This is the first in a series of three articles on risk and PE firms, this installment will deal with the definition of risk.
In a recent Axial study on Evaluating Risk and Return in Private Equity, most respondents (76%) said they do not regularly measure risk. This raises the question—is this due to a lack of a clear definition of risk, the lack of available data to identify and measure risk or both?
Financial risk refers to those factors that could affect a company’s ability to make a profit. It comes in many forms and can be internal or external as well as strategic, financial, operational, compliance, etc.
For a private equity firm, the primary financial risk is the possibility that investors will lose their money or not get the expected return on investment. This can put additional pressure on portfolio performance as well as impact future fund raising.
Risk for a private equity firm can be directly linked to the level of risk in its portfolio companies. Identifying the financial risk of a new deal is just as important as evaluating the company’s management, operations, customers, etc.
During the due diligence process, the financial risk of a company should be the easiest to identify, yet there are often hidden risks that normal financial analysis alone does not identify. The result, per DBO’s annual PE study, over 20% of PE-backed companies are underperforming and another 8% are likely to declare bankruptcy on one or more of their portfolio companies.
Establish a standard
Financial risk is often looked upon as the company’s credit worthiness. But financial risk can come in many forms: too much or too little inventory, falling profit margins, inadequate cashflow, or even an ill-informed business model.
To handle risk a standard should be used for both identifying and measuring.
Benchmarking uses a set of over 30 key financial ratios and KPIs that can be uniformly applied across a variety of industries. They define areas of risk across a company in areas of liquidity, profitability, asset efficiency, and sustainable growth. For example, current ratio, quick ratio, collection period and deferred payment period are used for measuring a company’s liquidity.
To identify risk some form of data standard must be used in which to measure against.
Analyzing a company’s year-over-year KPI, such as sales, is good for meeting corporate goals and objectives, but can be misleading in understanding and managing risk.
An accurate method for identifying risk is to look at data from the best performing companies within a company’s industry. This provided an unbiased, independent standard of excellence that is established by the market and company performance. The issue with privately held companies is where to find available competitors information.
Benchmarking provides the data for identifying the industry’s best- performers; their associated KPIs and financial ratios to establish these standards for identifying risk. Comparative benchmarking can ensure the risk standards are based on same size companies for true apples-to-apples risk analysis.
The process of identifying risk begins with performing comparative analysis between a company’s financial data and corresponding industry data. The company’s financial ratio or KPI’s position relative to the industry standard, top 10% performing companies, identifies the level of risk as illustrated below: