Why private equity firms should seek political risk insurance in today’s geopolitical environment

It’s news to no one that our world is in a state of turbulence, from the political climate to the actual climate. One of the numerous effects of political change is that organizations operating in international emerging markets face potentially significant business risks, from elections and coups to wars and sudden nationalizations.

Global economies are still rebounding from the social unrest and supply-chain issues of the COVID-19 pandemic, a crisis that led investors to consider adding inequality measures (such as the Gini coefficient/index) to country-risk profiles that traditionally relied on political stability measures. More recently, the Russia-Ukraine war has been producing global ripple effects, including reduced agricultural output to regions like Turkey, the Middle East & North Africa, and Bangladesh; a worsening of the continued energy crisis; and sustained and elevated inflation.

In fact, in a recent annual survey of PE and VC practitioners conducted by S&P Global Market Intelligence, 26% of respondents highlighted political upheaval as one of the top five risk factors of most concern.   

There is, however, a solution. Learn more about a well-established but underutilized tool that can help mitigate the risks private equity firms face investing in today’s shifting geopolitical environment: political risk insurance (PRI).

First, let’s examine some of the specific risks a company funded by a PE firm faces in a volatile political climate. These risks include, but are not limited to:

“Foreign direct investment is crucial for developing countries,” says Amy Gross of Liberty Mutual’s Global Private Equity Practice. “For example, many countries where these emerging markets exist have a significant need for clean and sustainable energy sources. This need has driven a number of those initiatives—solar energy, wind projects, etc.—all requiring a capital investment of anywhere from $10 million to $2 billion. However, to attract that kind of capital, investors need to know that their political risk is mitigated.”

Based on the very real risks listed above, it’s no surprise that PE firms have been cautious about expanding their international portfolios. However, avoidance of overseas assets means firms are missing out on substantial business opportunities—investments that could be less risky if more firms leveraged political risk insurance.

Just as traditional insurance is leveraged by PE firms to reduce risk to businesses in a domestic portfolio, PRI helps firms manage the unknown liabilities associated with investing in emerging markets across the globe. A risk management strategy that includes PRI gives private equity companies more dependable access to opportunities in the developing world and more confidence in valuation and pricing when it’s time to exit.

Private equity fund managers face significant challenges in raising capital to invest in emerging and frontier markets. Private investors are uneasy about unpredictable losses due to political risks associated with emerging markets, such as government interference, discriminatory changes in regulations, currency exchange restrictions, and political violence.

While PRI offers a way to invest more confidently in emerging markets, few private equity firms have taken advantage of the insurance. One reason is the fact that many risk managers at PE firms have had limited awareness of the utility – or even the existence – of PRI. And those investors who are aware of PRI perceive it as too expensive for the value it provides, impeding its use by private equity firms as a risk transfer solution.

A recent independent study by S&P Global, commissioned by Marsh Specialty, helps demonstrate the value of political risk insurance. According to the report, “using PRI has measurable positive financial impacts — by way of reducing certain components of the country risk premium, which in turn decreases the discount rate used for valuing project cash flows. A lower discount rate then can feed directly into improving the net present value of the project, in some cases by a significant margin, depending on project location and specifics. By tempering the impact of political risk events on the future cash flows of the insured project, volatility and country risk can be measurably improved, in some cases resulting in a multiple notch improvement in adjusted country risk ratings for the project or an enhanced internal rate of return (IRR) of as much as 5% in the cases examined.”

Insurers such as Liberty Mutual have also been able to reduce the costs associated with PRI by sharpening their risk analyses of both the industry and the region in which the firm is investing.

That’s where insurance experts, like those at Liberty Specialty Markets’ Financial Risk Solutions team, have a vital role to play. “Our political risk and non-payment insurance underwriters and analysts can provide protection from risks such as expropriation, other government interventions, political violence, and credit default, and significantly decrease the Country Risk Premium of investors in emerging markets” says Alexandre Egnell, head of North America, Financial Risk Solutions.

With a better understanding of the benefits of PRI and by working with insurance partners that have expertise in developing PRI solutions, risk managers in the private equity space can help their firms pursue opportunities more confidently in developing countries that they might not have considered previously.

Want to learn more about how Liberty Mutual harnesses its political risk underwriting and a data-driven approach to mitigate your overseas investment risk? For more information, visit our pages for political risk and private equity.