Taking Risk To the Marketplace
By Thomas A. Stewart

(FORTUNE Magazine) – "You should always value the ability to move and change, because that creates options, and options are valuable," says Jeffrey K. Skilling, chief operating officer of Enron, the big energy company. Not for Skilling an energy company's usual penchant for holding lots of fixed assets and long-term contracts. Says he: "I prefer a smart person to an asset."

Enron is one of a handful of companies that have learned new ways of managing risk. Last time (The Leading Edge, Feb. 7) we talked about how traditional risk management, with its emphasis on real property and financial events, isn't enough for knowledge companies, whose big risks are intellectual assets, such as brand equity, human capital, innovation, and their network of relationships.

Before doing anything, you have to know what's at risk-- which isn't always easy for intangible assets. For example, a chemical company's ability to customize products is probably attributable to its knowledge assets rather than to its retorts and alembics. But what is the structure of the knowledge asset? It might be people-based--i.e., the skill to concoct custom chemicals might reside in the knowledge of experienced chemists. It might be media-based (found in cookbooks, manuals, databases). It might be relationship-based, found in ties to customers, suppliers, universities, etc.

Each has a different risk profile. To protect the cash flow from a people-based asset, you might want to diversify the ownership of vital knowledge by emphasizing teamwork, guard against obsolescence by developing learning programs, and shackle key people with golden handcuffs. Those are not the usual subjects of talk in treasurers' offices--yet they cry out for treasury's mathematical and actuarial rigor.

To see why, consider the analogy between managing risk and planning strategy. Says Art deTore, senior vice president for strategy at Lincoln Re, one of the largest reinsurers in the U.S.: "Our strategic planning process works like asset allocation for a portfolio." Existing lines of business are like bonds, deTore says, providing a steady cash flow with a high degree of certainty; Lincoln Re evaluates them using discounted cash-flow analysis. New opportunities are less predictable and best evaluated as if they were stocks. Untried ideas are startups, and evaluated using real-option pricing models, which take the tools that Robert Merton, Myron Scholes, and Fischer Black developed for financial options, and apply them to real investments. They allow you to set a fair price for an asset today, even though its ultimate value might vary.

Thinking like a portfolio manager works for risk management as well as for strategy, says Bruce Pasternak, head of the strategic leadership practice at Booz Allen & Hamilton. In either case, adaptability is a cardinal virtue; the top goal is organizational flexibility. All-or-nothing bets like insurance have limited use in protecting cash flows from intangibles because their value is so uncertain, says Anjana Bhattacharee, director of Aporia, a British startup developing tools to manage those risks. Hedging also has problems. Says Bjarni Armannsson, head of the Icelandic Investment Bank in Reykjavik: "It's difficult to find a counterparty for intellectual risks." To hedge against falling gas prices, Enron can sell the risk to someone who fears rising prices, like a utility, but how do you hedge against a loss of expertise or brand equity?

General managers instinctively want to reduce risk by planning; portfolio managers exploit it via markets. Thus Armannsson makes equity investments in companies whose main asset is intellectual capital, but won't give them loans. He says, "These companies are volatile. If you lend to 100 companies and just one or two go bankrupt, you lose all your profit. If you have equity, you might need just one or two winners to get an excellent return."

Many intellectual risks can be securitized--at least metaphorically--and managed as part of a portfolio. Innovation, for example: Pharmaceutical companies like Merck use real options methods to keep tabs on R&D portfolios, periodically reweighting bets as each project's value becomes clearer.

Enron lowers business-model and human-capital risks with a flexible internal labor market. They are subject to what COO Skilling calls "the recurring nature of nonrecurring events"--he cannot know where change will strike but can be sure it will be somewhere. In 1992 long-term fixed-price gas contracts for independent power producers were Enron's biggest moneymaker. In 1993 the market changed, and Enron didn't sell even one. Yet, he says, "we didn't skip a beat, because we have a free market in people internally. They started gravitating to other businesses--we started our power marketing business in 1993--and we redeployed almost painlessly. We didn't lay off anyone--we hired."

Enron's labor market rests on five pillars. Common compensation structures mean no one loses money by moving. Titles go with the person, not the position; once a VP, always a VP. Equity is a substantial piece of pay, giving people an incentive to put their talent where the company makes the most money. Performance appraisals are made by committees of 24 people, not just by supervisors. That way, says Skilling, "your performance rating comes from the organization, not your boss, so you have very little risk to mobility. " Last and most important, Enron keeps people by promising to challenge and develop them constantly.

Markets are full of risk, but it turns out that they're a lot safer than rigid structures. Intellectual assets and operations obey no one's command and are subject to discontinuous--i.e., quantum--change. There are four ways to respond to risk: Avoid it, reduce it, transfer it, or accept it. The one thing you can't do, if it's intellectual risk, is tie it up and subdue it.