One sign of a successful risk culture within an organization is when management parcels out enterprise risk management (ERM) throughout the firm to make it meaningful for all employees. In my CFO advisory practice, I have found it useful to create a subset of strategic risk that I call “planning risk”—the failure to meet your strategic objectives due to weaknesses in your planning process.
Planning risk management contains quantitative and qualitative elements. In order to assure alignment among the board, management and staff around the desired risk appetite of the company, there needs to be an agreement of an expected growth rate and appropriate volatility that businesses and even investments can tie back to. In addition, there are qualitative assessments of capabilities relative the company’s current positions. What may be risky for one company with little experience or capability will be business as usual for a different company.
To help me assess a company’s planning risk, I have created a list of questions that I ask in the beginning of an engagement; below is a selection of some of my favorites. The ultimate goal is to create a common understanding of a company’s risk appetite and to determine whether their plan will satisfy that appetite. Capital alignment
The purpose of these questions is to ensure that management’s plans align with the risk appetite of those supplying the capital for the company. This provides the minimal threshold for growth, and expected volatility around that growth rate.What type of investors do you have, and what are their short- and long-term expectations?
External sources of capital come with requirements and constraints, and often the ability to replace management. For example, private equity may have an expectation of a CAGR they would like to see, or the type of exit they want to occur. Publicly traded companies need to understand what type of shareholders they have and whether they think they are investing in growth, mature or defensive company. Is there an activist investor making a play for the company? Lack of alignment will cause friction—among management, competition for resources, selection of inappropriate projects. For example: Is it most important to focus on revenue, income, operational metrics or economic value? The answer often depends on who has control of the company, and that is often the investors.What amount of volatility would you/BOD/equity/debt investors accept in hitting the growth rate over the planning period?
The long-term growth targets from the first question establish the aggressiveness and aspiration of the company; the next step is to determine how much latitude exists to “make the numbers.” It is critical that management understand the latitude they have to invest or make key investments in organic or acquisitive growth.Strategy alignment
The purpose of strategy alignment is to transform the capital alignment to the company, lines of business and initiatives. What business are we really in?
A bit of historical perspective is useful to understand how your company got to its current space. Companies can stand still and find that the market around them has changed, and that can open new business opportunities. One client of mine was a testing company, until it realized that the tests were really data that could be mined, repackaged and sold as a product. This is both an introspective question as well as a market-based view. Are company business lines and products interrelated operationally and financially? What are the goals and metrics for each business line and product set?
If a company is thought of as a portfolio of business lines and products, there may be flexibility to have lines that grow faster or slower, are cash cows or dogs. This can provide operational freedom for the team, and also informs on the amount of coordination, collaboration, and degree of flexibility across the units.Objective alignment
The questions here become tactical as risk management moves to the ability to execute on the areas of growth.What is our customer lifetime ROI/ROIC?
Companies are trying to develop long-term relationships with customers, which means attracting customers, anticipating their needs, and servicing them better than the competition. The investment in customer acquisition, number of customers acquired and the return on those customers can be correlated to the growth and return rates (or other key metrics) and supports our thesis of aligning with top-level goals. Note: using a fully-loaded ROI as well as a marginal ROI can inform your efficiencies and returns to scale. What is the likelihood we can execute this initiative?
This is the risk side of a risk-reward tradeoff, where risk is defined as the ability to execute on the project. This is a change from above where risk was the volatility of earnings. Most risk ratings are qualitative assessments that are given numerical identities (e.g., scale of 1-5).
Consider that you are creating a portfolio of investments, much like a portfolio of stock and bond securities. How would they look if they were plotted on a risk-reward graph--would you have a mix of conservative and stretch investments?A longer version of this article will appear in a future edition of AFP Exchange.