Risk Based Performance Revenue Targets – Part 4
When creating something physical whether it be a building, a home, or a child’s playhouse, it is clear that certain materials are necessary. The bigger the structure the more materials required. When investing money into the equity markets or buying a bond, again it is obvious to most that a certain amount of capital invested should yield an expected or target return, barring unforeseen events.
While this is readily apparent when building a house or investing one’s hard earned money, in many corporate environments it tends not be explicitly acknowledged when defining target revenues relative to associated risk.
At times it seems that some companies attempt to be medieval alchemists, who claimed they could create gold from lead, when it comes to creating revenue. Often times revenue targets are created without consideration of the amount of risk capacity required to create those revenues under reasonable and normal business conditions. Energy trading is a prime example to illustrate how this occurs. Limits are set as an explicit or implicit proxy for risk capital without analytic consideration of the revenues that should be expected at that level of risk. Furthermore, that allocated risk expressed in the form of a limit in many cases, becomes more of something to be avoided and not optimized.
This failure to properly consider revenue in light of risk is often embedded in the way companies and decision making bodies are empowered, organized and operated. Typically revenue and associated earning targets are defined in a budgeting process, risk “appetites” and limits are typically established under some type of “risk” committee, and capital investments are considered under an invested capital process and committee. All of these processes need to be highly coordinated and not treated as separate and distinct decisions.
The net result of this dichotomy of process and decisions are unattainable revenue targets, or an underestimation of the risk being taken to meet defined revenue targets. In a worst case scenario this could also create the potential circumvention of controls which attempt to align business activities with defined objectives and risk tolerances, to achieve targeted business goals. The recent Wells Fargo fake account scandal is an example where unrealistic business goals led to such rogue behavior.
Linking Target Revenue to Risk
With some companies, we have observed that a historical look back at risk based performance in light of achieved revenues does occur. When this is done, It is typically focused on trading activities since this is the most likely area to be subject to explicitly defined risk “appetite” limits, and return against these limits can be readily determined. Most other business activities are not as readily assessable in this manner because risk capacity or capital is often not calculated or explicitly defined.
An historical look back is a first and critical step towards a risk based budgeting process, and the recognition of the risk capacity and cost of achieving revenue. This association of revenue and risk needs to be explicitly when budgeting for revenue targets along with appropriate levels of allocated risk capacity. This should be performed across all business activities at levels of granularity consistent with decision making authority and autonomy.
A well defined process to establish target revenues and recognizing appropriate levels of risk to achieve these results should be integrated into a company’s budgeting and planning processes. During this process a discussion between desired revenue, the amount of risk allocated, and what that infers regarding expected risk adjusted performance is essential. Additionally, it is at this stage where trade-offs between various risk/return opportunities can be considered to optimize return to stakeholders given the available risk capacity.
The establishment of an allocated risk appetite and desired earnings targets should be viewed as an optimization exercise where key questions are addressed:
• Are the expected returns on risk reasonable? Earnings targets are frequently established without due consideration of the amount of risk required to achieve a target level of earnings. Implicit in this consideration is an assumption of some level of risk based performance. Back in business school days this risk based performance was referred to as a Sharpe ratio.
Without an integrated consideration of these three factors, various issues could result. There could easily be a failure to achieve targets, or result in behavior creates more than desired levels of risk being taken to achieve revenue targets. In a trading environment, this imbalance between allocated risk and expected return can result in the so called rogue trader outcome. When considering the appropriate assumption of performance to incorporate when defining revenue targets given a certain level of risk capacity, two approaches should be considered. The first would utilize benchmarking information associated with other companies that have similar business activities and adequate granularity of disclosure. Third parties are usually the best source for understanding the risk adjusted performance of market competitor companies. These benchmark results should be normalized to reflect the specific circumstances and differences associated with various industry participants and your company’s specific needs.
Supplemental to external performance benchmarks would be to utilize internal historical analysis of risk and return information. Defining an expected level of risk based performance, can also be used as a mechanism for compensation decisions, where superior performance above expected and benchmark levels is rewarded appropriately.
• Does more risk capacity need to be allocated to achieve targets? When consideration is given to the balance between allocated risk capacity and expected performance, informed decisions can be made. This could result in the allocation of additional capacity to a particular business, or the reallocation to alternative activities that demonstrate a higher probability for better risk adjusted returns. During this part of the process, portfolio implications of business activities, overall risk capacity and appetite, and available options should be considered. If certain areas of business singularly appear to offer the best risk return trade-offs, allocating too much risk capacity may result in two outcomes that could decrease overall portfolio performance. First. depending on the depth of the market additional investments may yield diminishing returns, and becoming overly concentrated will diminish diversification effects, and available risk capacity.
• Should business targets be reassessed in light of projected returns market opportunities? After consideration of the three key considerations of risk, performance and revenue, business targets can also be revised to reflect the balancing and optimizing against these constraints. This is the opposite side of the coin as compared to allocating more or less risk capacity to achieve target revenues. The challenge is how best to optimize overall return based on finite capacity to take on risk, the alternative market and investment options available, and expectations of reasonable risk based performance. The optimization of possible risk based adjusted return on deployed risk capacity requires a thorough consideration of these factors among competing business alternatives and evolving market conditions. Unlike the magic possessed by the medieval alchemists who claimed the ability to create gold from base metals, most corporations do not possess the same magic potion.
However, superior risk adjusted returns for stakeholders can be optimized through a careful and thorough consideration of risk capacity, portfolio considerations and application of available risk capacity, and an assessment and allocation based on performance and market opportunities. Integrating a risk based calculus into the budgeting process will enable an optimal allocation of risk capacity, and revenue targets consistent with a company’s risk appetite and performance objectives. As I’ve said many times, risk management isn’t something else to do, but should add value to what you need to do. Incorporating risk based thinking into the budgeting process accomplishes this mandate.
Bob Young, Partner, TechCXO, New York
Bob Young is a New York-based partner at TechCXO, and leads TechCXO’s risk management practice. See his full bio here.