By Andrew Lichter (email@example.com)
Many factors impact the success (or failure) of corporate growth initiatives. Whether organic growth capex, new partnerships and joint ventures, or M&A, a successful project involves a thorough view of macroeconomic factors, project/acquisition synergies, and potential operational improvements. While standard DCF based models are robust and are good at valuing opportunities under a given set of assumptions, they often fail to address risk and market based factors that should be key decision points. This failure to properly understand and price market based deal risk is one of the reasons why commodity based deals so often fail (sometimes spectacularly). In fact, along with poor financial hedging (the term hedging used loosely in many cases), mispricing the risk of assets and acquisitions is one of the primary reasons why commodity intensive firms fall into financial distress.
Rather than valuing a deal under static assumptions (or simplistic bull/bear cases), deals should be valued based on the distribution of potential outcomes, both on a stand-alone basis and in conjunction with the existing business. This allows the risk weighting of returns, apples to apples comparisons between opportunities, and transparency into the correct capital structure. By utilizing the right technology and decision science analytics, corporates as well as capital sponsors gain a sharper view of value throughout the deal cycle and superior risk adjusted returns.
The first step in this process is to ensure that projected financials are based on real time market pricing. Even if a project has 30% gross margins through cycle, it may still become unprofitable if a large move occurs in a commodity where it has heavy exposure, and for a lower margin project, adverse market movements can turn it unprofitable very quickly. While an outsized move will generally be seen and valuation assumptions adjusted, smaller moves are often missed, and while this may not eliminate profitability it can still have a material impact on margins. Given that an acquisition or capital project may be in the works for months between approach and closing, pricing must be constantly monitored. In the case of approved capital projects firms shouldn’t be afraid to explore hedging prior to completion, and in the case of M&A they must be willing to adjust pricing or walk away if appropriate. Deal fever is never a good thing, but is particularly dangerous in deals heavily exposed to commodity volatility.
A more subtle application to deal pricing is in the discount rates used. While discount rates in a valuation model can be adjusted to reflect perceived risk, this is often based on peer group comparisons or internal hurdle rates rather than a more sophisticated look at the actual project attributes. Proper use of risk adjusted discount rates allow for apples to apples comparisons between opportunities, and ultimately serve the goal of driving superior risk adjusted returns.
Another way that risk management drives valuation is in pricing optionality. Out of the money assets and reserves tend to be priced either at book value or on a per ton (or btu) basis, when in reality they are options and should be priced as such. As market volatility increases, the economic fair value of out of the money assets increases as well, even if market prices are unchanged (and sometimes even if prices have declined). While this is not always reflected in the market value of these assets, this represents an opportunity for firms with the wherewithal to price and value this optionality.
In addition to the accurate pricing of the standalone risk, and often overlooked, is the impact of a project on a firm’s overall risk profile. As with any investment portfolio, how one investment interacts with others should be a key factor in its evaluation. If project A has 25% volatility it would appear riskier than project B with volatility of 10%, and on a stand alone basis it is. However, if has negatively correlated returns to the company as a whole, the higher volatility might actually make it risk reducing. While the risk analysis of a deal can appear intuitive at first glance, the truth is often more complex. Moving into a new market vertical can be risk reducing due to diversification-but not if the macro factors driving sales are the same as existing business lines. Likewise, downstream integration can be risk reducing, but depending on standard industry lead times and contract structures can drastically increase risk if it means holding 6 months of inventory rather than 1. This doesn’t mean that the deal shouldn’t get done only that expected margins and synergies must support the incremental risk, and that an appropriately conservative financing structure should be used.
The broader point is that risk is a form of leverage. By taking variability out of operating cash flows, whether through financial hedging, contractual structure, or by risk adjusting growth opportunities, a firm can support greater financial leverage and higher returns on equity with the same overall risk profile, or lower the risk of distress/default while maintaining returns. Risk management is not necessarily about taking risk off the table, but rather about maximizing risk adjusted returns. This is where a narrow focus on “hedge advisory” misses the point. While financial derivatives are an important tool, they are not the end game. Without a thorough understanding of balance sheet management, physical structuring, and risk analysis around large-scale deals a firm can’t optimize returns. Moreover, they are still vulnerable to making the same mistakes they might make in financial derivatives, only now on a potentially much larger scale.