Political and Financial Risk Analysis: LG, Sony, and Xiaomi

Introduction: Evaluating Three Acquisition Targets

The three companies evaluated for potential purchase are LG, Sony, and Xiaomi. While portions of this report address the individual companies, much of the analysis focuses on the country situations in which these companies operate. They hail from South Korea, Japan, and the People's Republic of China, respectively. The differences among these Northeast Asian countries can be significant, and it is these differences that should capture the attention of any executive evaluating the investment decisions.

There are two elements of risk that are most important in this report: political risk and financial risk. Political risk reflects the possibility that the value of an investment could change based on shifts in the political environment of the target country (Investopedia, 2014). Any evaluation of a major overseas purchase will include political risk as a factor; when political risk increases, it raises the discount rate applied to future cash flows, thereby reducing the value of the investment. Nobody is particularly concerned about a reduction in political risk — the concern runs in only one direction.

Financial risk comes in several forms. One of the most important is foreign exchange rate risk, which differs considerably across these three countries. Other financial risks also merit attention. Some countries have enacted currency exit controls, making it difficult to repatriate investments. In other cases, there are limitations on how much currency can be converted at any given time. These different financial risks are evaluated throughout this paper, concluding with a recommendation about the best country in which to invest. The choice of company will likely involve a number of operational factors that are beyond the scope of this report.

LG and South Korea: Political and Currency Risk

LG was founded in South Korea in 1947 but emerged on the international scene in the 1990s, growing considerably in prominence since then. LG's structure is typical of a South Korean chaebol: a holding company with several major groups beneath it. For LG, these groups are electronics, chemicals, and telecommunications. If a purchasing company is interested in one of these groups specifically, there will be significant political considerations, since breaking up a chaebol is somewhat unusual and carries more complexity than a simple acquisition.

Industry data shows that LG holds 4.8% of the mobile vendor market in the United States, making it the fifth-largest company in a relatively diffuse industry where the companies below it collectively hold a 46.7% share (IDC, 2014). The mobile business is therefore important to LG and would likely command a premium. It would also bear significant political risk, because the South Korean government has invested considerable energy in building LG and its compatriot Samsung into global telecom and mobile powers. The political risk factor for LG must therefore be considered at least moderate.

There are several aspects to consider regarding the financial risk associated with doing business in South Korea. LG has a global presence, which is favorable in that it produces diversification of cash flows worldwide, but the company's share is particularly strong in South Korea and most of its employees are based there. Purchasing LG would therefore expose a buyer to the South Korean won to a significant degree. The won has floated freely since 1997, a change that coincided with the Asian financial crisis and led to immediate and substantial devaluation. It has been since that point that South Korea was able to grow its export businesses substantially — a weak won is advantageous for a company like LG that exports a wide range of goods globally. Freely floating currencies are favorable because they allow companies ample hedging opportunities. While the market in won is only of moderate size, there are still opportunities to hedge won exposure through futures. The one downside is that the won–USD pairing does not achieve the best spreads, especially on derivative products.

Exposure to the won also means exposure to the Bank of Korea and the Korean economy more broadly. There is an element of destabilization risk, and it would be remiss not to note that both the nation and its currency carry a high level of exposure to the uncertain conditions across the demilitarized zone. North Korea remains in a state of uncertain leadership, and any deterioration in its political stability could affect the South Korean economy and currency.

Another consideration is the short-term condition of the South Korean economy. The country has experienced long-run expansionary conditions since 1997, but the current state has been characterized as a "fragile recovery," to the point where further stimulus — either monetary or fiscal — may be required (Kim, 2014). Monetary stimulus, including interest rate cuts, would result in further devaluation of the won. One noteworthy point is that the Bank of Korea sets monetary policy in part through consultation with the major chaebols, so it is quite possible that LG has a seat at the table when monetary policy is being determined. Monetary policy is also often set with China in mind, since the PRC is the major destination for South Korea's manufacturing and component exports (Kim, 2014). Whether a new foreign owner of LG would retain the same degree of privilege is unknown, and if a buyer acquired only one part of LG, it would not retain any of LG's existing privileges.

Overall, South Korea is a moderately favorable country in which to own a company. The economy is relatively stable and modern, with an emphasis on a healthy manufacturing sector. LG is one of the major chaebols that play a large role in the Korean economy, to the point of being invited to participate in monetary policy discussions with the Bank of Korea. The South Korean won trades freely, enabling currency hedging, and South Korea conducts trade with the major nations of the region as well as the United States. Foreign exchange rate risk is therefore moderate at best. Political risk exists, primarily associated with instability in North Korea and the likely reduction in political privilege that would accompany any LG unit separated from the broader LG chaebol. Such a reduction needs to be priced into any acquisition.

A final factor is that any acquisition must be a good fit not only strategically but operationally. Culture is a significant risk factor in foreign acquisitions, and when cultural fit is poor it can be difficult to realize the advantages expected. In this instance, the choices are among South Korea, Japan, and the PRC — all are challenging cultures for an American company, and all are likely to make for difficult integrations.

Sony and Japan: Stability and Macroeconomic Concerns

Like LG, Sony is a major conglomerate operating across a wide range of industries, including photography, televisions, video, data storage, computing, and entertainment. Sony's sales are geographically diversified, with the United States as its largest market, followed by Europe and then Japan. Where LG is a chaebol with strong political ties, Sony is not considered part of the Japanese equivalent, the keiretsu. Instead, Sony operates more as a typical multinational, which actually reduces political risk because it is less central to the health of the Japanese national economy and less tied to national pride than a keiretsu member would be.

Japan is a modern, stable economy and a full participant in global trade. It has a strong manufacturing base but is moving toward a service economy, certainly more so than the other two countries under consideration. Japan is one of the world's largest economies, both in raw size and on a per capita basis, and is therefore the closest of the three countries to the United States in terms of economic development. This does not mean, however, that the two countries share many other similarities — they do not — and there will inevitably be cultural issues with any acquisition of a Japanese company or subsidiary.

Sony, being a global business, presents a different foreign exchange rate risk profile than either LG or Xiaomi. Sony's sales are split fairly evenly among USD, JPY, and EUR, with some GBP and other major currencies as well. However, the vast majority of costs are denominated in JPY. This means most revenue is already in the world's three major currencies, and Sony's other significant markets tend to be in other major currencies such as CAD, AUD, and CHF. This is advantageous for a potential acquirer. The United States is Sony's biggest market, which minimizes USD exposure on the revenue side, and the diversified nature of Sony's revenue among major currency pairings reduces the overall need for hedging. When hedging is required, it will be straightforward, as the USD–JPY, JPY–EUR, and USD–EUR pairings are among the most liquid in the world. Foreign exchange rate risk with Sony is therefore low.

There is some measure of economic risk, however. Though Japan is a wealthy and stable country, it occupies an unusual macroeconomic position that generates financial risk. The overnight rate has been approximately 0.1%, and the Bank of Japan's policy rate has been essentially zero for nearly all of the past fifteen years (Global-Rates.com, 2014). This means the central bank has limited conventional tools to address recessions or stimulate economic growth. As a result, Japan may be more susceptible to economic downturns, particularly in Asia, than almost any other developed economy. The prolonged period of economic sluggishness has also placed the Japanese banking system in a precarious position — a factor that any company considering a major stake in a Japanese corporation should bear in mind (IMF, 2012).

The political environment in Japan is considered stable, and Japan is valued as a business partner because of its stable democracy and well-educated, affluent population. Political risk would be categorized as low. There is essentially no risk of nationalization. Because Sony is not part of a keiretsu, there is less likelihood of government involvement in any sale of a Sony business unit, particularly if Sony's own management supports the transaction with the Japanese government. As a general rule, an acquirer can expect few difficulties, particularly if it commits to maintaining employment levels — the one genuinely sensitive political issue in Japan.

Culture will nonetheless be a factor in Japan, which does not have a strong history of successful mergers with Western companies. While examples such as the Renault–Nissan alliance show that cross-cultural partnerships can work given sufficient time and effort, language and cultural barriers raise the risk that an acquisition will not integrate well with a parent company, making it harder to extract expected value from the investment.

Overall, Japan is a relatively low-risk environment in which to invest, particularly if local management of Sony or its subsidiary is essentially left in place — an approach that would further reduce political risk. Sony offers diversified revenue flows from around the world in major currencies, substantially reducing foreign exchange rate risk. While some risks exist in the Japanese economy and banking system, this is a major world economy, and even if a crisis were to damage the Japanese economy, recovery would be expected.