Four things you need to be doing with risk capital

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Risk capital gives financial firms the cushion they need to protect liability holders from unexpected losses. Simply put, risk capital is your home-run money — funds that are invested in high-risk, high-reward investments. It reduces debt overhang that could limit borrowing capability and makes the costs of bankruptcy or firm distress more remote.

But there’s a catch — adding risk capital can only benefit firms’ balance sheets if it is allocated efficiently, according to a study co-authored by Isil Erel, Academic Director of the Risk Institute and Distinguished Professor of Finance at The Ohio State University Fisher College of Business.

The study, “A Theory of Risk Capital”, was co-written by Erel, Stewart C. Myers at MIT Sloan School of Management, and James A. Read Jr. at The Brattle Group Inc. in Cambridge, Mass. In the study, Erel, Myers, and Read focus on diversified firms with safe and risky businesses in their portfolios. The firms have customers and counterparties who are not willing to bear significant default risk.

Know if your company’s risk capital really working for you — here are the four things you need to know and be doing.

1) Risk capital must be allocated

  1. To assess profitability,
  2. To make investment decisions,
  3. To price products and services, and
  4. To set compensation.

2) Efficient risk capital allocation has to do two things: 1) there can be no risk that changes in the business portfolio that would affect the credit quality of the firm’s liabilities, and 2) firms have to avoid shifting risk capital from one business to another.

3) Of course, your business is doing all that already, so what do you really need to focus on? Your marginal default rate in order to allocate the risk capital.

The marginal default rate is the derivative of the value of the firm’s option to default with respect to a change in the business size, according to the study. The required amount of capital depends on the target credit quality and on the risk of the business portfolio. Businesses with the largest marginal default values should receive the most risk capital and be charged most of the costs of the risk capital.

4) Risk capital can help expand your business, but keep in mind that riskier businesses need free passes to expand, which will increase the default risk. These risky businesses might also operate at a lower credit quality.

To mitigate the effects on credit quality of the overall business, businesses shouldn’t use risk capital that’s fixed in the short term.

Remember, any asset or activity with uncertain returns requires risk capital. By focusing on marginal default values, credit quality, and risk within the business portfolio, firms can us risk capital efficiently to help improve their bottom lines.

If you want to dig deeper into this (and other) of the latest risk research, the full paper and accompanying translation are available on our website.

Show me the money

Are private equity investments worth the risk?

investment-trees

Question: Do private equity returns and diversification benefits adequately compensate investors?

This is the debate swirling in investment circles, and it’s the question that researchers Berk A. Sensoy from The Ohio State University Fisher College of Business and Nicholas P.B. Bollen from Vanderbilt University work toward answering in their paper, “How much for a haircut? Illiquidity, secondary markets and the value of private equity.”

Private equity investments have illiquidity and market risks related to the timing of capital flows and require management fees that are usually two percent of investors’ capital commitments per year, plus performance fees typically equal to 20 percent of the profits. According to the researchers, the returns and diversification benefits do justify the risks and costs borne by investors.

The drawback is that secondary sales could result in discounts from fund net asset values of as much as 50 percent during financial crises. During other times, the discount could be 20 percent. Despite these discounts, the study finds that the historical performance and diversification benefits of venture capital and buyout funds, the main types of private equity firms, are sufficient to justify their risks and fees. For example, buyout funds have on average outperformed public equities by about 3% per year.

So what percentage of your portfolio should you allocate to private equity?

If you’re an extremely conservative investor with an extreme risk aversion, the researchers recommend that you should allocate no more than about 10 percent of your portfolio to private equity investments.

If you’re an investor with low to moderate risk aversion, you can comfortably allocate up to 40 percent of your portfolio.

To set yourself up for the best chance of success, the study notes that you should be particularly willing to take the risk of private equity investments if you can access average-performing funds.

While this study will certainly not end the debate, Bollen and Sensoy’s study shows that the returns and diversification benefits of private equity appear sufficient to compensate for the risks and costs for limited partners who have a broad range of risk preferences at portfolio allocations typically observed in practice. The findings offer limited partners a guide in making their portfolio allocation decisions.

If you want to dig deeper into this (and other) of the latest risk research, the full paper and accompanying translation are available on our website.

 

Intellectual Property: Defense is the Best Offense

Intellectual property is worth a good strategy for risk management.

Identifying a company’s intellectual property can sometimes be a fuzzy exercise, but it’s clear that failing to do so and not having a risk management strategy to safeguard a business’ “secret sauce” can lead to dire consequences. That’s especially true for startups whose only real asset may be the big idea that got them going in the first place.

Still, intellectual property and risk management consultants say companies may not be doing as much as they can to protect their IP assets, which can include everything from product formulas to customer lists.

Risk Institute Portraits Fisher Hall - Third Floor Feb-02-2016 Photo by Jay LaPrete ©2016 Jay LaPrete

Philip Renaud, executive director of the Risk Institute at Ohio State University’s Fisher College of Business

“I wonder if inside the doors people are having enough robust conversations about what their intellectual property is and what needs to happen to manage the risk,” says Steve Snethkamp, a partner in the Columbus office of EY. His consulting practice covers a variety of industries with a focus on information technology.

The stakes are high, he says, pointing to incidents in which the technology behind a new product has been stolen and implemented by overseas competitors even before the IP owners can get that product to market. And it’s not easy to manage that risk, especially with all the data that can be shared—and exposed—through the ever-increasing use of mobile technology and interconnected devices.

“There is no silver bullet,” Snethkamp says, “but the first thing (for companies) is to create a cultural awareness that security is important and IP is the lifeblood of the organization. That needs to be the mantra of every person in the company from the janitor to the CEO.”

Then businesses need to clearly define their intellectual property, identify where it is located, make an inventory of it and put in place controls, processes and procedures to protect it appropriately.

“It’s hard stuff to do,” Snethkamp says.

But it’s also essential given the findings of a 2013 study by the independent Commission on the Theft of American Intellectual Property. It estimated that international thefts of intellectual property have an impact of more than $300 billion annually on the US economy, costing the country millions of jobs and dragging down economic growth and investments in research and development.

Risk managers historically were focused on hard assets—buildings, equipment and inventory—but that has shifted to intellectual property and intangible assets such as copyrights, patents, technical processes, trade secrets, customer lists and distribution networks, says Philip Renaud, executive director of the Risk Institute at Ohio State University’s Fisher College of Business. He has worked in the risk management field since the early 1980s, including stints with L Brands, Kmart, Exel and Deutsche Post.

“It’s much more difficult to value an intangible asset and protect it,” Renaud says. “I can’t put a sprinkler system and firewall around a copyright.”

In his opinion, IP risk management in many cases becomes a defense strategy in which companies must educate team members about the importance of protecting the brand. That is particularly the case of detailing the risks when employees are working online and sharing data.

Such preventative steps are especially important, Renaud says, because of the difficulty and expense of stopping an IP infringement after the fact.

“That’s the greatest challenge,” he says. “If the company that has infringed on you is exposed, the only way to get there is through legal proceedings. That costs a lot of money.”

There is also the thorny issue of taking legal action when an IP infringement occurs overseas. “How do you get enforcement in China?” Renaud asks.

His best advice for companies is to make sure they understand their intangible assets—how they are used, their value to the business and how they are being protected.

When looking to protect intellectual property, companies should consider registering their rights with patents, trademarks and copyright, says Susan Rector, an attorney at the Columbus office of Ice Miller LLP. She represents companies in all aspects of IP ownership and information technology transactions.

“Inherently, taking the steps to register the rights to your intellectual property gives you a leg up,” Rector says. “That’s important from a defensive standpoint. It can also be used offensively against people who come too close to your (IP) rights.”

She works with a lot of startup companies that are building their business model around a proprietary product that is far and away their most valuable asset.

“Often it’s two guys, a laptop and an idea,” Rector says. “A lot of them will get big valuations (from investors), but people will only back them if no one else has done it. … They need to think about an intellectual property strategy early. If they don’t, they can lose their ability to protect that product or device.”

Intellectual property presents some specific challenges for risk managers, says Nicholas Kaufman, head risk manager at Battelle in Columbus.

First, it can be difficult to place a value on IP assets because they can be hard to measure, especially compared to property risks or auto liability. Second, Kaufman says there really is no insurance market for intellectual property because mature insurers tend to organize around areas they understand and know the likelihood of payouts on policies. That’s not the case with IP because of the difficulties in placing a value on the assets and calculating the risks to them.

Despite those issues, companies still need to have a risk management program in place for their intellectual property assets because the stakes can be so high. Kaufman says Battelle’s program takes an enterprise-wide approach in managing the IP risks for its range of products, services and research it conducts.

“We look at it holistically,” he says. “It’s not just about defending our intellectual property but making it as easy as possible for our scientists to create IP.”

Kaufman says intellectual property best practices start with an understanding of your organization and how IP brings value. Then it becomes a matter of aligning resources to protect that value.

The sooner that companies think about protecting new intellectual property the better, says Ari Zytcer, a Vorys, Sater, Seymour and Pease LLP attorney who has worked in the IP field for more than 10 years. But he also recognizes that can be easier said than done.

“In identifying intellectual property,” he says, “you’re starting in the dark. Is this going to be a commercially successful product or an intermediary that leads to something down the road that you would like to protect and stake a claim? You don’t know what aspects you’d like to protect (with a patent) … so we see broad coverage at the beginning. As development continues, you home in on what is commercially viable and blocking other companies from getting into that space.”

Zytcer also says there is no one-size-fits-all approach for IP risk management.

Small companies, for instance, have to consider whether it is best to spend limited resources on patent procurement versus funding research and development and breaking into a market. Large companies generally take a more holistic view with IP committees drawn from the business side—risk management, legal, finance and marketing for example—and R&D side of the enterprise. They track new inventions and make the call on the allocation of resources for patents, trademarks and other IP safeguards.

“Having a cohesive policy for the company is crucial,” Zytcer says. “It’s almost like a marriage. The right hand needs to know what the left hand is doing.”

Jeff Bell is a freelance writer.

Area Companies Learn to Navigate Political Risk

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Whether an organization is a multinational player or just starting to explore expansion into the global market, political risk cannot be ignored or underestimated. Political risk is taking on new forms, both real and perceived, and may be at its highest level since the Cold War.

In order to succeed, companies must elevate their awareness of inherent challenges of everything from political violence to currency inconvertibility.

On November 15, The Risk Institute at The Ohio State University Fisher College of Business welcomed dozens of area and regional professionals to Navigating Political Risk in Uncertain Times (part of this year’s Risk Series) — an executive education session that explored effective ways to manage political risk and gain insight on how to navigate the landscape and find potential for competitive advantage.

The Risk Institute is thankful for the informed leadership of our session experts: Les Brorsen, Americas Vice Chair Public Policy at EY; Professor Richard Herrmann, Professor & Political Science Department Char at The Ohio State University; Roger Schwartz, Senior Vice President at Aon Risk Solutions; and Sarah Brooks, Associate Professor of Political Science at The Ohio State University.

The session centered around three concepts:

  • Learning to identify, measure, and manage political risk
  • Examining the macro-level political risks that could affect business interests
  • Exploring the relationship between the state and market in social and economic relations

The session’s thought provoking ideas and dialogues advanced The Risk Institute’s unique role in uniting industry thought leaders, academics and highly respected practitioners in an ongoing dialog to advance the understanding and evolution of risk management. The Risk Institute’s conversation about risk management is open and collaborative and relevant across all industries.

Start the New Year off right — registration is now open for our next Risk Series on supply chain resilience on January 24, 2017. We’ll see you there!

Risk Case Competition a Success

img_5464The Risk Management Association at Fisher College of Business in partnership with The Risk Institute held a case competition earlier this month which exposed its participants to the technical aspects of risk management while also developing their critical thinking and presentation skills.

Seven teams competed in the two-week competition, which culminated in presentations to an expert panel of judges: Nick Kaufman, Head Risk Manager at Battelle; Dr. George Pinteris, Associate Professor of Finance at The Ohio State University; Dr. Jay Wellman, Associate Professor of Finance; Daniel Chizever, Senior Director of Risk Management at Abercrombie & Fitch; Jonathan Caruso, Risk Manager at Express.

The winning team included John LaVange, junior; Sam Bernardo, senior; Zhe Wang, senior. Awards were also given out for Best Speaker — George Valcarcel and Carly Smith — and Best Q&A — Ryan Patrick.

Navigating Political Risk in Uncertain Times

social-media-politicsJoin us on November 15 at 10 a.m. to explore effective ways to manage political risk and gain insight on how to navigate the landscape and find potential for competitive advantage.

Whether your organization is a multinational player or just starting to explore expansion into the global market, political risk cannot be ignored or underestimated. Political risk is taking on new forms, both real and perceived, and may be at its highest level since the Cold War. Companies have to elevate their awareness of inherent challenges of everything from political violence to currency inconvertibility.

Executives will learn:

• To identify, measure, and manage political risk

• To examine the macro-level political risks that could affect your business interests

• About the relationship between the state and market in social and economic relations

The Institute will welcome Les Brorsen, Americas Vice Chair Public Policy at EY; Professor Richard Herrmann, Professor & Political Science Department Char at The Ohio State University; Roger Schwartz, Senior Vice President at Aon Risk Solutions; and Sarah Brooks, Associate Professor of Political Science at The Ohio State University.

If you’re interested in attending, contact Denita Strietelmeier at (614) 688-8289 or send an email to RiskInstitute@fisher.osu.edu. For more information about this and the upcoming sessions in our Risk Series, please visit our website.

Build a bridge or blaze a trail: how companies respond to major technological change

Technology is changing our world more quickly than anyone ever anticipated. Everything from customer tastes to regulations is forcing companies to develop radically new capabilities in order to compete. So when faced with these major developments, managers are faced with a tough question: build a bridge or blaze a trail? choose-path

According to the findings from the study “Alliance Activity as a Dynamic Capability in the Face of a Discontinuous Technological Change” by Jaideep Anand, Raffaele Oriani, and Roberto Vassolo, some managers attempt to develop new technologies in-house while others seek alliances to access those technologies.

Option #1: Blaze a trail & develop new technologies

  • Many managers choosing to develop technologies in-house do not realize that existing technologies can be a handicap — not a help.
  • Firms with stronger technological capabilities are more likely to enter new domains.
  • Remember, even though you aren’t building external relationships, you still need complementary capabilities, such as being proactive in seeking new technologies and having a strong internal development research team.
  • Firms with capabilities in traditional technologies do not have an advantage in entering emerging technological fields through internal development. In fact, capabilities in the traditional technology not only decrease the likelihood of entering new domains but also might have a negative effect

Option #2: Build a bridge & form alliances

  • Managers seeking alliances may not know that successful alliances require more than connecting technological capabilities.
  • Technologically disadvantaged companies also are less likely to enter new domains.
  • Firms with good complementary capabilities are more likely to find competent partners and access their capabilities.
  • Alliances build the “give-and-take” relationships that effective alliances require. In the study, creating alliances in the pharmaceutical industry gave companies the technology they needed in exchange for testing, marketing and distribution.

If you want to dig deeper into this (and other) of the latest risk research, the full paper and accompanying translation are available on our website.

Risk Institute board chair elected chair of Risk Management Association

Helga Houston, chief risk officer at Huntington and chair of the board at The Risk Institute, was elected chair of The Risk Management Association (RMA). Her one-year term began September 1, 2016.

Helga Houston speaks at Risk Institute Annual Conference 2016

Helga Houston speaks at Risk Institute Annual Conference 2016

Helga Houston is past vice chair of RMA’s Board of Directors.

Houston has over 30 years of diversified banking experience in risk management, business development, and client relationships. Prior to joining Huntington, she held positions with Bank of America, Crocker National Bank, and Home Federal Savings and Loan.

Houston earned her bachelor’s degree from Westmont College and her MBA from the University of Southern California.

About RMA

Founded in 1914, The Risk Management Association is a not-for-profit, member-driven professional association whose sole purpose is to advance the use of sound risk management principles in the financial services industry. RMA promotes an enterprise approach to risk management that focuses on credit risk, market risk and operational risk. Headquartered in Philadelphia, Pennsylvania, RMA has 2,500 institutional members that include banks of all sizes as well as nonbank financial institutions. They are represented in the Association by 18,000 individuals located throughout North America, Europe, Australia, and Asia/Pacific.

About The Risk Institute

The Risk Institute at The Ohio State University Fisher College of Business exists to bridge the gap between academia and practice. The Institute is a collection of forward-thinking companies and academics that understand effective risk management strategies not only protect firms, but position firms to create growth and value. The Institute operates in a unique intersection between our faculty, students, and professionals from a broad cross-section of industries.  With our leading-edge approach to risk management, The Risk Institute creates a space for risk-centered conversations, ideas, and strategies that are unlikely to happen anywhere else.

This release originally published on Sept. 6, 2016.

3 things you need to know to succeed in risk

Panelists from the Women. Fast forward panel at this year's annual conference

Panelists from the Women. Fast forward panel at this year’s annual conference

Disruption and gender diversity are two of the biggest topics facing business leaders today. Both issues are critical to the future of every industry. And they’re closely connected.

The best way to navigate disruption is to harness the power of diverse thinking by enabling people with different experiences, ideas and knowledge to come together in an inclusive culture. Gender diversity is a critical part of the equation. Not only this, gender diverse leadership is proven to increase the skills businesses need to navigate the disruptive trends transforming their industry.

So what does this mean?

If a person, or company, wants to succeed in mitigating risk, they must embrace gender diversity at every level.

In short, everyone benefits from thinking like a woman.

  • “You need to get comfortable being uncomfortable” — Jessica Jung, Director, Oswald Companies

Achieving success isn’t something that just happens to a person. It requires a lot of hard work, tough choices, and generally being willing to put yourself out there— trying something new.

  • Have an entrepreneurial spirit

No matter if you’re the intern grabbing Starbucks for your department or a C-suite executive, don’t be afraid to think outside the box. When approaching any situation, don’t come to the meeting and just point out the risks — offer real solutions.

  • Communicate. Communicate. Communicate.

Every panelist punched this point home — communicate with everyone, from your spouse to your organization and boss. By being an open communicator, you project to others that you are confident, open to compromise, and available.

Each year, The Risk Institute at The Ohio State University Fisher College of Business hosts an annual conference that brings together thought leaders, industry experts, and academics to engage in a dialogue about the latest trends in risk management. This year the conversation focused around governance, culture, and the vital role women play in the field.

One of the Institute’s founding member’s, EY, cosponsored a panel spring-boarding their Women. Fast forward initiative, which aims to accelerate the achievement of gender parity in business.

The Risk Institute will continue this conversation and others through this year’s Risk Series.

Governance and culture take center stage at The Risk Institute’s Annual Conference

Conversation surrounding governance and culture recently took center stage at The Ohio State University Fisher College of Business, as The Risk Institute explored the impacts of the two key aspects of business at its Annual Conference. The two-day conference brought together Risk Institute members, business leaders, experts and faculty thought leaders from Fisher for an in-depth examination of the risk management and strategic implications of governance and culture.

Phil Renaud and Jeni Britton Bauer of Jeni's Splendid Ice Creams discuss maintaining culture through crisis.

Phil Renaud and Jeni Britton Bauer of Jeni’s Splendid Ice Creams discuss maintaining culture through crisis.

Considering the various sides of governance and culture is critical to understanding how to leverage risk management to create value for an organization. The conference featured four keynote speakers, Gordon Bethune, former CEO of Continental Airlines; Cameron Mitchell, founder and CEO of Cameron Mitchell Restaurants; Randall Kroszner, former Governor of the Federal Reserve System; and David Gebler, author of best-selling book The 3 Power Values.

Bethune opened the conference and focused on his experience turning around Continental Airlines over a decade, which is detailed in his book, From Worst to First. He emphasized the importance of building accountability between employees and the organization saying, “What gets measured and rewarded, gets done.”

Mitchell is a self-described serial entrepreneur who understands that taking risks is necessary to be successful in business saying, “I may shoot myself in the foot and walk with a limp, but I’ll never shoot myself in the head and make a fatal mistake.”

Academic Director Isil Erel speaking at Annual Conference 2016.

Academic Director Isil Erel speaking at Annual Conference 2016.

During his time with the Federal Reserve System and as a professor of economics at the University of Chicago, Kroszner never imagined he would be helping guide America’s economy through the worst financial crisis since the Great Depression. He discussed the potential ramifications of the Fed keeping interests rates at historic lows since 2008 saying, “When your short-run policy becomes a long-run policy, you will always run into unintended consequences.”

Named one of America’s top Thought Leaders in Trustworthy Business Behavior, Gebler is an innovator of new approaches that integrate culture, ethics, values and performance. His talk detailed how to know if your organization’s culture is a risk factor utilizing the three power values— integrity, transparency and commitment.

In addition to the keynotes, the third-annual conference brought together business leaders and experts for a series of RISKx presentations and panel discussions on women in risk, governance and culture related to business. The culture discussion explored  employees’ attitudes toward risk, mergers and acquisitions, maintaining culture through crisis, and emerging risks in the energy industry.

The Risk Institute’s Executive Education Series will resume November 15 with a discussion on Political Risk.