The Risk Tightrope

The balance sheet, in particular the equity base, underpins the downside outcome of all risks that are taken. It seems obvious, therefore, that the balance sheet should be structured to allow for the risks, both operational and financial, that are taken by an enterprise.

All changes in risk positioning should be taken by reference to the balance sheet. Companies usually think about this balance sheet positioning by reference to a credit rating objective, or some cashflow measure relative to net financial liabilities. Unfortunately, this is often the last time the balance sheet gets looked at in regard to risk management.

Focus typically leaps from here to the profit and loss account and protecting earnings per share, often on a pretty short-term basis. This is a shame, because keeping focused on the balance sheet is critical to developing a proper position on risk. Figure 1 is an economic rather than an accounting balance sheet. The operating assets are the businesses we run.

Our friends, the equity analysts, value these for us, often short-cutting the complex NPV calculations for an EBITDA multiple. Unsurprisingly, therefore, growing EBITDA well, relative to new capital to deliver that growth, will enhance shareholder value. The other relevant areas of the balance sheet are the role of corporate finance, the treasurer and the CFO - debt, off-balance sheet non-business economic assets (few and far between unfortunately) and off-balance sheet liabilities - this may include contingent liabilities. Then, of course, there is the area of pensions.

LIQUIDITY RISK

Before looking at the big risks, one can never forget liquidity risk - which doesn't naturally fit anywhere. How much surplus borrowing capacity or cash-in-hand does one want to carry, and what sort of regular refinancing activity does one want to be exposed to? This is based on the old mantra that most companies don't go bust because they are bad businesses simply because they run out of access to money, though these are often correlated - where they are not clearly offending, the company has been rather careless.

Debt only has two main risks: interest rate risk (fixed risk and floating) and currency mix (what currency to hold debt in). The latter is enormous. If we look at Figure 1 again, but without off-balance sheet and pensions, it looks like Figure 2

CURRENCY HEDGING

It is blindingly obvious that if a UK company's operating assets are in non-sterling currencies, then the company should carry debt in non-sterling currencies to match those. What is not quite so obvious, though, is why businesses typically constrain themselves at the level of their debt. Look again at Figure 2 and imagine you are an asset manager. Let's say the operating assets are £5bn in non-sterling currencies and the asset manager is trying to generate constant steady growth in sterling. The entity only has £1bn of net debt placed in non-sterling currencies. An asset manager would hardly describe this position as fully hedged. My CEO talks about driving the share price up in terms of explaining it to 'the little old lady shareholder in Brighton.'

Imagine explaining a large share price fall due to sterling strengthening - especially when management could have mitigated the loss. It is not an easy call to gross-up the balance sheet using derivatives to provide more asset-hedging through the debt book, but like all risk decisions it is far better if it is thought about before a position is taken rather than simply taking the position by default. It is also an area where common sense conflicts with P&L focus, since accountants require positions in excess of the book-keeping assets (not the economic assets) to be marked to market through the P&L account - though some people have faced up to this to do the sensible thing.

OFF-BALANCE SHEET WOES

Returning to Figure 1 again, we know that off-balance sheet liabilities have been the downfall of many a company. Historically these cases have included genuine economic liabilities, which, because they haven't been captured on the accounting balance sheet have not been known to investors. Apart from the impropriety of this in any case (they should always be disclosed no matter what the accounting standards say), management clearly have to factor them in to the economic balance sheet when thinking about risk. Accounting standards are fortunately making these arrangements more visible these days. They also include consideration of the infamous contingent liabilities - often legal cases that ‘will be defended vigorously'!

A good lawyer friend of mine once said he was always surprised how many of these we had lost, but also how many cases we won that he thought we would lose!

PENSIONS

Pensions are now very much at the forefront of financial risk management and are having an enormous impact on equity market valuation. Until the advent of FRS17, pensions were hardly looked at by investors. If the issue is large relative to the operating assets, then the risks to the enterprise and its market cap will be enormous. A fully funded scheme (say, on an FRS17 basis), with all the assets invested in equities, could have something of the order of a 5% chance of moving into a 50% deficit within three years.

There is nothing wrong with investing in risk assets (primarily equities) to pay pension liabilities (basically, a short position in long-dated inflation linked bonds), as history shows us that, in the long run this is normally okay. However, it is a long-term gamble with a perceived guaranteed pay off. It is absolutely crucial that one has the capital (equity base) to see it through to maturity.

OPERATING RISK

Now to the most important thing on the balance sheet: the operating assets. Despite all the effort that goes into financial risk management and the occasional appearance of pensions centre stage, enterprises are there to make chemicals, sell telephones, build buildings or whatever. It is what we come to work for. However, business risks can be hard to pinpoint; if you have to take them, they can be mitigated through investment in process, audit and possibly risk transfer (insurance), and they are invariably downside (ignore a financial risk and you might get a pleasant surprise). There is probably one over-riding risk that sticks out like liquidity does on the financial side: strategic choice. Strategic choice is often very concentrated, probably a biannual activity and it is in the active and passive decisions taken from this process that most value is created or destroyed.

STRATEGY EXECUTION

Moving on to strategy execution, these are the things we are supposed to be good at and the things that drive value: good people processes, marketing, product development and an efficient supply chain to support it all. Poor execution or failure here is a risk that is not generally transferable, but consideration of all these areas is important, particularly as they fall within general management processes. A typical output from a risk review, based on much of the methodology out of Turnbull, involves a combination of high-level and low-level assessment of possible risks, an attempt to put a numeric quantification on them (invariably, a qualitative assessment of probability - possibly high, medium and low) and a subsequent assessment of mitigating controls (see Figure 3).

INSURANCE: HOW MUCH IS TOO MUCH?

In terms of insurance, catastrophic risks need to be immunised if possible and insurance market may have a major role here if you can't immunise by control. Much of the focus on insurance decisions is again P&L-based. Buying one or possibly two years' cover for cash flow losses often doesn't cover the full NPV of failure. Loss of business from a supply chain failure (fire or other event causing supply interruption) can lose customers for a long time, and getting one or two years' cash flow back from the insurance market is no compensation. In the long run, companies often find they have been self-insuring.

Insurance often averages out at a net expense equal to an amount that would cover the overheads of insurers and give them a sufficient reward on capital for their own shareholders. This simple analysis emphasizes the need for good internal operational risk management and implement effective controls above all else, rather than placing heavy reliance on the insurance market.

LIVING WITH RISK

The $64,000 question that has been asked for quite some time is whether one can combine the relatively sophisticated risk management of the financial markets with the operational risk challenges of the business. At one level, if your complete range of risks have had some form of quantification and probability assessment, and have been looked at in the context of the balance sheet, then they have been connected. We have done some simple cross-risk VAR modelling, but at the end of the day, for most corporates, any attempt to take a holistic look at risk, across finance and operations, involves judgement and pragmatism. To make a decent job of it, though, one still needs identification of the inventory of risks (financial and non-financial), some quantification assessment, and a clear position on what is important and how it is going to be managed. All this needs to be earthed back into the group's balance sheet, its risk capacity and a chosen position on the company's appetite for risk.