CFO Leaders: Mapping And Pricing Risk
When asked about failure, R Shankar Raman, chief financial officer of Larsen & Toubro Ltd., recounts a story.
“We got into thermal power at a time when it looked very promising. Every Tom, Dick and Harry had plans to put up thermal plants. So as an EPC (engineering, procurement and construction) contractor we thought that there is a huge opportunity available. We didn’t realise the nuances around making a thermal plant work efficiently. We didn’t bargain for fuel shortage, disputes around the PPA (power purchase agreement) that promoters will have. We definitely didn’t bargain for the financial collapse around thermal power plant projects. So, today we are fully geared and invested in the thermal power plant business but we don’t see the environment supporting that investment today. When we look back, I didn’t anticipate this environment.”
‘Risk’ is a four letter word that makes the best CFOs sweat. It is shape-shifting—policy risk to financial risk, M&A risk to compliance risk, and more common nowadays, technology risk to cybersecurity risk. Each has to be mapped, measured and priced. And mitigated.
At Mahindra & Mahindra Ltd., Group Chief Financial Officer VS Parthasarathy outlines how his team and he map risk. It’s an almost mathematical model, he says. First they create a budget with clear assumptions. Then they create a risk matrix for both inherent risks and residual risks. So whether it’s volume/sales risk, margin risk, cost risk—each is mapped in a 2/2 matrix of impact and probability. High probability and high impact would amount to extreme risk, as would medium probability and high impact. And for each, there is a risk-mitigation plan.
“It is not rocket science and it is not just at the top. It is for each line item and for division level and at the smallest unit level, plant level, sales operation level and it is built up to each business unit and built up to a company. Then it rises. All high risk and extreme risk items come to a central risk committee to look at and extreme risks go to the board.”
This mostly applies to operational risks. For other kinds of risk, say technology risk or even environmental risk, the mapping is more qualitative.
L&T follows a similar process - a risk dashboard where key risks as perceived are put in project and bid wise. And mapped based on probability and severity. The difference lies in the nature of the business—the engineering giant works on projects that often take years to complete. So depending on the severity of the risk, a risk owner is appointed.
“Unless the project has risk owners defined, we don’t get into the project and we don’t allow the bidding to be done,” says Shankar Raman.
This helps in pricing the risk as well, a critical factor for the company to get bid pricing right. Overpricing risk can make for uncompetitive bids.
“When we try to price risk, once we know there is a certain owner at seniority and there are certain mitigants possible, we try to put (ascertain) probability and price that. We add all of it and see in our judgment, given the competition, whether it is good enough to win the bid. Then the chiseling starts, of what risk you can manage or ignore. Is there something that we are being conservative about? And then that chiseling happens. But it comes to a point where there is a cut off beyond which no more. Via trial and error we try to find the ideal price and go in. The fact that we win one out of four projects...shows that we are reasonably there.”
Once in 3-4 years, there happens a blow out. Hopefully the backlog of good projects is sufficient to absorb this kind of blow out. I have not seen a period of 3-4 years go past without blow outs.R Shankar Raman, CFO & Director, L&T
For instance...what happened in Oman...
“We had a four-year project. Midway in the project, may be 1.5-2 years in, the laws of the land changed. They said that minimum 30 percent should be Omanis, in terms of engaging resources. They realised quickly that there is no skilled labor which will account for 30 percent. How many car drivers and office assistants can you hire? You need people to work on a project live. They gave concessions saying that you can engage local subcontractors. At a point in time when there are so many foreign companies who are doing it (taking on projects) on assumption that they will move their resources and their machinery in, when you have this kind of change of law, everybody scampers to the few available subcontractors and the demand of supply changes. Then the cost becomes prohibitively high. What looked profitable, the labour arbitrage, in one instance became a disadvantage. This kind of risk is very difficult to price or even anticipate.”
Watch VS Parthasarathy and R Shankar Raman discuss risk with other finance leaders.
What about the risk of missing out? That’s an unquantifiable risk, isn’t it?
Parthsarathy puts it in the context of the reward. “For example, Uber in cars has already happened. Can I get an equivalent of that shared mobility in tractors? Should I wait or do it now? So, we created a platform called Trringo and we have put it outside (the company) to compete. Maybe it will not come out to be same. Maybe it will be very different in tractors as compared to auto. This is the balance between risk and reward.”
It’s the ultimate in tick box challenges. But M&M claims to have found a solution as recently as a year ago. An e-governance portal that monitors compliance. For every business unit a CEO-CFO report is issued that certifies compliance with existing laws and regulations.
The reports are submitted to Parthasarathy, Managing Director Pawan Goenka and Chairman Anand Mahindra for certifying after review.
But that’s compliance. The bar is much higher for governance.
Governance is a contingent liability. How are you looking at it and what kind of risks it throws up? It is not a direct compliance area, but it goes with—are you reporting right? When does a contingent liability become a real liability? When will it go to provisioning? All this needs to be reported. We are bringing in all these facets. A cockpit which is available to all the board and very senior management to look at.VS Parthasarathy, Group CFO & CIO, M&M
At L&T there’s safety in numbers - after all its board has 22 directors.
Nothing gets approved by a single signature, Shankar Raman says. He describes it as taking the face away from decisions as far as possible and trying to put a body around them.
Being a professional company, the weight of responsibility of taking a decision if it’s shared it’s better appreciated. If I have to take a decision on Rs 500 crore, I will worry myself to death. Whereas if I am going to be part of a three-member team which takes the Rs 500 crore decision, it becomes easier.R Shankar Raman, CFO & Director, L&T
Despite being a professionally managed company and widely owned one, L&T has witnessed a curious governance challenge—that of the unretiring CEO, MD and now chairman. AM Naik joined the company in 1965 and worked his way up, rising first to MD and CEO and then to chairman and MD in 2003. Then group executive chairman in 2012 and then giving up the executive responsibility in 2017. Despite threatening to retire, Naik is still chairman.
What are the checks and balances that apply to such a situation?
“In our structure, however powerful the one man could be, he has to carry committees with him,” Says Shankar Raman.
“It is very important to give space to a CEO to grow the business and at the same time the right values and right conduct is something that the collective system around him should be able to contain him. It is a challenge. It is easier said than done.”
CFO Leaders is a knowledge and experience sharing series to engage the best financial leaders, understand their approach to conventional challenges, such as capital allocation and risk control, and new challenges such as rapid tech changes and a narrowing world.
Watch the full CFO Leaders - Episode 1.