“S**t Happens” Isn’t How To Manage Risk
Many people had never heard of force majeure before a few weeks ago.
It’s often buried towards the back of legal contracts, and typically viewed by business leaders as a check-the-box, legalese section of the contract rather than something to thoughtfully review.
For years now, executives have told their procurement managers to bring back a rote 1-2% annual rate reduction from vendors. Just make it happen.
Now, many of these same executives are changing their pants a couple times per day as they realize their supply chains are full of inter dependencies and single points of failure. On-time delivery, and even the survival of their businesses are at stake.
With financial markets turning downward, everybody is thinking about their risk exposure. But if you weren’t thinking clearly about risk before, it might already be too late.
Force majeure (sometimes called an act of God) is suddenly an important concept because Chinese (and soon American) companies are using it to get out of contractual obligations. I’m not sure if these claims will hold up in court, but it has me thinking more about Alliance’s risk strategy.
While lawyers can come up with long lists of things that might go wrong and remedies for those situations (like force majeure claims), I think this approach is misguided. Those lists will never be complete, and they don’t really mitigate black swan risks.
Black swans, like coronavirus, can suddenly shift macro conditions for everybody, exposing unseen counterparty weaknesses. During the financial crisis of 2009, some large insurers were over-exposed and couldn’t honor all their obligations. Customers who were counting on insurance to cover them faced a rude surprise. Today, many businesses are finding that companies they rely on might be quick to wiggle out of obligations.
At Alliance, we take both a broad and a deep perspective on risk. Truly managing risk depends on having a deep understanding of your business. What could go wrong is just the first question. We also need to understand how likely and how costly those outcomes would be.
To manage our risk, we look carefully at the details like flood maps, insurance policy fine print, and the leanings of the relevant legal jurisdictions. I believe in the value of relationships, but also in the importance of drilling down to the details and getting contracts right. And we always have to consider the possibility that vital counterparties might default. We also think about appropriate reserves and critically evaluate downside scenarios with each investment.
The best investors are prepared to win under challenging conditions, not just rack up returns when things are good. S**t happens. It takes preparations to be resilient.
