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The risk of lawmakers to a business

Lesson in Course: Medes Newsletter (advanced, 7min )

What risks do lawmakers pose to business I invest in?

Governments, when functioning as intended, are tasked to provide their people with the best quality of life, equality, and justice. Businesses are constantly evaluated and re-evaluated by governing bodies with the purpose of determining if rules and regulations are necessary to protect the people’s best interests rather than those of the businesses.

The Factory Act of 1802, 1833, and the Employer’s Liability Act of 1880 were new regulations put in place to protect workers in response to the explosive growth seen during the Industrial Revolution. With new advances in technology, workers flocked to factories where hand labor became replaced with machines. The new, unregulated work environment resulted in a magnitude of increase in production along with new problems around safety at work.

Today, regulation of the technology sector takes the lion share of governing and media attention. Notable examples: Facebook, Cambridge Analytica, and the involvement of Social Media companies on news distribution and domestic politics; net neutrality and ISP providers; how Uber, Postmates, and other Gig economy companies are defining work relationships with the workforce they employ; and personal data protection with GDPR in Europe, COPRA in the States, and CCPA in California.

Intuitively, the rise of regulations targeted towards tech makes sense. The tech companies of today are toddlers compared to the mature industries and it’s been impractical to apply rules of old to the new and unknown. Like the Industrial Revolution of the past, it’s only after the boom can outcomes be measured and appropriate protections be put in place.

New laws or actions, directly affecting how companies can operate, bring uncertainty to the economics of the respective businesses moving forward. In certain cases, new laws can hurt or help businesses — this economic uncertainty perceived by investors is also known as risk.

Understanding risk and the management of risk separates the skilled investors from the lucky. In this write-up, I’ll cover the basic concept of risk and how legislative risk can affect specific industries.

What is risk?

In broad strokes, the concept of risk is how humans come to terms with outcomes that are outside of our control.

Rockefeller Center skating rink in NYC

For example, ice skating at Rockefeller center presents the possible risk of falling and spraining a wrist. We instinctually don’t want to hurt ourselves and will take the precautions to not fall; however, if someone else accidentally bumps us and we end up falling, it’s a circumstance outside of our individual control. The number of circumstances that can lead to an uncontrolled outcome increases or decreases the risk taken. To continue the example, it’s more risky skating in a busy rink vs skating in an empty rink.

Thus far, the unwarranted outcome of risk has been negative, or downside risk. Risk can also include upside risk, an outcome which exceeds expectations or what is controllable. An example of upside risk while skating would be running into a celebrity crush, or possibly friends you haven’t seen in a while.

Risk, upside or downside, is inherently uncomfortable and investors demand a premium or a good reason to take on more risk. This incentive or payoff is known as the risk premium. If two choices are presented with one being less risky than the other and the outcome is the same, there is an absence of a risk premium and everyone will pick the less risky choice to mitigate the possible downside.

While difficult, sophisticated investors spend significant time and effort to try to quantify the amount of risk in each investment opportunity into the premium that is acceptable to them. Different investors will have different risk appetites and may expect a different premium for the same amount of risk. This difference in the premium allows for a free market to exist where one side would be happy to buy a risky investment while the opposing side would be happy to sell and de-risk their holdings.

Risk in an investment can be broken down further into specific categories. One of which is government risk or the amount that new laws and regulations can influence the health of a business.

Government risk

The amount of government risk or legislative risk of an investment depends on the space the company operates within. Industries with large amounts of government risk include healthcare, utilities, and energy. We’ll take a quick look at how some of the domestic* government risk, both upside, and downside, play out in the different industries below.

*Trade agreements and foreign policies are examples of international government risk that can affect large swaths of businesses.

Healthcare

As researchers better understand the pathology of certain diseases, therapeutic treatments are developed. However before the therapeutics are made available to the public and commercialized, the US Food and Drug Administration (FDA) must give approval on the efficacy and safety of the new drug. It’s common to have millions of dollars invested in the development of drugs that never gain approval.

Due to the complete dependence on FDA regulations, biotechnology and pharmaceutical stocks can be very volatile. Prices can swing significantly one way or another based on the news of the FDA approval or rejection of a new drug candidate.

The upside of FDA regulations targetting the drug development industry is the creation of opportunities for businesses in adjacent industries. Due to the strict requirements on patient safety data, there is a strong demand for skilled clinical trial operators and statisticians to help design the clinical trial experiments. In addition, there are some FDA regulations that accelerate drug approval timelines and passing standards for rare diseases with no current cure— these drugs are called orphan drugs and biotech companies developing these drugs have been largely successful in the past decade.

Utilities

 

Utilities such as power, gas, water, telecoms, and recently arguably the internet are key to the infrastructure of cities, towns, and countries. The companies operating within this space are highly regulated even down to the amount they can charge for their services. The argument for regulatory scrutiny is that these companies are too big to fail and also too big to compete against. In other words, the infrastructure needed to provide these services is so vast and entrenched that they serve as a deep moat to protect the existing incumbents from startups. Imagine how expensive it would be for a company to compete against Comcast; the company would have to dig and bury fiber cables all around the US before being able to serve a single customer. Utility companies tend to operate as monopolies or at best, business oligarchs.

The upside risk of government regulations for utilities is interesting and not as straightforward as other industries. Due to the companies being naturally monopolies or close to, they are able to take advantage of incredible economies of scale. As long as these companies remain protected and not dismantled by the government, they enjoy decades of profitability.

Energy

The energy sector is largely affected by environmental protection and conservation laws. Locations, where oil companies can drill, are highly regulated in addition to how spills are handled and fined. Transportation of oil, e.g. where pipelines can be built, has lead to intense lobbying with over $300M being spent on politicians for the Keystone XL pipeline in one year. Emission standards also dictate processes invested in the oil and gas refinery business, which is downstream of the oil production process.

Tax incentives for renewable energies have served to create new opportunities for companies — something that Elon Musk has been strategically keen on. By purchasing SolarCity panels or a Tesla, the consumer receives a big tax credit from the government, thus boosting the demand and sales for those products. For shareholders in Tesla, it will be interesting to see sales trends in the future as these tax incentives start getting phased out in early 2020.

Government risk in technology and the future

While it’s still too early to see how regulations will change the tech sector in the long term, companies are making material business decisions on the basis of current or pending regulations. Google, Twitter, and most recently Spotify have decided to stop selling political advertisements. For context, Google has collected close to $159M in political advertisements since May 2018. These decisions may impact earnings and short-term stock price and as a public company investor, they are important to stay abreast of.

As a startup founder and investor, I think remaining actively focused on identifying the upside of government regulations can present really interesting opportunities. For example, as more data protection laws are put in place, I foresee a rise in startups working on a product solution to help large, technology-enabled incumbents get up to speed and compliant—maybe that’s already a YC pitch.

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