If the game of basketball is to score more points than your opponent, then the game of investing is to sell your assets at a higher price than it cost you to buy. This is the result that we all know and want for our portfolio. To get there, we need a game plan. In basketball, we need to get the right formation and good players. In investing, we need a right portfolio strategy and assets that fit the portfolio and have attributes that make them “good” assets. In its simplest form, a “good” asset is one that generates cash flows at a rate that is superior to other assets on a risk-adjusted basis. There are other considerations such as revenue growth potential (similar to a player's potential to improve) or cost reduction potential (similar to the ability to reduce the number of unforced errors made on the court) but cash generation (same as the ability to score baskets) is the key. This is why we have the term “Cash is King”.
You would note that I use the terms “cash generation rate” and “risk-adjusted basis”. These are important concepts, as we prefer asset that generates steady and stable (therefore low risk) cash flows at a rate better than other similar assets (therefore higher cash generation rate). In basketball, a team will benefit from a steady performer that scores more than his opponent does. Do you prefer a player who scores consistently 20 points every game or a player who can score 30 points in one game but only 10 points in the next game right?
Just like a basketball player developing from a high school potential playing in a high school team into a matured superstar playing in a NBA team, an asset goes through the same development cycle and find itself appealing to different types of investors as it matures. Typically, an asset moves from high growth (funded by entrepreneurs and/or Venture Capital), to medium growth (funded by Private Equity) to matured asset (funded by large corporates, life insurance companies or pension funds or sovereign wealth funds). More importantly, the return expectation decreases as the asset matures. Just like a NBA team willing to pay high salary to matured superstar for their quality, different types of investors have different risk appetites and therefore different return expectations.
Risk is essentially the exposure to harm of a particular situation and in the case of investment risk refers to the exposure to the event of losing money. This can be further broken into – first, the probabilities of various lost events happening and second, the amount of losses of the various lost events. A high probability huge lost event is consider a major risk while a low probability small lost event is consider a small risk. In parallel, similar exercises can be conducted for various profitable events. Professional mangers appreciate that probability is unpredictable and therefore their primary approach is to review the various loss (and profitable) events carefully when evaluating an investment opportunity. This approach is different from the concept of "expected return", which is more common among entrepreneurs and the general public. In basketball, a risk approach is one where a coach evaluates the use of each player based on their ability to positively and negatively influence the game (through various events) while an expected return approach is one where the coach simply adds up the expected points per game of the players and hope that he has a higher aggregate score vs the opposing team. What would be your preferred approach?
Understanding the risk approach is important towards appreciating the various capital providers and tools in the market. For investors with higher return expectation (i.e. VC, angel investor, etc.), they have a greater ability to accept higher risk as one successful investment (e.g. Facebook) might be able to “cover the loss” of a number of failed investments (names we probably do not even remember!). On the flipside, investors with lower return expectation (i.e. insurance companies or banks who provide debt financing) have a very low risk appetite as one major failure will need 8-9 successful investments to cover. As such, VC might give entrepreneur the feeling of an energetic offensive-focused coach who encourages individual interpretation of each play while insurance companies will give a feeling of an overly protective defensive-focus coach who demands the players to stick to the plan. There is no right or wrong and ultimately depends on the situation, like if your team is leading 6 points with 1 minute to go, any rationale coach would prefer their players to stick to the plan to play out the game!
A renewable project is a good example due to the simplicity of its risk return profile development. It goes through a maturing cycle similar to grooming a high school basketball player. The key components of a renewable asset are (1) land, (2) availability of grid connection or offtaker and (3) permits. To acquire these key components, developers and investors need to spend a significant amount of development capital and efforts.
At the very beginning, development capital would need to be spend to acquire the option to buy or lease the land, undergo resource study, go through the local permitting process while paying staff along the way. At this stage, the asset only has negative cash flows but potential to generate cash flows in the future – similar to a high school potential player.
Once the assets acquired the land, completed its resource study and received all required permits, the next stage is to evaluate the investment attributes of the asset –how much capital would be needed to build the asset, remaining time before the asset turns cash positive and whether the cash generation rate is attractive relative to other assets. For renewable project, it is possible to fix the investment framework and evaluation criteria at the start. Once the evaluation is completed and the project is economical to proceed, the next stage is to build the asset and bring it into operational stage.
At operational stage, a renewable project becomes an asset that generates stable positive cash flows with a number of easy-to-be identified risk factors that are potentially mitigatable. With a well-developed risk-mitigating plan, the project can matured into an asset with stable and strong cash generation ability, similar to a matured NBA superstar!
Renewable investment is not new in Taiwan but institutional-type renewable investment is still at its infancy. To achieve 20GW of solar capacity by 2025, the sector would require NTD 60-80 billion of capital so a more mature renewable investment market is needed to get there.
Please sign up for this (2017) October conference organized by Green Impact Lab and Sin Yi School where I will share more about the concept of risk, profiles of the different types of institutional investors and the development of a “typical” renewable market.
See you next week!