The concept of risk and reward is ingrained in all facets of life. Of a new product launch with an aggressive roll-out date, we’ll say “no risk, no reward.” At the baseball diamond, when the coach gives the sign to steal home to win the big game, we deem it “worth the risk.” It would be my guess, however, that we never really think deeply about the actual meaning behind these phrases. What exactly is risk-reward and how do we come to these conclusions?
In simple terms, we are making a calculated bet where outcomes can be ascertained and after analysis of all the possible outcomes relative to the goal or reward that can be achieved, we deem that it would be an appropriate measure to go forward with a plan, task, or investment.
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In normal environments, one is able to make assessments of possible outcomes. This isn’t to say that there is certainty of these outcomes but rather, that there is a certainty to the possible uncertainties. Market data, experience, and the sound advice of professionals enables you to decide all of the possible outcomes, then assign a percentage of likelihood. Let’s use a new product introduction as an example. The percentages for likely outcomes may look like this:
- Unprecedented product adoption with no modifications: 10 percent
- Moderate success of product: 25 percent
- Product requires substantial additional enhancements and expenditures: 10 percent
- Market reception is mixed, not much added to incremental revenues: 28 percent
- Market is yet undefined and product fails: 25 percent
- Product fails, marring reputation of company and existing products: 2 percent
Monte Carlo Simulations
The best course of action in this case appears to be doing more market research and product development before deciding to roll out the new product—a course of action that may seem conservative, but one that is supported by the likelihood of the various outcomes. These calculations are known as Monte Carlo simulations. Consciously or unconsciously, all individuals, investors, and businesses make these calculations each and every day.
With the world grappling with unprecedented uncertainties, individuals, companies, and investors are now trying to figure how to factor in an ever-increasing array of possible outcomes. Ideas once thought of as absurd or impossible, are suddenly considered possible, if not very likely. In recent days, I have had people ask me about the likelihood of some of their thoughts and fears, such as “What happens if people don’t fly on planes for three months or more?” or “Can we survive if not one person comes to our restaurant for a full month?” or “What happens if people never go out again to shop and instead order everything from home?”
Until risk takers of all sorts can come to some sort of conclusion as to what to expect, action becomes impossible. In the present private equity environment, this is freezing up investments. Until probabilities can be calculated and a course of action can be deemed the appropriate risk-reward, inaction seems to be the best action.
Alternative Assets: Life’s Been Good Pre-COVID 19 Pandemic
But there is more danger that private equity investments are facing than just uncertain times. If I can borrow from the immortal words of musician Joe Walsh:
In the pre-COVID-19 days, the early-stage, speculative nature and relative illiquidity of a private equity investment was balanced out by the potential of outsized returns relative to more liquid investments like listed stocks or bonds. As a case study, let’s take XYZ Co., which has a new, unique software application. Sure, it was in the process of revolutionizing the world while waiting to be validated by the market, but when — let’s think positive here — it is successful, an investment in XYZ would offer outsized return relative to any puny old listed stock or bond of a more established company.
Now, however, with stocks down more than 30 percent in just a few weeks and bond yields of formerly high-quality companies soaring, investors can look elsewhere for high returns. Take the fixed-income market: Bonds that not too long ago were yielding less than 4 percent, are now approaching 10 percent. That means it’s harder for private equity to stand out. On a relative basis, PE, venture capital, hedge funds and indeed all investors are weighing where is the best bang for their buck.
So, what does this mean for private deals today? For starters, if they hope to attract any attention with investors in today’s environment, debt deals need to consider contributing more equity kickers, and private equity investments need to rethink their valuations. It’s just that simple. Investors are financially driven. We know that. At times, however, founders can get so focused on their vision that they forget that money is the ultimate motivator for investment. Investors are always considering relative returns. If a more liquid, listed alternative is offering outsized returns, for at least the short term, those instruments will be the focus of most private investors.
Asset Class Performance Prior To The COVID-19 Pandemic: Honey, Haven’t We Seen This Show Before?
Does this mean private equity is irrevocably changed? Do all founders need to accept that this is the new reality? If this is the new reality, how can private equity even compete?
The short answer is that we all need to catch our collective breaths. The famous last words of any investor are “this time it’s different.” While the COVID-19 pandemic does present some scary times and uniquely different challenges, the short-term flux will definitely be disruptive to private equity, but not forever. The silver lining is that we will eventually return to normalcy.
How can I be so certain that we will return to a stable normalized market? Well, being a financial professional for 32 years, I have seen my fair share of cataclysmic market disruptions: the Black Monday crash of 1987; the Russian ruble crisis of the mid-90s; the late-90s Asian financial crisis; the early 2000s dot-com bubble; the market disruption following the attacks of September 11, 2001; and the late-2000s Great Recession, to name just a few. After each of these events, the world felt irrevocably changed. In many ways, it was. But the financial markets persevered.
Did it take some time to rebuild, to feel confident enough to evaluate risk and make intelligent, well thought out bets again? Absolutely. Yet after each crisis, we learned a little bit more and we came back stronger. Prior to the COVID-19 pandemic, private equity investments were at record levels, even with all the crises occurring in our past. Given time, we will no doubt surpass those levels.
We Need To Stabilize The Markets
First, however, we need to stabilize. We need to be able to properly analyze risk-reward again and for that, we will need some clarity. Investors will no doubt pursue public investments, but that pursuit will eventually drive them back to levels where they no longer compete with the returns that private investments offer. In short, we need to be patient.
In the meantime, there is a lot we can do together to strengthen our standing when markets stabilize and liquidity returns. Founders should continue to drive their innovation forward, hone their stories, conserve cash, and continue making connections that strengthen their business. They need to be mindful of the world around them and understand that investors have a lot of balls to juggle. There are plenty of ideas that can still get traction but for all of us, patience and collaboration are the keys to help each other through these difficult times.
For our part, we need to continue to help offering guidance to our clients, to point out government programs that will help fund their small business during this uncertainty, to offer services that can help keep the ship afloat—not for profit, but for the good of our clients. Getting the word out on the great things our founders are achieving and raising their voice above the din of difficult times will better position us all for the inevitable, better tomorrow yet to come. Most importantly, we need to understand that we will go down this road and succeed if we all work together. To me, that risk is worth the reward.