GETTING IT (THE MODEL) RIGHT!
This one is going to be a bit business-y, so bear with me, my life has literally revolved around nothing but this over the past few days. The major work that I am responsible for this week is the risk model. This is the tool that we are going to use to tell us how risky the cash flows of the fund are, and then convince investors that it is a winning proposition after we adjust for risk. As you now by now, there is no precedent to this project and so it’s tough to ascertain just how much risk is inherent, and how deep should we cut their forecasts to arrive at a more realistic idea of the profit they can confidently expect.
The stakes are high: if we reduce forecasts by discounting too much, the NGO looses out because they will not be able to fund as many projects as they originally thought. If we cut too shallow, the return promised to investors will be overstated and the organization will not be able to deliver – which will have serious repercussions for similar future initiatives (not to mention the reputation of yours truly). To complicate all this, my colleague and I had little context on what was driving their forecasts. In interviewing some internal experts, we routinely felt that the assumptions were too vague, there was a lack of focus, and nobody fully understood the complexity of what we were doing. When we discussed an approach and questioned the validity of the business cases, the client brushed it off like it was no big deal and assured us their estimates were fine. We were led to believe that it was formulated by marketing directors in a workshop earlier this year. Thankfully, we later learned that this was somewhat misinformation and got to the bottom of the projections. Sachin, you will be happy to know that it was based off of some of the metrics you spoke about (e.x. corporate spend on software as a proxy for the available market for corporate donations) – all sound indeed.
This one is going to be a bit business-y, so bear with me, my life has literally revolved around nothing but this over the past few days. The major work that I am responsible for this week is the risk model. This is the tool that we are going to use to tell us how risky the cash flows of the fund are, and then convince investors that it is a winning proposition after we adjust for risk. As you now by now, there is no precedent to this project and so it’s tough to ascertain just how much risk is inherent, and how deep should we cut their forecasts to arrive at a more realistic idea of the profit they can confidently expect.
The stakes are high: if we reduce forecasts by discounting too much, the NGO looses out because they will not be able to fund as many projects as they originally thought. If we cut too shallow, the return promised to investors will be overstated and the organization will not be able to deliver – which will have serious repercussions for similar future initiatives (not to mention the reputation of yours truly). To complicate all this, my colleague and I had little context on what was driving their forecasts. In interviewing some internal experts, we routinely felt that the assumptions were too vague, there was a lack of focus, and nobody fully understood the complexity of what we were doing. When we discussed an approach and questioned the validity of the business cases, the client brushed it off like it was no big deal and assured us their estimates were fine. We were led to believe that it was formulated by marketing directors in a workshop earlier this year. Thankfully, we later learned that this was somewhat misinformation and got to the bottom of the projections. Sachin, you will be happy to know that it was based off of some of the metrics you spoke about (e.x. corporate spend on software as a proxy for the available market for corporate donations) – all sound indeed.
Getting to that point was painful, but it clarified everything and finally gave me a hell of a lot more confidence to model.
In between talking to a number of experts (folks in fixed income securities, and a McKinseyite named Sachin Kadakia) I re-engineered my model to reflect two approaches:
1) The Income Approach – This model adjusts the income they propose to receive while maintaining the current cost structure
2) The Discount Model – This model is the classic model where we take a risk free security, tack on risk premiums as appropriate and discount their cash flows like there’s no tomorrow
For the finance guru’s reading this, relax – It’s a gross oversimplification. Furthermore, initial testing on both models seems to yield realistic results – I finally feel confident that I can go to an investor and address their concerns appropriately (and prove it with quantitative rigor)!
Tomorrow will consist of more meetings (including a guy who started a Private Equity firm and a fund in Malaysia) as well as creating a deck to explain the risk model. A lot of thought needs to go into the structure of the workshop we are hosting in Hong Kong next week. On Friday, we have a detailed review of the business cases, which should leave us in a place to make recommendations on what projects will be part of the fund, and what will not. This weekend we will prep for a short presentation we have to the Shareholders Executive Committee on Monday, as well as begin the process of building the case to invest, and really focusing on the value proposition and the key messages we want to sell. The faster we can get ahead of this, the more we can preview the fund with key investors, tweak as necessary, and then go to market.
One thing that has become interestingly apparent to me is the simple fact that in every scenario you try to quantify, the key driving force always ends up resting on some aspect that is just not tangible. If you think of the iPhone as an example (albeit not a very good one), research probably showed Apple what the potential market was, but there was no assurance that Apple would succeed in making a phone, that the market size would materialize and people would spend much more than the next best alternative, and that competitors would not catch up faster. So much rested on the marketing team to generate the buzz and get it right. The same way, we can model the crap out of these projects, but it fundamentally lies on the team on the ground to make it happen and deliver what they committed to. If Major Donors, and other network offices have faith in the Chairman selling this fund, they will undoubtedly invest – but their investment is a bet on the Chairman, not so much on the cash flows that we modeled. Sure, they will take a look at the model, but just like other financial instruments that are essentially securitized, very few truly understands the detail and nuances behind them. I think this part (simplifying it in the prospectus so they think they understand it) is going to be the hardest. It’s funny how much of the world ‘just works’ on blind faith almost. Anyway, that’s my $0.02 for today.
For those of you who made it to the end of this rant, here’s a treat. This is a picture of the bomb-sniffing dog that is king of the property I’m staying at. His name is James, and he is ALL business. He’s 3 years old, a happy dog, but never wags his tail, and is on alert at all times. It’s funny watching him always looking around for which direction the next thing is going to come from. Love this guy….
In between talking to a number of experts (folks in fixed income securities, and a McKinseyite named Sachin Kadakia) I re-engineered my model to reflect two approaches:
1) The Income Approach – This model adjusts the income they propose to receive while maintaining the current cost structure
2) The Discount Model – This model is the classic model where we take a risk free security, tack on risk premiums as appropriate and discount their cash flows like there’s no tomorrow
For the finance guru’s reading this, relax – It’s a gross oversimplification. Furthermore, initial testing on both models seems to yield realistic results – I finally feel confident that I can go to an investor and address their concerns appropriately (and prove it with quantitative rigor)!
Tomorrow will consist of more meetings (including a guy who started a Private Equity firm and a fund in Malaysia) as well as creating a deck to explain the risk model. A lot of thought needs to go into the structure of the workshop we are hosting in Hong Kong next week. On Friday, we have a detailed review of the business cases, which should leave us in a place to make recommendations on what projects will be part of the fund, and what will not. This weekend we will prep for a short presentation we have to the Shareholders Executive Committee on Monday, as well as begin the process of building the case to invest, and really focusing on the value proposition and the key messages we want to sell. The faster we can get ahead of this, the more we can preview the fund with key investors, tweak as necessary, and then go to market.
One thing that has become interestingly apparent to me is the simple fact that in every scenario you try to quantify, the key driving force always ends up resting on some aspect that is just not tangible. If you think of the iPhone as an example (albeit not a very good one), research probably showed Apple what the potential market was, but there was no assurance that Apple would succeed in making a phone, that the market size would materialize and people would spend much more than the next best alternative, and that competitors would not catch up faster. So much rested on the marketing team to generate the buzz and get it right. The same way, we can model the crap out of these projects, but it fundamentally lies on the team on the ground to make it happen and deliver what they committed to. If Major Donors, and other network offices have faith in the Chairman selling this fund, they will undoubtedly invest – but their investment is a bet on the Chairman, not so much on the cash flows that we modeled. Sure, they will take a look at the model, but just like other financial instruments that are essentially securitized, very few truly understands the detail and nuances behind them. I think this part (simplifying it in the prospectus so they think they understand it) is going to be the hardest. It’s funny how much of the world ‘just works’ on blind faith almost. Anyway, that’s my $0.02 for today.
For those of you who made it to the end of this rant, here’s a treat. This is a picture of the bomb-sniffing dog that is king of the property I’m staying at. His name is James, and he is ALL business. He’s 3 years old, a happy dog, but never wags his tail, and is on alert at all times. It’s funny watching him always looking around for which direction the next thing is going to come from. Love this guy….
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