By Jarrod Musick, Client Wealth Strategist, CFP®
"It ain't what you don't know that gets you into trouble, it's what you know for certain that just ain't so." - Anonymous
We plan for the business risks that we can see and feel are likely to happen. But, what about the low probability, high impact risks? How confident are you when thinking about how bad things could get for your business or for how long? How would a restaurant owner's perception of risk have changed between Q4 2019 and Q1 2020? What about the owner of a flight school on September 10th and September 12th, 2001? What probability would you have assigned to the risk of a pandemic shutdown of in-person dining or a terrorist training cell having used a United States flight school?
Are you prepared to mothball your business for a year and still survive? Are you prepared for a 70% drop in revenue for six months? What about a liability claim that goes against you for seven figures? Hedging these tail risks can be done with a few tools, but let us look at the four primary methods:
What percent of expenses can you change without defaulting on obligations or being unable to deliver your core business services? If you have $10 million of annual expenses, but your fixed expenses and non-discretionary operating costs are $7 million, you have a $3 million or 30% expense flexibility. Exercising discretion over the amount and/or timing of expenses is an essential tool inside your business and, for most of us, is the primary way to navigate bad operating periods. But, adjusting expenses has its limitations; you can only cut expenses so much and still retain the talent and capabilities needed for your long-term success.
My favorite analogy for this is an overused one, but it is a perfect warning for those who are tempted to slash their way to survival. First, you trim the fat. If that is not enough, you then cut muscle, and if it keeps going, you then cut bone. Adjustable expenses are an excellent tool for the expected but are frequently inadequate for the big and unexpected.
What do you have in cash and liquid investments? What could you get your hands on in the next 90 days if you had to? If you combine business and personal resources, this number is likely another 20% - 40% of operating expenses. With this method, instead of cutting costs by merely eliminating profitability and trimming things that you are reasonably comfortable shaving, you are now depleting reserves that took time and effort to accumulate. Depleting reserves is painful, and draining them feels like digging a big hole that you will need to fill back in later.
Let us go back to our $10 million example where you cut $3 million of fat and muscle in the business and still feel pretty good about coming out of it. What if you also had to access another $2 million of liquid reserves to make it through? You would then be looking at a much longer road to recover your revenue, which creates the ability to distribute money out of the business, which has to be accumulated to replenish the $2 million that you had to kick back in. Images of years ahead come to mind, and it makes this a tough decision. What are the odds you get back to where you want to be, and how long will it take to recoup this additional infusion? Tapping your reserve assets hurts, but if the goal is to ensure business survival and protect your long-term equity, using them makes a great deal of sense.
As a significant number of business owners found out during the first few months of the COVID-19 pandemic, business insurance can be fantastic or problematic, depending on the quality of your coverage. If something is not covered in the insurance contract's language, it won’t be protected. In many cases, entrepreneurs held business interruption insurance with the expectation that stay-at-home orders would qualify, only to find out that there was no coverage. Others were concerned with potential liability issues of having employees or customers interacting in-person during the pandemic, and they had to go back to their liability policies to see what was and was not covered.
In general, insurance is there to help you plan for the low probability but known risks. What insurance is not great for is planning for the unknown risks that may sink you. Cutting expenses and having capital available are both much more flexible tools than insurance, because they can be used no matter the cause of the disruption. Insurance is powerful (you can cover most seven-figure risks for a few thousand dollars each year), but it lacks flexibility. Since it’s impractical to cover for every possible adverse event with insurance, stick to the big three: death, disability and liability.
If you are looking for the least understood and most outside-of-the-box method, I give you “hedging using derivative instruments”. In essence, this is a way of using capital to hedge more powerfully than capital alone, and it is more flexible than classic insurance contracts. If you are worried about systemic disruption, you can purchase derivatives that benefit asymmetrically during times of systemic disruption. If you are concerned about a specific disruption to your industry, customer base or supply chain, you can purchase derivatives that behave the way you want them to in that scenario. This is not a replacement for building flexibility into your expense structure as a business, holding cash and liquid assets if you need to use them, or insuring specific risks with insurance; using derivatives is something you can choose to do once you have already done all those other things.
For the first-use case, let us look at broad, systemic disruption and how you might hedge that risk. Say you are concerned that the economy enters a recession, you could buy far out-of-the-money put options on broad indexes like the S&P 500. For instance, if you are in a particularly vulnerable financial position over the next year, you could purchase a series of put option contracts against the S&P 500 that expire throughout the following year. If a recession does hit and disrupts your business, the options pay out, and you have the proceeds to fund operational needs. If a recession does not hit, you may be able to deduct the investment loss on the option premium that you paid, and consider it a revenue insurance premium.
Understanding the pricing and payoff structure of derivatives is complicated and should be done by someone who has experience. For example, if you want to have a payoff of $1 million in the event that a recession hits in order to offset a portion of your projected revenue decline, ask yourself what this insurance will cost you in order to achieve that outcome. Should you buy puts against the S&P 500, the Russell 2000 or something else? Should they all expire in 12 months or some in three months and some in nine months? Should they be at the money, meaning more likely to pay off (and more expensive), or 30% out of the money (and cheaper)?
The number of variables is significant, and only by understanding them will you be able to get an accurate figure for the option premium cost for the right structure. Suffice it to say, you should plan on at least 10% of the desired payoff amount being spent on the option premium itself. Hedging against systematic risk is only viable when that systemic risk represents a mortal threat to your company. Hopefully, that is a state that dissipates over time.
Hedging a specific risk to your business is often much more viable. The first derivative contracts were invented to allow commodity producers to de-risk their possibility of ruin in a single season. For example, imagine a farmer who grows corn near Des Moines, Iowa and is concerned about the price tanking during harvest season. He or she builds their budget for seed, fertilizer, labor, equipment leasing and fuel based on a price of $4 per bushel. Most of that money is spent between December and May, but they will not sell their crop until September or October. Expenses are looking to be $3.70 per bushel, but what if the price drops to $2.50 at harvest time? If they have to sell at the market, they incur a loss of $1.20 per bushel and will likely lose their farm.
Enter the futures contract. That same farmer can buy a futures contract that allows them to effectively lock in a price at some future date for a premium payment. For the purpose of this example, let us say that they can lock in a price of $3.90 per bushel for a cost of $0.10 per bushel. That de-risks their whole season as long as their crop comes in, and they are able to cover all their costs and generate a small profit. If they have a significant profit or the market price ends up much higher at harvest, they end up better off with only the premium for the future lost. This farmer also likely has personal life insurance, insurance on their equipment, crop insurance for severe weather events and hopefully some reserve cash available, so this futures contract is in addition to all those other elements.
Most of you reading do not grow corn for a living, but do produce a product or service that carries risks unique to you. If the bottom falls out of the corn market, most of us would not notice unless we happen to be in or directly connected to the corn industry. But, the John Deere dealer in Scottsbluff, Nebraska? You better believe they will. So what are the corn prices for your tractor dealer business? That tractor dealer would be able to hedge revenue risk in the same way as the farmer by using a futures contract based on the commodity's price.
A glass manufacturer who designs in Montreal and manufactures in Thailand likely has risks related to the price of raw materials, shipping, distribution and internet protocol (IP) security. Based on those broad risk categories, they could hedge the IP security with cash reserves to fund legal action and the distribution by using multiple distributors. The shipping contracts could be hedged with fixed-price contracting or owning call options on the seaborne shipping industry. Should shipping volume (and therefore pricing) drastically increase, the options would increase in value, and the profits would offset the increased shipping costs. This leads us back to our example of hedging commodities - they could hedge the risk of raw material inflation using futures contracts.
Looking at individual risks and breaking them down into component parts is the key. We are also back into the precarious world of hedging against the things we know are risks. Hedging broadly against systemic disruption is expensive, but it offers the great benefit of not needing to understand the risks that are out there. We do not know the next big problem, but we know that it is coming. Does it make sense to hedge against it for your particular business? That is a very personal decision based on where you and your business are at this moment in time.
Important note and disclosure: This article is intended to be informational in nature; it should not be used as the basis for investment decisions. You should seek the advice of an investment professional who understands your particular situation before making any decisions. Investments are subject to risks, including loss of principal. Past returns are not indicative of future results.