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.

Sunday, July 29, 2007

Alpha Returns Require an Alpha IT Capability

Demand for IT in business continues to rise. Looking backward, over the last 10 years the IT market has absorbed the new capacity in Asia and South America, yet still we find global and national/regional IT employment is up since 2000.1 Looking forward, all indications are that demand will continue to rise. More importantly, there are very strong indicators that IT will increasingly be a strategic capability: the forecasted increase in worldwide investable assets is creating demand for new sell-side financial products;2 fact-based management is increasingly being applied to sweat assets or improve competitiveness of operations, which in turn demands increasing amounts of data about specific businesses and processes;3 and the re-emergence of high-risk capital (the recent downturn in credit markets notwithstanding) is funding start-up companies suggest that demand for IT will continue to rise.

This presents both a dilemma and a competitive opportunity for companies today.

IT is, fundamentally, a people business. While the systems and solutions it produces might automate tasks of the business, not to mention allow for complex tasks not otherwise practical to be manually executed, the production of those systems is a people-centric process. It stands to reason also that the more complex the solution, the more skilled the people behind the solution. The challenge facing an increasingly strategic IT isn’t a capacity question, but a capability question. Skills and capabilities are not commodities. It takes a great deal of individual skill to solve business problems through IT systems, specifically to model, code and construct solutions that scale, are secure, and are reliable. The highly-capable IT professional, one who has the ability to perform technical tasks as well as understand the business context, is already rare. But as IT becomes a driver of strategic imperative, these professionals will be in that much greater demand. The problem facing IT, then, is that the increase in demand for strategic business solutions that have a significant IT component will outpace the arrival rate of new highly-capable IT professionals, making the highly-capable IT professional that much more scarce.

This is obvious through the example verticals posited above: an increase in development of sell-side products, or an increase in the demand for greater and more accurate data on the business (and business processes) are clear examples of companies trying to achieve returns that beat the market by making use of a significant IT component. The trick to yielding higher ROI through such strategic IT solutions is not to reduce the “investment” on the IT component. Such strategic solutions can’t be sourced based on cost-of-capacity; they need to be sourced specifically on the capability of those delivering the solution. Capacity - the time available to work on developing these solutions - will not alone deliver the solution as emergent products and greater business insight are arrived at iteratively, and through business-IT collaboration. Looking simply at IT capacity to do such tasks is to hold skills as a constant. In a people-centric business, skills are not constant. The trick to yielding higher ROI through strategic IT solutions is to achieve “alpha” IT capability relative to the market – that is, to have an IT capability that beats the average, or “beta,” market IT capability. Specifically, sourcing an IT capability and allowing it to improve at the same rate of the overall market (beta) isn’t going to be sufficient if IT is to be a driver of above-average returns (alpha.) To drive above-average market returns, that IT capability must itself be above average.

Being “above average” or “below average" is difficult to assess because there is no “IT capability index” and thus no baseline for IT in general, let alone within an industry. Subsequently, any assessment of IT capability is likely to be laden with assertion. Worse, we have often allowed “results” to act as a surrogate for an assessment of IT effectiveness, but looking exclusively at results is often incomplete, and there is a high degree of latency between results data – the quality of delivered IT systems – and capability development. It is possible, though, to take an objective assessment of IT capability. We can look to a wealth of indicators – development excellence measures such as code quality and delivery transparency, staff peer reviews, customer satisfaction, and business value delivered – to create a composite of IT effectiveness. In some cases, we may need to have relative baselines: e.g., we measure over time against an initially assessed state of something like customer satisfaction. In other cases, we can identify strong industry baselines, such as code quality metrics we can run against the source behind such open source projects such as CruiseControl, JBoss, Waffle, PicoContainer and many, many others to provide an indicator of achievable code quality.

Gaining a sense of relative strength is important because it provides context for what it means to be high-capability, but it doesn't define what to do. Clearly, there must be things a strategic IT organisation must do to become high-capability, and remain so over time. And this isn’t just a money question: while compensation is a factor, in an increasingly competitive market you quickly end up with a dozen positions chasing the same person, all the time.4 The high-capability IT organisation must offer more than comp if it is to be durable. It must be a “destination employer” offering both skill and domain knowledge acquisition as well as thought leadership opportunities. This requires investing in capability development: skills, specialisation, innovation, and so forth. Going back to our examples, the development of cutting-edge sell side products (e.g., structured credit products) will require business domain fluency as well as a high degree of technology skill. Similarly, if companies are to “sweat the assets” of a business to their limits requires a very low noise-to-signal ratio of their business intelligence; that requires IT to be highly fluent in business process and business needs. Companies seeking alpha through IT cannot be obtain this capability through beta activities such as the acquisition of new technology skills through natural turnover and changes in the overall market capability, or the introduction to the business domain through immersion in an existing codebase. Indeed, companies relying on beta mechanisms may find themselves underperforming dramatically in an increasingly competitive market for capability. Instead, to be drivers of strategic solutions and thus alpha results, capability must rise from strategic investments.

The successful development of this capability turns IT into a competitive weapon in multiple ways. The business context is obvious: e.g., new sell-side products will clearly allow a trading firm to attract investment capital. But it goes beyond this. In a market with a scarce volume of high-performance people, being the destination employer for IT professionals in that industry segment can deprive the competition of those people. Hindering a competitor from developing an alpha IT capability will undermine their ability to achieve alpha returns. This makes IT both a driver of its host firms returns as well as an agent that disrupts the competition. This clearly demarks the difference between beta reactions, such as anticipating IT demographic changes in anticipation of recruiting efforts, and alpha reactions that create those shifts through recruiting and retention activities that force competitors to react.

This does not apply to all IT organisations. Those that are strictly back-office processing are simply utilities, and can, with minimum risk, trail the market in capability development. But businesses with significant portions of alpha returns dependent on IT systems development require a similarly alpha IT capability. If they follow the utility model, firms dependent on strategic IT are going to post sub-optimal returns that will not endear them to Wall Street. If instead they do the things to build a high capability captive IT or by partnering with a firm that can provide that high capability IT for them, and by building out the governance capability to oversight it, they’ll not just satisfy Wall Street, they’ll be market leaders with sustainable advantage.

1The Department of Computing Sciences at Villanova University has published some interesting facts and links.
2"Get Global. Get Specialized. Or Get Out." IBM Institute for Business Value, July 2007.
3"Now, It's Business By Data, but Numbers Still Can't Tell Future." Thurm, Scott. The Wall Street Journal, 23 July 2007.
4The Battle for Brainpower" The Economist, 5 October 2006.