This is the first half of a feature examining how advisors and clients should think about political risk in decision-making.
Even before the financial tsunami of 2008, political risk – an area that had seemingly fallen off wealth managers’ radar screens during the supposed “great moderation” of the 1990s – returned. Rising discontent with the political landscape, as seen most obviously with the election of Donald Trump in 2016 and the Brexit vote in the UK of the same year, means asset allocators need to pay more heed to political risk than a decade ago. To some extent awareness of political discontent may also be fuelled by channels such as social media. How much of the noise around the political world translates into economics and business is not always easy to fathom. In wealth management, there is no doubt that political risk is a subject tracked more than used to be the case. A standout case is Tina Fordham, a politics analyst who writes and talks frequently about political risk from her berth at Citigroup, a post she has held for 15 years.
Withers, the international law firm, is also well placed in some ways to discuss political risk and how advisors should address such issues. In this article, which is being run in two instalments, authors Hussein Haeri, Philip Marcovici and Iraj Ispahani consider the terrain. (Philip Marcovici is a familiar figure to readers; he was one of the architects of the Liechtenstein Disclosure Facility between the UK and the tiny European state a few years ago, and writes regularly on tax and wealth structuring issues.)
The editors of this news service are pleased to share these views; they don’t necessarily agree on all contributors’ opinions and invite readers to use this news service as a place to respond and air their own views. Email firstname.lastname@example.org
Political risk, in its many manifestations, is one of the most salient concerns of international investors today, including family offices. Such risks are far from being confined to nationalisations or direct expropriations of international investments. More frequently, family offices investing in foreign countries can over time face materially different regulations and legal frameworks to those which informed - and perhaps even partially motivated - their investments in the first place.
Changes in governments routinely throw up particular challenges for international investors. Such challenges can arise from host government political considerations that seem to bear little relation to the prospects or progress of the underlying investment projects. Issues of favouritism and discrimination frequently pose obstacles for family offices.
The economic prospects of international investments may furthermore be damaged or even destroyed by an array of state actors ranging from ministries and legislatures, to regulators and tax authorities.
Local courts may be unresponsive to legitimate legal claims, and due process issues in foreign courts in proceedings that will frequently be against the host state or other local counterparties can further complicate matters.
Political risk is also a home country reality for many wealth and business owners and this not only in the developing world. Populist governments, confusion about how best to address income and wealth inequality and many other factors have made political risk something that wealthy families internationally need to consider. Often, however, family offices fail to adequately address political risk in their development of asset ownership and succession structures. But they should and must.
Minimising political risk
In simple terms, political risk has to be considered at three levels. First, attention needs to be paid to political risk in the country of the citizenship and/or residence of the family. This may involve dealing with more than one country given that there may be multiple citizenships and places of residence involved. Second, political risk needs to be considered in the location that investment structures are maintained. The family may live onshore in the UK, for example, but there may be trusts, companies, partnerships, investment funds or other holding vehicles located somewhere else. The jurisdiction in which the structure is maintained is also highly relevant to any political risk minimisation strategy. Third, of course, is the country in which an investment is made.
Compared with commercial risks, political risks can be amorphous and hence difficult to predict and manage. Moreover, the political risks in the country of investment are likely to be different to those of the home country. Political risks can manifest in varied and challenging ways. Examples range from circumstances of revolution, civil unrest and civil war to politically charged changes in regimes or governments, or - more prosaically - marked policy and regulatory changes or discrimination. Moreover, recent and wide-ranging international changes to tax and transparency frameworks are related to political risk. As mentioned above, risks can exist in the countries of intermediate structures, such as investment vehicles, partly due to ongoing challenges to traditional offshore centres.
The means for family offices to minimise political risk has historically been limited. A possibility for an aggrieved investor is to sue the host state government, such as for expropriation of investments, in the host country domestic courts. However, the likelihood of successful host country litigation against the host state and local counterparties is often low, frequently leaving investors with inadequate or no compensation, even in cases of expropriation. Local court litigation is therefore rarely the preferred option, not least because the judiciary is part of the host state apparatus. In some circumstances, the problem may indeed have arisen from actions in the host state courts, in which case those courts are particularly unlikely to be receptive to a complaint. A reality is that under international law, it is generally accepted that a country has the sovereign ability to act within its borders, such as would be the case in relation to expropriation.
The (often only theoretical) possibility of securing diplomatic protection from a home country government can be subject to complex political considerations and may not necessarily be forthcoming or effective. It is within the home country government’s discretion as to whether or not to bring a claim on the family’s behalf and the investor is forced to rely on an unpredictable political process. The home country government may have no wish to engage in a dispute with another government for any number of geopolitical or economic reasons unrelated to the family’s claim. Moreover, a state-state legal confrontation can precipitate international tensions beyond the circumstances of a specific investor and investment.
Although political risk insurance can be a potential means of managing certain political risks, such as expropriation risks, its ambit is often narrow and the costs can be high. As experience shows, these historic limitations in managing political risk are far from academic.
Learning from history
But family offices can learn from history, and pay more attention to what has worked and has not worked in the context of political crisis. Wealthy investors can also reflect on steps others have taken in uncertain times.
In and around the Second World War, for example, a number of European companies, including the Philips Electronics group, took steps to isolate their European assets from holdings elsewhere, such as in the US. In the case of Philips, the group’s US assets were held in a trust carefully designed to separate the ownership of US assets in the event of an expropriation or other political risk event in Europe. In the
1980s and early 1990s, many businesses in Hong Kong were restructured in view of perceived political risk associated with the return of Hong Kong to China in 1997. Most common was the undertaking of corporate inversions – the removal of a holding company in the location of risk and its replacement by a holding company elsewhere, isolating the assets in the location of risk. Companies ranging from the Hong Kong and Shanghai Banking Corporation (now HSBC), Jardine Matheson and many others replaced their Hong Kong holding companies with holding companies in other jurisdictions. In the case of HSBC, the choice was the UK; in the case of Jardine Matheson, the choice was Bermuda.
For a family office, the corporate inversion is only part of the political risk minimisation strategy. If the family involved lives in country A and developed their business in that country, it would be quite common to see the progress of the business having involved the establishment of a company in country A. As the business expands cross-border, subsidiaries are established in other locations. A corporate inversion involves the group restructuring such as to establish a new holding company in a “safe” jurisdiction, and ideally one that can benefit from investment protection agreements and otherwise provide political risk minimisation. Now there is no holding company in Country A – only a subsidiary of a holding company elsewhere. While the assets in Country A remain at risk, how those assets are owned can help to ensure compensation payments in the event of expropriation, something elaborated on below. Leveraging the assets in Country A can shift political risk to lenders, depending on the terms of the loans involved.
But if the family office remains a resident of Country A in the example, having a holding company in Country B may be an incomplete approach to political risk minimisation. Country A could take steps to force a repatriation of assets held abroad by the individual involved, and parallels to this can be seen from recent events in Saudi Arabia. To further minimise political risk, a family office can separate itself from the ownership of the assets held abroad, or adopt approaches designed to automatically create such a separation in the event of a political risk event occurring. An example of the first approach could involve having assets overseas held in a single premium life insurance policy over which the family retains no power to have the assets returned to them – the assets pass to the next generation on the death of the family head, and until then are simply owned by the insurance company located, of course, in a safe jurisdiction other than Country A. An example of the second approach could involve ownership by a trust, with provisions that exclude as possible beneficiaries any individual residing in a country that is subject to a political risk event, such as repatriation orders or otherwise. Initially a member of the class of potential beneficiaries, the family members living in Country A are cut out of possible benefit if risk manifests itself in Country A.
Political risk presented by third countries
It is interesting that political risk can also be presented by third countries. The US, for example, has a number of means through which such risk can arise. Freezing or vesting orders can and are used against perceived enemies of the US. A family office in country A may find itself unable to access assets held internationally by virtue of this. Separation of ownership, through one of the approaches described above or otherwise may be designed to minimise the risk of a freezing or vesting order applying to a particular set of assets.
Changing borders and revolutions
History serves as a reminder of the disruption that occurs when revolutions happen, borders are redrawn and wars develop. Some notable examples of geopolitical disruption are the general expropriations which occurred following the Mexican Revolution, the Bolshevik Revolution, the Nazi German invasion of Europe and the Cuban Revolution.
In South West Asia in 1947, we witnessed the partition of India and Pakistan and the creation of a third country Bangladesh in 1971. The Soviet invasion of Afghanistan and the Iranian Revolution both followed in 1979 adding to regional volatility.
In every instance assets, including key industrial and commercial assets and land, were seized from private citizens by governments, in some cases by being declared abandoned property. This taking of private property for supposedly public use is something which wealth owners globally still fear. However there are more options today to diminish the impact of big geopolitical changes via thoughtful asset protection strategies. Precedents are being established though many wealth owners are not aware of the possibilities given that much of the body of law in this area has been developed in the arena of international dispute resolution between sovereign countries.
Managing the downside risk of emerging markets
Emerging and frontier markets represent growth opportunities. They attract cross-border investors looking for returns, including through private or listed equity. It is noteworthy therefore that there are according to the International Committee of the Red Cross (ICRC) 35 conflict zones in the world today, across emerging economies. In emerging markets GDP held by family business owners is often in excess of 80%. For these business owners, geographical diversification from their home country was not historically a priority since in many cases they were operating in relatively new nation states whose independence had been hard won. Today, however, it is very much the case since diversification, and growing beyond ones borders, is generally recognised as a practical business strategy. We are seeing these disruptive events with increased frequency because of the lack of political and economic stability in host sovereigns. These events include direct governmental interference from military takeovers, expropriation, or mandated national ownership of all or part of particular businesses as well as indirect actions such as currency restrictions or punitive income or estate taxes.
For international or cross-border investors, seeking additional levels of protection from geopolitical changes is pragmatic. However, wealth owning families in emerging economies tend to be part of the fabric of the countries where their offices are or were headquartered. For families like these, leaving is not a preferred option and neither is it straightforward for them to challenge their government in the local courts. Often these wealth owners have contributed to societal improvements through education and healthcare and are important local stakeholders by holding governments to account and by encouraging public private partnerships. They often represent the preferred partners international investors seek and take comfort from in these markets. These families should also seek advice on asset protection strategies more proactively.
While political risks will shape some investment decisions and flows, such risks cannot easily be bypassed by international investors. For one thing, political risk is now a fact of life across the world; it isn’t confined to a select few countries that can be avoided. Second, given greater growth prospects and investment opportunities in many emerging markets, investors will continue to make investments there.
Furthermore, many family offices are giving greater focus to direct investments. 1 Family office investments are often international and increasingly include direct investments (whether by way of a controlling interest, minority shareholding, joint venture structure or otherwise) into foreign companies and foreign assets. While this capital moves across borders in search of greater rewards, it also brings risks. It is axiomatic that direct investments into other countries carry direct risks to those investments, particularly in times of increasing instability and uncertainty. Emerging or frontier economies carry risks which are often political and can be difficult to predict (such as sudden changes in attitudes to foreign investment or radical changes following government transitions).
Protectionism and political volatility are also on the rise more generally with the rise of populism and potential antecedents of trade wars. These threats can affect economic fundamentals, but they can also affect the very integrity of international investments.
1 See, for example, Axial Forum Article (Nora Zhou) “Family offices are going big on direct investments”, 16 November 2017, on iCapital Network’s report on single-family offices: https://www.axial.net/forum/family-offices- are-making-more-direct-investments/ See also Bloomberg article (Peggy Collins and Simone Foxman) “Rich families go solo on deals, moving away from private equity”, 3 May 2017, https://www.bloomberg.com/news/ articles/2017-05-03/rich-families-go-solo-on-deals-moving-away-from-private-equity