The preconception that risk analysis is only about avoiding worst-case scenarios is an inhibitor to recognizing the upside potential of a more holistic and quantifiable process.
By Luke Phenicie, Lead Transaction Partner, HKW
Time can warp an investor’s view of risk. Ten years removed from the global financial crisis, average entry valuations in private equity once again hover above or near pre-crisis heights, while leverage for large corporate LBOs, at 7x EBITDA, is also eclipsing levels in early 2007. At the front end of an economic recovery, when investors typically have a longer runway for growth, this aggressiveness can be less concerning. However, in the late innings of a cycle, risk assessment and mitigation management provide a competitive advantage in the race for higher valuations and lower volatility, while preparing for an eventual downturn.
Few if any firms would ever admit they are not attuned to the risks of a deal at a given point in time. Universally, every sponsor will track and assess prospective threats on a deal-by-deal basis. Yet, still rare today is a more holistic and systematic approach to risk management – one that continually tracks and quantifies the most acute threats over the life of an investment and factors the data into portfolio construction and exit decisions.
A strong risk management framework also provides firms visibility
into where the biggest threats lie, not just within a specific company,
but also across the entire portfolio.
This was evident at a private equity conference this summer when a panel polled the audience, asking delegates to identify the most important differentiator of their respective firm. Over half of the more than 300 in attendance cited culture as the primary differentiator, while nearly a third pointed to their operating-partner networks. Other characteristics – ranging from investor-friendly terms to ESG policies — also received votes. Risk management was the only option that did not receive one vote.
To imply that sponsors are not thinking about risk would be a gross mischaracterization. There is a whole industry of consultants dedicated to helping sponsors identify risks and perform due diligence ahead of any prospective deal. There is also a host of insurance products marketed to sponsors that protect against everything from transactional risks to potential fiduciary liabilities. But far from offering any material differentiation, the ease of outsourcing these vetting activities has turned risk management into a check-the-box exercise when it should arguably be ingrained in the very investment philosophy that makes a firm unique.
At its highest level, risk analysis generally serves as the most prominent “gating” item, determining, first, if a firm should move forward with a particular deal and, second, at what price. These types of assessments are usually qualitative in nature and provide a snapshot of a company and potential headwinds at one, fleeting, point in time. To create a truly differentiated skillset requires a process that can quantify the risks, coupled with a dynamic framework to continually monitor and update risk levels throughout the investment life-cycle.
It can be easy to forget the individual-company risks that
may have been acknowledged two or three years earlier, at the
initial closing of the deal.
At HKW, for instance, our teams identify the initial perceived risks as part of all initial reviews of confidential information memorandums (CIMs), which most firms will do either unconsciously or through a formal strategy. However, this is just the beginning of our risk analysis. Utilizing our proprietary rate360 framework, a comprehensive list is assembled, scored, and updated as the deal progresses through various stages to closing. This scoring framework influences valuations from the initial bid through the final closing and is updated throughout the due diligence process as individual risk profiles change. Beyond helping sharpen our pencil on price, this analysis creates a foundation to prioritize and improve value creation initiatives over time and is intended to eventually optimize exit timing as well.
A strong risk management framework also provides firms visibility into where the biggest threats lie, not just within a specific company, but also across the entire portfolio. Recall the damage incurred 15 years ago, when the telecom implosion torpedoed several of the largest LBO firms or the cascading impact that a change in government reimbursement rates can have on segments within healthcare. Certain threats that seem insignificant at the portfolio-company level magnify as those risks compound at the portfolio level. Understanding this risk is important for operating teams thinking about the next downturn. The sponsors who can identify risks that are more controllable or likely to manifest, can be better prepared and aligned with company management on action plans in downturn scenarios.
Best-performing companies usually correlate to
lower risk scores at both the entry and the exit.
This framework can be an important tool for senior-level oversight. Managing partners within a firm, for instance, are often more concerned with risks that exist at the portfolio level. As such, it can be easy to forget the individual-company risks that may have been acknowledged two or three years earlier, at the initial closing of the deal. Perhaps more importantly, how those risks change over time can also be overlooked without a lens that tracks and quantifies the evolving threats to the business. A consistent risk management program, however, provides insight into portfolio risk that then informs portfolio construction initiatives and facilitates accountability to ensure risk mitigation strategies are progressing as planned.
We believe prudent investors should not overlook the impact of a strong risk mitigation program on portfolio exits. When all else equal, if a company has improved its risk profile over the life of the investment, it should yield a higher valuation when the time comes to sell. Similar to operational growth initiatives, risk mitigation objectives can also be tracked to completion and provide insight into when the transaction has run its course and is optimized for a sale. Risk management can also reduce the odds of a broken auction process by removing unknowns that might otherwise surface during buyer due diligence. More directly, though, a deep understanding of past, current and potential future threats coupled with a view on the direction of market trends, are invaluable to firms when thinking about exit timing.
Creating a comprehensive and repeatable process around risk management is no easy task. But we’ve found that our best-performing companies usually correlate to lower risk scores at both the entry and the exit. In a market in which so few see risk management as a differentiator, those that do, can benefit from this differentiated approach.
About the Author
Luke Phenicie joined HKW in 2004. His primary responsibilities include leading the firm’s transaction team and evaluating potential investment opportunities. Luke spends most of his time with management teams of potential investment opportunities in the U.S. and Canada.
Prior to joining HKW, Luke worked in the M&A group at A.G. Edwards & Sons and also for Prospect Partners, a private equity firm based in Chicago. Luke earned an MBA from The University of Chicago’s Graduate School of Business and a business degree from Indiana University Kelley School of Business. Luke is a past president of ACG’s Indiana Chapter and serves on various economic development, alumni, and non-profit boards in the State of Indiana.
HKW invests in companies with revenues between $20 million and $200 million and EBITDAs between $5 million and $30 million. Sectors of interest include business services, health and wellness, and infrastructure services and products. In October 2019, HKW held a final close of its $365 million fifth fund, HKW Capital Partners V LP. The firm was founded in 1903 and is headquartered in Indianapolis with an additional office in New York.
© 2020 Private Equity Professional | January 23, 2020
