Adding Value for Stakeholders Through Improved Risk Management

BY: François Masquelier

Honorary Chairman EACT

Vice- president Finance, Treasury, ERM Group RTL

Axiom Advisory Permanent member

European companies have been using to varying degrees Enterprise Risk Management (ERM) as part of an ongoing effort to raise awareness and promote appropriate risk management responses and deliver value for stakeholders. More recently rating agencies have added to the clamour for increased transparency of risk management providing senior management of an organisation increased incentive to revise and improve ERM processes.

ERM is an initiative that, by definition, is never complete

Some European companies, including RTL Group (RTLG), have decided to embrace Standard & Poor’s (S&P) initiative to assess ERM processes of non-financial companies as being an opportunity to revise and improve their existing practice.

In November 2007, S&P consulted users of their rating services in order to validate their approach to benchmarking ERM processes across non-financial institutions. S&P have subsequently developed their ERM assessment - the outcome of which is a rating of a company’s ERM competency as being either “weak”, “adequate”, "strong”, or “excellent”. It appears the S&P assessment will concentrate on the culture of risk management and governance concentrating on specific examples to demonstrate how this works on a day-to-day basis. The adoption of a recognised unifying standard such as COSO ERM Framework or the Australian and New Zealand Standard on risk management (AS/NZS4360/2004) is helpful but is not a pre-requisite nor sufficient proof of having adopted good practices[1].

RTLG has used the pending S&P assessment to review existing practice with a view to then revise internal control processes to make them more effective and efficient. This step was taken as part of a continuous process of improvement initiative.

The first step in evolving ERM at RTLG was to understand where the gaps were…

A decision was made at the outset to undertake a review of existing risk management capabilities determine where improvement effort should be focused. There was a strong desire to build a business case for improvement in ERM but without having to resort to using a myriad of consultants. Further, a strong emphasis was put to having practical and pragmatic solutions for improvement.

A decision was made to work with Avantage Capita[2], whose methodology and approach based on comparison (benchmarking) was found to be fairly unique in execution in that the output is presented on “one page” which was useful when discussing risk with senior stakeholders who had little time to read a detailed analysis. A long form report on suggestions for improvement was discussed with those of us more heavily involved in the improvement effort. The outcome of the joint effort was to identify any weaknesses or gaps and to define a roadmap with priorities for improvement for the next two years.

The approach enabled the weaknesses in the current risk infrastructure and capabilities to be identified and compared to good practice in peer organisations. The listing of actions to address weaknesses served as the basis for the business case aimed at defining the prioritised improvement initiatives.

The insights from the IRPM assessment formed the basis for developing a consensus for where effort should be focused to improve risk management

One of the objectives of the ERM review was for Senior Management to make a clear decision on how to develop ERM internally. The group's management wanted to formalise their risk and capital management strategy based on their operations strategy. This involved consideration of whether to implement a recognised risk framework.  It was acknowledged internally that risk measurement should be an integral part of the establishment of the group’s strategy, planning, and allocation of resources. Further, those ERM initiatives should be integrated into and aligned with the group’s operational activities and overall strategy. The ERM thus enabled them to enhance the degree of sophistication of operational procedures and information to be produced as part of the decision-making process.

Using the heat map and the conclusions from the score card, the company determined the possible areas of action in order to improve their ERM processes. With the desire to remain practical and realistic, it was then necessary to specify some of the primary objectives and to allocate the associated resources in order to establish the road map for the next two or three years.

Useful insights from the RTLG experience can be applied to other non financial institutions as they consider ways to improve their ERM

It was noted that, in general, the same type of problems can be observed from one company to another. For example, defining and clarifying the appetite for risk is often a weak point, and yet it's one of the first things a rating agency seeks to understand. The KRI (Key Risk Indicators) are often incomplete, non-existent, or scattered. It is important to centrally define and control them. When the risks are measured the company can then set objectives and targets.

Similarly, even though IFRS 7 imposes stress testing exercises, sensitivity analyses are often insufficient. It is equally essential to make the V@R-type approaches (e.g. market share at risk, EBIT(A) at risk, free cash flow at risk, etc…) or Monte-Carlo-type simulations an evolving and sustainable process to reflect changes in strategy, changes in the business model, and other external and internal factors. But whatever efforts are made to improve ERM processes, it is an ongoing exercise that should consist of comparing oneself firstly against senior managements vision for risk management but also against one’s peers and to the best practices in the respective industry. We found the latter of these points difficult to assess so used an external party, in this case Avantage Capita, to provide an independent assessment. Just as in financial matters, good practices need to become compulsory and widespread. It's simply a matter of time that risk measurement and management becomes more entrenched in non financial institutions.

Creating value through ERM – is competitive advantage attainable through investing in risk management?

This is where the greatest challenge lies for persons leading the risk improvement initiative – in convincing management of the opportunities to create value through improved risk management. For the most part, risk based decision making is seen as stifling value creation. In fact the reverse is true - the group should have the ability to take more risks in those areas where they have a core competency (through limits and controls and applying other mitigants) by creating a risk aware culture through visionary leadership. “The better the brakes are, the faster the car will be.” The group should establish its risk management strategy on the basis of its core values. When a group’s value is “entrepreneurship”, the principle of risk taking seems inherent and essential. In my experience, ERM frequently falls down due to a lack of alignment of the approach to risk management with the company's core values and strategy. The Chief Risk Officers (CRO) repertoire of skills must include a sound knowledge of the business and the need to apply excellent communication skills in order to convince other senior management that attaining strategic objectives requires an understanding of both reward and risks. A recent article in the Harvard Business Review (September 2008, “Owning the Right Risks”) refers to the fact that the Board of Directors often lack the knowledge and the risk vocabulary to engage in dialogue with management. CRO’s needs to demonstrate conviction in order to gain the support and essential resources for developing ERM. Gradually and with patience, he or she can generate a culture and awareness regarding risks and the importance of managing them. It is a long-term job that requires patience and perseverance.

BY: François Masquelier

Honorary Chairman EACT

Vice- president Finance, Treasury, ERM Group RTL

Axiom Advisory Permanent member

The Necessary Evolution of German Conglomerates As a Result of the Crisis

BY: François Masquelier

Honorary Chairman EACT

Vice- president Finance, Treasury, ERM Group RTL

Axiom Advisory Permanent member

This article addresses the specific financial situation encountered by a few of the German family-owned groups. This situation may also apply to other multinational companies elsewhere in Europe. The economic crisis will force these companies to completely revise their organization and their financial and shareholder structure. Is this worldwide recession sounding the death knell for the large family-owned groups? It may be, because some, like the frog in the La Fontaine fable, wanted to grow larger than an ox.

Major Dynasties of Capitalism

The theme of merciless capitalism featured in the famous American soap opera of the 1980s, Dallas, could also easily apply to German family-owned capitalist enterprises, as well as to certain other companies of this kind elsewhere in Europe. Many family-owned groups had eyes that were larger than their stomachs and tried to acquire major targets all for themselves. Of course, not very long ago, the case of RBS in the financial sector was a prime example (prior to the attempt to purchase ABN.AMRO). Other examples proved that when everything is going well (particularly the economy) large “pills” can be swallowed. However, the cases of Schaeffler and Porsche seem to be exemplary in more than one way. They show that sometimes it is important to remain prudent and that these solo acquisitions can turn out to be complicated. There is good reason to believe that many will say that they will not be making any more such acquisitions. Alas, in order to avoid making the mistake of pursuing colossal acquisitions in the future, they must first survive the current crisis. Unfortunately, it is a safe bet that some of them will not. Others have understood that they needed to lighten their load. This was the case, for example, with IN-BEV. The Belgian-Brazilian brewery recently separated from Sing Tao quickly, effectively and, in the end, under optimal circumstances given the unfavorable economic situation. It has to digest the purchase of Anheuser-Busch and therefore had to make some choices.

In Germany, many groups are family-owned (over 90%) and they are major employers (over 70%). It is therefore safe to say that Germany, more than any other European country, has founded its economic history on powerful family dynasties. These have been involved in their share of sagas, classic love-hate relationships between rich families; they form an alliance, a dispute arises, and in the end it is resolved, or worse, one acquires the other and attempts a squeeze out. In short, family relations are and always will be tumultuous. The crisis will do nothing to improve this; on the contrary, it will only make them more difficult. We have even seen suicides, such as that of Adolf Merckle, shareholder in Heidelberg Cement and Radiopharm, among other holdings. Speculation, specifically in Volkswagen, was the fatal blow. The more recent case of Schaeffler illustrates what many are encountering. They became bogged down in refinancing the purchase of the tire giant Continental.

Access to credit, which has become more difficult and much more expensive, can completely change the game. We should also mention the case of Haniel, which recently purchased the Metro group. Germany has plenty of other giants, such as Henkel, Lidl, Aldi, Bertelsmann, Bosch, Springer, Arcandor and BMW. Some large groups may turn out to be giants with feet of clay, and their growth could be halted in the current financial slowdown and recession.

Difficulties of Family-Owned Groups

The big problem encountered by these family-owned groups, particularly in Germany, is the issue of succession. It is never easy. The longer a company exists, the more the generations multiply – through marriage, children and various alliances – and the more succession becomes a major issue. It is also often the case that one person disagrees with everyone else with a certain vision that no one else shares. Adolf Merckle and Maria-Elisabeth Schaeffler both came up against their families and employees.

We have seen a few private companies attack companies listed on the DAX (three in 2008). Since the end of the Second World War, Germany has always supported these large family-owned industrial groups, as they are major sources of labor. Yet the egos of patriarchs, succession wars, skills and talents that are not always hereditary, and a lack of long-term vision can sometimes be penalizing or even fatal. Their business approach is unfortunately too often monolithic and behaviors irrational because the family strategy differs and egos can be excessively large.

They prefer and seek to fully control their shares, while preserving the entrepreneurial spirit that made them successful. With only very few or no other co-shareholders, they automatically limit their access to credit. They have very little recourse to structures such as A. Frère (GBL, CNP), in Belgium, or to sources of holdings and ventures.

The key question is determining whether today, in a changed, hardened economic climate, it is possible to preserve this state of mind that makes them strong, to maintain full control (100% or nearly 100%) over shares, and at the same time avoid refinancing problems. This is no easy task.

Partnerships are too often exaggerated and overestimated with respect to reality. There are very few examples of successful operational and commercial integration, whether the company is family-owned or not. Giant acquisitions always involve enormous risks. Sometimes it is necessary to cut off an arm to survive. The ego must be toned down. It is also important to avoid reaching critical mass and becoming too large. Size can turn out to be a handicap. Didn’t Arcelor-Mittal become too large? Don’t partnerships have their limits?

The clash of family shareholders with investment fund shareholders (equity funds or pension funds) can also be dreadful. The culture shock is often violent. Confrontations sometimes become blood baths, which is never good for the company. The culture is sometimes thrown off balance and the company loses stability. In our opinion, the great paradox of multinational family-owned companies is the entrepreneurial spirit that seems to be in direct contradiction to the idea of 100% control, which is often sought by family-owned groups in particular. This spirit would perhaps be best expressed and even thrive in a situation of majority rather than total control.

What Should Change

If we had to identify what needs to change in the coming months, we would give the following advice:

1. Open share capital to third parties, either directly or by holding an IPO.

2. Haul in the sails a bit and sell assets, whether or not they are redundant.

3. Modify holding companies and corporate centers to increase efficiency.

4. Create new alliances and structures to prevent and limit family disputes regarding vision – shareholder conflicts. (When times are tough, you see who your enemies are.)

5. Demonstrate greater prudence before making new acquisitions and digest the acquired company before any new purchases are made.

6. Maintain majority stakes rather than 100% control.

7. Establish more streamlined approaches to acquisitions and business in general.

8. Give up the Icarus myth – the sky has limits.

9. Growth cannot come solely from external acquisitions.

10. Governance of these groups should be revised in depth in light of this crisis.

Governance and Correct Proportion between Families and Managers

The governance model must sometimes be revised in family-owned groups, as their very structure comes from and can be explained by family roots. Sometimes they have to begin by engaging the services of a skilled CEO. Being a member of the family is not always sufficient criteria, and the most clear-sighted have often preferred external talent over a family member. The issue of alliances between heirs and managers is often worth addressing. France also has many examples of large family-owned groups (e.g. L’Oréal, Michelin, Carrefour, Galeries Lafayette and Leclerc). These companies need to find the most efficient method of operation and ensure that effective, unbiased decisions are being made. Managerial strategy, as compared to family strategy, often lends a more rational quality to decision-making (although there are always a few exceptions). On the other hand, the family may have a longer-term vision than managers, who might have a more immediate, short-term vision. There will always be examples of growth through successful acquisitions (e.g. Publicis with Bcom3, Carrefour with Promodès). Examples abound of families whose infamous third generation brought about their downfall. In Italy, Fiat abandoned the family’s managerial hold. Forces of opposition and skill, whatever their source, are essential in every way. Unfortunately, there are no ideal examples in this area, but more or less successful models from which to learn.

Conclusions

It is reasonable to believe that the European economy, and the German economy in particular, will evolve and gradually change. It may be safe to say that the era of large family-controlled companies, whether they are publicly traded (with little float) or not, has come to an end. The current economic crisis should finish off some, punish others, and hurt nearly all. Certain models could have worked or could still work, but only under normal or good economic conditions. This is no longer possible in a (serious) recession such as the one we are experiencing. Sometimes one is hoisted by his own petard. In some cases, the reversal of the economy will turn out to be fatal.

The structures of these industrial giants will need to be more flexible and better adapted to the current economic environment and to the inevitable changes that every company will have to make. Organizational and shareholder structures can no longer afford to be monolithic and set in stone. They must be able to evolve and sway in the volatile economic environment we are experiencing. We will see further examples of excess and regrettable cases or stories in which we would have liked to believe. In economic and financial history, unfortunately the small Davids do not always knock down the big Goliaths.

“…The small fool swelled up to the point of bursting (…) The world is full of people who are not any wiser. Every land owner wants to build like the great lords, every prince has ambassadors, every marquis wants to have pages.” (Jean de la Fontaine – The Ox and the Frog).

François Masquelier

Honorary Chairman EACT

Vice- president Finance, Treasury, ERM Group RTL

Axiom Advisory Permanent member

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