Would we have invested in that project and released the funding ahead of closing if we had fully considered the financing risk on its own? Would a dispassionate review of the closeability of the financing caused us to forgo the investment? What would our view of returns have been if we had focused on the issues the revenue plan alone offered? What would our view of their expense estimate had been had we trained our analysis on the set of costs alone?
A useful and yet little attended part of the investments is a pure risk analysis. I advocate that as principals creating investments and investors placing capital in investments. That we should add a step to our analysis. I suggest a good term for this is the “Risk Focus Analysis”. In business school, they teach reviewing each alternative and placing a probability of success on that alternative along with estimating its value. Using this technique you are advised to make a choice for your action plan. Unfortunately, this view is in my opinion over simplistic. Instead, I suggest modifications to this approach. First, for plan alternatives that match the business school scenario take the following steps.
- Describe the choice(s) you are making and the anticipated results.
- Determine their value.
- Determine whether there are “events” in the chain that can cause the plan to fail.
- Determine the probability of success.
- Assign the value based on the probability.
- Make a decision based on the “failure events” to keep the option in the list or not.
- Choose from the remaining alternatives.
Considering further, many projects don’t really lend themselves to this “alternative analysis” process. Instead, we are looking at an investment project and evaluating its executability and expected profitability. For these cases, a process to determine whether or not to invest and under what conditions to invest is needed. Rather than the simple brute force due diligence analysis let’s consider what our concerns are:
- What is the risk that part or all of our capital be lost?
- What conditions should we place on the investment to protect our capital?
- What are the risks to the projected returns?
- What are the risks to the exit plan?
With these items in mind, the investment risk analysis should help work out whether to invest or not and then under what conditions to invest or not. Also, as an investor or investment fund, this can determine basic investment protocols for agreements. To work these our investors should:
- Define the issues effecting the potential safety of the capital including financing, guarantees, inventory, or working capital consumption for example.
- Define the assumptions determining income.
- Determine the assumptions determining expense.
- Determine the assumptions determining capital purchases and their amounts.
- Determine what issues create a risk of capital lost and if they can be avoided. Make a go / no go decision or place restrictions on the investment based upon this.
- Determine assumptions that impact the potential returns and if they can be avoided. Make a go / no go decision or place restriction on the return management based upon this.
In all cases, if the restrictions and approaches become to complex, the investor should consider foregoing the investment.
If as investors we apply this view, we can significantly reduce our capital risk and strengthen our capital gain potential.