Systemic and idiosyncratic risk are two very different things.
The distinction is important. When risk turns into a real problem, the best way to solve it usually depends on whether the problem is idiosyncratic or systemic in nature. Failure to make this distinction often leads to wasted time, effort and money.
Today's newsletter explains the difference and offers suggestions for developing an appropriate course of action.
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Founder and Principal
Goodrich & Associates
Idiosyncratic Vs. Systemic Risk. What's the Difference and Why Does It Matter?
In the investing world, idiosyncratic versus systemic risk refers to risk related to a specific security. In theory, idiosyncratic risk can be diversified away while systemic risk cannot.
So, idiosyncratic risk affects only one security; systemic risk affects all (or at least many) securities.
For example, when British Petroleum
had its spectacular oil well disaster in the Gulf of Mexico, only BP and its drilling partner's debt and equity securities were directly impacted. That is idiosyncratic risk. The impact of the global recession that was happening at the same time affected all securities and that is systematic risk. Systemic risk need not be global, it can be industry-specific.
For example, today with oil prices in the basement, not only are all
petroleum companies affected, all companies that supply energy as fuel are too. That is systemic risk.
This distinction is important in general business as well, since the best way to solve problems usually differs, depending on whether the problem is idiosyncratic or systemic.
In BP's case, because it experienced a problem unique to itself during high oil prices and otherwise boom times for the industry, it was able to raise money by selling off assets into a healthy market. Today, with low oil prices and lots of exploration and production companies in trouble, there are plenty of assets available for sale and few buyers. With systemic risk, selling assets to counter problems won't be nearly as successful as when faced with risk that is idiosyncratic. A few pointers about how idiosyncratic and systemic problems differ.
When it is an idiosyncratic problem...
- It is easier to raise debt or equity. All else considered, investors aren't down on or suspicious of your industry. If you are experiencing liquidity problems, creditors, particularly trade creditors, won't have you flagged as a risk because of your industry. That doesn't mean you won't have to pay more or that the terms won't be severe, but there likely will be money available.
- Customer problems are isolated. If you have a problem with a customer, it is only one customer, not all of them or an entire segment.
- Liquidating assets to raise funds will likely yield more. For example, when I shepherded a scrap metal company through bankruptcy in 2008, scrap metal prices were very high as the global economy was still booming. We were able to sell the business for a price far in excess of what was warranted by cash flow if well run.
The buyer was a steel mill that shut down most of the operation to lower scrap prices and thereby lower its cost of raw materials. Scrap metal prices were so high that it made economic sense to dig up three feet of ground under the scrap and run it through a process used to salvage auto fluff (the mostly plastics with some small metals that comes from the innards of crushed cars) to retrieve the costly metals.
When 2009 came and with it a global depression, it was time to sell the company's crushed car shredder, the largest in the world. The poor lender that financed that equipment was screwed. No buyers (except the low ball bid from the steel mill that bought the company) made an acceptable offer. Systemic risk trumped.
As far as the source of the idiosyncratic risk, well, if you repeatedly shoot yourself in the head, you will eventually die, metaphorically speaking at least.
- Fingers may point inward. When the problem is idiosyncratic, important people (e.g., directors, customers, creditors) may think you are the source of the problem - it is just happening at your company, after all. These are common situations in which people like me are brought in to run the company from the outside. When the whole industry is in the toilet, on the other hand (systemic risk), a common refrain from lenders is, "Good company, bad market. Let's just sit and wait for better times."
When it is a systemic problem...
- Customers and creditors expect you to have a problem. There will be less concern about the capability of management. That said, everyone will be looking for your problem, so you have less time to recover. But creditors, customers and even lenders will have less faith in your recovery plan. Not because they don't think you can execute the plan, but because that plan may matter little in the face of industry or larger market problems.
- Lenders tighten up and, in aggregate, may opt to reduce exposure to your industry. Unfortunately, this comes at precisely the time when you need to borrow more and with a higher risk profile.
In late 2008, just days before the crash, an equity investor in a factor (a business that buys accounts receivables from cash-strapped companies) with a mediocre record at best, cashed out his equity with junior lien debt held by (surprise) a now defunct high yield fund. The factor's senior secured lender, like many in the industry, was CIT.
For those who forgot or never cared about the details of the great crash, CIT imploded in 2009. They could not fund all of their customers. They picked mine not to fund, because, well, my customer's portfolio of credits had lots of problems and other clients were more profitable and promising. Worse, CIT's main competitor as a lender to factors was Wells Fargo which decided to raise the minimum size loan they would make to squeeze out the smaller factors, since most of their portfolio was at the larger end. So, in the end, my client was forced to sell the performing part of its portfolio at unfavorable terms to another factor. Those terms were so unfavorable, my client got little in the way of recovery from the "good" assets.
A few more pointers
- It is harder to unload assets to raise cash - and doing so brings less cash. In truly dire situations, this can be good. Underwater secured creditors may opt to wait things out until better times bring better collateral recoveries.
- The world doesn't have to be in a global recession to have systemic risk. Industry risk is sufficient. Think of the oil and energy industries today.
- Even if your problem is at heart an idiosyncratic one (your company didn't execute well, for example), if you are experiencing systemic risk, that should govern how you respond.
In short, the response to your problem should be dictated as much by the type of problem as by the details of the specific situation at hand.
- Idiosyncratic vs systemic matters for opportunities as well as problems. But that is for another newsletter.
Applying a systemic strategy to an idiosyncratic problem - or vice versa - can lead to much wasted time, effort and money, with little results to show for it.
When faced with a problem, first sit back and assess whether the problem is idiosyncratic or systemic. Then, shape your action plans accordingly.
Heard on the Street
If you read the popular press - and much of the academic press - you are told that we are living in a time of easy money around the world.
Not so fast, says the Danish economist Lars Christensen
, who shows that money is tight for the G20.
Read why here
Goodrich & Associates is a management consulting firm. We specialize in helping our business clients solve urgent liquidity problems. Our Founder and Principal, Charlie Goodrich, holds an MBA in Finance from the University of Chicago and a Bachelor's Degree in Economics from the University of Virginia, and has over 30 years experience in this area.
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