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Types of Investment Risk: Operator/Management Risk

We are in the middle of a series breaking down the various types of investment risks. You can read the introduction here. We are posting one article covering one risk each weekday until the series is complete.

Yesterday we covered, and today we are covering...

Risk #14: Operator/Management Risk

Description: Some investments are very dependent on operator or management experience and execution on an ongoing basis. If the management/operator fails to successfully implement the business plan or is a poor manager, management dependent or operationally intensive investments will suffer or could be lost altogether.

Primarily Applies to... Operationally intensive real estate and equity investments (private or public) or derivatives tied to businesses (rather than assets), hedge funds, money management operations, managed futures, or any other quantitative or discretionary asset management related investment.

AOL Time WarnerReal World Examples: If you buy stock in Facebook you're not investing in a widget factory or even a social platform, it is an investment in the leadership's ability to anticipate, direct, and integrate social networking trends - it's all about the people who constantly adapt the platform. For years, when you bought AAPL you were investing more in the vision and leadership of Steve Jobs, than Apple. It remains to be seen how they will manage that transition, but others failed miserably: the AOL/TimeWarner merger, JC Penney and Ron Johnson, HP and Mark Hurd, Dell after the departure of Michael Dell, and Disney had trouble towards the end of Eisner's tenure.

Extreme Avoidance Measures: Only make investments into assets directly controlled by you as opposed to third-parties.

Potential Mitigations: Other than sole-ownership and direct control and management, diversification is the only way to potentially mitigate operator or management risk. Choose investments that are managed by operators who are established, experienced, have a strong track record, are aligned in interest with the investors, and have their own capital at risk in the same venture. Above all, diversify your capital across many different investments with separate management/operators who embody these characteristics.

Stay tuned, tomorrow's highlighted risk is: Counterparty Riskwhich will mark the conclusion of our series.