Since the late 1990’s, analysts have been observing a good number of companies encountering major value losses. Although independent, such companies have a cumulative impact on the global economy. The indirect effects are inescapable.
The valuation of an organization is the worth of business, which is generally based on the net value of all assets. Even after paying enough attention to risk, compliance and governance, boards are perplexed about the factors contributing to a loss scenario.
A study conducted by Deloitte investigated 20 companies (2003-12) that incurred a loss percentage of 20 or above in a month’s period. Deloitte discovered the drivers of major value losses through that effort. While the losses were dissimilar, a pattern of veiled risks were detected, and they might have applied to all the companies studied.
Here are the risks that play a chief role in value killing:
Black swan events
Risks that occur less frequently but create a high impact are a major cause of concern. The 2008-09 financial crisis and natural disasters are such largely quoted occurrences. Organizations lose major stock values due to these events.
Such risks are hardly anticipated. They have the potential to hit too many assets at once, and expose a company’s strategic, operational and financial insufficiencies.
To manage low-frequency high-impact risks, a board should execute scenario planning, conduct stress tests and prepare for the consequences they bring along. By doing so, organizations can identify their vulnerabilities and revamp them.
Risk interrelation and interdependency
This is another nature of risks largely neglected before the recent financial crisis. It is still trouble for companies not having learnt or understood the interdependent nature of risks.
Black swan events leave companies more susceptible to them. Risk management processes collapse as organizations end up dealing with multiple risks simultaneously.
The nature of risk is such that a risk that occurs in one department flares up a series of risk events in other business units. The initial risks are treated in isolation without much heed for their contagious nature. Businesses have to come out of their silos and view & treat risks with a holistic approach.
Many risks are interlinked, and their collective impact affects different assets and reduces the company’s value considerably.
Liquidity risk was among the top risks that led to the 2008-09 financial crisis. Companies, especially financial institutions that didn’t have enough capital, confronted enormous losses during the housing bubble burst. Investors had little idea about liquidity requirements, which caused organization credit ratings to plummet.
It is crucial to analyse the impact of liquidity risks and credit crisis on the organization and adequately arrange for capital and supplementary credit solutions.
Most M&A related risks can lead to liquidity risks. Scenarios have been observed during the financial crisis, when organizations took debt for acquisition and succumbed to liquidity risk as well.
M&A makes companies prone to risks like distinct cultures and standards, shift in customer trends and preferences, lack of transparency, inadequate communications and so on. There has been a substantial rise in the number of companies which have undergone M&A related losses.
Organizational culture on compensation
Whether or not compensation risk contributed to the financial crisis is a hot topic still debated by analysts.
Organizations that support the culture of short-term compensation tend to induce excessive risk-taking. There were compensation risk scenarios wherein short-term goals and gains hadn’t materialized, and the bonuses and compensations went down the drain. Abiding by the regulatory policies on executive pay, and following a firm compensation policy in relation to long-term goals can help mitigate risks directly related to pay-outs.
Mohammed Nasser Barakat is Consultancy Director at UK-based CAREweb Corporate Governance Consultancy offering Governance, Risk & Compliance (GRC) software used by the well known global business organizations. Nasser is Certified Control and Risk Self Assessment Practitioner (CCSA) and has 8 years experience in Internal audit solutions and consultancy. He has contributed to a consultancy services of Business risk management strategies.