The Problem of Capital Allocation for a non-Investments business

Note: Any business outside of the Financial Investment Management Industry is a “non-investment business”

Introduction:

Every year or so, Chief Strategists/CFOs are faced with a critical question “How do we allocate the cash we generate?”

Their constraints:

1.       Shareholder expectations: This could vary from purely financial (e.g., dividends) to reputational expectations

2.       Budgets: Demands on cash from working capital and manpower to maintain a healthy debt level

3.       Political nuances: Managing the balance of power & relevance

4.       Tactical imperatives: Considering market realities and competitive pressures to act

5.       Strategic continuity: Remain on the critical path as planned

Solving all the constraints every time is tedious, time-consuming, and leads to sub-optimal results.

Here are three levers that could help:

1.       Risk Appetite Statement: Assess appetite scientifically, socialize and get it accepted by Board of Directors

2.       Investment Policy Statement: Address expectations and constraints on capital allocation, investment mandates, and handling of opportunistic/special cases, and get it approved by Board of Directors

3.       Investment Governance: Establish a representative decision-making body with charter and thresholds

Isn’t this a theoretical exercise with little practical value?

History proves that humanity marches from order to chaos and back to order. Each of these levers brings in just enough order to chaos and assists in driving beneficial agendas.

In this first article, we will address the Risk appetite statement and its power over constraints.

What is risk appetite?

Risk appetite is the articulation of the uncertainty you are willing to bear for the expectations you have from exposure.

Expressed formulaically: Risk Appetite = Expectations*Tolerance*Ability to manage and benefit from risk exposure

How to assess risk appetite?

This question requires us to answer two sub-questions –

1.       Who should contribute their insights to assess risk appetite?

2.       What manner will they use to assess the risk appetite?

Answer#1: Typically, Senior Management of the company and Board of Directors (or relevant Board Committee) are supposed to provide inputs to the risk appetite assessment exercise. Their inputs are then generally weighed in a ratio of 40% (Management) and 60% (Board of Directors) to determine the company's risk appetite.

Answer#2: To assess risk appetite, we ask a set of questions to determine current and target risk appetite. The answers to the risk appetite questionnaire provide a solid foundation to guide stakeholder group behavior.

Risk appetite questionnaire –

Each Investment group/Holdco. has their own way of articulating this, but all of them boil down to the following –

1.       Expectations

a.       Cashflow stability

b.       Strategic desires

c.       Payback period/Return expectations

2.       Tolerance

a.       Withstand temporary loss (financial e.g., share price; non-financial, e.g. reputational, influence, etc.)

b.       Accept permanent loss (e.g., financial and/or strategic setback)

3.       Ability

a.       Organized pool of experts to mitigate risks

b.       Contextual Governance experience

c.       Value realization capabilities

Each of these eight items can be structured into a rubric with low, medium, and high categories. All your Delphis must indicate for each item where (low, medium, high) Holdco today is and where it wants to be in the next 3-5 years.

Risk appetite’s power over constraints

Risk appetite provides a means to guide the forces of expectations, political nuances, and tactical imperatives. Here is how –

1.       To guide shareholder expectations –

a.       Align expectations with reality (high returns expectations will require higher risk appetite)

b.       Risk appetite drives investment policy constraints

c.       Pre-empt top-down off-policy asks by classifying these as exceptions

2.       To guide political nuances –

a.       Align proposals with risk constraints and budgets

b.       Investment risks are measured via a transparent process

c.       Business owners to be held accountable for returns commensurate with risks taken

3.       To guide tactical imperatives –

a.       Stay on the course, avoid knee-jerk reactions

b.       Take planned risks and beware of pitfalls

c.       Seek expertise and build consensus, mitigating finger-pointing