Risk should be thought of in the vein of Fermat and Pascal:
Probability of loss X amount of possible loss from the probability of the gain X amount of possible gain.
When I was a young analyst I had the opportunity to work on behalf of a private equity firm that was evaluating if they should put more money into an oil field services business.
Oil field services firms referred to as “OFS” companies are notorious capital sinks. The companies are very capital intense requiring lots of tractor trailers, cranes, equipment haulers, fleet trucks and personnel. They are the first guys to make money when oil prices are skyrocketing and the first guys to go bankrupt when commodity prices implode. Typically capital intense, they often overly rely on debt financing to fuel rapid expansion.
At this time, the price of oil was in the gutter and the company had a rather large geographic presence in the southern United States. The private equity firm wanted to know if they should put more money into the firm and wanted our opinion as specialists in the energy industry. Our objective was to evaluate management, review their capital equipment stock, understand if the go forward business plan was sound. We were to present a judgement of how much money should be put into the company, if any.
In our diligence we spoke to just about every senior management member and the investment bank the company had hired to ‘certify’ their claims to the private equity and banks. The recapitalization was to include not only equity but also some debt.
Collecting datapoints as we went we eventually got to the point in discovery where we spoke with the executive responsible for the acquisition and disposition of capital equipment. For this company, the rolling capital stock, tractor trailers, represented the bulk of the firm’s assets and the primary use of new capital that was to be injected into the company.
We evaluated how the manager made his decisions and received buy in from other executives. He nervously explained that he tried to extend the useful life of assets by paying to conduct Mote Carlo simulations on every major component of the rigs including break pads. He went on to explain that this type of thinking extended to every other aspect of the businesses major capital stock and was a key datapoint for management decision making. Interviews with revelations like this one continued for several more days after which we returned to headquarters and compiled the information to present to the client.
The analysis showed that the amount of capital required to resurrect the company would be far more than what was perceived by the private equity firm. The capital stock would be materially depreciated by the time the commodities prices had picked up to any significant level of activity. And, the useful life of older rigs would require more maintenance capital than previous rolling stock which could immediately be put to use, chewing into profits. Because of weak demand for services, the company was going to need to spend more money all at once to increase capital stock if market demand rebounded.
We had come to our conclusion. The deal was a no go. It was going to take too much money to produce a low return. The company should be liquidated to the highest bidder. One internal analyst asked the question, “would you put money into this deal”. The response was “not if you paid me.” In presenting our findings the private equity firm rejected our conclusion and decided to move forward with the investment anyway.
Not fourteen months later, the private equity firm called us back and stated that our conclusion was correct.
What happened? Why was it not more obvious that a company doing expensive simulations on break pad replacements as a leading indicator was doomed to failure as an investment?
As an analyst, anyone looking at the transaction objectively could see that oil prices were in the gutter and not going anywhere unless the middle east and west Texas blew up on the same day. Nobody needed to hire the business at the time and no amount of measuring brake pads for replacement was going to change that reality. The fundamentals of the business had shifted because of commodity prices and available oil volumes on the market. The change in the value and quantity of commodity prices decreased the demand for the businesses services.
The lessons from this story are simple but profound and tell us a great deal about risk. Consider three important questions related to risk. What is real risk in a business? Dangers of academic thinking? What is market risk?
Lets start with the easiest question first.
What is the market risk?
Maybe it is better to start with what market risk is not.
“Risk does not equal beta. Risk comes around because you don’t understand things, not because of beta.” – Warren Buffet
In economic terms market risk is an adverse selection problem. In adverse selection situations, sellers generally have more information than buyers. In a market system the onus is on the buyer to gather more information than the seller.
In the case of the OFS company, they were the seller, the private equity the buyer. Management wanted to stay in place, they presented their side of the story with the investment bank raising debt capital. And, in effect, they sold their side of the story to the private equity firm. Uniquely, the private equity firm had our expert advice but choose not to listen and fumbled the ball.
Clearly, investment risks and market risks are not one and the same. Volatility isn’t a measure of risk. A cheaper newspaper at the news stand doesn’t make it riskier. Risk comes from the change of underlying microeconomics of the business. If that risk is understood it should be priced into the investment. If management understood that the world could experience volatile commodity prices like it had in years before, it would have properly priced the acquisition of its assets into its capital structure. As a result the private equity firm would have priced in our analysis of the capital cycle the firm was going through.
“When I do invest, I don’t care if the stock price goes from $10 to $2 but I do care about if the value went from $10 to $2. Avoid debt. I decided early on that I never wanted to owe more than 25% of my net worth, and I haven’t… except for in the very beginning. I like to play from a position of strength. I always try to have the odds in my favor. When I go to Vegas, I don’t go around putting $5 dollars on the blackjack tables. If someone wants to come to my room and put $5 on my bed, well that’s fine. I like those odds better.” – Warren Buffet
Actions should only be taken by management and investors where there is absolute certainty and knowledge asymmetrically favors them as the buyer or actor.
What is real risk within a particular business?
Some businesses are inherently riskier than others. Commodity driven businesses such the example of our oil and gas firms have commodity price risk that is typically too difficult to quantify. The result is managers can’t price risk into their own investment decision making process.
Other business, such as the airline or declining newspaper industry may be so price competitive that they fail to return adequate returns on capital. Capital intense businesses may likewise require a long term bet. Future returns on capital outlays become less certain or more subject to inflationary pressure and technological innovation. Commodity businesses that are not low cost producers typically struggle.
Shifting microeconomics of a business are what make it risky and only low purchase prices can compensate as risk mitigants.
What are the dangers of academic thinking regarding investments and risk generally?
While this is a broader topic than can be fairly considered for this article, it is worth addressing briefly. The example of the OFS company illustrates how capital intense companies subject to commodity price risk can overextend themselves. Academic thinking often finds its way into situations where failure is the result of poor prior decisions that didn’t adequately assess broader risks.
The answers to the problems of the OFS businesses were not to be found in the added volatility with parts breaking. The injection of debt and attempts at rapid expansion in prior years was the real risk. The company should have held significant cash positions, not paid out as much money to owners and only waited to do things that made sense.
They took undue risk laying out so much capital without a reserve and then tried to justify their decisions with scientific methods that didn’t solve for the other uncertainties inherent in the business, only extremely narrow corners of it.
The human mind seeks absolute clarity for things. And the mind will make mental shortcuts to reduce the decision making process to as many inputs as possible. Why would management decision making differ from this? The difficulty of situations where failure must be solved for is that tools like Monte Carlo Simulations give false conclusions.
The lesson is a simple one, managers should avoid false precision. Especially in situations where the broader microeconomics of a business can easily shift. Instead they should opt for a margin of safety in decision making.
Finally – what is investment risk when managing a business
At the end of the day a manager of a firm is also a capital allocator. While it is certain that managers make and will make plenty of mistakes when investing the capital of the firm, reorienting opinions of investment risk can produce better outcomes.
The conclusion that we want the reader of this article to draw is that risk can be reduced materially by not overcomplicating the investment decision making process. Managers need to only take simple steps:
- Stick to things that are certain investment outcomes, where asymmetric information is available in favor of the buyer producing a positive outcome.
- Don’t invest in an something that can result in the loss of principle or at least in a manner that would produce inadequate returns in aggregate.
- Don’t inject additional systematic risk into a business like in the example above, hedge for it with capital and conservative purchase prices.
Risk is a basketball player taking a shot every time they get the ball in their hands even if they are on the opposite side of the court. Performance risk can be mitigated with the right positioning and competency to make the shots statistically likely to go in the net.
