Benefits of risk assessment applied to investments

by Edward Robertson

Exempt Market Dealers and investment firms carry out due diligence. Each firm seems to have its own method; it is scarcely evident to the investor that there is a universal standard guiding due diligence. Beyond that, it is even less evident that risk assessment -- that is, the investigation of uncertainty -- is actually done. I propose that many prior signs of project failure or under-delivery are detectable and manageable in advance.

Distinction between maturity assessment and risk assessment
Could not the investment product candidate be analyzed in two stages? The first is to assign a degree of maturity as a result of the due diligence exercise. It means verifying the presence of certain tangible features – for example, audited financial statements; management qualifications and experience; financial measures, etc.

The second stage is risk assessment – a separate exercise that is forward-looking. The object of risk assessment is to identify the uncertainty associated with the intended project execution.

Conventional risk assessment vs High Quality Risk Assessment
Financial risk methods usually rely on historical data to estimate the probability of loss, and on the stress testing of models. Such models are limited by the data available; they do not reflect the idiosyncrasies of the case. Other conventional views of risk are confined to audit and controls, or oriented to commercial insurance. However, the trouble is that financial risk assessment "cannot simply be outsourced to a quantitative model without understanding the context..." [1]

When the concept of risk is limited to the quantitative approach, a wide range of strategic, operational and administrative risk is ignored. For example, many firms with sound insurance portfolios and financial controls have foundered because they failed to detect that competitors were destroying their markets. Other operations have failed to enact corporate values (like transparency); understand and respond to stakeholders; carry out administrative processes efficiently; or properly analyze contractual risk -- all deficiencies, identifiable as risk ahead of time, and found later to have significant consequences. With "too much dependence on the math, you lose sight of the dynamics..." [2]

High Quality Risk Assessment - Benefits
A merely informal discussion of enterprise risk usually ends in a bland rehash of familiar management issues. The answer to this lies in a systematic and rigorous risk ID and assessment process, which I call High Quality Risk Assessment.

High Quality Risk Assessment uses a careful preparation of context, a structured discussion at a round table of subject matter experts, and strict rules of risk formulation. The result is a coherent set of risk statements that are directly relevant to goals and values, and ranked in order of priority.

Participants in High Quality Risk Assessment, which I have facilitated in dozens of contexts, including financial services, commonly report a more profound appreciation for the project at hand. The following positive outcomes are notable:

1. Shared understanding. Rather than participants working in their own "silos", each now sees how other people view risk. They build a common blueprint to take the project forward.

2. Comprehensive risk capture. The process tends to capture the vague, unstated and previously undetected thoughts and issues that go undocumented. The real risk profile (as opposed to merely obvious or alarmist risk) is now evident. Team members have more confidence that they are pro-actively managing the project.

3. Multi-dimensional risk profile. The risks can be sorted (in a risk register) along many different and useful parameters: by order of criticality; source of risk; contract clause; department; manager responsible; etc. This is very useful to understand in greater depth the risk profile; to manage it; and to compare it to that of other projects.

4. Tracking tool. The risk register is not just a snapshot; it is a management tool to monitor and track progress on risk mitigation at regular meetings.

5. Breakthrough risk mitigation. As the team brings its collective thought to difficult, chronic and seemingly intractable issues, they find novel solutions. And innovative risk mitigation need not be costly; it may be a simple administrative action that has high value.

 

Notes
[1] Flaherty, J., Gourgey, G., Natarajan, S. (30 Apr 2013). "Five lessons learned: risk management after the crisis", The European Financial Review.

 

[2] Carteret Islands Project (10 May 2010). Transcript of video interview with Peter Bernstein by McKinsey Quarterly, Jan 2008: