, with weaker regulatory frameworks, lower levels of transparency and low levels of foreign ownership.’

Increasingly, international investors in these markets demand robust corporate governance standards and strong risk management frameworks in addition to solid financial returns. In the past, they were satisfied with just the financial returns, however risky the region was perceived to be. This is a major shift from the prevailing general theory that the high returns in local financial, telecoms, fast moving consumer goods, commodities and real estate sectors were immune to the weak governance and risk management structures in the companies producing the financial surplus.

In fact, there are a growing number of adherents to the view that poor governance practices and flyweight risk management structures rather than the torrid economic climate of the past two years are the main culprits in the challenges these companies face today. Those who hold this view argue that porous governance and risk screens caused the wreckage because they predate the economic crisis by several years.

While the scale of the current reformatory wave may be dwarfed by that which swept through Asia in the late nineties, its results will be no less substantial or significant. The wild, wild markets of Africa are going to be tamed. Domestication is the new order. Exoticism is no longer an excuse for playing outside the rules.

So what are the factors driving the new regime? There are several. However, four stand out.

First, these markets are the victims of their own success in attracting international attention. In the past three years, FTSE, MSCI Barra and Standard & Poor’s, the global index providers, have all launched frontier market indices which include a number of African countries, thereby raising their visibility among portfolio managers. In the same period, a number of ETFs which offered exposure to these markets were listed on developed market exchanges. Due to the poor liquidity characteristic of these markets these investors were unable to exit quickly enough in the immediate aftermath of the crash. With their fingers burnt but still stuck with the stocks, managers took a careful look at the companies and realized that atrocious governance and inept risk management practices amplified the damage triggered by the market turmoil.

Second, the linkage between governance and returns is now impossible to ignore. For example, recent events in the Nigerian banking sector reinforce this point of view. The takeover of a number of the country’s leading deposit money banks by the Central Bank of Nigeria last year has exposed the extent to which lax governance and risk sieves threatened the very existence of these institutions. The stellar returns they offered investors during the boom years are a meagre consolation in comparison with the huge losses investors have had to bear.

Third, as these companies seek to shore up their depleted equity capital, fund managers are demanding changes to and strict adherence to governance codes and risk management procedures. The cutoff mark has been raised from the laissez-faire attitudes of the past. Since these investors now realize that the chances of them becoming de facto long-term shareholders are very high, the dip-and-flip mind set has been replaced by that of long-haul passengers. The tourists now realize their two week holiday may turn into a three year stay.

Finally, these markets are not quite the diversification cordon that they once were. In a report released in March 2009, Hartnett pointed out that ‘frontier markets went from being an increasingly popular growth theme to a lonely and illiquid trade in a matter of weeks. Correlations with the S&P 500 spiked from a 32% to a very high 90%, in line with emerging and developed markets.’ What is the point of making excuses for their idiosyncrasies when they offer so little correlation fencing? If they could not provide that shield then they might as well meet the same criteria as markets elsewhere. It was as simple as that.

Those frontier market companies that recognize that these demands are in their long-term interest and embrace them accordingly will be the better for it. The sooner they do, the better for them. Adulthood may well turn out to be the best thing to happen to them.

The English version of the original article may be read here on the Alrroya website. The Arabic version may be read here.

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