Mitigating Risk and the "Sweet Spot"

24, Aug 2017


 

By Ron Robichaud
Principal, Robichaud Financial Services 

Harvard University professor and corporate strategy expert Michael Porter writes that “the value in any business is its ability to consistently generate superior returns on investment.” A successful home building company generates great returns on equity and great returns on invested assets. 

At the same time, the life of most home building companies is a bit of a roller coaster. Between the ever-changing market conditions, the unique characteristics of every new site, and the perennial need to find new customers, the company needs to be constantly reinvented and earnings must be constantly reinvested to fund growth. 

So, while the returns are great, risk is also great. For most home builders, their equity in the company constitutes the bulk of their net worth, and distributing earnings to invest elsewhere never seems to be an option. An active strategy to mitigate risk must be front and center in every builder’s operating strategy if they want to eventually monetize the value they are working so hard to create in their company. 

The purpose of mitigating risk is obviously to protect that value as it is being created. 
It’s easy to bet the ranch when you don’t have one. The bigger the ranch, the more stressful and dangerous it is to risk it all. 

There really are only two major strategies to minimize the risk. The first is the judicious use of OPM (other people’s money), either in the form of non-recourse debt or non-recourse investor funds. Builders tend to underestimate the level of risk associated with personal guarantees, particularly as the last recession fades from their memories. 

Unfortunately, in the last recession, as well as in every preceding recession, builders learned very painfully that the personal guarantee is very real. Many builders have had to start over more than once. 

Long-term goals

Therefore, one major long-term goal must be to build sufficient equity in the company to access non-recourse debt. Additionally, builders must be able to identify a stable of investors that can provide non-recourse capital in the form of either equity or subordinated debt that can fill the gap between institutional debt and the builder’s personal funds. 

Obviously, there is a cost associated with the use of OPM. In the long run, the cost is less than the cost associated with the risk of the personal guarantee.

The second strategy to minimize risk is to pursue a dual strategy that balances growth and earnings distributions — a strategy that balances profitability and growth. Given the size of a market and the builder’s strategic vision, there is usually a sweet spot in terms of:

volume at which the company is functioning at optimum efficiency, 
the ability to maximize pricing, and 
protection from extreme market fluctuations because of inherent scarcity of the product. 

Growing beyond the sweet spot increases risk significantly and impacts pricing power negatively as a result of competitive pressures. Operating within the sweet spot is critical to maximizing pricing and thereby maximizing profits.

Limiting exposure

If the two policies of non-recourse debt and operating within the sweet spot are rigorously pursued, the company can operate with a relatively fixed balance sheet. If the balance sheet is relatively fixed, the required equity can also be fixed, the principle being that the amount of equity to remain in the company is whatever it takes to access non-recourse debt. Any excess can be distributed, thereby taking chips off the table. 

If a builder’s financial exposure is limited to the equity in the company, and if significant earnings can be distributed regularly and invested in more traditional and less risky ventures, the builder will monetize the value he is creating. This can be done without having to wait for the execution of an exit strategy and will greatly mitigate the inherent risks associated with home building.

Ron Robichaud is the principal of Robichaud Financial Services, where he advises home builders on mergers and acquisitions, exit strategy development, strategic growth, and maximizing company value. He can be reached at ron@robichaudfinancial.com or (603) 527-1994.


 Mitigating Risk and the "Sweet Spot"

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