I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

I work for ThoughtWorks, the global leader in software delivery and consulting.

Sunday, June 30, 2019

Come On and Take a Free (Regulatory) Ride

Within 24 hours of last month's post on regulation of technology firms, new anti-trust probes into Google and Apple were reported by the Wall Street Journal. Around the same time, Renault stirred up a hornets nest of regulatory furore over its proposed (and subsequently withdrawn) merger with Fiat Chrysler. It's worth examining the prior in the context of the latter to understand why the regulatory free ride Big Tech Media firms enjoy will continue for quite some time to come.

Instead of thinking about companies as financial entities that reward investors, think of them as agencies that fulfill public policy. Let's start by looking at the automotive industry. Economies benefit from the physical mobility of their citizens: the more affordably they can get around, the more flexible they are as a labor force, the more likely they are to get out and spend, etc. To be competitive in the transportation business, a company needs scale; that means transportation companies are large direct employers. The complexity and sophistication of modern cars means that automakers have expansive supply chains, making them large indirect employers as well. Transportation is an industry of great national importance: jobs create middle-class households that spend money, pay taxes, and vote.

But transportation creates a lot of other problems such as energy consumption and pollution, so cars are regulated for their safety equipment, the types and quantities of energy they use, and the amount of pollution they generate. In this way, government can get its citizenry mobile with fewer negative consequences. It isn't a stretch to say that automakers are executors of public policy on the combination of transportation (mobility is good), labor (jobs are good), energy (fuel efficiency is good), and environment (clean air is good).

It takes quite a while for a society to figure out the consequences of its innovations and the price it is paying directly or indirectly for the benefits it enjoys, hence regulation lags commercial innovation for a very long time. For example, corporate financial disclosures were not regulated with the first stock sale or even the first equity market crash: the Philadelphia Stock Exchange was established in 1790, but the Securities and Exchange Commission didn't come into being until the 1930s. Similarly, cars were not subject to emissions regulations with the sale of the first car; delays in emissions regulation stemmed from the fact that the good of affordable mobility outweighed the bad of pollution in the minds (and perhaps the wallets) of policy makers for a very long time.

Let's look at the aborted Renault-FCA merger in this light. Aside from the tantalizing potential for the best buffet cuisine ever in the history of annual general meetings of shareholders, in financial terms this appeared to be a rational merger. A combined Fiat Chrysler Renault with a side order of Nissan and Mitsubishi would have girth in all of the numbers automakers have been traditionally measured on: production volume (third largest, globally); market access (full-scale distribution networks in every major car-buying market including the US, Europe and China); and margin (Dodge and Jeep light trucks.) In short, the proposed merger would have yielded everything except for the specific electronic vehicle technology that governments are adamant that auto manufacturers must deliver. Even there, the combined R&D spend would effectively double, reducing wasteful redundancies: US$8b goes a lot further than US$4b twice over. Given the fact that for the time being EVs are doing more damage to automaker P&Ls than being a source of industry disruption, that combined R&D spend would go a long way to charting a course for a successful future of the two companies.

Unfortunately, the tie-up of the two firms quickly ran afowl of labor policy. Part of the sales pitch of the merger was that Renault would gain access to the US market through Fiat Chrysler dealerships. But it doesn't make sense for a dealer to be selling a Renault Clio side-by-side a Fiat 500, with a Mits Mirage in the showroom just through that door over there and the Nissan Versa in a showroom across the parking lot. It makes even less sense given both dealer and manufacturer are losing money on the wholegoods sale of the small car. There is a stronger argument to be made that these products on nearby showroom floors will simply cannibalize sales from one another, much as the Jaguar F-PACE did to the Land Rover product lineup. If that proves to be the case, than the combined companies will stage their own private fight clubs of their products. Sooner or later, the rationalized product portfolios will result in rationalized production capacity. By way of example, look at the lineup of Fiat Chrysler products: the Chrysler and Dodge brands have no small cars; FCA meets US CAFE requirements with the small Fiats. And, of course, Kraft made similar assurances about maintaining production facilities before acquiring Cadbury only to abandoned them one week after the completion of the merger. The leaders of Renault and FCA said they anticipated no plant closures, but it was difficult to take those assurances very seriously.

In financial terms, consolidation made sense because a consolidated manufacturer can produce just enough small cars (which are by and large unprofitable) to offset their production of light trucks (Chrysler, Nissan pick-up trucks), designer vehicles (Alfa Romeo), performance vehicles (Nissan GT-R, Alpine A110) and exotic vehicles (Ferrari), all categories where automakers make money. But in political terms the merger did not make sense, because it is easier to ramp up production of the facility producing (currently) money-losing small cars to offset any gain in money-making larger cars than it is to perpetuate a lot of factories producing small cars. Gains for a factory producing small Fiats in Italy really would translate into reductions at a factory producing small Renaults in France if the consolidated automotive fight club rewards the Fiat model over the Renault model. While the combination would make financial sense and make it more likely that the two companies would survive the transition to electric cars, the loss of jobs was too great a risk for either the Italian or French governments to bear.

What does this tell us of the ramp-up of anti-trust probes into Apple and Google?

Google is a big media firm which it monetizes through advertising. Google did not invent advertising, mass advertising, or targeted advertising; it found ways to provide a scale of advertising at a level of reach greater than any outlet had ever created before, which it can sell to advertisers at a price lower than what traditional media could offer, with more accurate targeting to boot. Google provides this ad space in media outlets that did not exist previously, ranging from browser-based search, to geographic search (maps), to in-home search (Google Home), to in-car (Android Auto), to many other media outlets. Google's imagination for the possibility of monetizable moments is many decades in front of that of any government.

In the process of becoming Big Media, companies like Google have become Big Surveillance, both directly (the data they capture and analyze) and indirectly (the multitude of 3rd party firms in the analytics chain). Cross-analyzing data creates infinitely targeted opportunities to pitch a consumer transaction: by capturing payments (Google Pay), Google knows you have an affinity for Mediterranean cuisine; by capturing your location, Google knows you travel to San Antonio and stay in the same hotel every week; by capturing your boarding pass info, Google knows your flight is running a bit late. It might be a great convenience - in fact, it might even delight you - if Google Express not only suggested a Mediterranean restaurant, but built an order based on your previous menu choices and scheduled the order to be delivered to your hotel in time for your late arrival.

Consumers are not the only ones who stand to benefit from such analysis. The accelerometer in the phone and the spacial-temporal data captured by maps mean that Google know whether you drive the rental car you get in San Antonio every week in an aggressive manner. The rental car company and your auto insurer would like to know that, as they could price in the risk of accident based on characteristics of your actual driving patterns as well as the responses by the drivers around you to how you drive. (Yes, Progressive Insurance has offered something like this for years, but with Progressive the insured is making an explicit decision to expose driving data; Google could choose to collect that data and provide it to insurers and rental car companies and law enforcement agencies without consumer consent). The contract between insured and insurer has traditionally been based on reported events, specifically moving violations and accidents. The insured had a great deal of leeway in deciding how to behave as long as the what happened showed no indication of trouble to the insurer.

Western societies. and the United States in particular, are based on the rights of the individual, the wellspring of personal freedom. Individual anonymity is a contributing factor to protecting those rights, as the individual is free to make decisions - what to do, how to drive, what to eat, what to invest in, what to read, how to be entertained - without fear of repercussion for the choices they make. Continuous surveillance all but eliminates the anonymity of the individual, exposing not only what people do but providing potential clues as to why they do them because a person's decisions and actions expose their own preferences, beliefs and values. Plus, any one person's decisions erode the anonymity of the people around them: the data collected on one person may indicate an ailing parent or struggling child. Continuous surveillance raises some thorny questions for western societies. What are the consequences when the individual effectively loses decision rights over how they do things to the companies they do business with? What is to stop a company from predatorily monetizing a condition that a person wishes to keep discreet? What prevents an individual from being targeted for the values they are perceived to hold through the decisions they make? What if the algorithms conclude the wrong things about an individual based on the data that it has?

Western governments have historically intervened (ostensibly) on behalf of the individual to level the playing field with large companies. The rise of the American middle class in the first three decades of the 20th century created a large new category of individual investor, enabling legal but ethically questionable (that is, exploitative) financial reporting practices by corporations; with middle-class investors wiped out by the market crash and confidence in public markets all but non-existent, the US government created the SEC. The shift of the American economy from agrarian to industrial in the 19th century allowed for legal but ethically questionable labor practices by industrial firms; as labor unions arose, government eventually supported (and in many cases, enabled) worker organization. The plot is no different this time around, with Big Media engaging in legal but ethically questionable consumer practices. The scale is much different, though: 20th century Big Industry was large in economic might but still human in scale; Big Surveillance is large in economic might and machine in scale.

The anti-trust probes revealed earlier this month target the commercial activities of Google and Apple. These are regulatory probes within the constructs of established policy stemming from the industrial era. The question any probe has yet to ask is one of public policy: if and how to protect individual freedom against constant surveillance and activity derived from that surveillance at machine scale. Before it can answer that question, government must be able to frame the problem in that light, define what rights individuals really have, can conscionably waive and under what circumstances they can be waived, and what rights the individual has no right whatsoever to expect.

Labor policy is well established, so it wasn't difficult for either the French or Italian governments to conclude the risk of combining state champion companies was too great. Data and information policy is not well established and it will take time for the US government to define it in such a way that companies that rely on Big Surveillance do so in a manner that advances desirable, multi-faceted public policy, and not simply exploit its absence. The scale and complexity of forming that policy, in what is new regulatory territory for every government, means that the regulatory free ride will continue for quite a long time.

Friday, May 31, 2019

The Safe Haven of Regulation

Big tech has historically been lightly regulated. True, both IBM and Microsoft were subject to regulation in 1956 and 2001, respectively, to limit their monopolistic powers. But neither suffered dents in their financial returns as a result (attorney fees notwithstanding), and the tech industry innovated in ways that made their respective monopolistic states very short lived. Today's cash-gushing tech companies such as Oracle, SAP, and ironically the most valuable of them all, Microsoft, are all utility providers that enjoy light regulation. The light-touch regulation party will not end for them any time soon.

Facebook is not big tech, it is big media. Facebook enjoys - for now, anyway - the status of being a lightly regulated cash gushing media utility. Although it has become ubiquitous, it makes money in ways that national regulators of media are still years away from catching up with. That regulatory lag means Facebook is effectively regulated by national and trans-national governmental bodies such as the US Congress, UK Parliament, and European Commission. That has been a boon to Facebook as national legislatures have many more things to concern themselves with than a media outlet.

While the threat of regulation creates uncertainty, the bigger challenge facing Facebook isn't regulation but the threat of being both a tool and political beach ball for many, many more election cycles to come. To the average citizen of any country, it may stand to reason that the nature of media outlet that Facebook has become needs codified regulation spanning everything from what gets published to who has decision and economic rights over user data. But to the political classes, Facebook is heads-I-win-tails-I-win. If people are easily manipulated through Facebook in the actions they take from how they vote to how they immunize their offspring, Facebook is a channel to be exploited. If there is evidence that political opponents have used disreputable tactics to manipulate people through Facebook for their own purposes, Facebook is a convenient punching bag. The downside risk to Facebook is that while it may enjoy light formal regulation for some time to come, it will be continuously on trial in the court of public opinion. That isn't a fun problem for marketing to solve, or for their lobbyists to navigate. Investors get tired of this.

Facebook are evidently considering going into the payments business. By entering into payments, Facebook would be choosing to become a regulated business. Facebook would be regulated by bodies such as the US Fed and the UK's Payment Systems Regulator and their equivalents in every jurisdiction where they offer payment services. That introduces technical jargon that is more specific than political jargon, which is easier for the regulated to succeed under. Where there is regulation by rule the burden is on the regulator to prove non-compliance, whereas today Facebook is regulated by principle, and as a result must argue it is neither out of compliance with societal norms nor complicit in acts by those who use it in ways that are.

Entering into payments is a logical first step into the four functions of finance that John Kay identifies in Other People's Money: facilitate payments, match lenders with borrowers, manage personal finances across lifetimes and generations, and manage risks associated with everyday life. Once in payments, it isn't difficult to imagine Facebook creating a credit function to provide microloans that facilitate purchases. Over a span of a few years, it isn't difficult to imagine Facebook leveraging their trove of data to offer algorithmic solutions to manage personal finance and manage risks. Financial services would offer a lot of growth runway: WeChat derives 60% of its revenue from payments and only 30% from advertising, and payment processors like PayPal and Square write a lot of loans to merchants.

It will not be easy to change from being an unregulated to regulated company (it's a bad idea to break things where people's money is concerned), costs will go up (compliance isn't cheap), and the potential for bad headlines - money laundering, robbed wallets - will only increase. But these are comparatively benign problems for a company with a product that has been used in the commission of numerous felonies.

Facebook has largely escaped regulation to date. However, its enormous size and influence, its economic power, and its existence as a lightly-regulated multi-jurisdictional entity all suggest that regulation is coming. The regulatory lag between old media (print and television) and social media make it clear that governments are not prepared for the task. By redefining its business as a commerce platform rather than a media platform, Facebook would be able to choose its regulators rather than wait for legislatures to pick one - or worse still, create one - for them. It would then have the pick of mature regulators, agencies that are less likely to be politically charged than an upstart chartered specifically for the purpose of regulating social media. A mature regulatory agency would also bring an imprimatur that carries weight with consumers and politicians worldwide.

As a move designed to defend their greatest asset - data - regulating key aspects of the business under the auspices of financial services would be pretty shrewd indeed.

Tuesday, April 30, 2019

Excellence

“A fishing crew may be organised and understood as a purely technical and economic means to a productive end, whose aim is only or overridingly to satisfy as profitably as possible some market’s demand for fish. Just as those managing its organisation aim at a high level of profits, so also the individual crew members aim at a high level of reward. Not only the skills, but also the qualities of character valued by those who manage the organisation, will be those well designed to achieve a high level of profitability. And each individual at work as a member of such a fishing crew will value those qualities of character in her or himself or in others which are apt to produce a high level of reward for her or himself. When however the level of reward is insufficiently high, then the individual whose motivations and values are of this kind will have from her or his own point of view the best of reasons for leaving this particular crew or even taking to another trade. And when the level of profitability is insufficiently high, relative to comparative returns on investment elsewhere, management will from its point of view have no good reason not to invest their money elsewhere.
“Consider by contrast a crew whose members may well have initially joined for the sake of their wage or other share of the catch, but who have acquired from the rest of the crew an understanding of and devotion to excellence in fishing and to excellence in playing one’s part as a member of such a crew. Excellence of the requisite kind is a matter of skills and qualities of character required both for the fishing and for achievement of the goods of the common life of such a crew. The dependence of each member on the qualities of character and skills of others will be accompanied by a recognition that from time to time one’s own life will be in danger and that whether one drowns or not may depend upon someone else’s courage. And the consequent concern of each member of the crew for the others, if it is to have the stamp of genuine concern, will characteristically have to extend to those for whom those others care: the members of their immediate families." (MacIntyre, 1994, pp.284-285)
Now MacIntyre is a moral philosopher, and there is no reason why he should ask the question which would concern a business economist like me: which of these crews catches more fish?
-- John Kay, Ethical Finance

In the early 1980s, Tom Peters and Robert Waterman co-authored a book called "In Search of Excellence." At the time, US products and services were generally regarded as inferior in quality to those from other countries. It was bad enough that American manufactured goods and consumer services were so poor; what really made it annoying were the tens of thousands of corporate bystanders who were unwilling or just flat-out helpless to do anything about it. That inaction in corporate America was brought home with a video of a Japanese manufacturing line worker electively inspecting the windshield wipers on finished cars on his way out of the plant after his shift was over. Needless to say, Peters and Waterman had struck a nerve.

Although In Search of Excellence presented an empirical case for a correlation between economic success and excellence in operations, their case studies didn't stand the test of time as a number of their exemplar companies suffered problems within a few years of the publication of the book. While those companies didn't necessarily underperform for operational reasons, their disappointing results did cast doubt on the causality. Still, that didn't invalidate their thesis: at most, the evidence of causality is fleeting owing to multiple business conditions; at the very least, In Search Of Excellence was the first to articulate some common sense stuff.

There are other ways to look for the relationship between excellence and outcomes. Dr. John Kay has long argued that a company that is in the business of what it does will outperform a company that is in the business of making money. When Imperial Chemical Industries was in the business of "the responsible application of chemistry" and Boeing's purpose was to "eat, breathe and sleep the world of aeronautics" they were dominant firms in their industries. Each changed their focus to be in the business of financial outcomes. Once that happened, the latter lost its previously unassailable grip on commercial aviation while the prior disappeared entirely as an independent company. When a business disconnects the value of what it provides from how it provides it, and connects it instead to the financial results it wants to achieve, it tends to fall well short of goals. Worse still, once that transition happens the business itself can erode very, very quickly.

In his book Good Strategy, Bad Strategy, Dr. Richard Rumelt lays out characteristics of bad strategy, including mistaking goals for strategy. "Bad strategy", writes Dr. Rumelt, "is long on goals and short on policy or action. It assumes that goals are all you need. It puts forward strategic objectives that are incoherent and, sometimes, totally impracticable." Good strategy consists of a diagnosis, a guiding policy, and coherent action. By definition, strategy is execution-focused; without execution, strategy is worthless. Financial results are not a strategy, they are byproducts of identifying gaps and challenges, meeting and overcoming those - and that the hoped for opportunities that lie beyond them do, in fact, materialize.

If strategy is execution, then what a company does and how it does it will drive the outcomes that it achieves. Yet there is a subtle differentiator in the "how" that Alasdair MacIntyre, the author of the introductory narrative, draws attention to. The first fishing crew has incentives to achieve performance targets. They have clear alignment of values, skills, and outcomes, on which they are supervised and measured. The second fishing crew has a social contract with one another. They also have clear alignment of values, skills, and outcomes, but that alignment happens through how they function as a community: they teach and reinforce values, skills, norms, and behaviors, and they extend their duty of care to the families of their members. Whereas each member of the prior group is committed to themselves individually, each member of the latter group is committed to each other. Mr. MacIntyre makes clear that a commitment to excellence is a product of a community, not a group of individuals no matter how like-minded they may be. He also makes clear that the value yielded by excellence is more than just financial remuneration for doing the job.

But does excellence matter?

Given how narrow measures of business value tend to be, the evidence tends to be on the negative more than on the affirmative. Excellence is like governance, in that it is most obvious when it is absent than when it is present. For example, you can argue as Dr. Kay does that American automakers, having never quite leveled up to the quality standards of their Japanese and German peers in sedans and small cars, suffered more acutely in the 2008 recession than perhaps they would have otherwise. American manufacturers couldn't compensate for a big fall-off in demand for SUVs and light trucks by selling more sedans and small cars, and as a result two out of the three took a tour through bankruptcy, wiping out a lot of investors. In the story of the two fishing crews, Dr. Kay cites the case of the Prelude Corporation which tried to bring modern management to the commercial fishing industry, only to misunderstand that excellence in operations matters more to success in fishing than do measurements and supervision. The Prelude Corporation, which had been a large lobster producer, went out of business within a few years of adopting those modern management techniques.

A company can create the appearance of financial mastery over operations through things like aggressive cost management and starving itself for investment. But as Kraft Heinz reminded investors recently, burning the furniture to keep warm only lasts for so long. If you believe financial goals are more likely to be met by the absence of bad (no accidents, no shutdowns, no product failures) and the presence of good (high netpromoter score, high quality ratings, high uptime), then you can accept that excellence in what a company does and how it goes about it will be a contributing factor to both limiting impairments and generating value. Not necessarily as quantifiable as we would like it to be: the counterfactuals aren't provable and customer decision-making rationale is wooly. But it is enough to say that excellence - as a socio-cultural phenomenon - amplifies the upside and buffers the down.

Sunday, March 31, 2019

Sometimes the Strategy is Buoy the Credit Rating

These drastic actions provide reassurance to creditors that big companies will do just about anything to keep their investment grade ratings.

FT Lex, US credit ratings: attack of the killer Bs

As a company grows, and the rate of its growth slows, it changes its capital structure. Early-stage capital is speculating on future cash flows, while later-stage capital has expectations of future cash flows. Growth is risk, so early stage capital is equity. Reliable cash flows stem from operational consistency, so later-stage capital tends to be debt.

Equity capital absorbs losses. Equity tolerates downturns, disappointments, failures, we-thought-it-would-work-but-it-didn't-quite-turn-out-that-way by losing value or disappearing entirely. The equity investor takes a risk that a scheme will turn out for the positive. If it does, the investor has a claim on success; if it does not, well, thanks for playing.

Debt capital is loss intolerant. An investor loans money with the expectation that the borrower can regularly pay the interest on the money borrowed and has means of making the lender whole on the principal. A business borrows against future cash flows from its business operations. The credit-worthiness of a business impacts the interest rate associated with its debt.

Stability of cash flows is a major factor in determining the credit rating. The more volatile the cash flows, the lower the rating, the higher the risk to the lender, the higher the interest rate on the debt. The higher the interest rate, the more future cash flows are pledged to debt service and the less cash there will be to distribute to equity owners and employees, and for the company to invest in itself. Because corporate debt is generally rolled-over - that is, bonds that mature are replaced by newly issued ones - a business must sustain its credit rating all the time.

To investors, equity capital is higher risk than debt. But to a company, debt is higher risk than equity. Suspend dividend payments and the company keeps on ticking; default on an interest payment or two and the company will be forced into bankruptcy and sold or liquidated.

Sadly for remaining shareholders, that means slashed dividends, M&A freezes and turning away from growth.

A company with a substantial debt load will prioritize servicing that debt above spending on opportunities that might help it to crawl out from under that debt, e.g., investing for growth. Cash flow is a contributing factor to keeping the credit rating above junk, which keeps the interest payments low and makes it economical to roll over. If the credit rating falls below investment grade, a lot of institutional buyers will not only have to sell the bonds they currently hold, they'll not be able to buy new bonds issued by the company, which makes the roll-over more expensive (fewer buyers == less demand == higher coupons). A challenged incumbent laden with excessive amounts of debt does not have the right capital structure to invest in itself because it is beholden to bond markets.

That seems like a paradox. Isn't this the very existential threat that leaders of incumbent companies are supposed to be responding to through inventive and innovative means? If the operating numbers tell us we're at a disadvantage, shouldn't we be addressing that disadvantage head-on through transformation, investment and acquisition?

The question here is: how existential is that operating disadvantage? Lex makes another very interesting observation:

The lessons? First, never underestimate institutional inertia. Second, big established companies have more resources and market power to weather a downturn. Bosses and bond investors should be grateful. A downgrade of a few notches to junk status would be devastating for them.

As long as credit rating agencies play ball, lenders will continue to lend at investment-grade interest rates and borrowers will have time to shore up cash flows through disposals, cuts, and efficiency drives. That lending can go on for a very long time.

The longer this lasts, the longer incumbents can use their financial resources to co-opt their upstart challengers. Not many start-ups have access to equity capital that is as patient or as deep as what bond markets offer to incumbents. And, because the market opportunity defined by the disruptors becomes crowded quickly (there are rarely barriers to entry, so a lot of copycats appear before too long), disruptors look for new ways to generate revenue. That creates the opportunity for incumbents to gradually do deals with new entrants to buy their assets, license their technology, take minority positions, or take outright control. All the while, as those start-up businesses mature they begin to resemble their legacy competitors. For example, Fintech firms are under increasing regulatory pressure, as well as applying for banking licenses.

An incumbent may be able to shape the future of its industry as convergence with rather than replacement by new entrants, through the startups ability to attract capital and the incumbent's ability to direct it. If that's a possibility, the start-ups represent less of a threat and more of a path of evolution for the incumbent: a new source of assets it is not able to originate but happy to put on its balance sheet (e.g., banks buying usurious loans made by P2P lenders); a new source of technology that makes its operations more efficient (banks licensing new lending technology to replace their own); financial exposure to the success of new products and services without risking volatility of the cash flows from operations (GM investing in Lyft). The incumbent can reap the benefits of change without needing to lead the change, all through exercising its market power and access to finance.

There are no guarantees that an incumbent can successfully execute any strategy, let alone a strategy of co-option. But betting on its strength - its financial resources and market power - is a safer course of action than doing a massive capital restructure through debt/equity swaps to finance a corporate re-invention.

Sometimes CEOs will concede that working for shareholders means working for bondholders first.

The Lex article serves as a stark reminder that companies are financial phenomenon first, operating phenomenon second. The type of capital invested determines the strategy a company pursues and the way it operates. It also reminds us that institutional inertia is a very powerful force in capital markets, where both incumbents and lossmaking startups have intractable dependencies.

Thursday, February 28, 2019

The Obsession with Metrics

In recent decades, what I call “metric fixation” has engulfed an ever-widening range of institutions: businesses, government, health care, K-12 education, colleges and universities, and nonprofit organizations. It comes with its own vocabulary and master terms. It affects the way that people talk and think about the world and how they act in it. And it is often profoundly wrongheaded and counterproductive.

Metric fixation consists of a set of interconnected beliefs. The first is that it is possible and desirable to replace judgment with numerical indicators of comparative performance based on standardized data. The second is that making such metrics public (transparency) assures that institutions are actually carrying out their purposes (accountability). Finally, there is the belief that people are best motivated by attaching rewards and penalties to their measured performance, rewards that are either monetary (pay for performance) or reputational (rankings).

-- Dr. Jerry Z. Mueller, The Tyranny of Metrics

In his book Other People's Money: The Real Business of Finance, Dr. John Kay confirms the fallacy of the beliefs Dr. Mueller lays out. The societal utility that banks once provided to the communities they served evaporated once bank managers familiar with their client's character and intimate with their client's needs were replaced by bank salespeople hawking financial products to clients on the basis of credit-scoring algorithms. An increase in published corporate financial data has led to a decrease in transparency as the data published is beyond the comprehension of all but the most sophisticated consumers of it. Rewarding people for hitting financial targets created trading for trading's sake and runaway bonuses, culminating in an "I'll be gone, you'll be gone" culture that intensified the 2008 financial crisis. The misplaced beliefs pointed out by Dr. Mueller lead to the undesirable outcomes described by Dr. Kay.

Dr. Mueller goes on: "Not everything that is important is measurable, and much that is measurable is unimportant."

The first part of this statement begs the question: what is important in business? I posit that in most enterprises today, the outcomes are actually less important than the means. Let that sink in for a moment. Companies have lost a lot of tribal knowledge about their systems and even their core business. They need to first regain that knowledge to put themselves on a path to make their legacy systems (a) accessible, then (b) extensible, and eventually (c) malleable again. What most enterprises desperately need is learning and growth, not more software endpoints on the fringe of an impenetrable legacy hairball. What truly matters is being able to systemically achieve outcomes; achieving outcomes in isolated instances is not a proxy measure for the intrinsic ability to do so.

This sounds great, but it is easier said than sold: regaining lost knowledge and developing the ability to do different things with it may be important but it isn't really measurable in any meaningful manner. Because boards are financially - not operationally - focused, learning and growth will never be a board priority because it doesn't appear on any financial statement. Or at least, not in a positive way: "learning" is cost bloat on the income statement, while "knowledge" is not a leverageable asset on the balance sheet. Making learning and growth a long-lived business priority is a leadership challenge that goes beyond reporting "training hours" and "number of people trained". It takes persistent, compelling storytelling that relates how successful outcomes have been directly and indirectly enabled by the journey and application of organizational learning and growth - and therefore how these outcomes have become organizationally systemic, and not accidents of chance.

Proponents of metrics champion causality: that for an action to be important it must yield some sort of measurable result. I've written elsewhere that causality can be difficult to establish, particularly in complex business environments where constant and dramatic changes inside and outside a business will create volatility of an observable metric. But the causality argument can work against prudent decision-making. For example, suppose we expect to achieve a specific cost efficiency in several stages: we first make business process change supported by some crude technology, soon followed by major technology change to more comprehensively automate that process change, and along the way we look at the data for stubbornly high-maintenance customers to weed out. Common sense tells us these are all good things to do and that the combination of these events gives us operational lift. Unfortunately, a spreadsheet analysis would conclude that investing in the comprehensive tech is useless as the bulk of the cost efficiency will be captured by the manual changes supported by crappy technology; vulnerability to things like manual error is a thin justification for allocating capital when capital is held dear. The spreadsheet analysis also concludes that efficiency cannot come at the cost of topline growth; to the spreadsheet analysis, every dollar of revenue is the same, so we keep all customers, no matter how inefficient it may be to serve them. Ironic that the spreadsheet-based decision-making makes a company both more valuable and a worse business at the same time.

The second part of Dr. Mueller's statement - "much that is measureable is unimportant" - points to the idiocy of many metrics. First, there are vanity metrics. I've relayed this case in a previous blog, but I once worked with an insurance company that used a nominally dollar-denominated coin called "business value" to measure the total impact of IT projects. In a single year they reported yielding more business value than the market capitalization of the firm. It's entirely possible they were woefully undervalued by markets, but it's more likely that their "business value" was as worthless as the PowerPoints they were pixelated on. Then there are the tenuous proxy metrics. A universal bank that had caught the Agile bug used the number of teams using Jira and Jenkins as the measure of how many teams had "gone Agile". Never mind what was actually going on in those teams, or the fact that nothing else - quality, throughput, customer satisfaction - was being effectively measured, let alone changing. The boss said we're going Agile, these are Agile tools, so once all of our people are using Agile tools we must be Agile, and the rest will follow.

Pursuing measurable value can create bigger problems if it is used to prioritize local optimization over systemic optimization. Consider a technology that accelerates systems integration and therefore reduces the cost of development of individual projects, but will very likely result in redundant integration activity across multiple project teams, a higher total cost of ownership across the portfolio of software assets, and a higher cost of change when a common system changes. A bankable lower cost today will will win out over potentially higher costs tomorrow. The prior can be measured - and managers rewarded - in the context of beating budgets for specific projects. The latter is absorbed into a business-as-usual budget, where the incremental inefficiency cannot be meaningfully disentangled from all the other incremental inefficiency piled into it. Urgent priorities always crowd out good lifestyle decisions; but metrics that justify the urgent are always more compelling than metrics that prioritize the important.

Dr. Mueller makes several recommendations for overcoming a metrics fixation, among them: "... [A]sking those with the tacit knowledge that comes from direct experience to provide suggestions about how to develop appropriate performance standards. [...] A system of measured performance will work to the extent that the people being measured believe in its worth." To do so recognizes that domain familiarity is necessary to determine the appropriate measurable outcomes. That implicitly means a definition of worth is not something that is going to come out of an abstract analysis of value. An ounce of context is worth a pound of measurements.

"With measurement as with everything else, recognizing limits is often the beginning of wisdom. Not all problems are soluble, and even fewer are soluble by metrics. It’s not true, as too many people now believe, that everything can be improved by measurement, or that everything that can be measured can be improved."

The better that we holistically understand our business and the more imaginative we are about our understanding of it, the better we intrinsically understand what it takes to make it a better business. In human systems, the whole is greater than the sum of the parts because of the intangible elements that humans bring. Consider baseball. The game of baseball has entered a stats-heavy era that has changed how people think about the game, but numbers, as Steven Kettmann put it, "eclipse a nuanced understanding of the game." Numbers provide insight and can help to re-think long held assumptions. But numbers don't tell the full story of the game. "Being alert to the twists and turns of a game is vital, since it’s the glimpses of character that emerge during these unlikely sequences that give baseball its essential flavor." Mr. Kettmann cites the example of a player's anticipation for how a play will develop as the deciding factor in a playoff game, and possibly a series. There is no spreadsheet for human decision-making in the moment.

It will take some time for the dust to settle, but results reported by Kraft Heinz last week have brought 3G Capital's management tactics - heavy cost-cutting deduced from heavy data analysis - into severe question. Those management tactics appeared to be successful for a number of years, until they weren't, and quite abruptly so. That sudden change in fortune has drawn attention to things critical to a business - asymmetric exposure to a single consumer market with subtly changing consumer tastes and an irrelevance of the consumer-products marketing model in people's daily lives - that required more than data to perceive, let alone prepare for.

"Managers agree. 'I watch the game,' said Bruce Bochy, the manager of the World Series champion San Francisco Giants. 'You don’t see me writing down a lot of things or having to look down at stats. They’re important, but there are some things that you can’t see on a spreadsheet.'"

Metrics help us to better understand something that we've learned through experience and observation. But we can never appreciate something through numbers alone: we must have the wisdom of experience and observation. Metrics are sources of data and potentially sources of information, but they are not sources of wisdom.

Thursday, January 31, 2019

Enterprise Change is Leadership Change

From the COO's perspective, the corporate IT department has hit rock bottom and they keep digging. Very little gets deployed, and the software that does make it live is embarrassingly bad.

IT is not exactly a clean canvas. ERP, CRM, document management and other key systems started life as COTS products but have been configured beyond recognition to a point where they can't be upgraded, and they're so ancient they've been disavowed by their vendors. Adding insult to injury, we're sitting on decades worth of data, but can't point to a single insight we've ever gleaned from it. The COO is not going to be jockeying to get IT reporting up to him any time soon.

The CEO has all but lost patience. She can't understand why she gets the same dead-end answer of "legacy systems" when she asks the CIO "why do we have to spend so much on IT?", "why are our systems not in the cloud?", and "why aren't we mining our data?" The board is asking her these questions, and she's got to have answers, not the same excuse.

* * *

IT knows it has a lot of problems. More than a few believe that the way it works is a big part of reason why. Every delivery team is blocked for reasons of access, authorization, and answers it needs from armies of people spread across a myriad of IT functions. Organizationally, there are silos within silos and shared services within shared services. If teams could work more independently toward a goal they would get a lot more done.

Somebody gets the idea that maybe we can solve this through better process. If we were to adopt Agile we'd have control and predictability and quality and speed-to-market. If we reorganize into cross-functional product teams, we'd get better solutions and some real insights.

A pilot or two here, a consultant or two there, a few slide decks and a site visit to a respected technology firm, and it's decided: we have seen the future, and it works. We're going to change.

We’re a large enterprise, so we need to roll out change at scale, and in a controlled manner. And so we get the enterprise Agile change program...

* * *

Over the years I’ve had the opportunity to examine several enterprise Agile change programs that are well under way. Those that were not living up to their initial fanfare (and quite a few of them were not) share a few common characteristics.

All organizational communication flows still go on one direction. The new "product operating model" bears striking resemblance to the old "program operating model": it moves from analysis to specification to development to deployment, all in a sequence of straight lines going left to right. There are no feedback loops anywhere in this cycle. As a result, there is no tolerance for team-level discovery let alone empowerment to act of its own accord on what it has discovered. Every team is free to build the product they were told to build. People are still bound to the plan, just like always.

Labor is assumed to be interchangeable. The Agile team model assumes there are no silos within a team: once a developer pair is free they take the next highest priority Story. But enterprise IT is loaded with specialist labor: this person only does front-end development, this person Java, this person Tibco, this person ABAP. Creating "cross-functional" teams doesn't cut it: the work distribution will be asymmetric and the team will lurch from blocker to blocker. It doesn't help that enterprise IT is also primarily staffed by contract labor. Contracting firms and their employees have incentives that favor labor specialization. The Agile operating model needs poly-skilled people, but enterprise IT doesn't have many people like that today and there are institutional headwinds against there being more of them tomorrow.

Process is the primary problem we face. No matter how collaborative and encompassing, a different mechanical process will not overcome the rot that plagues enterprise IT organizations: messy and multiple point-to-point integrations, a shortage of systemic knowledge, overloaded data structures, and poor data quality are not problems solved by a change in how work gets done. These problems are much larger than any one delivery team can possibly solve. Worse still, a process that requires a low-friction working environment to be successful doesn't stand much of a chance of taking root when the friction is very high.

As a result, enterprise Agile change programs don't make sense through an Agile lens, but they do make sense through a Waterfall lens. The change is largely cosmetic: Agile has just introduced surrogate terminology for how we’ve always done things. “Intake” and “portfolio management” are new words for “big up front design” and “detailed project plans” and rob the teams of functional discovery. Architecture activity that surfaces technical design before development robs the teams of technical discovery. Cross functional and even co-located teams can’t solve the big problems mentioned above in data, dependencies and system knowledge. Our new process might make us a little better on the margins, but in the main we still have the same integration hell, the same usability shortfalls, the same systemic brittleness and the same quality problems that we always did. The result, as others have written, is Agile in name only.

All right, so top-down change risks getting neither the mechanics nor the values of Agile. Wouldn't a bottom-up change program be more values-centric? A couple of months ago I wrote that bottom-up change - that is, linear scaling of team-level phenomenon - is inadequate for enterprise needs because there are enterprise dynamics and challenges that do not exist at the team level. This means there are classes of need that a focus on team-level process misses entirely.

The answer is not simply "do both top-down and bottom-up at the same time". To change an enterprise requires a change in leadership, not process.

Top-down change must not be charged with trying to answer the questions that enterprise IT has always mistakenly thought it had to solve: those of predictability and control. The only valuable top-down change is cultural. Cultural change is a leadership problem, not a process problem.

If we care about feedback, then by definition we value learning over being right all the time. If we value learning, than our operating model needs to be a picture of knowledge acquisition and application, not a picture of output control. There need to be at least as many (if not more) arrows depicting communication flows going backwards as forwards in the process. More importantly, it must be clear how that feedback is internalized and acted upon in the operating model. In the absence of that, learning is at best an accidental curiosity.

But even cultural change is not enough. Devolving authority and creating a means for genuinely incorporating feedback to team level execution is useless unless people are able to do these things in an unencumbered fashion. That means acknowledging the ground truths of the state of our technology and staff, and taking deliberate action on them. This is not easy to do. Long-tenured people in the organization likely made decisions that contributed to the current state of affairs. It's humiliating for somebody to admit that "past them" contributed to the reality of "present dysfunction."

As hard as that is, acknowledgement only goes so far. As Lisa Simpson pointed out to Homer as he came face to face with the fact that he is a rageoholic, acknowledging the problem is the first step. Dispiriting for Homer, it is not the last step. Acknowledgement has to lead to action that reforms. Without definitive action and lasting commitment to that action, the learned helplessness that plagues organizations with these conditions will erode the will to change.

It's all well and good to champion process, and by looking at process we can understand how ineffective we are and what we can aspire to be. But process will not overcome years of bad choices that have infected our people, assets and data. Process change that ignores these problems or denies they are encumbrances will at best be rendered inert, at worst will result in giving people responsibility without authority.

Leadership is not asking one group of people to make good on another's bad choices. Leadership creates the conditions where the rank and file have a fighting chance. Process is part of that, but in enterprise IT with large legacy estates, process is rarely the primary solution.

Monday, December 31, 2018

I'll be Gone, You'll be Gone

The Financial Times recently ran a long article describing the breakdown of governance over the Crossrail development, the first new underground railway in London in over a century. Good governance is usually only appreciable by its absence, but the Crossrail case allows a before / after contrast between the presence of good and, after the sacking of a key board member, the presence of bad. Early on, "TFL's representative on the Crossrail board ... had kept a close eye on costs, and asked all 'the difficult questions' according to one individual close to the board". Yet after his departure, "It [the board] endorsed everything rather than challenging [management] and asking questions.". As a case study in governance, the FT article is an analysis very much worth reading.

The article also describes a nefarious management phenomenon common to complex, long-term investments: "And the management often doesn't care because they know they won't be there when the project isn't delivered on time and to budget."

I recently read John Kay's book Other People's Money: The Real Business of Finance. In Chapter 4, Dr. Kay describes the trading mentality that replaced that of stewardship across much of the banking sector from the 1980s onward. He introduces the subject using a quote from a senior industry figure: "''We are investment bankers. We don't care what happens in five years.'" The people who make the promises and ink the deal are not the people responsible for fulfilling the promises and seeing the deal through.

The FT article describes this phenomenon within Crossrail: "...like all long-term projects, it suffered from management changeovers at contractors and suppliers. 'You always have a lot of baton changes on large-scale projects like this... So although they will have been suppressing bad news, none of the people who were round the table at the beginning are still there - it's the nature of careers that no one stays for 10 years.'"

Or, as Dr. Kay put it, "Traders need not wait to see when or whether the profits materialise. I'll be gone, you'll be gone."

A little over a decade ago, a collapsing mortgage market in the United States metastasized into a global financial crisis when the value of complex structured products (think collateralized debt obligations backed by sub-prime mortgages) on bank balance sheets suddenly collapsed. Chuck Prince, CEO of Citigroup during the run-up to the global financial crisis of 2008, will forever be enshrined in the annals of finance history for his regrettable statement that 'as long as the music is playing, you've got to get up and dance.' "Soon after," writes Dr. Kay, "Prince was forced from office and Citigroup was bailed out by the US taxpayer."

Earlier this year, Crossrail development, which had appeared to be moving successfully along, fell off a financial cliff, requiring two capital injections in rapid succession, just so they could keep paying the bills. Per the FT: "'It feels as if they clung on to the schedule they had until it became clear that it absolutely couldn't be delivered,' he says. 'But when they dropped it, it seems that they had nothing left to work to. That would explain what looks like a sudden collapse.'" The chairman of Crossrail has been forced to resign (its chief executive having exited just before the bad news broke), and Crossrail has been bailed out by the UK taxpayer.

In the post-collapse analysis of financial crises, Dr. Kay points out that the principal actors are not particularly adept at critical self-assessment. "Rogue traders normally protest that the activity would eventually have been profitable if the bank had not closed its position, just as the gambler dragged home from the casino tells his wife and the world that he would have come out on top only if he had been allowed to stay longer." Additionally, the principal actors in the early stages - who are the primary beneficiaries of "cash borrowed from destiny with some random payback time" - have a tendency to deflect any doubts about the merits of the rewards they reaped in the time before the crash. "With the cognitive dissonance of the tailgater, he [Mozilo] would explain that the considerably larger amount he had received for his services as chief executive of Countrywide was justified by the profits that his company had reported from the sale of mortgages before the borrowers failed to pay them back." While deflection on the grounds that the collapse was episodic rather than systemic may be delusional, it is a convenient pound-the-fist-on-the-table argument to justify individual financial rewards of questionable merit.

In the banking sector, the problem was borne of a combination of the agency problem (the objectives of managers are materially divergent from those of the board) twined with moral hazard (no downside exposure to idiotic risks). It remains to be seen whether or not this proves to be the case with Crossrail. But with a management extracting high compensation derived from other people's money, a large number of contractors each working in a silo, an established pattern of suppressing bad news, and a forced buyer of last resort, Crossrail certainly appears to possess many of the same characteristics.

Per the FT, "People are always adventerous on costs and time because they don't want to tell the truth." The first and last line of defense against the agency problem and moral hazard is good governance. Poor governance plagued the banking sector in the years up to the 2008 financial crisis: few directors of financial institutions had any "sophisticated understanding of banking and risk", consisting as they did of "leading clients, ex-politicos and community leaders". Crossrail appears to have become plagued by the same, with one of it's principal stakeholders having the attitude of "'give him a call when it's time to cut the ribbon.'"

There is no easy fix to poor governance because governance tends to be self-referential among its members and lacking in tools for self-correction and continuous improvement. As Dr. Kay writes, "Their attitude was not the comprehensive immorality of the overt fraudster but the willful blindness of those who do not ask questions when it would be embarrassing, or at least inconvenient, to know the answer. Upton Sinclair's remark is again relevant: 'it is difficult to get a man to understand something, when his salary depends on his not understanding it.'"

Governance is only as effective as each governor, which is why I advocate for everybody in a governing role to study and practice the positive behaviors of activist investors. Given the variable - and generally poor - standard of governance in place over most investments, there needs to be a standard of excellence in governance practice. Activist investing is the closest thing we have to such a standard.