Without a doubt, companies have had to change how they view risk over the course of the financial meltdown. Risks that were either ignored or considered a low priority have now risen to the top of their lists of musts-to-avoid.
At Constellation Energy Group, which had a cash scare last year, liquidity risk is now one of the top issues on chief risk officer Brenda Boultwood’s watch list. The company’s stress tests for determining its cash needs did not prepare it for the “extreme” rise in commodity prices of 2008, Boultwood says. To compensate, in late August, Constellation decided to divest its upstream gas assets and sell other parts of its business to create more cash flexibility.
However, those plans weren’t enough. For one hair-raising week in mid-September, Constellation was in crisis mode and its stock price in free fall following the collapse of Lehman Brothers, which was one of its trading partners. At first, Constellation tried to assure investors that the Lehman failure wouldn’t have a material effect on the company and that it had access to a $2 billion credit facility. But by the end the week, Constellation had agreed to be bought for $4.7 billion by MidAmerican Energy Holdings, a Berkshire Hathaway company, which pledged to make an up-front, $1 billion cash investment in Constellation. The deal later fell apart after Electricite de France (EDF) offered to buy nearly half of Constellation’s nuclear subsidiary for $4.5 billion.
Months later, says Boultwood, who will talk about risk management at the CFO Core Concerns Conference in Boston on June 15–17, Constellation took several actions to reduce its liquidity risk to avoid a repeat of last year’s scramble. For example, the company freed up $1 billion in capital by divesting its coal and freight business, as well as its wholesale natural-gas business. That collateral had been posted, under regulatory requirements, in case of rising commodity prices.
“We’ve lived through a five-year period when credit for all companies was very much available and inexpensive, and now all companies have to adjust to that change,” says Boultwood.
The company also implemented new models for measuring risk. For instance, Constellation has introduced more sophisticated probabilistic and scenario-based stress tests of the company’s liquidity requirements over a rolling two-year time horizon, according to the risk chief.
Indeed, Boultwood’s partial list of her top risks right now — she declined to list all of Constellation’s biggest exposures — reflect the heavy responsibilities CROs face as they shift their company’s approach to risk management in the current economic environment. Among her top worries: the recession, which could affect the solvency of Constellation’s counterparties, and the pending transaction with EDF.
One of Boultwood’s duties right now is keeping the company’s board of directors updated on how her team is mitigating the risk that EDF will delay or back out of its investment promise. “If we don’t close that transaction, the biggest issue for Constellation is potentially our reputation,” she explains. “It will indicate that something Constellation said we were going to do for whatever reason did not get done.”
Risk managers are indeed paid to stay on their toes. And in the midst of an uncertain economic environment, other executives are also expected to view risk as a high priority. Nearly half of the 701 executives (most of them CFOs) responding to a recent study by researchers at the Enterprise Risk Management Initiative at North Carolina State University said their board is asking senior executives to increase their involvement in risk oversight.
Sometimes, though, as the events during the current downturn have often proved, an unpredictably malign side of human nature is the chief risk. Last year at options brokerage MF Global, for instance, a trader who has since been fired used a personal account to trade wheat futures beyond the amount allowed under the company’s policy. The firm took a $141 million write-off and, likely, a major hit to its reputation. A year later, just about all the senior managers have been replaced.
One of the new executives, CFO J. Randy MacDonald, has been picking up the pieces, and he helped recruit the company’s CRO. The centralized role, which carries with it the cachet of a senior manager, will help prevent “hiccups” and resulting nonrecurring charges against earnings, MacDonald says. “You work really hard every day to get a client, to do trades, to get their balances, to get their assets, and then you have something bad happen,” he adds. “It’s the equivalent of millions of trades, millions of dollars a spread, and it’s all gone in an instant because you didn’t have good risk management.”
For some companies, improving the way they manage risk and avoiding the hiccups may begin with the hiring of their first chief risk officer. In fact, corporate interest in hiring a top cop of risk may be on the move. Richard Meyers says his recruiting firm, Richard Meyers & Associates, has seen a 9% increase in inquiries about CROs since February. Clients are asking for “someone who can focus their attention on all matters of risk,” he says. What’s more, the calls are coming from beyond financial-services firms, the traditional breeding ground of CROs: some have come from companies in the consumer-products, restaurant, and pharmaceutical industries.
Still, smaller companies may feel satisfied with spreading out risk oversight among a variety of employees without creating a separate function. At $1.3 billion Virgin Mobile USA, all 400 employees have to keep risk in mind, says CFO John Feehan, who will also be speaking at the Core Concerns conference. “With just 400 people, if one person doesn’t do [his or her] job, everyone suffers. Everyone takes accountability very seriously.”
The prepaid-wireless operator doesn’t have a CRO, but senior management meets regularly to discuss potential risks along with financial results and forecasts. “It is very much a part of our DNA to look at risk from all perspectives, from internal to external risks, almost on a daily basis,” says Feehan. Among the issues at the top of his list: the U.S. economy, liquidity, and the tight competition among wireless providers that are often in price wars.
Since most of Virgin Mobile’s customers are in the low- or middle-income range, the company noticed early on in the recession that its clients were beginning to feel financially pinched. In response, it decided to cut back on the level of energy it expends on riskier customers.
Its business model doesn’t make that easy. Unlike other cell-phone service providers, Virgin Mobile doesn’t lock in customers with two-year commitments but rather offers two main products: pay as you go — in which customers put money into an account that diminishes for every minute they use their phone — and a monthly plan for unlimited calls.
With the pay-as-you-go plans, Feehan says, Virgin Mobile could spend, say, $100 to acquire a customer, but may not get that cash outlay back until 12 months to 18 months later. But with the monthly plans, the company makes back its investment sooner, at three times the amount of revenue as the pay-as-you-go plans.
Virgin Mobile wanted “to focus on the quality of subscribers in order to provide shareholders with the proper use of cash,” says Feehan, noting that focusing on the monthly payment-plan customers could provide the company with more cash: cash that could be used to either acquire more customers or boost free cash flow. “We felt in this economy that was a better strategy than trying to get every customer.”