Risk – Half-empty or half-full?
Richard Kirkland is partner in Deloitte’s Enterprise Risk Services practice. Here he discusses an approach to conducting risk review of your business.
We tend to want to protect ourselves, our children, our houses, our cars – it’s natural, instinctive and we buy ‘insurance’ against the bad things. It’s pity though that our creative side in avoiding the negative things can desert us when it comes to thinking about how we can turn these situations to our advantage. Worse still, as we have seen play out across the globe, negative thinking can so easily become self-reinforcing – even debilitating. This can lead to the worst outcome of all: inaction or maintaining the status quo for its own sake.
So how might reviewing risk help you now, and how should it be approached to leave lasting positive legacy? Take time to reflect critically on:
• the environment you operate in, and past, current and likely future trends;
• key premises/assumptions underpinning your corporate strategy;
• resilience of your business processes
• the basis for decision-making and the quality of interaction and communication between members of the management team, and between management and the board.
The table (opposite) captures “three-step conversation” that management and the board should be holding on near real-time basis in coming months. The board will be aiming to develop or validate your suite of strategic options (defensive and offensive); and management will be seeking to align the business response and the chosen strategy, then execute with discipline.
Both private and public sector perspectives are offered as no one is immune, the principles are universal, and we are seeing the boundaries between the two being redrawn.
1) Understand the key drivers
Stay in touch with what’s going on in the economy and take time to systematically understand the resulting ‘cause and effect’ in your markets and on your organisation. Make habit of asking probing questions: “What if?”, “Why?”, “Why not?”
We have become all-too aware of how interconnected the world has become and there has been much written about the causes of the global crisis. The immediate effect of these developments on our businesses is abundantly clear – falling demand, rising inventories, deteriorating credit quality etc.
However, how clear are you about emerging or ‘secondary’ drivers and how will they impact on your organisation and your markets? Things can change rapidly with compounding consequences: for example, debtor book might begin to haemorrhage value, putting liquidity under pressure and in turn jeopardising future funding. Secondary and ‘knock-on’ effects are often less well understood than the initial ‘event’.
Mobilise senior management and the board to tackle the key issues through combination of practical tools including: scenario analysis, de Bono’s “six thinking hats” technique, SWOT analysis and external facilitation. This will see thinking and operating styles challenged – unconventional times demand unconventional approaches – and will encourage broad-based creative thinking.
2) Assess their business impact
Work through the positive and negative impacts of these ‘key drivers’ on your business, questioning fundamental strategic assumptions and carefully identifying inter-relationships.
Recognise that there is distinction between the behaviour of risk factors during normal and stressful conditions. Under normal conditions, the factors are easier to predict and future behaviour can, to an extent, be predicted from past performance. However, during stressful conditions the factors become far more unpredictable and past behaviour offers little help in predicting future behaviour.
In the current environment, management is well-advised to supplement ordinary business risk management practices with stress-tests to identify the sources and magnitude of likely losses and potential opportunities.
Subjecting all facets of your business to stress-test can prove enlightening and expose areas of vulnerability that might not otherwise have been evident during good times. As the Warren Buffett classic put it: “You only learn who has been swimming naked when the tide goes out.”
Consider going beyond your normal ‘top-down’ financial stress-testing (and the levers of sales and expenses and so on) to incorporate credit, contract/counterparty stress tests, in the context of the scenarios you have already considered. Identify and capture the resulting business impacts as either ‘positive’ or ‘negative’ to the business.
3) Create options: Act purposefully
Your thorough, systematic analysis will inevitably offer up range of alternative courses of action. Having options available, particularly during testing times, is good place to be.
Options seldom, if ever, drop out of thin air – they need to be created.
M&A strategy, covered by Chas Cable in the accompanying column, is just one example where revisiting offensive and defensive options in this time of turmoil could be highly rewarding.
M&A in time of turmoil
Chas Cable leads Deloitte’s corporate finance practice. He speaks with NZ Management about the impact of the recession on mergers and acquisition strategy.
First, what are the traditional drivers of M&A activity?
There are three main reasons that business is put up for sale. Either it is non-core division of larger company, small player in consolidating industry, or the owner is cashing out. We often see the third scenario occur where there is an ageing founder with no internal succession options.
On the other side of the deal, the corporate or “trade” buyers will see the business as core or complementary. Perhaps it is part of consolidation strategy where the aim is to boost market presence and extract “synergies”.
Financial buyers, typically private equity funds, may also be executing an industry “roll-up” strategy, or simply be prepared to pay an attractive price. These are often assisted by using higher level of debt than the business previously operated with.
Do these drivers still apply in the current market?
All these reasons why people buy and sell businesses still apply, however the credit crunch and recession mean there are also more sellers due to financial distress, but also fewer buyers because of the shortage of capital, the higher cost of finance, and the increased uncertainty regarding the economic outlook. The result is reduced M&A activity and lower prices being paid for businesses.
Looking ahead, we see the private equity firms returning to the market with more conservative pricing and leverage, and the banks increasingly active as sellers of distressed businesses.
So is it good time for buyers to pick up bargain?
In principle yes, but with couple of caveats: it may not be bargain, and don’t overstretch and put your business at risk.
While the acquisition may be at much lower price than the buyer would have paid two years ago, that may be fair reflection of the higher cost of capital currently being experienced, and the lower forecast cash flows in recession. True bargains are more likely to arise if the seller is under financial stress, and there is only one buyer.
Has the cost of capital gone up?
Government interest rates have come down, leading some commentators to speculate that the cost of capital overall has reduced. Academics and valuation practitioners are actively debating how theoretical models of the cost of capital should be applied in the current market. My view is that company borrowing rates have typically not declined as the risk margin has expanded to offset reductions in risk-free rates. In addition the cost of equity has probably increased, and there is reduced access to both debt and equity. It looks like the capital markets are somewhat dysfunctional at present, and the cost of capital s