Risk Management Decisions
Only recently, Ahold’s interest in risk management issues increased significantly. In the latest annual reports (1998 – 2003), Ahold mentions several actions taken to avoid risks. Remarkable is that the 1998, 1999 and 2000 annual reports do not mention the phrase “risk management” even once. When mentioned in 2001 and 2002, this concerns mainly financial management decisions (currency swaps etc. ). However, in the annual reports before 2003, Ahold does not devote a chapter or even a paragraph to risk management or mentions specific risk factors.
The 2003 annual report gives notice of 31 identified risk factors, varying from retainment of employees to poor performance of stock markets and the application of International Financial Reporting Standards (“IFRS”) instead of Dutch GAAP. Not only did Ahold mention risk factors, also the amount of words spend on the subject of corporate governance tripled from 1998-2002 to 2003. Furthermore, the annual report 2003 has a separate chapter on remuneration policy.
From the attention to risk management (and corporate governance) can be concluded that the importance of these subjects to Ahold increased significantly since the 2003 fraud-scandal. Risk management became an agenda point in the (supervisory) board-meetings, and Ahold even appointed a Chief Governance Counsel. We group the 31 identified risk factors into 4 groups: 1) stakeholder relations- and reputation factors, 2) organisation and operational factors, 3) economic environment factors and 4) financial risk factors. For each of these “risk groups”, we discuss how Ahold makes decisions.
Next to this, we compare the Ahold risk management on these subjects groupwise with available literature and give our personal opinion. Appendix 1 shows the identified risk factors. Concluding for the identified risks regarding stakeholder relations and Ahold’s reputation, we note that Ahold identifies risks that they can influence a great deal (employee commitment and liability etc. ), while other risks are more difficult to influence and not entirely in their own hands (negative publicity, results of future investigations and legal proceedings etc. ).
For a large part, Ahold’s strategy regarding acquisitions, joint ventures and growth determines the risk they are facing. After all, foreign joint ventures means extra financial and reputational risk, but also more stakeholder relations (suppliers, shareholders, partners, customers etc. ) and thus risk. Remarkable is the observation that Ahold has “contingent liabilities with its joint venture partners”. In earlier years, Ahold closed deals with partners in the form of a joint venture in order to keep up the growth rate [De Jong, DeJong, Mertens, Roosenboom, 2004].
According to Jensen (2004), high values give management more discretion to make poor acquisitions that value growth over shareholder value. From studying the available information [Ahold annual reports 1998-2003, internet, newspaper articles Financieel Dagblad), we get the impression that Ahold didn’t cover these risks yet. However, Ahold is aware of these risks, as is evident from the annual report 2003. The risks coming along with these joint ventures aren’t (totally) hedged. In case of financial difficulties of their joint venture partners, Ahold faces possible considerable losses.
Because Ahold buys shares in the joint venture partners (usually around 50%), the potential loss of Ahold is for the amount invested. Next to this, there is the possibility of loss of reputation. Literature [Grinblatt, Titman, 2002] shows that these kinds of deals can be hedged by using put options for the share in the other firms. In this way, decreasing stock of the joint venture partner has a floor and losses remain relatively small. Ahold runs an extra risk with the joint ventures, since it usually involves entering a (new) foreign market.
On the one hand, a joint venture reduces the operational risk, while the counterpart “knows what he is doing”. On the other hand however, Ahold might damage its reputation (as was the case with Disco), as was mentioned in the previous chapter. Hedging might help in this case, since management performance can be measured more accurate. Literature usually mentions hedging to decrease the volatility of cash flows. Especially in case of foreign markets, this can be done by hedging currency risks, for instance by means of forward/future contracts.
Not only does Ahold run the risks described above when entering a new market, it also has more difficulties to achieve the 15% growth of earnings as time proceeds [De Jong, DeJong, Mertens, Roosenboom, 2004]. Therefore it might take more risks. This sort of risk is covered in the paragraph that deals with financial risk. The risks mentioned are classified in this paragraph because they involve risks that are fully in control of Ahold itself or have a close relation with Ahold’s performance. We distinguish two groups. The first group involves risks that include failure to carry out plans or reduce costs.
The second group contains risks of increasing competition and the reduced margin that comes with increased competition. In our opinion, these kinds of risks are the least transparent to hedge. Inability of management to implement a cost reduction successfully is not to hedge. It is however possible to make management performance better noticeable by reducing the variation in Ahold’s financial performance. Hedging makes management performance more visible since matters like unexpected increases in profits due to exchange rate change exist no longer.
This might avoid expanding as in the late 90’s (“the sudden and extensive number of acquisitions that differed from Ahold’s past approach to implementing its strategy in a particular region, a steady pragmatic sequence of acquisitions and consolidation”). If Ahold wants to better assess the quality of the management, it should hedge its earnings or cash flows [Grinblatt, Titman, 2002]. One way of doing this is by using futures. However, we don’t find evidence of the use of hedging for this purpose.
Not only did Ahold use hedging to make management performance more transparent, they also “launched a new share bonus program for certain employees, known within Ahold as the 2004-2006 Ahold Performance Share Grant Plan. This is a performance-related share plan based on the development of Ahold’s Total Shareholder Return (“TSR”) benchmarked against the TSR development of a selected group of ten companies with the same core activities as Ahold (the reference group). TSR development is measured over the 2004-2006 period. Ahold will be ranked within the reference group on the basis of its TSR results.
The number of shares to be allocated at the end of the three-year period depends on Ahold’s ranking within the reference group. ” In our opinion, this bonus plan reduces the aforementioned operational and organisational risk, because performance depends on the performance compared to competitors. Risks arising from the “economic environment” are all risks that are out of the hands of Ahold. They vary from matters where Ahold doesn’t have any influence (economic downturn, interest rates) to matters where Ahold can have some influence (increasing competition, union contracts).
Ahold is exposed to fluctuations in interest rates. Just after the February 2002 fraud announcement, Standard & Poor’s responded by downgrading Ahold’s credit rating from BBB to junk. The next day Moody’s downgraded Ahold from Baa3 to B1 [De Jong, DeJong, Mertens, Roosenboom, 2004]. Downgraded credit ratings result in higher interest rates and therefore an increased indebtedness in case the borrower doesn’t sufficiently hedge interest rate risk. As of year-end 2003, approximately EUR 1. 2 billion, or 16%, of Ahold’s long-term borrowings (excluding our capital leases) bear interest on a floating basis.
Accordingly, changes in interest rates can affect the cost of these interest-bearing borrowings. As a result, Ahold’s financial condition, results of operations and liquidity could be materially adversely affected. Attempts to mitigate interest rate risk by financing non-current assets and a portion of current assets with equity and long-term liabilities with fixed interest rates and the use of derivative financial instruments, such as interest rate swaps, to manage risk could result in Ahold’s failure to realize savings if interest rates fall.
(Ahold Annual Report 2003) In our opinion, this last sentence shows that Ahold takes the chance that interest rates might fall (resulting in savings). This is a typical example of speculation wi?? thout hedging. We believe that hedging should be used in order to have less volatility in interest payments and not just to speculate.