Risk, Return, and the High Wire Act
“The received wisdom is that risk increases in the recessions and falls in the booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materializing in recessions.”
– Andrew Crockett
Everyone likes to talk about returns; it’s what you can eat, boast about, and use to estimate your value added. But the flip side of the coin, risk, is of equal importance. In a world on the upswing, here’s a shot across the bow.
Risk is tricky. It’s always in the background and underneath the surface, lurking and waiting. Ignore it and you’ll probably be fine – until you’re not. And when that happens, watch out, you’re likely in a world of trouble. Embrace risk mitigation and your upside will necessarily suffer. Eliminate risk and you will get between almost nothing and literally nothing, especially in today’s low-inflation, low-rate environment. As I said, it’s a tricky topic.
Risk is not uncertainty. It is not volatility. At its core, risk is the likelihood and magnitude of permanent loss. It is the probability of a collision between a detrimental event and a lack of planning, resulting in a permanently negative outcome of some potential size. Howard Marks said, “Loss is what happens when risk meets adversity.” But as I’ll dive into later, real risk can quickly develop from unlikely sources and circumstances, converting a temporary hiccup into a death-knell.
While returns are easy to measure, risk is elusive. Economists and financial gurus constantly attempt to quantify it, but its estimation is more art than science. If you took a piece of real estate and asked 100 investors to gauge the risk of owning it, you might get many of the same risk-related topics, but few, if any, would agree on a precise score. Risk represents a rough approximation because the permutation of each actor’s circumstances are indefinite and constantly changing. Plus, each participant’s actions influence the system’s outcomes. What is high-risk to one, may be de-risked to another.
So if risk is undefinable, subjective, and obscure, how can it be understood and controlled? As John Maynard Keynes said, “It is better to be roughly right than precisely wrong.” The path to managing risk is to understand yourself, your situation, and the controlling factors that might lead to negative outcomes. The goal is to operate responsibly, allowing for enough risk to gain rewards, while not playing financial Russian Roulette. Think Goldilocks. Not too hot, yet not too cold either. But only you know the appropriate temperature.
For operating companies, there are numerous sources of risk and the purpose of this article is not to cover them all. In fact, volumes of books have been written on the subject. What I’d like to do is raise the warning flag in what feels like a “heated” environment. While most middle-class American families may not feel excited about their personal finances, the current state of business is looking uncomfortably optimistic. Everyone can see public company valuations, which are somewhere between elevated and nearly euphoric, depending on the measurement technique. In the private markets, we’ve recently seen small, mediocre, and cyclical businesses go at auction for 8X current year projected pre-tax earnings. That’s stout and while that individual situation may turn out just fine, the odds don’t work out favorably. It’s kind of like a craps player having a good night. Good for her, but play enough craps and it probably won’t work out profitably in the end.
My digression into valuation is to demonstrate risk. The less risk investors feel, the more they’re willing to bid up assets and as long as everything is up-and-up, the game continues. Risk taking in good times leads to outsized returns. But assumption of risk alone won’t drive long-term gains. It results in an opacity between being lucky and being good, or what Nassim Taleb would call “lucky idiot” syndrome. Every bull market produces a class of lucky idiots who won (temporarily) for all the wrong reasons.
So what? I’ll let Warren Buffett explain: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” Elevated valuations, aggressive transactions, and a general feeling of financial FOMO (fear of missing out) should give you pause, lead you to take inventory, and provoke a plan for the future. Cycles happen and the good times don’t always roll. So when the music stops, or gets inaudibly quiet, how quickly and easily can you find your seat?
The most glaring source of risk I see time-and-again for businesses of all shapes and sizes is financial. How do you monitor and maintain cash flow? How have you structured equity and debt? What are the likely outcomes from growth or shrinkage? Two recent first-hand experiences stand out to me.
A well-known and well-respected entrepreneur recently approached us about investing in an “emergency round” of capital, the other Series E. They had been “killing it,” growing like crazy, and had raised a moderate seed round from a variety of angel investors. They were actively talking with VCs about doing a Series A round of financing. The problem was that they had started their raise too late, while simultaneously experiencing margin compression, lower lead conversions, and a few large, late-paying customers. The result was a “successful” company about two weeks away from death.
We had another recent opportunity to provide emergency financing for a company on the opposite side of the spectrum, an established firm of over 20 years. The founder/CEO was a prominent member of YPO and a big charitable donor. He had experienced decades of success and his company was an undisputed leader in their niche industry. A few years back he took on growth capital to expand, which included a preferred return and a big payment that was quickly approaching. His customers had stopped pre-paying and he struggled to finance the up-front investments needed to start receiving the long-term contractual payments. He continually took on very expensive short-term financing, the business equivalent to payday lending. Despite being highly profitable and growing, he recently found himself insolvent and with no way out.
Risk doesn’t only manifest in bad times. Loading a company with debt, maintaining small cash reserves, and not closely monitoring the results from the business’s trajectory can all prove disastrous. But risk comes in many more forms:
Culture Debt: Internal company politics can be brutal. Rivalries form. Factions get created. Turf wars rage. In good times, money can cover up a lot. In challenging times, watch out. While this debt may not be reflected on the balance sheet, it’s real and spring loaded.
Code Debt: For software-based companies, there’s always tension between shipping product and quality. The result is risk embedded in the code base. Band-aids and patches can be effective short-term solutions, but eventually problems arise and long-term solutions are expensive in every way.
Systems Debt: Robust systems are major drags on resources in the short term. A company doesn’t become more profitable by hiring in HR, accounting, or legal. Resources dedicated to building out internal systems are costly, regardless of efficacy. As companies defer these costs, risks build and eventually things explode.
Expectations Debt: When it comes to bringing on outside investors, or high-level employees, expectations matter. If you raise money with high expectations, very bad things happen when you don’t perform. The higher the expectations, the less your margin of error. The same goes for employee promises. Stock options can be extremely attractive, or utterly worthless. It just depends on expectations.
Leadership Debt: People sometimes succeed despite themselves, but as Charlie Munger has said, “If you live long enough – most people get what they deserve.” In the short term, it’s almost impossible to differentiate luck from performance. But if the company has out-grown its leadership, watch out.
Aggregation Debt: Most risks are correlative and additive, meaning they are mutually connected and the addition changes both profiles. This makes most risk non-linear, where the addition of small risks over time can create explosive situations. While individual risks can be looked at in a vacuum and reasonably estimated, Yogi Berra seems particularly apt: “In theory there is no difference between theory and practice. In practice there is.”
Concentration Debt: The special sauce that allows most companies to prosper is a form of human equity. It’s specialized knowledge about how a system works, or some hard-to-gain expertise, or a handful of high-value relationships. People leave, die, or get addicted to something unfortunate and go off the rails. The more concentrated this human equity, the higher the risk.
People go through ups and downs. Every company experiences favorable results and hits potholes. Economies cycle. The trick is to plan for it. I equate running a company to wire-walking. Regardless of the participant’s skill, the nature of the wire matters. How much does it flex? How wide is it? How slippery is it? How long is the wire? The risks of a business are similar. More debt, of any type, makes the nature of the wire more challenging. The height of the wire is irrelevant until you fall off, but when that happens, what is the result? Is it complete destruction, or merely a suboptimal outcome?
As an investor, the higher the valuation, the higher the wire. The more cyclical, debt-laden, and inexperienced, the more likely the fall. As a general rule, we like our companies walking on two-by-fours about six inches off the ground. We certainly won’t produce the highest returns this year, or next, but we’ll be around in twenty years.
This post originally appeared in Forbes.