A central problem in business is financial risk allocation. When a person or a company assumes an excessive amount of risk for a potential gain it often has a negative impact on shareholder value. While calculating and pricing risk is difficult under any circumstances, it is particularly challenging in times of heightened financial volatility when known risks can have unforseen impacts and new types of risk may appear. Given the negative consequences that inefficient risk allocation can cause, both for individual companies and the economy as a whole, this article suggests that using risk sharing approaches as a basis for financial risk allocation may be a better way to build corporate value, stabilize liquidity levels and acclerate the process of economic recovery.

Risk Pricing in Financial Transactions

All financial transactions involve risk: if I provide a loan, there is always some degree of uncertainty as to whether I will be paid back; if I purchase the shares of a private company, there is always a degree of uncertainty as to whether I will receive the funds I invested back and what return I will make. Even though there are many ways that risks in connection with financial transactions can be reduced they can never be completely eliminated.

One of the ways that this uncertainty is managed is through the cost of capital. If a company has a high risk profile, a lender not surprisingly will charge a high rate of interest to be compensated for that risk; if the future financial performance of a company is highly uncertain, an investor will require a high rate of return, which generally means buying the shares of the company at a lower price.

While there are different ways of pricing risk, as a general rule the required rate of return in connection with a specific investment opportunity is determined based on market-derived parameters. If funds are generally lent to companies with a certain credit rating at an interest rate of 6%, it is likely that, all other things being equal, funds will be lent to another company with a similar risk profile at a similar interest rate.

With regard to equity investment, risk pricing is generally based on the process of company valuation. While companies can be valued in different ways, market and cash flow valuation approaches are closely tied to market-based valuation reference points. If companies in a certain sector tend to be valued at 8x their EBITDA, this multiple will often serve as the baseline benchmark for valuing other companies in the same sector. If the present value of the future cash flows of a company in a particular sector are discounted at a rate of 9%, the cash flows of similar companies will often be discounted at this rate as well.

Risk Pricing in Volatile Market Situations

Pricing risk is, of course, much more challenging in times of heightened economic uncertainty. This is due to several reasons, including:

• The number of market transactions may fall, reducing the size of potential points of valuation and risk pricing comparison
• Assumptions about the core relationship between risks and economic value may become significantly less reliable as costs and revenues may respond to risks in unpredictable ways
• New realities may create opportunities or risks that are significantly different than what has historically been the case.

These challenges often translate into two risk pricing outcomes, both of which have disadvantages. The first is that capital providers simply do not provide funding, which restricts the amount of funds that businesses have access to and, more generally, reduces financial system liquidity. Reduced financial system liquidity raises capital costs and increases many types of operational risk.

Apart from the impact on businesses and the financial system, choosing not to invest funds in times of heightened market uncertainty has a negative impact on capital providers, because these institutions often need to invest capital to generate profits for themselves, create returns for third party capital providers or provide funding for different types of projects in the public interest. Apart from its financial significance, reduced levels of investment can have a significant impact on expenditures that are needed for economic growth.

The second pricing outcome in situations of heightened market volatility is that a transaction goes forward, but one party to the transaction has an increased likelihood that they will either gain more or lose more than would be considered financially reasonable based on a normal market analysis of underlying transaction risk.

For example, let’s assume that under normal market conditions a company with a certain risk profile would be valued at US $100. Given the greater market volatility and the fact that company revenues and costs may deviate in unexpected ways from what has occurred in the past, the company may turn out to have a value of US $50 or US $150 which obviously represents a significant windfall for one party and loss for another.

It is important to keep in mind that a significant loss for a party to a financial transaction may have consequences that extend far beyond an investment gain or loss. For company, the shortfall may affect the company’ ability to employee additional people, make new investments or even remain viable, all of which can set in motion a chain of events with compounding negative economic consequences.

Risk Sharing Approches

An alternative to basing transaction terms on fixed point risk perceptions that will likely turn out to be false is to use more creative financing structures where the relationship between economic return and risk is balanced over the life of the investment.

One area where this type of approach can be utilized is the valuation of financial assets. Returning to our earlier example, let’s assume that an asset with a value of x in an increased market volatility environment has an equal possibility of ultimately generating cash flows of x(2) or x/2. In other words this means that the parties are entering into a transaction where there is a very significant chance that the valuation will turn out to be significantly wrong.

An alternative valuation approach is one where the base valuation of the company is set at x but there is an adjustment mechanism based on future events. For example, assume that the value of x is based on the assumption of 100 in free cash flow in year 1, 150 of free cash flow in year 2 and 200 of free cash flow in year 3. By applying this type of valuation structure, if the company turns out to have greater cash flows than expected, company shareholders could receive a portion of this windfull; similarly, if it is lower than expected, there could be some adjustment in the investor’s favor either in the form of a purchase price clawback or through an increased share of dividends that the shareholders receive.

While forms of this type of wait and see approach can be seen in some private equity investments, they are less common in other types of transactions that involve longer term payment streams such as commodity offtake agreements. In these arrangements, as a general rule commodity prices are driven by market prices, which can fall or rise abnormally in situations of market volatility. An alternative to this pricing model could be one where prices were paid in accordance with market conditions within an agreed upon band, but if prices moved above or below that band the buyer or seller would receive some price protection.

This type of analysis can even be applied in real estate transactions involving cash streams where rent levels can be adjusted to make rents more affordable in times of economic difficulty but where above market rents are charged once normal market conditions return. This type of financial flexibility may help reduce events, such as tenant evictions, which can have significant negative economic consequences for landlords as well as property renters.

Conclusion

Market uncertainty created by Covid 19 poses significant challenges for financing transactions. While reducing financial transaction volumes and waiting for more recognizable market conditions to return is a market option, reducing market liquidity may further exacerbate the many economic challenges that Covid-19 has already created. An alternative approach involves risk sharing financing structures which, although not eliminating risk entirely, would distribute risk more symetrically across market participants and the market itself. This would act as a counterbalance to the tendency of financial liquidity to fall in situations of market uncertainty.

The photo for this article was taken by Tomoe Steineck.