New risk analysis technology helps manage uncertainty in transactions

Feb 01, 2017
Risk consulting Mergers & acquisition

The client had a deal that looked good on paper. But as we dug into the financial statements of their potential acquisition, we found increasing levels of uncertainty about the risks in the target company.

There were a lot of moving parts, including conditional triggers for executive compensation. If a given factor exceeded ten, then a bonus clause in the contract kicked in, and there would be an additional payout. If the factor exceeded 20, there was a different clause, triggering a bigger payout.

Each incentive on its own made perfect sense - to more closely tie executive compensation to the health of the business. In aggregate, however, the potential combined impact was hard to predict and might be prohibitively expensive.

It is critical to understand the variables and risk exposures to prevent stakeholders from overcommitting to get the deal done. Consequently, identifying how to manage risks may allow companies to leverage opportunities that would have otherwise been shelved because of uncertainty about costs.

Traditionally, most scenario analysis has involved perhaps three scenarios – good, bad and best estimate. Even the so-called ‘best estimate’ is sometimes actually a ‘most hoped for,’ whether likely or not. Running more scenarios is sometimes impractical or unproductive – it just produces more reams of paper and charts that people can’t properly digest.

New analytical tools give business leaders much more flexibility regarding the factors that they can consider, the weight of probabilities and calculated consequences, the range and number of scenarios that can be run, and the understandability of the results.

What’s new in understanding business risks?

Three types of technological developments are opening up these possibilities:

More data available: Today’s corporate information systems are able to produce a level of detail and granularity that was unimaginable even a few years ago. They can identify not just how much of Product X was sold during the previous period but can drill down to which colours, sizes and shapes Product X comes in, through which channels, and who did the selling. Current enterprise systems can be configured to produce a wide range of information on which management can base decisions. The challenge is not so much gathering data, but rather finding a way to deal with it in a meaningful way.

Better business models: The flood of data can now be better corralled and directed into meaningful and actionable information, given the robust nature of current business models that can realistically predict how the enterprise would perform.

Smarter use of computing power: The volume of data, plus the elaborate and comprehensive business models, might be like a car missing its wheels – plenty of power but no place to go. The real power is not just in the ability to generate results. The real power is in the ability to visualize results in a manner that can be easily understood and acted on.

Providing reassurance about an expansion

We saw the power of this technology in a recent project for a major airport that was considering an expansion of its terminal. The question was, what if they took on a lot of debt to build the expansion and then didn’t get the traffic they needed to pay for it?

The airport authority considered some of the risks it faced, focusing on those not already managed by insurance. For example, what would happen if currency fluctuations meant that the price of construction materials suddenly rose? Or if an airline that was planning to take some of the new gates suffered a drop in traffic and didn’t generate the expected volumes? Perhaps the revenues received by some retail tenants and food service outlets turned out to be less than expected, reducing the revenue to be received by the airport as part of the lease agreements.

While the financial risks the airport faced were potentially large, our analysis found that, the chances of those events occurring were smaller than management feared. We could easily run a range of scenarios for every variable they had identified, plus a few more based on our own experience. Our intuitive modeling tools allowed us to tell the airport authority that in the worst-case scenario, they might have to increase the Airport Improvement Fee by three dollars to cover their downside. Now, clearly they were hoping to avoid any increase in the fee. But if $3 was the extreme downside, management felt they could live with that outcome and were encouraged to move ahead.

Business benefits to greater understanding

Many business people are comfortable with a certain degree of uncertainty, and are often willing to follow a hunch or gut instinct in making a decision. But there can come a point where the uncertainties are overwhelming. Current information technology can help business leaders inject a wider flow of firm data into their decisions.

In many cases, we work with company management to go through the financial statements to get an idea of what a reasonable ‘high’ value might be for a given factor, a ‘low’ value, and the likely range in between. This knowledge allows us to build a model that may have literally a thousand moving parts, and we use those to generate a range of results.

This process can help to understand the potential upsides and downsides of a particular decision. In many cases, what we provide is reassurance: A certain outcome might be a problem, but a manageable problem. From that, we can help develop plans for managing and mitigating the risks and leveraging the opportunities.

As well as providing reassurance to management, we provide it to other entities – such as a Board of Directors, who need to know that a decision that the management team is considering is sound. Sometimes, the party to be convinced is a bank, a venture capitalist, a source of private equity or other source of finance.

Sound risk analysis, using the tools now available, goes a long way in such situations.

But one of the biggest benefits risk analysis can offer is peace of mind – knowing the risks, and knowing their magnitude and consequences – but also knowing that the contingencies are covered and it is safe to move ahead.

RSM contributors

  • Steve Prince
  • Timothy Zimmerman

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