Strategic business risk 2008 — The top 10 risks for business 20 John Nendick Ernst & Young Responding to shifts in consumer demand The media and entertainment industry continues to evolve at a pace unimaginable even ve 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 and 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 nance 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 eld 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. Aware of the issues that faced and damaged the music business over the last 5-10 years, media and entertainment companies are focused on maximizing the healthy margins and cash ows 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 and Entertainment Center. “ Advances in technology have enabled improvements in content delivery at unprecedented levels. Consumers are now in charge, empowered by technology.” John Nendick, Ernst & Young 21 Strategic business risk 2008 — The top 10 risks for business • War for talent • Pandemic • Private equity’s rise • Inability to innovate • China setback Thenextve 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 ve,’ 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 and 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 signicant. The potential market, economic and operational impacts of an avian u 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. Strategic business risk 2008 — The top 10 risks for business 22 “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 marketsaregoingtobeamajorsourceofnancial sectorrevenueandprotgrowth.” Keith Pogson, Ernst & Young Most manufacturers’ largest markets are mature. Stagnation in mature markets means that companies have to innovate to ndprot.However,innovationis 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 rms 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 ow 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 nancial shocks. The threat of an Inability to Innovate is signicant 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 difcult: 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 nd prot. 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 ve’ 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 and 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 rms worldwide must manage the risks arising from potential instability in the US dollar or US nancial 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. 23 Strategic business risk 2008 — The top 10 risks for business Simon Perry Ernst & Young The importance of private equity 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 rms across the largest deals exited throughout 2006, the study conrmed that the annual rate of growth in Enterprise Value (EV) achieved last year by the largest private equity-backed businesses signicantly 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 signicant element. This includes the benets 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, including operational efciencies, 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? 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 efciencies through the business plan under their ownership. This nding 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 benets. 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 signicant 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 benets from leverage and enhance the importance of underlying prot growth, private equity will continue to be an important factor in the world’s nancial 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. Strategic business risk 2008 — The top 10 risks for business 24 Dr. David Shotton University of Oxford Will the pandemic make you or break you? 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 signicant prots. In the ght against infectious diseases that present a risk of epidemics, pharmaceutical companies provide the front-line weapons for the defense of humanity. However, an inuenza 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 u’ of 1968, was relatively mild, killing ‘only’ one million people. The last severe inuenza pandemic was the ‘Spanish u’ of 1918, which killed an estimated 40 million people. The most likely candidate for the next pandemic is the current H5N1 strain of avian inuenza, which is highly pathogenic to birds. This has spread rapidly (more than half the countries in which it has appeared rst reported the disease in 2006), and can infect humans, in whom it is abnormally deadly, killing roughly 60% of conrmed 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. A u 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 u 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 well-prepared will have large commercial advantages. Critical functions must be dened, 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 rened iteratively. • David Shotton is Reader in Image Bioinformatics within the Department of Zoology, Mathematical, Physical and Life Sciences Division, University of Oxford. “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 25 Strategic business risk 2008 — The top 10 risks for business Keith Pogson Ernst & Young Explosive expansion in Asian banking 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 diversication 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 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 nancial sector revenue and prot growth. 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 rst, implement their control infrastructure or grow revenues? Foreign banks can nd 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 difcult to address. Reputation is critical to market entry and a bad reputation could result in a foreign bank being barred from a market. The top risks for Asian banks The main threat for Asian banks is that they are transforming very rapidly from government bureaucracies into corporate governance and transparency-driven organizations. This could lead to signicant 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 protability 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. Strategic business risk 2008 — The top 10 risks for business 26 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 identied trends and uncertainties, and assessed risks and their impact both on individuals and on the markets the conclusions merit attention. Together, we have identied 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 signicantly. 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 specic 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 identied 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 dialogue 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? Properly approached, the process of risk management can add value even if, fortunately, the event never happens. 27 Strategic business risk 2008 — The top 10 risks for business 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 u on their business. In working through scenarios and impact analysis, the client identied numerous opportunities to tighten processes and controls that have had a benecial impact despite the non-occurrence of the pandemic that they feared. It was the dialogue 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 Benets of Alignment, 42% of global companies identied gaps in their risk coverage. Our subsequent study found that, overwhelmingly, these gaps were in business and operational areas, rather than nancial. 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 denes 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 ve 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 nancial 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. Test your corporate competency in identifying, assessing, managing and monitoring strategic risk. Turn today’s strategic risk into tomorrow’s strategic opportunity. Strategic business risk 2008 — The top 10 risks for business 28 Contacts Global advisory Name Telephone E-mail Norman Lonergan +44 207 951 6479 nlonergan@uk.ey.com Risk advisors Name Telephone E-mail Americas Frank Gori +1 216 583 2981 frank.gori@ey.com Central Europe Gerd Stuerz +49 211 9352 18622 gerd.w.stuerz@de.ey.com Continental Western Europe Maxime Petiet +33 1 55 61 3147 maxime.petiet@fr.ey.com Northern Europe, Middle East, India & Africa Alan McGuinness +44 207 951 4119 amcguinness@uk.ey.com Singapore Michael Sim +65 6309 6706 michael.sim@sg.ey.com Japan Takaaki Nimura +81 3 3503 1272 nimura-tkk@shinnihon.or.jp Oceania Craig M. Jackson +61 2 8295 6551 craig.m.jackson@au.ey.com Business Risk Services Inge Boets +32 3 270 1223 inge.boets@be.ey.com Financial Services Risk Management Lawrence Prybylski +1 212 773 2823 lawrence.prybylski@ey.com Tax Accounting and Risk Advisory Services Joseph Hogan +41 58 286 3184 joseph.hogan@ch.ey.com Technology and Security Risk Services Paul van Kessel +31 20 549 7271 paul.van.kessel@nl.ey.com Fraud Investigation and Dispute Services David Stulb +1 212 773 8515 david.stulb@ey.com Sector leaders Name Telephone E-mail Automotive Mike Hanley +1 313 628 8260 michael.hanley02@ey.com Asset Management Ratan Engineer +44 207 951 2322 rengineer@uk.ey.com Banking and Capital Markets Jim Fanning +1 212 773 3144 james.fanning@ey.com Biotechnology Glen Giovannetti +1 617 859 6598 glen.giovannetti@ey.com Consumer Products Howard Martin +44 207 951 4072 hmartin@uk.ey.com Insurance Peter Porrino +1 212 773 8468 peter.porrino@ey.com Media and Entertainment John Nendick +1 213 977 3188 john.nendick@ey.com Oil and Gas Rob Jessen +1 713 750 4952 rob.jessen@ey.com Pharmaceutical Carolyn Buck-Luce +1 212 773 6450 carolyn.buck-luce@ey.com Real Estate Dale Anne Reiss +1 212 773 4500 dale.reiss@ey.com Telecommunications Vincent de La Bachelerie +33 1 46 93 6205 vincent.de.la.bachelerie@fr.ey.com “ Just as the global market is everywhere and yet, paradoxically, nowhere, each point of contact,eachpurchaseorsale,isbothspecic and local. So it is with strategic business risk.” [...]... and their implications for industries and governments worldwide Further information about Oxford Analytica can be found at www.oxan.com © 2008 EYGM Limited All Rights Reserved EYG no AU0111 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... 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... leader in assurance, tax, transaction and advisory services Worldwide, our 130 ,000 people are united by our shared values and an unwavering commitment to quality We make a difference by helping our people, our clients and our wider communities achieve potential For more information, please visit www.ey.com Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited,... 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 . identied 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. Young 21 Strategic business risk 2008 — The top 10 risks for business • War for talent • Pandemic • Private equity’s rise • Inability to innovate • China setback The nextve Following these top 10 threats. impacts on the pharma and biotech sectors. Strategic business risk 2008 — The top 10 risks for business 22 “In the near future, banks will not be able to say they are global unless they have