You’ve got capital to invest and multiple investment opportunities, but you don’t know what the best targets are.
You could renovate your facilities and realize a reasonable long-term gain on overhead savings. Or you could buy some new plant equipment to increase manufacturing efficiencies. Maybe it would be better to pursue equity investments or acquire a portfolio of real estate investment properties. What about a direct investment in a technology startup company? Or does it make the most sense to allocate a percentage of your available capital to each of the options that hurdle your cost of capital? And if so, how do you determine what amount should go to each opportunity?
When you’re facing this type of situation, it’s critical to understand an important economic concept: the risk-adjusted marginal efficiency of investment.
What Is Risk-Adjusted MEI?
Marginal efficiency of investment, or MEI, attempts to govern how investment decisions are made. Whether a firm is considering capital improvement or an equity investment, MEI helps determine the investment targets with the highest expected return. Those investments with MEI returns above the firm’s cost of capital are candidates for investment. But MEI is not enough. How do you compare two investments that have obviously different risk profiles? By including risk capital in the calculation, you can extend MEI and put all investment opportunities on an equal footing. At its simplest level, here is how risk-adjusted MEI improves on the standard MEI calculation.
Standard MEI Calculation
MEI = ER/I
- MEI = Marginal efficiency of investment
- ER = Gross expected annual return on investment
- I = Total expected cost of investment
Risk-Adjusted MEI Calculation
- Risk-Adjusted MEI = Risk-adjusted marginal efficiency of investment
- ER = Gross expected annual return on investment
- EL = Expected annual losses from the investment
- I = Total expected cost of the investment
- EC = Economic capital or risk capital required to support the investment
Without a risk adjustment, and taking all investments in isolation one at a time without considering diversification benefits, MEI will skew investment decisions toward investments higher up the risk spectrum. Most investors have an inherent qualitative sense of risk avoidance, which prevents them from getting completely out of hand. Risk-adjusted MEI provides an investor with a quantitative tool for the task.
Of course, the devil is in the details. Quantifying expected losses and economic capital is arguably as much art as science, and they are nonstationary. They are a function of the risk of the investment (e.g., market, credit, operational), the size of the investment relative to the rest of the portfolio (i.e., its concentration) and how the investment is expected to perform relative to other investments in the portfolio (i.e., its diversification benefit). Complicating matters, you must use history as a guide to estimate risk and capital, but it is the future that is of concern.
MEI in Practice
In a simple world, your investment opportunities are constrained by your available capital. As you evaluate expected rates of return on a series of investments, you will typically select those that yield the highest ROI, subject to your qualitative risk appetite. Further investments will follow down the line of diminishing returns, typically until you reach the point at which your expected return equals your cost of capital.
Like many others, my firm, Percipio, is not uncommon in that we operate under capital constraints. We simply don’t have enough money to invest in all of the opportunities that we find. So we constantly have to make trade-offs between alternative investments as we determine where to invest Percipio’s money.
Because some investments are riskier than others, we don’t want to say we’ll definitely move forward with any opportunity simply because it clears a set hurdle rate. Going beyond the hurdle rate and evaluating investments with a risk-adjusted MEI framework drives us to optimize the expected return across a diversified spectrum of investment opportunities.
Many firms have certain asset classes for which they’ve developed a level of expertise. For Percipio, one of the classes we have a lot of investment experience in is residential real estate.
We’ve done a lot of deep value-add real estate investing, which basically means we bought multifamily real estate that was in bad shape, put a lot of work in to improve it and then restabilized it at much higher rents. And because we know how to do that well and have our heads around the cost of that type of investment, I don’t view it as terribly risky from an execution or operational perspective. To be sure, these investments carry plenty of financial market risk, but we manage that by avoiding excessive leverage and the use of relatively long-term debt financing.
Percipio has a relatively high cost of capital. In pursuing and maintaining a portfolio of investment properties, we strive to earn equity-like returns on our money. When evaluating residential real estate, for example, we look for unleveraged returns that are paying high single-digit percentages. We underwrite those deals with an appropriate amount of leverage and risk adjust them with our assessment of economic capital before comparing them to our equity hurdle rate.
It is interesting how this works in practice. Recently, buyers with either a lower cost of capital or a misunderstanding of the risks inherent to the asset class have driven the cost of residential real estate investments to much higher levels in our local market. The risk-adjusted expected returns on deals we underwrite today are no longer clearing our hurdle rate and we have chosen to stand aside in order to target investment opportunities with a more favorable risk-adjusted marginal efficiency of investment. We have experience with the asset class and infrastructure in place to manage it appropriately, so we keep looking at new deals. If we discover an opportunity with a favorable hurdle rate that passes the risk-adjusted MEI test we’d definitely want to do it, but we have the discipline to stand aside while it does not make sense.
Cashing In Through Risk-Adjusted MEI
Recently, Percipio was in a situation where we were evaluating an existing investment. If you want to be a smart investor, you should constantly be looking at your capital and investments to decide what, if anything, you should do differently with your money. However, when evaluating the liquidation of an existing investment you’re usually faced with a lot of friction from taxes and fees that weigh on the funds available for redeployment.
Using the risk-adjusted MEI as one of our evaluation tools, we were able to calculate the cost-benefit of selling an asset and rolling the gains into a tax-deferred opportunity zone fund investment. We had a fairly significant long-term capital gain in this asset, but by taking advantage of this newly created tax-deferring investment vehicle, we knew we could realize a better ROI than if we simply maintained our initial investment.
Why Should CEOs Understand and Use Risk-Adjusted MEI?
Many firms find themselves exposed to increasing concentrations of risk as an unintended consequence of a poorly designed incentive compensation program. When incentives are on the line, care must be taken because, as the old adage goes, you get what you pay for — sometimes more than you want or should have.
When employees in development roles are incentivized to execute transactions, you can expect them to do just that. Anyone who sits above those folks, up to the CEO, needs to have a good way of evaluating whether the deals they are executing make economic sense. Even if it’s just a quick and dirty, back-of-the-envelope calculation, it’s critical.
Without that baseline understanding, you’ll potentially start doing deals that aren’t as profitable as you want them to be. After that, you’ll find your firm executing deals that don’t make money, and if you keep doing it, you’ll get to the point where transactions could jeopardize the solvency of the company.
In any investment that is highly leveraged, you can get yourself into trouble fast. It’s one thing to lose your capital in a bad investment. It’s something else entirely when you’ve gone upside down on a debt-financed deal where you need to cut a check for multiples of your original investment.
As CEO, the buck stops with you when it comes to your organization’s health. If you don’t understand the investments your company is making and what is motivating them, you’re playing with fire. Along with other calculations, a properly structured risk-adjusted MEI framework can help inform a healthy decision-making process. And when the risk-adjusted marginal efficiency of investment of a deal no longer makes sense, you’ll know to back off and shift your focus.
Beyond Calculation to Application
It should go without saying, but the risk-adjusted MEI cannot be the sole tool used to determine where a firm should apply its investment capital. It is most advantageous when used in conjunction with multiple additional metrics. But if you want to be a true value investor and get the best risk-adjusted returns for your portfolio, you’ll be sure to calculate the risk-adjusted MEI of every potential investment opportunity.
Still have questions about risk-adjusted marginal efficiency of investment? Connect with me or visit PercipioPartners.com to learn more and find how we can partner with you.