4. Risk management
General information and areas of risk
The Company has a risk management policy confirmed by the Board of Directors. The policy sets out the principles for risk management, specifies risk definitions and risk classifications and also defines the main roles and divisions of responsibilities as well as the monitoring and reporting procedures. The goal for risk management is to ensure that risks borne by the company are commensurate with its risk-bearing capability. The risk-bearing capability is managed by carefully planning investment operations and by managing investments. The objective of risk management is to ensure that risks relating to the Company’s business operations are identified and assessed, that the Company responds to those risks, and that they are managed and monitored. Risk management aims to assuring that the targets set for profitability in the company’s strategy and action plan are met.
The Company’s Board of Directors confirms the Company’s strategy and action plan, in which the targets for different investment allocation classes are specified. In order to reduce risks, investments are deconcentrated to different allocation classes, different industries, different stages of development of investees, different time perspectives and also geographically, particularly with regard to investments in financial securities. Operative management is responsible for preparing and implementing investments. The Board of Directors makes investment decisions and supervises the implementation of investments.
The most significant risks of Finnish Industry Investment relate to venture capital and private equity investments as well as investments in financial securities. Both involve various investment risks, including business risks attached to venture capital and private equity investments, liquidity risks, market risks and credit risks. The most significant uncertainty regarding the accuracy of the company’s financial statements relates to the inclusion of different investment risks in the measurement of venture capital and private equity investments (valuation risk). The process for the determination of fair values of venture capital and private equity investments is described in note 5, Determination of fair value. The table below shows the fair values of the company’s investment allocation at 31 December 2015 and 2014.
Other risks to which Finnish Industry Investments is exposed include strategic risks, operational risks, risks of loss or damage, and risks for reputation. Strategic risks are managed by regularly evaluating the Company’s operations in relation to the environment and the expectations of various stakeholders. Operational risks are managed by good corporate governance and internal instructions, and these risks are covered by insurances.
Business risk attached to venture capital and private equity investments
The Company’s venture capital and private equity investments, whether through venture capital or private equity funds or as direct investments, are mainly made in unquoted companies in the starting phase or growth companies. The development of the value of these small and medium-sized companies if often affected by company-specific risks rather than by a general market risk described in the following paragraph.
The operations of companies that are in the starting phase, so-called venture capital allocation companies, typically generate negative cash flows. These companies often pursue strong international growth based on new innovations and/or revenue generation models and enabled by risk capital financing from venture capital and private equity investors. It is characteristic of high-risk venture capital investments that not all starting-phase target companies will succeed because of the realisation of risks relating to technology, business models, strategies, commercialization, competitors, key personnel or obtaining further financing.
Companies in the growth phase allocation have normally achieved positive profitability, and the aforementioned risks relating to the venture phase are typically lower. However, active ownership by venture capital and private equity investors clearly raises the target level of business growth strategies of these companies through, for example, stronger internationalisation, structural arrangements, new capital investments or well-considered utilisation of debt leverage and thus increases the companies’ overall risk profile. Furthermore, the development of macroeconomic environment has, on the average, a more direct impact on the business activities of more mature companies.
Business risks also comprise the counterparty risk for FII’s co-investors, which refers to uncertainties relating to individual co-investors in situations such as further financing of target companies. The management of this co-investor risk is emphasized in the operating model of Finnish Industry Investment as it always co-operates with private investors so that in any individual financing case, private investments cover at least 50 per cent of the financing.
Finnish Industry Investment manages the investment-specific risks relating to its venture capital and private equity investments through predictive generation of deal-flow, careful analysis in the screening phase, selective choosing of co-investors, monitoring of investments, active interaction towards managers of venture capital and private equity funds, administrative participation in the development of the business activities of direct investment target companies, and active participation in the exit phase of investments.
The liquidity risk management ensures that the Company has adequate funding available for its venture capital and private equity investment activities (unpaid commitments). The development of cash flows related to the Company’s liquidity, financial securities and venture capital and private equity investments is continuously monitored. When preparing new investments, the impact of the investments on liquidity and financial position is taken into account. Most of the Company’s cash flows and investments are denominated in euros.
Investments in financial securities are made at the selected risk level in compliance with the investment plan confirmed by the Board of Directors. Investments in financial securities aim to ensure adequate assets for venture capital and private equity investments and other payment transactions. Operative management is responsible for investment operations within limits set by the existing investment plans.
Investments in financial securities are mainly diversified between investments in fixed income and equity funds and in money markets. The sensitivity of financial securities to changes in the market conditions is regularly monitored. Investing activities relating to financial securities have mostly been outsourced with a discretionary mandate to asset managers supervised by the Finnish Financial Supervisory Authority. The counterparty risk attached to financial securities is managed with a thorough partner selection process.
At 31 December 2015, the fair value of the Company’s cash and cash equivalents and financial securities amounted to 422.8 million euros (254.5 million euros) and the amount of unpaid investment commitments was 265 million euros (274 million euros). Unpaid investment commitments consist mainly of commitments made to venture capital and private equity funds with an average payment period of four years. The Company also runs strategic direct investments programmes, for which it has received targeted government funding. A total of 114 million euros of government funding received still remains to be used for these investment programmes at 31 December 2015.
Market risk refers to the impact of general market fluctuations (such as stock market, bond market and currency market fluctuations) to the value and value development of investments. Besides the direct exposure to market risk relating to the Company’s investments in financial securities, the general market fluctuations may also have an indirect impact on the fair values of direct investments and funds in the Company’s venture capital and private equity allocation.
Market risks are mitigated by spreading the investments between different allocation classes (different market risk categories) for both financial securities and venture capital and private equity investments. Furthermore, important methods of risk management to mitigate general cyclical fluctuations for venture capital and private equity investments include a time-driven diversification of investments, acquisition of non-cyclic target companies, avoidance of too aggressive debt structures and the continuing development of target companies.
The Company’s fixed income investments, with a fair value of 317 million euros as of 31 December 2015, form the majority of the Company’s 420 million euro financial security portfolio. The market risks that affect the value of the fixed income investments comprise of the changes in general market interest rates as well as from spread risk. The computational weighted duration of the Company’s fixed income investment portfolio at 31 December 2015 was 3.9 years, and a hypothetical increase of the general interest rate level by one percentage point would decrease the fair value of the Company’s fixed income investments by an estimated amount of 12 million euros.
The fair value of equity investments included in financial securities at 31 December 2015 was 85 million euros. A decrease of 10 per cent in share prices would decrease the value of equity investments by 8.5 million euros.
The Company’s cash flows and investments are mainly denominated in euro. The Company does not hedge its currency risks.
The credit risk for the Company’s venture capital and private equity investments is mainly related to direct investments made in portfolio companies by using debt instruments. These are typically fixed interest of mezzanine instruments. The fair value of debt instruments included in direct venture capital and private equity investments at 31 December 2015 was 26.8 million euros, which was approximately 6 % of the total fair value of venture capital and private equity investments.
On the other hand, credit risk relating to financial securities arises from investments in publicly quoted bond funds, such as government and corporate bonds. The Company’s portfolio of bond funds is highly diversified, and accordingly the credit risk relating to individual governments, industries or enterprises is relatively small.
Capital management and investment returns
The Company is financed by equity, and it has no formal dividend policy. Debt leverage is used in the financing structures of some portfolio companies but not in the Company’s venture capital and private equity funds at fund level. The Company is not subject to any specific solvency requirements, but it has internally set risk limits for the ratio of the total portfolio of venture capital and private equity investments to the total equity of the Company, as well as for the ratio of unpaid commitments to liquid assets.
The statutory objective of the Company is to be commercially profitable over the long-term, taking into account the imposed economic impact goals. The below table contains the Companys’s investment returns (fair value changes) before taxes and operating costs from its venture capital & private equity and financial security allocations from the financial years 2011-2015. As the Company’s private equity investments are long-term by nature, the Company’s financial performance is also better to be evaluated over a longer time period.
Government investments in the company’s equity at 31 December 2015 were 655 million euros. The amount of equity was 868 million euros at the end of year 2015. The company’s accumulated earnings including the profit for the financial year 2015 were 213 million euros.