Long-Term Direct Investment Risks

Case Study: Risk Management for Long-Term Direct Investments

Background:

ABC Investments is an institutional investor specializing in long-term direct investments in private companies. As a CFA Level 3 candidate, you have been asked to discuss various methods to manage the risks arising from ABC Investments’ long-term direct investments.

ABC Investments has provided you with the following information:

1. Investment Strategy:
   • ABC Investments focuses on identifying promising private companies with solid growth potential.
   • The investment horizon for these investments is typically 5 to 10 years or longer.
   • The portfolio is well-diversified across industries and sectors.
2. Risks Involved in Long-Term Direct Investments:
   1. Business Risk:
      • Changes in industry dynamics, market competition, and consumer preferences.
   2. Financial Risk:
      • Exposure to market risks, exchange rate fluctuations, and interest rate movements.
   3. Operational Risk:
      • Risks associated with the day-to-day operations of the investee companies, including production, supply chain, and management.
   4. Regulatory and Legal Risk:
      • Compliance with regulations, changes in taxation policies, and legal disputes.
   5. Environmental, Social, and Governance (ESG) Risk:
      • Risks related to environmental impact, labor practices, and corporate governance.

Questions

1. Method To Manage Business Risk:
   1. How can ABC Investments conduct thorough due diligence on potential investee companies to assess business risks?
   2. How can diversification help ABC Investments mitigate business risks?
2. Method To Manage Financial Risk:
   1. How can ABC Investments manage market risks associated with long-term direct investments?
   2. How can ABC Investments mitigate credit risk associated with its direct investments in private companies?
3. Method To Manage Operational Risk:
   1. How can ABC Investments evaluate and manage operational risks associated with its investee companies?
4. Method To Manage Regulatory and Legal Risk:
   1. How can ABC Investments comply with regulations and manage legal risks in its direct investments?
5. Method To Manage ESG Risk:
   1. How can ABC Investments integrate environmental, social, and governance factors into its investment process?

Solutions

1. Method To Manage Business Risk:
   1. ABC Investments can conduct industry analysis, review the investee company’s competitive position, assess its growth prospects, and evaluate the management team’s track record.
   2. Diversifying investments across various industries and sectors can help reduce the impact of adverse events in any single sector and reduce concentration risk.
2. Method To Manage Financial Risk:
   1. ABC Investments can utilize hedging instruments such as derivatives to manage exposure to market risks related to changes in interest rates or exchange rates.
   2. ABC Investments can conduct thorough credit analysis to assess the creditworthiness of investee companies and implement proactive measures to mitigate credit risks. This includes evaluating the investee company’s financial statements, debt levels, and credit rating.
3. Method To Manage Operational Risk:
   1. ABC Investments can perform comprehensive operational due diligence to assess the investee company’s operational processes, supply chain, risk management systems, and management expertise. It can also actively engage with investee company management to address and mitigate any identified operational risks.
4. Method To Manage Regulatory and Legal Risk:
   1. ABC Investments can hire legal experts to conduct thorough legal due diligence on investee companies, assess potential regulatory and legal risks, and ensure compliance with relevant laws and regulations. Implementing effective compliance programs and policies can also help mitigate regulatory and legal risks.
5. Method To Manage ESG Risk:
   1. ABC Investments can adopt an ESG integration approach, considering environmental, social, and governance factors in its investment decision-making process. Engaging with investee companies to improve their ESG practices and monitoring their ESG performance can also help mitigate ESG risks.

Reading 16: Cases in Risk Management – Institutional

Los 16 (d) Discuss various methods to manage the risks that arise on long term direct investments of an institutional investor