Conclusion: A Long View On Risk Perception – The few who beat the traps, external influences and decision-making
Reproducing an article posted on my Linkedin profile on December 31, 2019
We had examined the risk perception shifts and the impact on availability of risk capital in part one for infrastructure and part two for financial services.
In this concluding part we will look at a few examples of lenders, investors and corporates who seem to beat risk perception traps, examine how external factors influence risk perceptions and touch upon a few decision-making factors
The few who beat the traps….
1. Bajaj Finance: In the aftermath of the Lehman crises when most lenders vacated the highly risky unsecured lending space, Bajaj Finance till then perceived as a two wheeler financier scaled up its consumer lending business massively and today in the last decade has provided multi bagger returns to its investors. Current valuation justifications though are an entirely different matter
2. HDFC Bank: While most of its peers were focussed on growing their Infrastructure Financing book or lending to NBFCs, HDFC bank focused on its retail customers. In several core NBFC segments HDFC bank is the biggest competition and by lending at substantially lower rates, it corners the prime customers. A focus on CASA enables a strong liability franchise adding to the robustness of the business model
3. Blackstone: While most of their peers were focused on investing in developers building large residential townships, Blackstone did lease rental based commercial property buyouts, banking on cash flows for the basic returns and real estate price growth, financial structuring and better property management for additional return kickers. Several other funds including Brookfield and others have followed suit since then.
4. JSW: Acquisition of operational energy and steel companies under stressed asset resolutions/ IBC. JSW focused on large scale operational thermal power projects, hydro projects and operating steel plants. It has also focused on operational projects with right sized debt and often with private equity partners. While the final word may yet have to be written, smart investing at the right time at the right price paves way for substantial downside protection.
5. Control investments in operational Infrastructure Projects: Several private equity funds, Actis, Brookfield, Secura, Cube, etc. have transitioned from minority investments in infrastructure companies developing under-construction projects to control investments in operational projects or platforms with an objective to earn return kickers from financial structuring. While a few have achieved successful exits such as Actis exit from its renewable energy platform Ostro, the next few years will prove the investment thesis on these control investments.
What sets them apart?
1. A more realistic assessment of risk. Often a 30,000 feet eagle eyed view of the market place and an ability to not lose sight of the fundamentals of cash flows, valuations and capital structures
2. An ability to have an independent view, separate from the herd. This also helps in protecting their investments from low barrier to entry areas often swept up by the latest investment fad and rising competition
3. Greater reliance on internal credit/ risk assessments over external agencies
4. Availability of risk capital at the right time, enabling investments at the right time
5. Not relying on the greater fool for an exit
The external influences
While we have seen the long view on how risk perception has shifted in two key sectors, let us know understand two critical external factors influencing risk perceptions
1. An actual/ imminent loss of an investment/ a loan
While the risk may remain the same, in a scenario of easy restructuring or refinancing the expectation of a greater fool or a turnaround continues. The music stops when either the loss is realized or is undeniably imminent.
Thus, a government inaction in mitigating the systemic losses or action in perpetuating it heightens risk perception multi fold and conversely dries up risk capital. Similarly, if a regulator is perceived to be hell bent on questioning past decisions but not in protecting investors or depositors, it results in a counter productive outcome of a decision-making paralysis of the lenders and a risk aversion of the retail investor.
Which means a default on deposits in a co-operative bank makes depositors question the safety of all banks and a default by one housing finance company raises doubts on all housing finance companies. This is because suddenly some very basic assumptions followed for decades have now been thrown out of the window and in turn the very reality of which other assumptions can one believe in is put into question
2. The curious case of reputation:
While every finance professional in the investing and lending community learns financing basics of looking at leverage ratios, cash flows and DCF valuations decision making is often at the mercy of reputations, past history and experiences and current perceptions of the same. A loan/ investment to IL&FS with 10.0x Debt to EBITDA was the result of an impeccable reputation of honouring their commitments for decades and a gold standard AAA rating. The destruction of this illusion and that of similar other highly rated companies in quick succession suddenly puts in doubt every such assumption made by the investment and risk managers, suddenly now no reputation is sacrosanct. Even a Birla group (a group which is part of the holy trinity in Indian corporate history of Tata, Birla & Reliance) investee company Vodafone can potentially default.
This transference of a heightened risk awareness among investors and risk managers is rapid and feeds of each other. In his book the hour between dog and wolf John Coates mentions this risk perception and stress transference on a trading floor, an almost instinctive reaction to subtle body language changes and a few overheard words even before a formal realization occurs. A similar instinctive reaction on risk perception is perhaps what we now see.
The reputation factor also plays a role with the government & the ministers, the courts and the bureaucrats. Is the government pro business? Does the minister have a reputation of finding out of the box solutions or trouble shooting? Has the government and regulator shown the understanding of a risk contagion effect and taken steps to resolve it? Do the courts make decisions based on contracts or emotions? Do the judges have the competency of understanding complex commercial matters, the simple aspects like difference between secured and unsecured lending or the intricate matters of bankruptcy remoteness? Is the bureaucracy geared to make fast decisions or is it only interested in following a bureaucratic manual and saving its pension? Is the signal emanating from these three critical pillars that of wanting to attract investors, entrepreneurs and risk takers or is the signal that thou shall invest as there is no other choice?
Thus, while an expectation of eminent loss heightens risk perception, the reputation loss/ doubt ensures the situation persists.
On the flip side one must consider the decision of the Tata Group to compensate DOCOMO their erstwhile partner despite regulatory restrictions in this light. Reputation after all is everything!
As a result, majority of the investor money in the last 6 months is concentrated in less than 10 Sensex stocks and these now drive the market returns. These groups with 'reputation' today are the those that all lenders want to lend to and investors want to invest in. with 29 companies accounting for majority of the market capitalization in India, this flight of risk capital is real.
A few decision-making factors that interplay with risk-perception
It is also critical to understand that the decision-making process especially in the wholesale lending and investing business is significantly influenced by the historical experiences, perceptions and intuitions of select critical decision makers in every institution. While an army of financial professionals may crunch numbers and undertake cash flow analysis, ultimate decision making is most often done in quite a short time by the experienced few. Malcom Gladwell in his book Talking to Strangers mentions a study on how judges influenced by in-person testimony of an accused often fail to beat computers in making judgement based on facts fed into the computer. In his book Blink he however also mentions how experts with years of experience are often able to make intuitive correct judgement in a ‘blink’ even before formal realization of the logical train of thought is clear. Perhaps a better combination of Thinking fast and Thinking Slow decision-making process, as Daniel Kahneman puts in his famous book is required.
Decision making is also influenced by recent memory. Recent memory ensures, that the same cycle rarely repeats itself immediately. A dot com bubble is not followed immediately by another tech bubble, but by a mortgage bubble and perhaps later by another tech bubble. A sub-prime crisis is hence unlikely to be followed by another such crises in its near future.
P.S.- Decision making is a topic worthy of a much more detailed examination and it is only touched upon briefly here.
Conclusion
To conclude the risk perception pendulum has swung to the other extreme in many segments and an economy India’s size cannot be limited to less than 30 corporates. The causes for the same are a mix of investor's, lender's, entrepreneur's mis-reading of underlying risk and external factors – governments, courts & bureaucrats under estimation of the influence of their actions on risk perceptions and risk capital and lastly Indian corporates, asset managers, lenders under/over estimation of the importance of reputation.
In other segments certain earlier scripts of hopeful thematic investing, build up of competition and expectations of greater fool exits are being repeated. Questioning the market and our own risk perceptions, reputation assumptions and going back to basics is required. If enough of the capital holders do this perhaps a more equitable distribution of risk capital and more secular returns may follow.
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| Source: Richard Lee, Unsplash |
We had examined the risk perception shifts and the impact on availability of risk capital in part one for infrastructure and part two for financial services.
In this concluding part we will look at a few examples of lenders, investors and corporates who seem to beat risk perception traps, examine how external factors influence risk perceptions and touch upon a few decision-making factors
The few who beat the traps….
1. Bajaj Finance: In the aftermath of the Lehman crises when most lenders vacated the highly risky unsecured lending space, Bajaj Finance till then perceived as a two wheeler financier scaled up its consumer lending business massively and today in the last decade has provided multi bagger returns to its investors. Current valuation justifications though are an entirely different matter
2. HDFC Bank: While most of its peers were focussed on growing their Infrastructure Financing book or lending to NBFCs, HDFC bank focused on its retail customers. In several core NBFC segments HDFC bank is the biggest competition and by lending at substantially lower rates, it corners the prime customers. A focus on CASA enables a strong liability franchise adding to the robustness of the business model
3. Blackstone: While most of their peers were focused on investing in developers building large residential townships, Blackstone did lease rental based commercial property buyouts, banking on cash flows for the basic returns and real estate price growth, financial structuring and better property management for additional return kickers. Several other funds including Brookfield and others have followed suit since then.
4. JSW: Acquisition of operational energy and steel companies under stressed asset resolutions/ IBC. JSW focused on large scale operational thermal power projects, hydro projects and operating steel plants. It has also focused on operational projects with right sized debt and often with private equity partners. While the final word may yet have to be written, smart investing at the right time at the right price paves way for substantial downside protection.
5. Control investments in operational Infrastructure Projects: Several private equity funds, Actis, Brookfield, Secura, Cube, etc. have transitioned from minority investments in infrastructure companies developing under-construction projects to control investments in operational projects or platforms with an objective to earn return kickers from financial structuring. While a few have achieved successful exits such as Actis exit from its renewable energy platform Ostro, the next few years will prove the investment thesis on these control investments.
What sets them apart?
1. A more realistic assessment of risk. Often a 30,000 feet eagle eyed view of the market place and an ability to not lose sight of the fundamentals of cash flows, valuations and capital structures
2. An ability to have an independent view, separate from the herd. This also helps in protecting their investments from low barrier to entry areas often swept up by the latest investment fad and rising competition
3. Greater reliance on internal credit/ risk assessments over external agencies
4. Availability of risk capital at the right time, enabling investments at the right time
5. Not relying on the greater fool for an exit
The external influences
While we have seen the long view on how risk perception has shifted in two key sectors, let us know understand two critical external factors influencing risk perceptions
1. An actual/ imminent loss of an investment/ a loan
While the risk may remain the same, in a scenario of easy restructuring or refinancing the expectation of a greater fool or a turnaround continues. The music stops when either the loss is realized or is undeniably imminent.
Thus, a government inaction in mitigating the systemic losses or action in perpetuating it heightens risk perception multi fold and conversely dries up risk capital. Similarly, if a regulator is perceived to be hell bent on questioning past decisions but not in protecting investors or depositors, it results in a counter productive outcome of a decision-making paralysis of the lenders and a risk aversion of the retail investor.
Which means a default on deposits in a co-operative bank makes depositors question the safety of all banks and a default by one housing finance company raises doubts on all housing finance companies. This is because suddenly some very basic assumptions followed for decades have now been thrown out of the window and in turn the very reality of which other assumptions can one believe in is put into question
2. The curious case of reputation:
While every finance professional in the investing and lending community learns financing basics of looking at leverage ratios, cash flows and DCF valuations decision making is often at the mercy of reputations, past history and experiences and current perceptions of the same. A loan/ investment to IL&FS with 10.0x Debt to EBITDA was the result of an impeccable reputation of honouring their commitments for decades and a gold standard AAA rating. The destruction of this illusion and that of similar other highly rated companies in quick succession suddenly puts in doubt every such assumption made by the investment and risk managers, suddenly now no reputation is sacrosanct. Even a Birla group (a group which is part of the holy trinity in Indian corporate history of Tata, Birla & Reliance) investee company Vodafone can potentially default.
This transference of a heightened risk awareness among investors and risk managers is rapid and feeds of each other. In his book the hour between dog and wolf John Coates mentions this risk perception and stress transference on a trading floor, an almost instinctive reaction to subtle body language changes and a few overheard words even before a formal realization occurs. A similar instinctive reaction on risk perception is perhaps what we now see.
The reputation factor also plays a role with the government & the ministers, the courts and the bureaucrats. Is the government pro business? Does the minister have a reputation of finding out of the box solutions or trouble shooting? Has the government and regulator shown the understanding of a risk contagion effect and taken steps to resolve it? Do the courts make decisions based on contracts or emotions? Do the judges have the competency of understanding complex commercial matters, the simple aspects like difference between secured and unsecured lending or the intricate matters of bankruptcy remoteness? Is the bureaucracy geared to make fast decisions or is it only interested in following a bureaucratic manual and saving its pension? Is the signal emanating from these three critical pillars that of wanting to attract investors, entrepreneurs and risk takers or is the signal that thou shall invest as there is no other choice?
Thus, while an expectation of eminent loss heightens risk perception, the reputation loss/ doubt ensures the situation persists.
On the flip side one must consider the decision of the Tata Group to compensate DOCOMO their erstwhile partner despite regulatory restrictions in this light. Reputation after all is everything!
As a result, majority of the investor money in the last 6 months is concentrated in less than 10 Sensex stocks and these now drive the market returns. These groups with 'reputation' today are the those that all lenders want to lend to and investors want to invest in. with 29 companies accounting for majority of the market capitalization in India, this flight of risk capital is real.
A few decision-making factors that interplay with risk-perception
It is also critical to understand that the decision-making process especially in the wholesale lending and investing business is significantly influenced by the historical experiences, perceptions and intuitions of select critical decision makers in every institution. While an army of financial professionals may crunch numbers and undertake cash flow analysis, ultimate decision making is most often done in quite a short time by the experienced few. Malcom Gladwell in his book Talking to Strangers mentions a study on how judges influenced by in-person testimony of an accused often fail to beat computers in making judgement based on facts fed into the computer. In his book Blink he however also mentions how experts with years of experience are often able to make intuitive correct judgement in a ‘blink’ even before formal realization of the logical train of thought is clear. Perhaps a better combination of Thinking fast and Thinking Slow decision-making process, as Daniel Kahneman puts in his famous book is required.
Decision making is also influenced by recent memory. Recent memory ensures, that the same cycle rarely repeats itself immediately. A dot com bubble is not followed immediately by another tech bubble, but by a mortgage bubble and perhaps later by another tech bubble. A sub-prime crisis is hence unlikely to be followed by another such crises in its near future.
P.S.- Decision making is a topic worthy of a much more detailed examination and it is only touched upon briefly here.
Conclusion
To conclude the risk perception pendulum has swung to the other extreme in many segments and an economy India’s size cannot be limited to less than 30 corporates. The causes for the same are a mix of investor's, lender's, entrepreneur's mis-reading of underlying risk and external factors – governments, courts & bureaucrats under estimation of the influence of their actions on risk perceptions and risk capital and lastly Indian corporates, asset managers, lenders under/over estimation of the importance of reputation.
In other segments certain earlier scripts of hopeful thematic investing, build up of competition and expectations of greater fool exits are being repeated. Questioning the market and our own risk perceptions, reputation assumptions and going back to basics is required. If enough of the capital holders do this perhaps a more equitable distribution of risk capital and more secular returns may follow.
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