This is the last in a series of three articles on risk and PE firms, this installment will deal with the definition of risk.
Mitigating PE risk is not one-time thing but an on-going process. For PE firms, it begins with the due diligence of a new deal and continues through with their portfolio companies until the exit. With financial risk defined, identify and measured, focus can now be spent on mitigating.
Gap analysis provides the road map to mitigating the risk as it measures the amount of risk between a company and its industry standard. However, reducing these risks can take time and require a combination to different approaches and actions.
What-if scenarios
Using what-if analysis various scenarios can be tested and evaluated, both individually and collectively, to see the impact on mitigating risk and measuring the financial impact on the company.
Based on this data analysis each risk area can be prioritized, risk reduction goals defined along with a timetable for action. A strategy can be developed, both short-term and long-term, and course of action that offers the highest degree of success and financial impact on the company.
Once a risk plan is implemented, benchmarking provides a tool for on-going financial monitoring of a risk mitigating strategy, keeping management focused and allowing action plan adjustments to be made as needed.
What-if scenarios are easily used to prioritize risk actions, the degree of action and what is the subsequent financial impact. Below, is an example of a company with inventory age of 132 days with a liquidity or net cash balance position of $138,122. By reducing the inventory by 30 days the company’s liquidity net balance position increases from $138,122 to $1,168,215 or a $1 million delta.
Making the risk benchmarking process work
Financial benchmarking is not a one-time event or to be used occasionally. Rather, it is a process. To maximize the effectiveness of benchmarking in reducing risk, and improving performance, it should be integrated as a core component of a PE firm’s process throughout the investment life-cycle.
Benchmarking obviously plays an important role during the due diligence process of evaluating new deals. It can establish financial threshold decision criteria to quickly and effectively determine a good deal from a bad deal. While no deal is perfect, benchmarking helps identify hidden risks, and what levels are acceptable, at what cost, and what action plan can be put in place to mitigate that risk. It becomes a useful tool in identify areas of concern to be addressed with management.
Throughout the oversight period of portfolio companies, benchmarking helps to identify what constitutes best-of-breed performance and where a company’s performance stands relative to industry peers and competitors. It provides the roadmap for reaching and maintaining peak performance which, in turn, helps drive a company’s growth, profitability and valuation. With add-on acquisitions it plays the same role for a portfolio company as it does for the PE firm in evaluating targeted companies.
Finally, at the exit stage of the investment life-cycle, benchmarking assists in determining a company’s valuation and positioning. Those company’s operating in the industry top 10% tier will command higher exit valuations while attracting better buyers, both strategic and financial.
In conclusion, PE firms risk exposure is directly in proportion to the risk levels of their portfolio companies, impacting exit valuations and investor returns. Effective risk management begins with a clear understanding of what financial risk is, how it looks, and how to measure it. Only then can the risk mitigation process begin. Comparative benchmarking offers PE firms the data and tools to better manage risk, improve the decision process and thereby increase investor returns.