Total investment loss risk is the risk everyone gets up with every morning and goes to bed with every night. Total investment loss is the risk the investment made will result in a total loss of future income and the principle investment made. In short: it’s the ultimate fear – a wipe out. Commercial real estate securities private placement offerings are often considered to be particularly prone to this subjective financial investment risk because the holding period required to realize the investment gain projected by the sponsor is so long. The longer it takes to get the return the more likely it is that return will be at risk. The outflow of the total investment loss risk calculus plays out in the capital markets every day and is a heavy cost to all participants that is paid as a condition of investment.
Due diligence reviews and underwriting attempt to lessen this risk by pointing out to investors and the sponsor the risks and issues that could conspire to create a total investment loss scenario outcome, but these reviews and analyses end the day the funding closes escrow. After the close of escrow the standard operating procedure is for everyone to hold their breath and hope for the best. Yet there is much that can be done towards putting an end to the ultimate nightmare scenario.
Total investment loss occurs when the net proceeds of the sale of the income-producing assets of a given company result in no distributed cash flows to the investors and when no distributed cash flows to investors from ongoing operations occurred prior to the sale. This gives us two (2) clear mandates for action that we can utilize to combat total investment loss risk: (1) creating distributions from ongoing operating events; and (2) creating distributions from the ultimate sale or recapitalization of the business. These risks are referred to as “term default risk” and “maturity default risk”, respectively.
Controlling Total Investment Loss Risk by Limiting Term Default Risk Exposure
Term default risk is the risk the business will not generate sufficient income over the investment holding period to meet its operating cost obligations and service the capital base that financed the the capital assets of its operations. Controlling and limiting the impact of term default risk means we have to address the following key subjective financial investment risks that serve to create term default risk:
- Distribution Payment Risk. Distribution payment risk is the risk that you will not receive distributions of profit even though the business generates a profit that you technically have an ownership thereof. It’s the ultimate insult: the company you put your capital in decides you do not deserve to receive a share of the profit it generated using your capital. Solution: companies organized as limited companies or trusts can eliminate this risk altogether.
- Yield Maintenance Risk. Yield maintenance risk is the risk the income-producing assets of the business will not generate sufficient profit to pay operating expenses and generate profits of sufficient magnitude to pay the yield promised by the sponsor at the time the investment was originally made. Solution: managing this risk requires proactive management of asset obsolescence risk, technology risk, regulatory risk and third-party claims risk (see below) to effectively reduce this risk to becoming reasonably insignificant.
- Asset Obsolescence Risk. Asset obsolescence risk is the risk the income-producing assets of the business will, over the course of time, become less and less efficient at producing income due to the impact of changes in competition that is brought on by innovation and advances in technology. Solution: the key to managing this risk exposure is managing the impact of technology risk in a proactive manner (see below) so that asset obsolescence risk cannot become a material impediment to generating long-term income for the benefit of the investors.
- Technology Risk. Technology risk is the risk that innovations and advances in technology introduced into the market at some future date will render the income-producing assets of a business obsolete to one degree or another. Technology risk is the one risk (also called “market risk” or “capitalism risk”) that cannot be eliminated, it can only be managed, and the management of technology risk can become a potential profit-taking opportunity for the business. Solution: technology risk manifests itself in the form of market disruptions that occur in the local trade area of the given business and usually take considerable time to fully manifest their impact. This risk becomes manageable if the business conducts monthly intended-use valuations of the site, a full market and financial feasibility study relating to the current intended-use, and an underwriting analysis and review of the business investment to determine if any market disruption events may be coming in the near future that would require the business to re-position its assets, re-develop the business opportunity into another intended-use or order the completion of a sale and exit before the value of the assets becomes impaired to a point where a material loss of investment becomes imminent.
- Regulatory Risk. Regulatory risk is the risk a unit of government will pass laws or regulations that have the effective result of degrading or ending future business operations, thus creating a potential investment loss. Regulatory risk events rarely occur overnight, but are not a risk that can be effectively eliminated by structure of the investment itself. Solution: regulatory risk management requires proactive assessment of operations and licensing on an ongoing basis to create an effective shield.
- Third-Party Claims Risk. Third-party claims risk is the risk that a third-party will make a claim of loss based upon something the business did, thus creating a potential loss to the investors. Solution: third-party claims risk is, by and large, an insurable event and business insurance lines maintenance can be used to help manage the potential impact of this subjective financial investment risk.
In Part II we will look at how these risks play out in operations and how maturity risk can be managed for profit.