Strategic Business Risk 2008 – the Top 10 Risks for Business
In collaboration with:
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It is never the risk that causes damage or creates opportunities – it is how we respond.
About this Report Risks are inherent in every forward-looking business decision so successful risk management should be an integral part of an organization’s strategy and operations – an important dimension of good management practice. There has been a great deal of work done in the area of risk management in recent years. Ernst & Young has been engaged in significant global activity to clarify stakeholder perspectives, map management activities and identify leading practice from which all can benefit. Likewise, many companies have invested significant resources globally in risk and compliance initiatives. Financial risk and regulatory risk have been the focus of much of this effort. In both cases, there are externally determined rules and frameworks with which companies need to comply and emerging best practice guidance on processes and controls that can help. We have worked with many companies who have found that the challenge of compliance can lead to opportunities for performance improvement through improved processes and enhanced communication. Some companies are now looking more closely at their operational risks, prioritizing these and thinking about how they can manage and monitor these in a coordinated way, the result of which can again be opportunities for performance improvement. What is clear is that to gain further business advantage, companies must increasingly look at the extended risk universe, from finance and compliance risk – to operational and finally, strategic risk.
A Different Perspective on Strategic Risk Our experience, however, suggests that strategic risk has not necessarily benefited from developments in management practice. Much that has been written about strategic risk seems to be at such a macroeconomic level that the implications for action by the management of a specific company can be lost. More significantly, the different implications for companies operating in different sectors can be blurred. Someone’s challenge is frequently someone else’s market opportunity. We decided to explore the area of strategic risk from a different perspective. In collaboration with Oxford Analytica we focused on the strategic risks facing 12 of the world’s most important sectors: asset management, automotive, banking & capital markets, biotechnology, consumer products, insurance, media & entertainment, oil & gas, pharmaceuticals, real estate, telecommunications and utilities. These sector studies served as the primary source for the overall comparative report of our findings.
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Contents The Ernst & Young Strategic Business Risk Radar
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Scanning the Sectors
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The Top 10 Risks for Business
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– Regulatory and Compliance Risk
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– Global Financial Shocks
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– Aging Consumers and Workforce
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– Emerging Markets
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– Industry Consolidation/Transition
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– Energy Shocks
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– Execution of Strategic Transactions
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– Cost Inflation
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– Radical Greening
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– Consumer Demand Shifts
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The Next Five
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Conclusion
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Contacts
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The Ernst & Young Strategic Business Risk Radar We have found the use of the radar – our risk radar – to be a simple and useful device to allow us to present a snapshot of the top 10 strategic business risks for a company, a sector or indeed the global economy as a whole. The radar allows us to show both the scale of the challenge and its nature. Strategic Risk (strә-tē'jĭk rĭsk) – a risk that could cause severe financial loss or fundamentally undermine the competitive position of a company.
To arrive at our findings, we worked with Oxford Analytica to interview more than 70 analysts from around the world and from over 20 disciplines that shape the business environment, including law, finance, the sciences, business strategy, geopolitics, regulation, medicine, economics and demographics. The focus of our interviews was to identify the emerging trends and uncertainties that will drive the fortunes of leading global businesses over the next five years. Our interviews were open-ended in that we did not provide a list of pre-determined risks for the analyst to rate. Rather we asked each analyst to tell us what he or she believed would be the most important strategic challenges for global business ahead. Many different risks and challenges were identified, with in excess of 40 by more than one analyst. In order to prioritize the top risks for each sector, panels of sector experts including journalists, researchers, advisors and our own Ernst & Young practice professionals rated the severity of each of the risks for the sector concerned. The risks that appear at the center of the radar are those that our panels believed will pose the greatest challenge to business in the coming year. Those on the outer edge – whilst not small and still in the top 10 – are considered to be of slightly lower priority.
tor
ats hre
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Operatio nal T
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Macro Threats
It rapidly became clear that not all strategic business risks are the same in nature. We have therefore also divided the radar into three broad sections: (1) macro threats that emerge from the general geopolitical and macroeconomic environment in which we all operate; (2) sector threats that emerge from trends or uncertainties that are re-shaping the specific industry; and (3) operational threats that have become so intense that they may impact the strategic performance of leading firms. We believe this distinction is helpful, whilst recognizing that these categories are not completely exclusive. Hence, we can present one radar for a company or sector, as collectively, these are the principle strategic risks that industry-leading firms must manage if they are to maintain their dominant competitive position.
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Scanning the Sectors Risk Weighting and Risk Prioritization Phase 1: • We asked the pool of analysts to list and to rate (on a scale of one to ten, with one having the least impact), the 10 most significant trends or uncertainties that may impact companies, and to provide commentary on why these are important to their industry. • Analysts were then asked to list the five most significant business risks to firms within their industries – considering in particular those of a strategic nature – that might bring about shifts in the industry or put leading firms in peril of losing their position. A numerical rating was applied from one to five. Phase 2: • In order to prioritize the top risks for each sector, panels of sector experts including journalists, researchers, advisors and our own Ernst & Young practice professionals rated the severity of each of the risks for the sector concerned. Panelists were asked to assign a numerical severity rating, from one to five, based on the likelihood that a risk issue would lead either to severe financial impact or undermine the competitive standing of the leading firms in their sector. The ratings assigned by each sector panelist were averaged to build the lists of top risks by sector.
We have assumed that a ‘scan’ is or should be the most appropriate collective noun for the resulting grouping of strategic business risk radars and present (overleaf) the results of this analysis for each of the 12 core sectors. We hope that what is immediately clear is the extent of variation between these 12 radar snapshots. The most significant strategic business risk is different for most of them and the nature of those strategic business risks is varied for all of them. Variation in Risk Close examination of the radars – individually and collectively – shows that there is no consistent list of top 10 strategic business risks faced by the sectors. It is not just the weighting of risk that varies, but the positioning and the nature of risk. Moreover, it is not just the sectorspecific risks that vary, but the macroeconomic and operational risks as well. This does not surprise us or any who recognize the importance of sector in determining business challenges. Variation in Significance of Risk We have highlighted one of the most significant strategic business risks – regulation and compliance – in red. This makes it easier to see that for four of the sectors – real estate, biotechnology (biotech), pharmaceutical (pharma) and oil & gas – this is perceived as one of the top strategic business risks. Banking and capital markets, insurance and telecommunications (telecoms) also perceive these risks as having high impact. Other sectors including automotive (auto), consumer products and utilities believe that the same issue rates lower in their top 10 strategic risks. Equally, a fundamental shift in consumer demand (marked in green) is a top risk for consumer products, asset management and media & entertainment, but rates lower for many of the other sectors.
• The risks that were rated as having the greatest impact across the largest number of sectors were identified as the ‘top 10 risks for global business in 2008.’
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The Ernst & Young Strategic Business Risk Radars Asset Management
Automotive
Macro Threats
Banking & Capital Markets Macro Threats
Macro Threats Environmental pressures
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Failed product launches
Biotechnology
IT risks
Competition from non-bank banks Corporate governance and internal and specialists controls failures
Consumer Products Macro Threats
Insurance
Macro Threats
Macro Threats Legal risk
Geopolitical or macroeconomic shocks
Accessing talent
Marketing and branding
Cutting edge IT
Demographic shifts in core markets
Climate change Securities markets
S
Consumer demand shifts
S
eats Thr tor c e
Protecting intellectual property
s at
Se
Strategic transactions
Managing sourcing strategies
Catastrophic events
Emerging markets Regulatory intervention
Channel distribution
Shifting regulatory threats
Indicates regulatory and compliance related risks Indicates consumer demand related risks
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S TRATEGIC B USINESS R ISK : 2008 – T HE TOP 10 R ISKS
Integration of technology with operations and strategy
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Opera t i o n al T hre
Product development and clinical trials
Strategic alliances and transactions
Product development and innovation
Opera t i o nal Th re
Demonstrating value
Pricing pressures and input price risks
Raising capital
Opera t i o nal Th re
eats Thr r o ct
Price pressures and access
s at
Harnessing emerging markets
Supply chain risks
Monitoring drug safety
eats Thr tor c e
Emerging markets strategies Regulatory compliance
Reputation risks
Increasing pressure on margins
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eats Thr tor c e
eats Thr r o ct
Se
s at
Poor execution of M&A
Growth of alternatives
Emerging markets
Compliance and regulatory risk
Opera t i o n al T hre
Changing needs of an aging population
Consumer demands
Opera t i o nal Th re
Rise of financial conglomerates as asset gatherers
Opera t i o nal Th re
Cost and pricing controls
Credit shocks and exposures
Cost controls and cash flow pressures
eats Thr tor c e
Polarization between alpha and beta business models
Global financial shocks
s at
Entry of private equity
Geopolitical shocks Global market liberalization and consolidation
Compliance risks
Consolidation, restructuring and poor execution of M&A
s at
Difficulty of developing retail competencies
Workforce aging and escalating legacy costs
Fuel price shocks
s at
Innovation away from traditional asset managers
Geopolitical or macroeconomic shocks Global financial shocks
Media & Entertainment
Oil & Gas
Pharmaceuticals
Macro Threats
Macro Threats
Macro Threats
Energy conservation Supply shocks Demand shocks
Backlash against globalization
Uncertain energy policy Adverse drug effects
Competition for reserves from NOCs
Privacy and security risks
s reat r Th o t ec
Damage or Climate change/ environmental awareness disruption losses
Entry of infrastructure and private equity Challenges of scale
s reat r Th o t ec
Inability to respond to market liberalization
S
S
Cost or accessibility of capital
Access to competitively priced long-term fuel supplies Strategic exploitation of monopoly advantages by incumbent firms Compliance and regulatory risks
Opera tio n a l Th re
Competition from internet companies
l Th re
s at
Infrastructure investment challenges
Opera tion a
Regulatory and compliance risks
Energy politicization
Failure to generate sustainable Inappropriate revenues from new processes and Technological systems to business models shifts support new business strategies Decline in Regulatory fixed and mobile voice risks ARPU Inaccuracy in forecasting returns from infrastructure Consolidation investments and M&A
s reat r Th o t ec
Shakeout of real estate finance
l Th re
S
Macro Threats
Globalization of markets and services
Opera tion a
eats Thr tor c e
Utilities
Macro Threats
Inability to find and exploit global and non-traditional opportunities
Increased complexity of real estate finance
Rise of private equity
Cost pressure
Volatility in emerging markets
Global economic and market fluctuations
Green revolution
Possible overriding of intellectual property rights
S
S
Macro Threats Geopolitical shocks
War for talent Product pipeline Price controls and reimbursement levels
Drug counterfeiting
Telecommunications
s at
eats Thr tor c e
S
s at
Real Estate
Political constraints on access to reserves
s at
Maturation of key markets
Cost controls
l Th re
Corporate governance and internal controls
l Th re
Emerging markets
Product diversion and parallel trade
Opera tio n a l Th re
Inability to control costs
Worsening fiscal terms
Opera tion a
M&A activity and entry of private equity
Opera tion a
Business model innovation
s reat r Th o t ec
Human capital deficit
Regulatory risk
s at
Climate concerns
Managing the infrastructure of new business models Consumer demand shifts
s at
Asset protection risks including piracy and digital intellectual property rights
Global pandemic
Indicates regulatory and compliance related risks Indicates consumer demand related risks
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Two of the sectors did not perceive a single macroeconomic threat... oil & gas and insurance, however, perceive that half of their top 10 strategic business risks are macroeconomic in nature.
Different Types of Risk It is also apparent that the nature of risk varies considerably between the sectors. Analysts in two of the sectors – biotech and consumer products – did not perceive a single macroeconomic threat as being in the top 10 strategic business risks, but were focused entirely on operational or sector-specific challenges. By contrast, the oil & gas and insurance analysts we interviewed indicated a much greater exposure to the global environment, and at least half of the top 10 strategic business risks for these sectors are macroeconomic in nature. Some sectors are undergoing dramatic transformation. Technological advances are driving change in the basic business models of many firms. In these industries, sector-specific challenges tend to dominate the risk lists. Particularly notable in this regard is media & entertainment. In five other sectors – asset management, biotech, consumer products, pharma and telecoms – analysts indicated that half of the most significant strategic business risks are also specific to their sector. This analysis highlights the importance of sector in driving strategic business risk analysis and management action. Hence, we have produced separate reports exploring strategic business risk in detail for each of these 12 sectors. (Contact information for each report can be found on page 28). Given the observations above, what conclusion, if any, can be drawn from the aggregation of these sector findings? We believe that there are two sets of valid conclusions to be drawn: Firstly, we believe that, because we have followed a consistent process and used a weighting system, it is possible to compare the riskiness of sectors one with another. Secondly, from consolidating the findings of the 12 sector studies, it is possible to form a view of the 10 most important strategic risks across these sectors and hence for the economy, and this is the focus of the bulk of this report.
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Identifying the Global Top 10 By consolidating and aggregating the findings of our 12 sector studies, it is possible to form a view of the 10 most important strategic risks across the sectors – concerns that will be common to leading firms in many industries. The table below shows the weighting of the top 10 strategic business risks across the 12 sectors that we studied. While many risks were unique to a sector, a few key challenges had a high or critical impact for many, or even all of the sectors. Hence the risks at the top of the chart are those that, according to the analysts we interviewed, will do the most to influence markets and drive corporate performance in 2008 and beyond. Our analysis would suggest that the sectors that broadly have the greatest exposure to the top 10 strategic business risks are automotive and asset management, with four critical strategic business risks each. Insurance and real estate follow with three of the top 10 risks rated critical within their sectors. At the other end of the spectrum, for telecoms, none of the top 10 strategic business risks were marked as critical. This cannot, however, be used to definitively conclude that one sector is more or less risky than another. It may be that the unique sector-specific factors are in themselves more high risk than these 10. However, we can infer that, compared with what we believe are the most common strategic business risks, some sectors are more exposed than others.
Industries Automotive
Media & Entertainment Consumer Products
Utilities
Telecommunications Asset Management Insurance
Oil & Gas
Banking & Capital Markets
Pharmaceutical
Biotechnology
Real Estate 1 Regulation and Compliance 2 Global Financial Shocks 3 Aging Population
Risks
4 Emerging Markets 5 Consolidation/Transition 6 Energy Shocks 7 Strategic Transactions 8 Cost Inflation 9 Radical Greening 10 Consumer Demand Shifts Key Critical Impact High Impact Medium Impact Moderate Impact
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The Top 10 Risks for Business In the following section, we explore the top 10 strategic business risks that have emerged from our study, and we share the thinking of some of the leading analysts to whom we have spoken. Macro Threats
Top 10 Strategic Business Risks
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Global Financial Shocks
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Aging Consumers and Workforce Emerging Markets
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Industry Consolidation/Transition
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Energy Shocks
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Execution of Strategic Transactions
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Cost Inflation
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Radical Greening
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Consumer Demand Shifts
Global financial shocks Industry consolidation/transition Execution of strategic transactions Regulatory and compliance risk
Emerging markets
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Aging consumers and workforce Radical greening Cost inflation Consumer demand shifts
Opera tion a l Th re
4
Energy shocks
ts hrea T r cto e S
Regulatory and Compliance Risk
s at
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Regulatory and Compliance Risk
As the greatest strategic challenge facing leading global businesses in 2008, the industry analysts we polled selected regulatory and compliance risk. This is being driven by an escalating regulatory burden in many markets, as well as numerous compliance challenges as companies extend their value chains well beyond Europe, North America, and the BRICs (Brazil, Russia, India and China). The possibility of regulatory intervention in sectors such as pharma, biotech, insurance, telecoms and utilities, is further elevating this risk. Such intervention could shape the competitive environment and drive fundamental change in business models. One telecoms analyst wrote, “Regulation has a tremendous effect on the competitive landscape, not only between incumbents and new entrants, but between countries.” In other sectors, the continued viability of current business models may be threatened by future regulatory decisions. Continued on page 10 8
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Beyond the Horizon: Forward-looking Risk Management
Jim Fanning Ernst & Young
There’s never been a more challenging time for banks and capital markets firms. The complexities of the business continue to multiply. The landscape keeps changing through globalization, the emergence of new markets, and the advent of cross-border expansion. Add to the mix ever-evolving risk management, regulatory, and compliance requirements and it’s easy to see why many senior executives spend their days scrambling to keep pace and their nights worrying about whether or not they are fully compliant and can meet expectations. The concern is not unfounded. Many of the largest institutions have multiple risk governance processes and infrastructures amongst various corporate and business units. Because these operating models have sprung up over time as needs dictated, they often operate in silos, leading to substantial inefficiencies. These models may prove to be insufficient tomorrow as cross-border consolidation adds another layer of complexity. Competing regulatory regimes and variances in compliance requirements are just a few of the ways in which the demands and challenges of risk management will be compounded. At the same time, companies will be expected to provide greater transparency and more accurate risk and control information. Institutions can prepare themselves today to effectively manage the risks inherent in this future scenario by aligning or “converging” their current risk and control processes.
Risk convergence allows organizations to coordinate the various risk and control processes, effectively and pragmatically. In our experience, the result is reduced redundancy, which drives down costs, and, perhaps most importantly, allows more comprehensive, enterprise-wide risk reporting to senior management and the board. While risk convergence is not a minor undertaking, it represents a major opportunity to more effectively mitigate current and future risks that otherwise could impact an institution’s reputation, bottom-line and ability to compete globally. A few, forward-thinking institutions have recognized this need to streamline risk and control processes and present a more consolidated view to senior management and the board. Consequently, they are beginning to take steps toward risk convergence. It’s uncharted territory, however, so few, if any best practices have been established. A critical foundational element is the creation of a common data structure, common terminology for risk and control process, and a common technology architecture. In addition, the following questions can also help to guide the process:
• Is there buy-in from the right stakeholders? Support from chief executives is important, but getting buy-in from key corporate control groups and business units is critical: they’re the ones that will make it work. • Can expected benefits be tested? The goal here is to support the future-state hypothesis with empirical information in order to build a compelling case to present to senior management and the businesses. With an eye on what the future operating model should look like, it’s possible to move toward the desired end-state in incremental steps. As each building block is put in place, efficiencies are gained and begin to multiply. This approach can maximize the return-on-investment in the short term by avoiding large-scale investment while reducing waste and process redundancy. Those financial institutions that embark on this journey may be rewarded with a flexible, efficient, and sustainable risk management framework that effectively meets not only today’s requirements but those of the future.
Jim Fanning is the Global Leader of Ernst &Young’s Banking & Capital Markets Center.
• Has the vision been clearly defined? It’s not sufficient to focus only on what’s not working. The future state-vision should be well-defined and communicated so that all parties are clear on what is to be achieved. • Has a responsibility matrix been established? A matrix of current roles and responsibilities helps to visually identify existing duplication of risk management resources.
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“ The failure of one or more major financial institutions remains a real worry and could turn the crisis into systemic failure in the year ahead.” Jens Tholstrup, Oxford Analytica
Continued from page 8
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One analyst noted, “The revenue generated from the US pharma market, the largest in the world, enables pharma companies to remain profitable [despite] strict price controls in other major markets and the inability of [customers] in developing markets to pay full prices for their products. If imposed in the United States, price controls could transform the global pharma market, including business models and the development of new drugs in the future.” The compliance challenges are particularly strong in highly regulated industries such as banking, insurance, pharma, and biotech, where the regulatory burden is increasing fast, and where firms are feeling pressure to demonstrate a return on investment for long-term risk management initiatives. One banking panelist noted, “Banks are experiencing significant fatigue around managing the myriad of often redundant compliance and regulatory reporting activities, the cost of which is massive and burdensome.” Similarly, a biotech analyst wrote, “A mounting regulatory compliance burden in areas such as privacy, post-marketing monitoring of drug safety and sales force compliance… poses a management and internal controls challenge to biotech companies.” Increasingly, companies may seek risk convergence initiatives which allow them to coordinate the various risk and control processes, reduce redundancy, which drives down costs, and, perhaps most importantly, more comprehensive enterprise-wide risk reporting to senior management and the board. As companies become more and more global, compliance becomes a greater challenge, forcing them to manage diverse regulations in different markets. A specialist in business strategy noted, “Managing regulations in 10 jurisdictions is one thing. What happens when a firm has significant markets in 30-40 countries at varying levels of development and with very different regulatory traditions? This is not to say that global regulatory [diversity] is necessarily increasing; but rather, that corporate exposure to existing [diversity] is increasing.” The importance of understanding local regulations, as well as major global industry regulations is crucial to those companies expanding their global reach.
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Global Financial Shocks
Our analysts acknowledged that few sectors would escape the impact of major global financial shocks. Biotech and utilities firms, for example, would have trouble raising capital; banking, asset management, and insurance companies would be likely to suffer direct losses from market movements; and after making high-cost exploration investments – oil & gas companies might suddenly find themselves facing low prices if the global economy moves into sudden recession. Since our research began earlier this year, the August credit crunch, forced by the US sub-prime mortgage crisis has provided a real-life demonstration of how highly contagious such shocks can be across sectors – and indeed – globally. Rory MacLeod, the former Head of Global Fixed Income at Baring Asset Management, somewhat predicted in April 2007 that if there was a “worldwide credit crunch – spread widening would not lead to bank collapses, as in the past, but would be spread throughout the financial system. There will be unexpected pockets of vulnerability. Disintermediation has replaced international banking as a finance source with a range of specialized credit instruments held widely, with risk exposures that regulators find it difficult to assess. A credit shock could lead to a temporary closing of the market for new credits, while traditional lenders such as banks have moved away from the area.” A crisis could spread from alternative investment vehicles such as hedge funds or private equity. One analyst wrote, “Financial innovation and structural changes have contributed to the success of private equity, but cyclical factors have also played an important part in their over-expansion… High-profile failures of some investee companies could lead to a loss of confidence among investors and lenders.” Another remarked, “A crisis in CDO/structured finance markets could lead to potential systemic problems. Sustainability of financial sector growth is more fragile than markets realize. There is the potential for dramatic fallout from excessive leverage. Carry trades are cited as a risk area, but other hedge fund strategies are exposed to a change in the macroeconomic environment. There are potential systemic issues in the financial sector.” In the future, continued financial innovation – which tends to disperse risks and, as a consequence, makes the detection of potential shocks more difficult – is likely to increase the potential for financial shocks.
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The Credit Crunch and Its Implications for the Availability of Capital A related issue that has made the sub-prime crisis more contagious is the use of pooling of financial assets. Any investment vehicle which has some exposure to sub-prime mortgages will be regarded as contaminated.
Jens Tholstrup Oxford Analytica
For the time being the world’s major central banks have eased the credit crunch that manifested itself in the beginning of August, but the risks to the financial system remain very real. The origin of this financial crisis has been well documented: the inability of large numbers of less creditworthy borrowers in the United States to service the debt on their home mortgages. What has made this development so contagious are certain innovations in the global financial system. The securitization of financial risks has resulted in a wide disbursement of such risk throughout the financial system. In theory, the dispersion of risk should reduce the risks of systemic failure but, in fact, the very opposite has been the case. The negative effects of disbursement are exacerbated by lack of transparency. In theory, all financial assets have been, or are capable of being securitized and traded. However, at the present moment, no regulator or market participant can be totally clear where the risks lie. The use of off-balance sheet vehicles to hold sub-prime and other risk assets, has further reduced transparency.
In this market environment, financial institutions become very wary of lending to other financial market players since they will be concerned that others will be holding impaired assets. Credit for all but the largest and most secure borrowers will seize up. This is precisely what has happened in recent events, where central banks have had to intervene and act as lenders of last resort. Any institution that is holding high-risk assets, particularly asset-backed or pooled vehicles, is facing substantial losses. In addition, the market for many securitized assets has dried up leaving the holder unable to sell the assets. The commercial paper market for asset-backed securities has all but dried up with the consequence that borrowers financing such assets will need to draw on standby lines of credit provided by banks.
The implications are: • Even in the event of central bank rate cutting, the cost and availability of credit for most borrowers will be negatively impacted for the year ahead. Banks will be forced to ration their lending and lower-rated borrowers will find access to capital difficult and expensive. • The capital markets may well provide better fund-raising opportunities especially if investors believe that the anticipated rate rises will be reversed. However, access is likely to be restricted to better credits for some time at least. • The funding of off-balance sheet assets and other structured finance products will become severely restricted.
Jens Tholstrup is an Executive Director and Director of Consulting at Oxford Analytica. Prior to joining Oxford Analytica in 2000, Jens had an extensive career in investment banking.
Contingent risks become real risks, underwriting positions become stuck and credit becomes severely restricted. The failure of one or more major financial institutions remains a real worry and could turn the crisis into systemic failure in the year ahead. The central banks and regulators have already shown their disposition to take the steps which they feel are necessary to maintain the stability of the financial system and in particular to minimize the likelihood of economic contagion.
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“ Only 41% of developed market companies have a risk strategy for emerging markets, with more than half (56%) saying that no strategy is in place.” Ernst & Young, Risk Management in Emerging Markets study, October 2007
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Aging Consumers and Workforce
An increasing strategic risk for the majority of industries is the threat posed by workforce and consumer aging. Sectors such as asset management and insurance are experiencing dramatic shifts in demand and competitive battles are being fought for savings products that will appeal to the growing group of older consumers. Other firms, for example, those in the auto sector, are facing severe competitive challenges as a result of their aging workforces. A number of industries are experiencing dramatic shifts in demand – often dramatic growth – as a result of the rising average age in, for example, Europe, North America, and Japan. Sectors most affected by these shifts include pharma, biotech, consumer products, insurance, and asset management companies, which could lose heir competitive edge if they cannot effectively respond to these new opportunities. One insurance panelist noted, “People reaching retirement age have very different financial needs.” As a result, a struggle is now emerging between insurance and asset management firms to deliver the innovative products that will meet these needs, such as income maintenance and health care spending. To be competitive, companies will need to gain an understanding of the specific needs of these new consumers, and many will need to have an aggressive approach to key competitors that may increasingly come from outside their sector. The other strategic challenge posed by an aging population is workforce aging, a risk issue that figures highly in oil & gas and is perceived to be a ‘next five risk’ for sectors such as banking. These sectors are already experiencing a significant human resource challenge. Perhaps the most extensive example of this threat can be seen in the US auto industry, which is particularly weighed down by pensions and health care costs. “There remains a possibility of insolvency in the US auto industry, and a long line of dependent component companies have yet to construct a path to safety.”
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Emerging Markets
The findings of our survey Risk Management in Emerging Markets 2007 reveal that, while many companies have been in these markets for some time, emerging markets remain dynamic for developed market (DM) companies. Over 60% of DM companies have been in these countries for less than 10 years, and almost 20% less than two years. In most cases, global firms are competing with other global players for opportunities in these markets, although in several sectors, emerging markets firms are themselves entering the global stage. Often companies are being driven to these markets by the saturation of existing markets. An analyst in consumer products commented, “Over the next few years nearly all of the increase in world population will take place in the developing countries. In the meantime, other established markets will reach maturity.” Similarly, in real estate, “Intense competition for a limited pool of desirable assets, combined with yield compression in most global markets, has resulted in real estate funds needing to broaden their geographic search for opportunities. This has created an increased number of competitive variables in real estate markets.” For other sectors, such as biotech and consumer products, emerging markets offer supply chain advantages. One biotech analyst remarked, “The sources of biomedical innovation will become more diverse in a globalized marketplace. The implication is that while, in the past, the main source of competitive advantage for firms throughout the industry has been technology, in the future the supply chain will be important as well. Global companies will need to partner/form networks with firms in many markets.” In many sectors, the value chain will increasingly extend well beyond the developed markets and the BRICs, and the volume of business conducted in these markets will be significant. On the downside, global expansion into foreign and/or emerging markets has always carried with it traditional threats such as: currency, operational, regulatory, language, and cultural risk. Increasingly, a significant challenge lies in firms effectively managing outsourced business and supply chains in these markets. Recent events in the consumer products sector, for example, have demonstrated the specific need to focus on quality control standards and compliance testing when sourcing from relatively unknown suppliers in emerging economies.
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Winning the Battle for the Savings Market attract the assistance of wire houses, retail advisors or independent financial planners. Only a handful of competitors are offering wellplanned, valuable services to these segments, although most major financial institutions are circling the opportunity. Chris Raham Ernst & Young
Changing Financial Needs The baby boomer generation is retiring just as employers and governments are progressively disengaging from pension provision. As a result, the financial needs of individuals are changing dramatically. The central financial challenge for these retiring baby boomers is how to transform the wealth they have accumulated in their pension accounts into a steady income stream. To a large extent this is a decision that they will have to face alone. The vast majority of baby boomers have only three assets: house, occupational plans and social security. With the exception of the high net-worth segment, the value of additional savings is minimal. These trends will transform the savings-products industry, which so far, has been accumulation-oriented. The business challenge over next 15-20 years will be to create products for the pay-out phase. The strategic risk for insurers is their inability to adjust, develop products for new needs, and compete against other sectors of the financial services industry. How Can Insurers Capitalize on New Opportunities? • Occupational pension/cash-balance plans, and individuals in the mass market offer the most significant opportunities. Successful ventures here will benefit the largest segment of the population – those without sufficient wealth to
• In the defined contribution market, insurers should offer employers products that combine the accumulation and payout phase. These products transfer most of the risk from the individual to the insurance company. Combining the two phases can represent a competitive advantage. At present, the asset management industry has the capability to offer only investment products. • To sell against investment-only solutions, insurers must have the ability to provide key constituents with clear information about product benefits and competitive advantages from the employee’s perspective. Such assessments will help employers and their benefit consultants understand the value of the product. Insurers may also support the plan sponsor by providing financial advice to employees. • In the retail market, insurers must take steps to leverage their ability to write contracts that will provide more dollars of lifetime income per dollar of investment. A retirement program that combines decisions around the timing of social security elections, the use of home equity, and the disposition of cash balance plans into an easy-to-use, cost-efficient menu approach will be effective in the mass market. Barriers to Success – the Threat of Competition To be successful, insurers must change their approach to the competition and take a broader view of the market. For years, they have been focusing on competition among themselves. In the
US, for example, insurance companies have only a small share of the US savings market. Their true competition is represented by other providers of savings products, in particular, mutual fund entities. Insurers must become as aggressive as other institutions competing for the same dollar. As the only writers of payout annuity products, insurers should be well positioned to take advantage of the shift from accumulation to payout. However, they face three significant obstacles. • Most of the retirement wallet is now in the hands of other asset managers, who are in a strong position to retain customers. • Even though pay-out annuities provide the most income for a given investment, individuals dislike the idea of suddenly transferring all of their assets to the insurance company. They feel that they are losing control over the wealth and they would prefer to keep the money with the insurance industry’s competitors. • Some sales practices related to deferred annuities, have created negative sentiments that have been actively expressed in popular media and by regulators. Twenty five years ago, insurance companies were strongly positioned against asset managers to dominate the savings industry. Mutual funds were vulnerable and their market share was relatively small. However, insurers were complacent and lost the battle for individual retirement assets. The demographic shift is creating new demands that insurers are well-placed to satisfy. It would be a shame for insurers to repeat the same mistake and squander their opportunity to recapture lost territory.
Chris Raham is a Senior Advisor in Ernst &Young’s Insurance and Actuarial Advisory Services.
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“ These [emerging] markets can see growth of up to 40 to 50% per annum. In such an environment, local entrepreneurs have an advantage, and right now, a lot of local media companies are beating the global players in China and India.” Farokh T. Balsara, Ernst & Young
From Emerging Markets to Surging Markets – The Future of Global Media Growth 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. Farokh T. Balsara Ernst & Young
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% 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%, enabling the pushthrough 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
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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.
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% per annum. In such an environment, local entrepreneurs have an 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 T. Balsara is the National Sector Leader for Media & Entertainment and the Markets Leader for Advisory Services at Ernst &Young, India.
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.
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Industry Consolidation/Transition
Part of the consolidation phenomenon has been driven by the global M&A boom, which several analysts believe may slow in years ahead. However the majority of sector analysts we polled believed that industry transition would continue to pose a key strategic challenge in 2008. This continued transition will be driven, in most sectors, by underlying structural trends. One analyst, commenting on the auto sector noted, “Population growth and GDP growth are highest outside of the US, EU, and Japan, resulting in a global misalignment in the location of industry capacity and the location of demand. The industry, especially in the US market, is in transition including consolidation, restructurings and spin-offs.” Another analyst highlighted that, in asset management, transition entails the migration of the industry’s leading firms towards one of two opposing business models, “On the one hand, massive asset gathering [companies] that drive down costs and provide cheap access to markets and market risk and, on the other, those companies that… (as a business proposition) offer better-than-market returns.” In the media & entertainment sector, M&A is a central feature of many companies’ attempts to respond to the internet’s impact on the sector, for example, via the acquisition of ‘new media’ firms. Companies in other sectors may continue to merge, driven by competitive pressure. In banking, “Many of the deals are of sizes never-before experienced. The trend to become bigger and more dominant by acquiring existing franchises is an ongoing driver for growth.” And in telecoms, “Accelerated M&A trends in the telecoms industry will lead a transition to three to four players per country.” In utilities, one analyst commented, “Size is vital when negotiating with the owners of major primary resources; size is vital as some protection against hostile acquisition. Hence, the impact of failing to grow can be a loss of competitive supplies or even loss of the business.” There is a growth imperative in many sectors, and if it cannot be met by organic growth, then it may need to be met by acquisitions.
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Energy Shocks
Fluctuations in energy prices and access to supplies pose a clear challenge to the energy sector, including utilities and oil & gas. In utilities, for example, loss of access to competitively priced long-term fuel supplies is the top strategic risk. One analyst noted, “The impact on the business is the need to acquire short-term supplies to meet demand obligations and can lead to a huge loss of profitability, hence the need for skilled hedging of sources, types and timing of fuel supplies.” However, beyond the energy industry, a large swing in prices could also trigger economic shocks that could impact sectors such as insurance, consumer products and real estate. Few leading global companies are immune to this risk. One telecoms analyst remarked, “As more and more equipment is racked up in data centers, more and more power is needed to run and cool down the servers that are at the heart of the web infrastructure.” Even the virtual world needs ‘real’ world energy. Various potential causes of such energy shocks were noted, including a US strike on Iran, a breakdown in relations with Russia, contests for control of ‘strategic’ energy supplies, or an action to disrupt shipping through one of several key maritime choke points. The risks of a shock are also dramatically heightened in today’s environment of increasing energy nationalism. One analyst noted that on the supply side, “The development of the world’s oil & gas supplies over the past 40 years, with concomitant advances in extractive technologies, has been undertaken largely by private sector enterprises. Now, however, the global supply of prime energy fuels has become dependent on a few national, state-owned suppliers.” In the future, the risks associated with the continued and sustained supply of such fuels to the developed world may rise significantly. On the demand side, the risks from rising energy nationalism may be even greater, “Governments are increasingly convinced that energy security needs to be pursued actively. The reality may be quite different, but the perception could trigger a crisis [caused by] desperate efforts that countries may make to secure their supplies (paying above market rates, long-term deals, etc.). If markets then panic, this would cause governments to respond with even more uncoordinated, unilateral steps, making the situation infinitely worse.”
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“ New technologies will change the market. The successful utilities of the future will be those who make the bold decisions to flex their assets, supply chains, and operating models.” Tony Ward, Ernst & Young
A Loss of Access to Fuel Supplies – Mitigating the Risk Managing the Risks for Contracts and Fuel Supplies
Tony Ward Ernst & Young
Whilst global primary energy prices remain volatile, power utilities remain generally high-volume, lower-margin operations. The primary risk for utilities is to balance relatively short-term customer contracts with the longer-term nature of fuel supply and, in doing so, deliver access to economically attractive, secure and reliable contracts, whether for their primary fuel needs, or eventual customer off-take. In part, this is a matter of trading strategy, procurement and hedging, but the choice of technology to convert fuel to power, is also a key issue. Decisions made today to embed fuel needs, emissions profiles and cost drivers may have long-term implications. These assets can have economic lives of up to 50 years, and investment lead times of over five years, as is the case with some coal and all nuclear assets. The interaction of these two short and long-term pressures is mirrored in the convergence of the respective interests of the private sector utilities and national governments – the former managing their discrete businesses for profitable growth on behalf of their shareholders, and in competition with others, and the latter focusing on the aggregated concerns of diversity and supply-security of fuels, minimal environmental impact and overall national economic competitiveness.
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Securing access to fuels and supply contracts for a utility carries with it substantial risks and uncertainties. This is true both in mature markets with an aging infrastructure and greater competitive pressures, and in developing countries that may struggle to match generation capacity to rapidly growing demand. In committing to asset construction programs, companies face significant regulatory, market, financial, and public relations risks. Access to adequate amounts of capital at reasonable rates may also be a factor as the industry enters a period of escalating infrastructure investment. The effective management of the risks associated with pursuing organic growth will enable utilities to deliver predictable value to shareholders. Being flexible is the key to success for both governments and companies. At a national level, certain countries are responding by moving towards greater self-reliance, focusing on making use of local resources and markets, and looking for diversity of fuel technology and fuel type. Companies are building up their portfolio of relationships and supply sources with crossholdings and minority interests in assets. Key strategies to reduce the risk of supply shortages include scale, collaboration, supply chain shortening, infrastructure investments, new technologies and ‘convoy’ procurement of scarce resources. By ‘racing for scale’, companies, and increasingly, countries and regions (for example, the EU), are pursuing joint efforts to create larger entities which automatically create larger off-takes for suppliers. Scale mitigates risk through spreading the portfolio of contract
timescales, geographies, and fuel types, reducing reliance on vulnerable areas. Joint operations, asset swaps and other alliances may provide an alternative to a single company striving for scale. Collective weight can help in negotiations and the mitigation of risk. Shorter supply chains can also help to reduce the risk arising from intermediaries. This is especially true from a security of supply perspective, but can also limit overall losses. The use of local resources, an approach increasingly taken by companies, can also reduce the supply chain. Infrastructure and Technology Investment Infrastructure investments are needed to reduce supply shortages, especially in developing economies, and also to restore aging assets elsewhere. Investors are aware of the degree to which national politics can destroy their contractual positions. Given the long-term nature of these investments, investors require a clear understanding of the political environment and the risks. A national framework on security of supply is crucial in order to achieve investors’ confidence. New technologies will change the market. The successful utilities of the future will be those who make the bold decisions to flex their assets, supply chains, and operating models. Governments, and corporates, should consider a diversified fuel mix as an important means of mitigating the risk of loss of access to competitively priced long-term fuel supplies.
Tony Ward is a Director within the Transaction Advisory Services Team at Ernst &Young.
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Execution of Strategic Transactions
Strategic risks often result from an attempt to take advantage of major opportunities. Nowhere is this more evident than in the area of transactions. Too often a move that seeks to quickly and significantly respond to an opportunity, becomes an expensive and long-term risk in its own right. There is a major risk that transactions undertaken in response to industry consolidation may fail to deliver, not because they are poorly conceived, but because of a failure to meet operational challenges. This was perceived as a high risk by analysts in a number of sectors including auto, asset management, media and telecoms. A banking panelist wrote, “Stakeholders expect M&A to very quickly have a positive effect on the bottom line and create synergies between the acquirer and the target. Required integration may challenge the people, process, and technology of the combined entity. Stakeholder expectations may not be met or the deal may ultimately need to be unwound.” New types of strategic transactions, including divestitures in real estate, spin-offs in auto, and separation of telecom companies into utilities and service providers are driving further risk. While it is the big mergers that dominate the headlines, in some sectors, excellent execution of small and highly strategic transactions may have as great a competitive impact. Consumer products companies are, for example, using transactions more strategically to acquire innovation. Similarly, in asset management, firms are employing M&A in the hope of “acquiring… talent that cannot be home-grown.”
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Cost Inflation
We have been operating in a low inflation global economy for some time. Our analysts believe that the return of high inflation is a major risk. Cost inflation, though the result of various drivers, is a significant operational threat for all sectors. In oil & gas, for example, the problem extends from exploration all the way through the value chain, impacting everything from refinery build costs to pipeline construction costs. One sector analyst commented, “The impact on oil & gas companies is increased pressure on operating margins, higher risk investment profile, increased asset portfolio optimization, consolidation, and risk sharing arrangements. Companies with high cost reserves could be at risk of failure.” In many cases, these cost pressures are driven by changes to the fundamental structure of an industry. Demographic changes and the rising costs of health care are creating a serious challenge for US auto manufacturers. One analyst noted, “American automobile companies labor under the weight of health care costs eroding their international competitiveness.” Another predicted, “The aging workforce at established Western producers leads to costly buy-outs, benefits, and so on. There will be an ongoing decline in employment in the sector in the Western World, with large impacts for affected economies.” In biotech, cost inflation is driven by regulation, as well as the increasing focus on drugs targeting chronic diseases, which means that “clinical trials are increasingly expensive, and higher costs to develop drugs put pressure on raising capital and drug pricing.” In consumer products, by contrast, the structural shifts that make cost control such a strategic challenge are related to consolidation in retail. Consumer products are being squeezed between, on the one hand, a “consolidating base of retailers that has resulted in greater control over pricing through strong buying power and hard discounters” and, on the other, “volatility of raw materials prices,” making management of input prices a crucial challenge. In other industries, radically changing business models are making cost a centerpiece of competitive strategy. One notable example is asset management, where the best performing companies are often those that control costs through overall scale, or product specialization.
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“ This issue of climate change extends beyond just managing regulatory risk. Climate change and the regulatory and consumer response must be seen as a fundamental strategic challenge. We can expect a future of carbon labeling on products, carbon trading worldwide, and tight regulation and heavy taxes on carbon.” Jonathan Johns, Ernst & Young
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Radical Greening
We use the term radical greening to apply to the increasing environmental concerns which could be the result of a wide range of pressures – from the voluntary world of corporate social responsibility – to hard regulatory and economic necessity. Radical greening is a strategic risk, partly driven by the consumer and regulatory responses to climate change, and also by the weather events resulting from climate change. A specialist in science and international affairs wrote, “Current climate predictions are based on models and, naturally, the scenarios communicated to the policy world are the scientifically conservative scenarios (i.e., those which most scientists agree are likely). Yet scientifically conservative scenarios are not necessarily what will happen; it is possible that the hazard is actually more imminent than is commonly understood. In this case, we may see physical climate surprises as well as an increased policy response that is more abrupt than most firms are currently planning for.” In the short term, barring such unexpected developments, the strategic challenge centers on how much ‘radical greening’ firms should undertake. Going green is expensive, but could pay dividends if consumer tastes and regulation shift quickly. For example, in real estate ownership, some analysts favored firms with ‘green’ portfolios. One analyst noted, “As ‘green’ becomes law it could result in forced obsolescence and write-downs for nongreen real estate assets along with substantial capital expenditure obligations to meet the new standards.” In a similar vein, in utilities, “Carbon trading is a reality in Europe and will almost certainly happen in the US. The caps that are set directly influence the cost of generation with different fuels and hence can make a nonsense of the wrong fuel generation mix strategy. Fixed ages for renewable generation are also likely to come. The imposition of fixed percentages of renewable power can expose severe strategic errors of corporate judgment.”
Consumer Demand Shifts
Our final strategic risk for business in 2008 is the failure to anticipate and respond to consumer demand shifts. There are a number of examples of such shifts, perhaps the most obvious being the demand for ‘green’ products or services. Other trends have already been mentioned, including those driven by demographic shifts, such as growing consumer aging. It is the task of business to identify and respond to changes in demand. Such a challenge moves to be a strategic risk when the changes are significant, fast or unexpected. A general theme across the sectors was the challenge posed by consumer empowerment making this an area of strategic risk. In media & entertainment, for example, one Ernst & Young panelist highlighted that, “Consumers today have more power than they did 10 years ago. Consumers are controlling the decisions about the content they receive and how they receive it. Consumers today are driving the content and distribution channels.” In auto, “Increased interest in customization of products requires a shift away from mass-production philosophies.” Or, as another consumer products panelist noted, “Factors such as the web, deregulation of markets and globalization will continue to lead to a rise in customer expectations and basic customer segmentation strategies are already becoming less and less effective, as customers look for individualized and customized purchase experiences.” As technology continues to expand consumer power, this challenge may well rise higher on the radar in the years ahead.
The pace and extent of this new ‘green revolution’ is hard to predict – but what is almost certain is that some firms will get the right fuel mix, real estate portfolio, or carbon footprint, while others will go either too radically green or, more likely, not green enough.
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How to Deal with Climate Change Regulation The climate change debate has made the environment the biggest single issue in the public’s mind. We are moving closer to a world of zero tolerance for environmental accidents and we have started to see this in recent incidents involving oil & gas firms. Jonathan Johns Ernst & Young
Many oil & gas firms are already demonstrating leading practice in environmental compliance, but in a zero tolerance environment mistakes will occur. New roles, such as an environmental officer, will begin to emerge at the corporate level. There may also be regular, independent audits of procedures and we could even see the emergence of environmental stakeholders on an independent board. This issue of climate change extends beyond just managing regulatory risk. Climate change and the regulatory and consumer response must be seen as a fundamental strategic challenge. We can expect a future of carbon labeling on products, carbon trading worldwide, and tight regulation and heavy taxes on carbon. Companies must make a fundamental decision about where they want to be in the new carbon economy. For many companies, the decision is whether to adopt a minimal response and simply follow regulation or to make an active decision to reduce their carbon intensity, which could be
achieved by offering blended products, a strategy of acquisitions or by mitigating through carbon sequestration and storage. Others may decide to go one step further and offer services that help their customers to manage their carbon footprint. The climate change agenda also presents opportunities for skills transfer, for example, many of the capabilities that make a firm a leader in offshore oil also apply to offshore wind. Moving into renewable energy is not a ‘one size fits all’ solution. The fossil fuel era is not over yet. For reasons of security of supply and economic growth, petroleum will be used for some time yet. The degree of repositioning will vary and will depend on the character of the company, but many firms are finding renewables and clean energy a profitable activity. Measures such as green-friendly tax regimes, carbon trading and carbon labeling on consumer products are, however, accelerating the movement. Those companies that are carbon-friendly will have a competitive advantage and also be able to better attract the young talent they need for the future.
Jonathan Johns is a Partner in the Infrastructure Advisory – Renewables, Waste & Clean Energy Group at Ernst &Young LLP, UK.
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“ Advances in technology have enabled improvements in content delivery at unprecedented levels. Consumers are now in charge, empowered by technology.” John Nendick, Ernst & Young
Responding to Shifts in Consumer Demand
John Nendick Ernst & Young
The media & entertainment industry continues to evolve at a pace unimaginable even five years ago. Advances in technology have enabled improvements in content delivery at unprecedented levels. Empowered by mobile technology and new home entertainment devices such as digital video recorders (DVRs), consumers are in charge. They insist on programming tailored to their individual tastes, preferences and schedules and they take their audio and video streams on the road and around the world. We now live in an era where consumers expect consumption of their personalized content anywhere, anyhow and anytime. Three years ago in an Ernst &Young survey of Global Media & Entertainment company CEOs, 75% of those surveyed believed that DVRs would have the biggest impact on the industry. In a similar Ernst &Young 2006 study of leading finance executives, over 80% of the participants thought that personal entertainment and communication devices and changing content and distribution models would have the biggest impact on the industry over the next 2-3 years. Technology is dramatically changing the playing field for content production as well. It seems that anyone with a digital device and broadband capacity can produce his or her own content overnight and distribute it to a global audience via the internet. This growth in user generated content with internet distribution capability has broken down barriers to entry and changed the traditional media production and distribution model overnight.
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Aware of the issues that faced and damaged the music business over the last 5-10 years, media & entertainment companies are focused on maximizing the healthy margins and cash flows from the mature businesses such as newspapers and magazines and radio and television broadcast, while being proactive in the search for new internet and mobile device enabled distribution platforms for both their content and the related advertising. Within this strategic process reside a number of key tactical issues whose execution can be as important as the strategy itself. These include assessing the nature of the relationship and business model with the internet media company or mobile device business, be it merger, joint venture, or basic contractual distribution or license arrangement. Digging deeper, a number of other issues arise including assessing the new risks and appropriate controls surrounding these new relationships, assessing the tax implications and ensuring that revenue is being received in accordance with the arrangement as well as appropriate contractual payments made for the rights of distribution.
John Nendick is the Global Leader of Ernst &Young’s Media & Entertainment Center.
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The Next Five • War for Talent • Pandemic • Private Equity’s Rise • Inability to Innovate • China Setback
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. We review here the ‘next five,’any of which could easily rise into the top 10 list in the future. 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.
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“ In the near future, banks will not be able to say they are global unless they have a presence in China, India and a few other countries, because these emerging markets are going to be a major source of financial sector revenue and profit growth.” Keith Pogson, Ernst & Young
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 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.
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The Importance of Private Equity including operational efficiencies, is also a very important element of earnings growth in both the US and Europe, accounting for 23% and 31% respectively of the total growth in earnings What are the Secrets of Private Equity’s Success? Simon Perry Ernst & Young
Growth Continues The annual Ernst &Young study ‘How do Private Equity Investors Create Value?’ revealed how the Private Equity (PE) industry is consistently able to grow and strengthen the companies under its ownership. By focusing on the business performance and strategies of PE firms across the largest deals exited throughout 2006, the study confirmed that the annual rate of growth in Enterprise Value (EV) achieved last year by the largest Private Equity-backed businesses significantly outperformed equivalent public companies in the same country, industry sector and timeframe. Average annual EV growth rates were 33% in the US and 23% in Europe, compared to public company equivalents of 11% and 15% respectively, with over 80% growth in total enterprise value. Private Equity ownership creates value from sustainable improvements in performance and business growth. Two-thirds of the earnings growth in PE-owned companies comes from business expansion, with increases in organic revenue being the most significant element. This includes the benefits of investment in sales and marketing, new product launches, acquisitions, investment into attractive industry sectors in the US, and expansion into new geographies in Europe. Cost reduction,
The study showed that Private Equity investors are highly selective and well researched when making the decision to buy a business and have the ability to drive real efficiencies through the business plan under their ownership. This finding was true across deals in the US and all main European countries. Three-quarters of investments resulted from proactive deal origination strategies, including company or sector tracking, building relationships with management, or introductions from established contacts. Across almost all deals and ownership strategies, Private Equity investors were actively involved in the business after acquisition, making rapid decisions alongside management, challenging progress and making available specialist expertise. The intensity of engagement between Private Equity investors and management was often stronger than under the previous owners. This rapid growth in the scale and success of Private Equity has brought with it increased scrutiny: politicians in many countries are reviewing whether and how to regulate and tax the industry; corporates are considering how to compete with and learn from the different business model; concerns are being raised about the security of jobs and employment benefits. Despite those concerns, the clear advantages of the Private Equity model are likely to result in continuing investment and growth.
The Credit Crunch – Implications for Private Equity Recent developments in the credit markets may have caused concern. The liquidity crunch has meant that the debt markets are more or less closed for new large LBO deals resulting in a significant slowdown in transactions. Market participants view this as a short term dip in activity prior to returning to a more rational climate in 2008. There is a long term belief in the PE model by the market and the long term fundamentals remain strong. The recent events may well prompt a more conservative approach by banks, when doing deals. This could result in an increasing need for due diligence at acquisition. Although the credit squeeze may reduce the benefits from leverage and enhance the importance of underlying profit growth, Private Equity will continue to be an important factor in the world’s financial markets. What are the implications of the continued growth of Private Equity for corporates? Every company needs to develop a strategy for engaging with Private Equity, whether partnering with, buying from, selling to or competing with them.
Simon Perry is the Global Head of Private Equity at Ernst &Young.
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“ Individual companies need to consider the potential impact of a global pandemic on their workforce, infrastructure, supply chains and operational capabilities.” Dr. David Shotton, University of Oxford
Will the Pandemic Make You or Break You? in whom it is abnormally deadly, killing roughly 60% of confirmed patients. The number of human deaths that might occur if H5N1 became easily transmissible between humans is impossible to estimate, but may far exceed the 67 million deaths caused by the Black Death. Dr. David Shotton University of Oxford
Pharmaceutical companies are well accustomed to dealing with frightening diseases. Think of it this way: the ability of pathogens to evolve rapidly into forms that can evade the adaptive defenses of the human immune system is, in a sense, a biological arms race. In any form of warfare, arms manufacturers stand to make significant profits. In the fight against infectious diseases that present a risk of epidemics, pharmaceutical companies provide the front-line weapons for the defense of humanity. However, an influenza pandemic is different. It is different because it will present overwhelming operational challenges that will cause many companies, including pharmaceutical companies, to fail. Flu pandemics occur on average once every 30 years. The last one, the ‘Hong Kong flu’ of 1968, was relatively mild, killing ‘only’ one million people. The last severe influenza pandemic was the ‘Spanish flu’ of 1918, which killed an estimated 40 million people. The most likely candidate for the next pandemic is the current H5N1 strain of avian influenza, which is highly pathogenic to birds. This has spread rapidly (more than half the countries in which it has appeared first reported the disease in 2006), and can infect humans,
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A flu pandemic differs in three principle ways from most other forms of natural disaster. First of all, it is of extended duration, with two or three successive waves of infection each lasting 10-12 weeks, separated by several months. Secondly, it will disrupt all aspects of society, causing a breakdown of most normal services and, most likely, widespread civil unrest (e.g., looting). Thirdly, because of its global nature, there will be no ‘outsiders’ to come to the rescue and thus recovery by the survivors will be slow. The potential economic cost of the global recession such a pandemic would trigger is put in trillions of dollars. Individual companies need to consider the potential impact of a global pandemic on their workforce, infrastructure, supply chains and operational capabilities. How will you continue to function when key staff are ill or dead, absenteeism is at 50%, normal travel and trade have been severely curtailed, and there are national shortages of food and energy? The decision to make adequate preparation for a flu pandemic must come from the highest levels of management and involve every department – this can make the difference between the survival or the collapse of companies. Pharmaceutical companies must
develop contingency plans detailing what to do in preparation now, how to cope during the pandemic, and how to survive afterwards during the long recovery process, where the wellprepared will have large commercial advantages. Critical functions must be defined, and plans made for backup, cross-training and working from home, using decentralized IT. Essential supplies including emergency generators, fuel and raw materials may need to be stockpiled if work is to continue. Provision must be made for illness and deaths on the work premises, and for the care and quarantine of those affected. Clear criteria are required concerning who will trigger the emergency plan and under what circumstances, and any plan must be tested in reality and refined iteratively.
David Shotton is Reader in Image Bioinformatics within the Department of Zoology, Mathematical, Physical and Life Sciences Division, University of Oxford.
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Explosive Expansion in Asian Banking
Keith Pogson Ernst & Young
Three of China’s banks are already included in the global top 10 banks by market capitalization. Chinese banks bring a new and decisive competitive advantage as they have a very different cost base. They have lots of cash, and with a 40% savings rate in China, that liquidity isn’t going away. These banks are also able to borrow at 1 to 2% so they can easily lend at 3 to 4% and make a couple of hundred basis points. These banks could be concerned about losses from a revaluation of the renminbi (currency of the People’s Republic of China), but these banks are extremely motivated to go global. Eighty to 90% of their exposure is to the Chinese economy, so almost anything outside of China creates diversification and reduces their risk. This makes major global expansion, including acquisitions likely to happen, which will have a major impact on global markets within three years.
The Risks for Global Banks Entering Asia
The Top Risks for Asian Banks
If foreign banks enter the Asian market too late, they will be unable to keep up with the competition. In the near future, banks will not be able to say they are global unless they have a presence in China, India and a few other countries, because these emerging markets are going to be a major source of financial sector revenue and profit growth.
The main threat for Asian banks is that they are transforming very rapidly from government bureaucracies into corporate governance and transparency-driven organizations.
The second major risk is the failure to manage internal controls. This is especially true for a European or American bank, that may have limited knowledge of the fast-paced growth in distant markets. The question for many is what to do first, implement their control infrastructure or grow revenues? Foreign banks can find themselves in a situation where they are suddenly managing 50,000 people instead of 50 people. This stresses existing controls and can lead to serious mistakes with global consequences. The third risk for foreign banks is regulation. Regulators in Asia have varying degrees of sophistication and regulatory responses can be local or political, which can be difficult to address. Reputation is critical to market entry and a bad reputation could result in a foreign bank being barred from a market.
This could lead to significant challenges, some of which could threaten their survival. For example, Chinese banks have enviable cost-income ratios of 35%. But these ratios often rely on cheap, manual labor. As China develops and labor costs rise, banks will need to automate to keep costs down. Some of these banks have 10,000 or more branches. If a system is automated incorrectly, this ‘cost saving’ might cause profitability to collapse. Another major issue is deregulation. Some of these banks will make the transition to a deregulated, more competitive environment, and some will not. In China, the central bank maintains a 300 basis point borrowing-to-lending spread. When this situation changes, and these banks suddenly need to manage interest rate risks, not all of them will be able to manage these effectively.
Keith Pogson is the Financial Services Leader, Far East Area at Ernst &Young.
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Conclusion This has not been a random selection exercise but, rather, a structured consultation with both sector and subject-matter experts from around the world. They have identified trends and uncertainties, and assessed risks and their impact both on individuals and on the markets the conclusions merit attention.
Properly approached, the process of risk management can add value even if, fortunately, the event never happens.
Together, we have identified the top 10 risks for business for the coming year and have outlined our view of other major risks that lie just “below the radar.” These are not predictions, but considering them can help companies to prepare. We acknowledge that this is just a snapshot of the risks that we see at this time. Change is constant in the market so risks will change over time; so do our perceptions. If we had done this exercise 10 years ago, it is fair to question whether climate change would have featured so significantly. The climate was already changing, but our awareness of the fact and our perception of its importance was much different. Yet, even as a snapshot and even recognizing the consistency of change, no company should treat this list as applying in totality to them. Just as the global market is everywhere and yet, paradoxically, nowhere – each point of contact, each purchase or sale, is both specific and local. So it is with strategic business risk. We have done the analysis and mapped out our conclusions accurately for the macro-economy. Yet, for every sector, and indeed, for each company within a sector, the strategic business risks will vary. This was the hypothesis for our research and why we have based the work on the 12 sectors. Our studies show tremendous variation in risk and the relative importance of each factor depending on sector. Today’s Strategic Risk could be Tomorrow’s Strategic Opportunity So what is the value of such analysis and what, most importantly, should management do with it? We hope that our work illustrates the range of strategic business risks that companies need to be aware of. We have consulted widely, but this is not an exhaustive study and there can be no exhaustive list of risks. We hope some of the risks we have identified surprised you and some of the weightings that we have attached to them in the rankings differ from those that you would apply. This is an ongoing dialog and one we believe that you need to have within your organizations. You may have in place your own equivalent of a strategic business ‘risk radar’, but how is this kept current, and does it adequately warn you of potential strategic risks in an appropriate manner?
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Test your corporate competency in identifying, assessing, managing and monitoring strategic risk. Turn today’s strategic risk into tomorrow’s strategic opportunity.
Properly approached, the process of risk management can add value even if, fortunately, the event never happens. One client we worked with was concerned about the impact of avian flu on their business. In working through scenarios and impact analysis, the client identified numerous opportunities to tighten processes and controls that have had a beneficial impact despite the non-occurrence of the pandemic that they feared. It was the dialog and management action that delivered the value, not an improved response to the event. Our work with companies around the world suggests that there is a body of leading risk management practice emerging, but that many companies are still doing too little in this area. In our recent study, Companies on Risk: The Benefits of Alignment, 42% of global companies identified gaps in their risk coverage. Our subsequent study found that, overwhelmingly, these gaps were in business and operational areas, rather than financial. There is a growing recognition of the problem – indeed 66% of companies in the same study forecast that their investment in risk management was going to increase over the next three years. 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% 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.
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Contacts Risk Advisors
Name:
Telephone:
E-mail:
Global
Jim Holstein
+1 216 583 4001
[email protected]
Americas
Frank Gori
+1 216 583 2981
[email protected]
Central Europe
Gerd Stuerz
+49 211 9352 18622
[email protected]
Continental Western Europe
Maxime Petiet
+33 1 55 61 3147
[email protected]
Northern Europe, Middle East, India & Africa
Alan McGuinness
+44 207 951 4119
[email protected]
Singapore
Michael Sim
+65 6309 6706
[email protected]
Japan
Takaaki Nimura
+81 3 3503 1272
[email protected]
Oceania
Craig M. Jackson
+61 2 8295 6551
[email protected]
Business Risk Services
Inge Boets
+32 3 270 1223
[email protected]
Financial Services Risk Management
Lawrence Prybylski
+1 212 773 2823
[email protected]
Tax Accounting and Risk Advisory Services
Joseph Hogan
+41 58 286 3184
[email protected]
Technology and Security Risk Services
Paul van Kessel
+31 20 549 7271
[email protected]
Fraud Investigation and Dispute Services
David Stulb
+1 212 773 8515
[email protected]
Actuarial Services
Tim Roff
+44 207 951 2112
[email protected]
Sector Leaders
Name:
Telephone:
E-mail:
Automotive
Mike Hanley
+1 313 628 8260
[email protected]
Asset Management
Ratan Engineer
+44 207 951 2322
[email protected]
Banking & Capital Markets
Jim Fanning
+1 212 773 3144
[email protected]
Biotechnology
Glen Giovannetti
+1 617 859 6598
[email protected]
Consumer Products
Howard Martin
+44 207 951 4072
[email protected]
Insurance
Peter Porrino
+1 212 773 8468
[email protected]
Media & Entertainment
John Nendick
+1 213 977 3188
[email protected]
Oil & Gas
Rob Jessen
+1 713 750 4952
[email protected]
Pharmaceutical
Carolyn Buck-Luce
+1 212 773 6450
[email protected]
Real Estate
Dale Anne Reiss
+1 212 773 4500
[email protected]
Telecommunications
Vincent De La Bachelerie
+33 1 46 93 6205
[email protected]
Utilities
Ben van Gils
+31 10 406 8555
[email protected]
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About Ernst & Young Ernst & Young, a global leader in professional services, is committed to restoring the public’s trust in professional services firms and in the quality of financial reporting. Its 114,000 people in 140 countries pursue the highest levels of integrity, quality, and professionalism in providing a range of sophisticated services centered on our core competencies of auditing, accounting, tax, transactions, risk and business advisory. We help organizations achieve their business objectives by delivering a wide range of Risk Advisory Services that are designed to help enhance risk management activities and improve business processes. From our network of member firms around the world, Ernst & Young’s 14,000 risk advisory professionals provide services that help clients assess, improve, and monitor their business risks. Further information about Ernst & Young and its approach to a variety of business issues can be found at www.ey.com/perspectives. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited does not provide services to clients.
Oxford Analytica Oxford Analytica is an international consulting firm drawing on over 1,000 senior faculty members at Oxford and other major universities and research institutions around the world. It acts as a unique bridge between the world of ideas and the world of enterprise. Founded in 1975 by Dr. David R.Young, Oxford Analytica has built an international reputation for seasoned judgement on and analysis of geo-political, macroeconomic and social developments, and their implications for industries and governments worldwide. Further information about Oxford Analytica can be found at www.oxan.com.
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© 2007 EYGM Limited. All Rights Reserved. This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.
EYG No. AU0076 Job No. 11106 11/07. Designed by Living Designs, London
