Linking Contingent Capital, Operational Risk Management and Pension Fund Holes
Generally the market sees earnings as the only measure of performance and does not recognise business as a life cycle. The amount of M&A activity and a lack of true venture capital indicate that risk investment is mostly focused on ‘safe’ grounds of existing businesses whose future is considered unbounded. Recognising a life cycle would increase the amount of start-capital and prudent choice would balance risk across a portfolio of life-cycles. Equally ‘earnings’ can be masked and underlying business viability sacrificed through the lack of transparency on operating data.
A solution to this problem would be to firstly address the lack of information and secondly support the business with capital in the event of unforeseen loss but not at the expense of hiding the facts. This is not something that has been easily achievable in the past. However new developments mean that it is now something that can be considered. The lack of information can now be addressed by a new method of monitoring operational risk (and modifying existing risk metrics to show the ‘effort made’ in arriving at them). Secondly Contingent Capital can be used to support the business with capital in the event of an unforeseen loss. Together these could provide a powerful combination.
The advantages of using Contingent Capital are that it is not ‘on balance sheet’ until called, so does not ‘mess-up’ existing ratio’s and metrics; and constructed properly it can be ‘sub-libor in resultant financing cost.
But it can only be used in the case of unforeseen events – what is meant by this and how is it different to mis-management? If you could dissect the operations of a business without interference, one could monitor how the network of decisions and functions perform to produce the required earnings. This would give an indication of the amount of ‘work’ required to achieve each year’s output in human terms and together with traditional risk metrics give a more transparent view of the underlying performance of the business and management.
Implementation will need to overcome the ‘silo’ management structure of many businesses and so one solution is to wrap the whole ‘system’ of the business with a program that doesn’t challenge the existing infrastructure, but creates its own metric based upon communications and the execution of decisions. To make all of this understandable to management there also needs to be a simple interface to show how risk and established processes are changing so that management can ‘address the alarm bells when they ring’.
A crucial element for management is to ‘see’ hotspots, whether deficiencies in resources or risk-rules that alert them to potential crisis. The above system takes the ‘to see’ literally and provide a ‘dashboard’ that shows the level of ‘work’ being done to achieve the objectives set through an intuitive representation of risk status.
The basis of this system is to view an enterprise as a special kind of ‘network’ which can be mapped using a set of rules reflecting the business’s functions; their business decision making ability; and the communications within it. The assumption is also that management do not want to know what every dial on the board means, just the important ones at their level because they have junior managers to understand the detail and explain why things are going wrong.
Using heat mapping can aid management if they want to know why events are moving outside pre-set parameters, they can enquire contextual help and ask junior managers to report functional changes. By knowing how hard a business is ‘working’ to achieve goals and how decisions are being made in the network you can modify existing performance metrics to bring the ‘human context’ into the equation, something not previously available.
The transparency of operation opens up the capital markets ability to take risk. In doing so it allows new businesses to begin if they also follow sound business processes that can be observed. This does not take away freedom, but focuses management on what they do best; think and decide quickly.
Why link these two items? The answer focuses upon the risk appetite of investors and a lot of experience. Let’s define what each means and then iterate to a conclusion but first a little history.
Contingent Capital has been around a long time but there were some major obstacles in its way the most prominent being that executive compensation schemes focus upon earnings. Earnings were the major governor of investor analysis and by default the derivation of credit matrices. Earnings now no longer holds sway, why? The results of investment analysis and hence credit downgrading found companies themselves under attack from investors who wanted more transparency in their business data as trust was eroded in their accuracy.
Fundamental investment assumptions become meaningless if the underlying business is being run-down operationally, or put at future risk just for the sake of high earnings. Yet there is no transparent way of seeing operational activity. In effect the result of an ‘earnings only focus’ mortgages the future of a business and this can most readily be seen in the Pension Funds raided for their surplus in the late 70’s and 80’s.
So what is Contingent Capital? It is a pre-priced and placed financial instrument designed to replace lost capital in the event of unforeseeable/unplanned loss. Dense though this statement may be we can take it apart (in reverse order) and see why Contingent Capital had some hurdles to climb:
‘Unforeseeable loss’ means unplanned; unknown or unexpected. It equally means that if you haven’t a complete view of the business, and its context, then the enterprise is likely being run ‘blind’ with the consequence that earnings are really ‘pure luck’.
‘Replaces lost capital’ means just that; losses or significantly reduced earnings expose the retained capital. Any loss must be immediately replaced (up to a limit) by the Contingent Capital reserved. It also means that management should be confident that they have planned well because foreseeable loss is not covered.
‘Financial Instrument’ means that it comes under IAS and FASB definitions but can be composed of any sub-instruments that equally satisfy their rules. This means that Contingent Capital can use all of the insurance and capital market structured finance rules. Its peculiar structure is that it is an ‘insurance’ therefore ‘off-balance sheet’ until called at which time it must be treated like any other instrument and the rules they operate under (IAS 39, FASB 113 etc). This also means that it is NOT designed as a P&L hedge.
‘Pre-priced and placed’ means that it is secure, available and its impact planned and foreseeable.
In total Contingent Capital is a flexible and adaptable friend but one aimed at proving a safety net for the ongoing viability of a business. It is not a tool to create ‘smoke & mirrors’ on earnings.
If we assume that fundamental investment assumptions aim to know the price and durability of an investment then we should also want to know the critical boundaries of the enterprises functional performance. Earnings alone will not give us this metric because it must include factors derived from the business context (surrounding economy), operational viability and decision making ability.
Looking at investment practice over the last 30 years we can see that without the above underlying economy went volatile, ‘smoke & mirror’ activity blinded certain investors with sustained earnings at the expense of enterprise viability. This is where true operational risk comes in; it maps the functional, operational and economic context to existing risk metrics in order to reflect ‘what’s going on’ on the factory floor.
With the advent of Enron, WorldCom and the dotcom bust, the need to have transparency and a return to fundamental investment rules is a must, indeed enforcement by regulators will grow unless a different way to achieve it is found.
But how does one identify the critical boundaries and report in real time? Well we already have a lot of good metrics for risk from historic data but what we don’t seem to apply is consistent measures of the ‘work done’ to achieve our results. If we could we would include an implicit measure of the marketplace and its tractability, equally we would have an idea of how decisions are made within the organisation to show how adaptive we are to the changes in demand we face.
Is there a science that understands all this and can give some rigour to our results? In short, yes. Whilst Cybernetics has a mixed history it is essentially a science that looks at ‘systems’ as a whole and before it got its current name encompassed operational research of all sorts including network theory and complexity studies. From these QCL has derived what it calls the ‘w-principle’, a set of rules that combine to provide a metric of ‘communication/decisions ability’, a proxy model for the amount of ‘work’ done in the business.
As such the w-principle provides a simple metric that can be used to modify existing risk measures to reflect the whole operations of the enterprise and because it does not take a vast amount of effort to implement can be installed quickly and without disruption to existing infrastructure.
An enterprise can be considered a network built from fundamental functions; production, planning/control, audit/learning and vision. How these functions operate and the decisions between them are executed can be simply mapped. Critical to any organisation is responsibility which comes in two degrees – immediate and ultimate. For efficient running of a business the execution of decisions depends upon the critical path ‘source-conclusion-source’. If the path of this network is too long or has blockages then even simple decisions can compound to destroy effectiveness. Equally, too rigid a decision-process destroys adaptability to new production ideas and products.
The w-principle maps communications and decision-process hence identifying how a business communicates with regard to itself and its market context. As you can see this captures data not previously available and which is critical if you are to convince a risk taker (investor or insurer) that you are in command of or at least understand the operations of the business.
Heat mapping allows the design of interfaces which addresses a three-dimensional risk space representing the data, rules and the metrics upon which a business depend. The output is visually displayed in terms of ‘hot-cold’ with explanations of their applicability. More importantly the functional management of the business is interpreted and resolved to a single metric indicating a proxy measure of ‘work-done’.
So, starting from earnings we can create a comfort range represented by hot-cold; good-bad, that ‘explodes’ into its core dependencies and then within as many divisions of risk/resource metrics the client names. As the w-principle shows the communications and the need for resources within the business, the modified traditional metrics become more meaningful.
If you know more about your business and make it transparent to all stakeholders by reporting such then more capital resources can be made available. Generally the problem in convincing risk takers to accept the current or new situation is down to the quality of data; provide them with transparency and the only real risk left is product demand which they can usually assess for themselves.
This process is how a major Contingent Capital Bond was structured and placed in the 90’s. It became a ‘sub-libor’ product, achieved the aim of maintaining ongoing viability but still allowed the component risk takers to make money. It even fits well alongside Sarbanes-Oxley and IAS 39 as a beneficial support, not excuse to repair, for management. More importantly it can be applied to private enterprises where statutory disclosure is not mandated.
Maintaining an enterprise’s viability is rarely considered in Pension Fund Asset Liability Management. Partly this is because there seemed no obvious instrument to use and secondly because of the differential responsibilities and practices between management and fund trustees. With Contingent Capital the single objective is to maintain the ongoing viability of a business when faced with outside and unplanned events. The structure and degree of ‘principle forgiveness’ depends on price and the financial objectives of the buyer. Principle forgiveness refers to a product whose contractual relationship is a premium for an indemnity whose principal on payout is not then repaid -e.g. insurance and options. So in this example the objective of the fund manager is to dynamically manage the returns/contributions, such as what each collective of pensioners likely requirements are, and in the case of unplanned severe loss obtain replacement capital.
The only question now is who should buy/own the protection? The trustees should own the product but the business should finance it as part of their duty of care to protect contributions. In this manner Contingent Capital could supply an answer to a thorny problem of unknown outcomes and ongoing viability of contributions.
Of course this does not mean that management is exempt from responsibility to the fund because the instrument excludes foreseeable loss, criminal acts and the duty of care to the fund itself. Equally management has an implicit obligation to maintain its enterprise viability as well as obligations to employee pensions; one should not be divorced from the other.
A practical example of a pension fund hole and enterprise value was seen in the recent W H Smith ‘WHS’ takeover attempt by Permira. The bottom line here was that a 10-year commitment to fund a pension hole was recognised as a diminution in company value. Had the fund trustees bought a Contingent Capital product for the same amount with guarantees and/or financing for the future premiums then a cleaner negotiating position would have been available.
As it transpired WHS did not want to sell to a heavily debt laden vehicle whose investment objectives were completely different from current shareholders. This shouldn’t have been a problem for the trustees if a product was in place and structured properly. One thing that is interesting in the WHS affair is the 10-year term of commitment. It would seem that this is an outer barrier in terms of duration because correlation with business planning and the number of financial instruments available to create secondary markets diminishes at this boundary.
One problem QCL sees is that certain credit related solutions break down when credit markets or triggers events becomes esoteric which is the case for the bulk of the business world and hence they do not merit a global solution unless other compensations are enacted. In order to solve the problem for a large risk sector the composition of risk-transfer needs to be in instruments that implicitly absorbs credit default but also ‘forgive principle’.