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.

Wednesday, October 26, 2011

Annual Budgeting and Agile IT, Part III: Operational Predictability versus Financial Rationality

We've seen how Agile IT conflicts with the CFO's goals, and why the latter tends to trump the former. What can we do about it?

Conceptually, our starting point is to hive off IT investment activity from utility services. If the CIO doesn't draw this distinction, the CFO isn't going to, either. Making this separation allows us to talk about strategic IT in financial terms as opposed to operational ones. Not to become more coin-operated, but to level the playing field between IT and the rest of the business.

Let's look at capital for a minute. Firms acquire capital through many different means. There’s the capital accumulated through retained earnings. There’s also the capital we can raise by getting loans and selling bonds (debt) or issuing shares (equity). At any given time, a firm has many different ways to deploy capital, such as investing in operations, awarding bonuses, or paying a dividend to shareholders, just to name three. The Board of Directors, CEO and CFO will use existing capital, or raise new capital, and deploy it where it is expected (or just plain hoped) it will provide a return.

From an operations perspective, some of those uses of capital may seem unusual. For example, it's not uncommon for a firm to borrow money to make a dividend payment to shareholders. By doing so, the firm is simply borrowing against future cash flows to compensate shareholders. While this may seem counter-intuitive and even risky from an operations perspective, it illustrates the point that capital formation is dynamic: a business will raise funds to go after an opportunity. By comparison, budgets are static: we will constantly look to squeeze money out of a business.

Strategic IT must be seen as investments competing for capital against all other uses.

Every capital investment a firm makes has a business case that comes down to a simple question: “we're investing y capital in pursuit of x result". There are countless candidates for “x” that a business can throw a limited “y” at. Not every result is financial. There may be no quantifiable ROI. We could be looking to make social or political impact, or improve employee retention. The point isn't to measure financial returns, but to ask: how much are we willing to pay to get something in return? And in the extreme, how far are we willing to stretch our balance sheet to achieve a collection of “x” outcomes?

This would seem to make things a lot more complicated for IT. IT can't write the business case, it has to come from the business. And before we get something into production, we don’t really know what an IT investment will do for a business (what business impact it will have), let alone what it will actually take to get it into production. We can study, analyze and guess, but we really don't know. Why not just leave the business to the business, and the tech to IT?

Because in Strategic IT, we're doing the latter in pursuit of the former, and what's true for IT investments is no different from any other investment a business makes. We can do all the market research we want, but marketing doesn't know whether a new product will sell well or not until that product makes it to market. We can agonize over population demographics, but we won't know whether we’ll find skilled labor to staff a new manufacturing facility we've built until we set up and start hiring. An acquisition may look good on paper, but we may never realize the expected cost savings from a merger.

The fact is, every capital investment is subject to uncertainty. 'Twas ever thus. The best we can do is to make well informed decisions and do everything in our power to minimize the things that operationally impair our success.

This helps IT tremendously. In this context, IT doesn't need to be operationally predictable, but financially rational. That's a better way to run a business. It levels the playing field for Agile IT: even a business with low tolerance for fluctuations in cash flow from operations will invest in itself. This means it has higher tolerance for investment variability than it does operational variability.

If Strategic IT is financial more than it is operational, it needs aggressive, Agile portfolio management. There are a lot of things that go into this, too much to cover in this blog post, so we'll focus on three: investment flow, hedging strategies, and activist investing.

Investment Flow

There are countless IT investment opportunities for a business. As technology continues to evolve, the number of those opportunities will only increase. This gives us a very broad portfolio of ideas we might pursue.

Clearly, some ideas are better than others. We can take a closer look at those ideas that look a little more promising by putting them through an initial inception: make a broad survey of the opportunity, perform some due diligence, and produce a business case and an initial estimation of cost. This will filter out the plainly bad ideas, and give us a portfolio of candidates that appear to be good ones. Agile inception practices are well suited for targeted, short duration discovery and for producing relevant (not to mention short and focused) artifacts. Agile inception gives us a simple litmus test to apply to any candidate investment, and it doesn’t cost a lot to apply it.

Those ideas that clear the first hurdle are subjected to a second, more rigorous inception. The objective is to refine the business case and fulfillment details such that business and IT are comfortable presenting an investable decision to an investment committee. To be clear, the objective is not to produce a definitive, closed-ended, detailed plan. Our facts, forecasts, expectations and assumptions are going to be wide of the mark. We're not trying to be predictable, we're trying to determine if there's an investment case given the information that we have today. In this second stage, we want to produce a sufficiently refined assessment of benefit, cost, execution expectations and risk guidance so that an investment committee can determine if this opportunity looks like a good use of capital given there are known and unknown risks.

Some opportunities will fail to live up to their promise and fail during the second stage of inception. Some will be rejected by the investment committee. Some will be approved and become investments that the business agrees to make.

Although we promote opportunities, investment flow is not linear. Continuous assessment of investment opportunities means a new arrival may cause an existing investment to be demoted or curtailed, while others previously deemed unviable yesterday may look attractive tomorrow. The portfolio of investable opportunities do not follow a one-way promotion from idea through fulfillment, but will fluctuate relative to each other.

The goal is to be constantly performing inceptions so that we get a healthy churn of our investment opportunities. This has residual benefits as well. It partners IT with the business to secure an investment. It gives us a defined collection of investments we want to make that will deliver some expected value (financial or otherwise) for some expected investment. It gives us a portfolio of things the business “intends to invest” in through IT, sufficiently well defined to satisfy guidelines for capitalizing intangible assets. It gives the CFO guidance on IT's expected capital needs.

Hedge The Investments

An investment that makes it into the portfolio of investable opportunities may still never be developed. It’s simply in the investment portfolio. Like any portfolio, we need to hedge our positions.

Suppose 10 opportunities are currently in the “approved to invest” portfolio. We don’t have to secure funding for all 10. Perhaps we work with the CFO to secure funding for 8, with 2 at the ready. We can still have all 10 “approved” by an investment committee because in just about every business, “approved” is not the same as “funded”.

Why leave 2 on the table? From a business perspective, this seems ridiculous, especially for the person leading the business unit holding the odd project out.

Let’s look at what happens when we’re delivering against this portfolio. All of these investments will be at-risk of losing viability during development for any number of reasons: because the business case becomes shaky, sponsorship fades, or we get into execution and find out it’s going to cost far more than our prior looks led us to believe. Not having a hedged position would put us right back in the long-range budgeting trap that we’re trying to avoid. Strategic IT is an investment arm of the business. Investments contain an element of risk. A good investment manager hedges his or her risks.

Which is why we have a hedged position in the form of other investments which have been approved, and why we’re constantly looking for new investment opportunities (inception flow) to promote. That reduces the overall volatility of our portfolio, which, in turn, gives us operational flexibility to reassign staff with minimal SG&A impairment. Should one investment fall out, we have another at the ready, and we're able to quickly move people (the most important thing we've got) into that next investment. This is important: maintaining liquidity in our project portfolio prevents an erosion of our solvency (that is, our capability to get things done) by avoiding a spending squeeze. Looking at it another way, hedging within the IT portfolio means operational continuity doesn't suffer as a result of misguided portfolio maximization.

It's worth pointing out that hedging financial risks is a big change from pursuing operational predictability, efficiency, or optimization. The CFO is directly accountable to the board and to shareholders for business returns. Performance is at the mercy of all kinds of factors outside the CFO's control: currency fluctuations, macroeconomic events, and political change just to name a few. The CFO will not be held accountable for failing to predict the future, but will be held accountable for hedging to a reasonable level of risk awareness, even of some Black Swan events. Sometimes risks will exceed expectations, and sometimes hedges will be excessive and appear to be waste. CIOs with responsibility for an investment portfolio would be held to this type of accountability. Being seen as responsible only for operating costs, however, the CIO is relegated to cost control.

Another hedging strategy is to have short-term horizons for every investment. The longer the time we spend delivering any single investment, the greater the risk accretion, the greater the risk of default. Large capital projects that default either need additional cash injections to keep them solvent, or face being written off. Making several small investments allows us to actively revisit the business case, viability, and priority of a large investment. Smaller investments keep our portfolio much more liquid, and increases our resiliency to operational default.

Activist Investing in IT

An IT portfolio must be reviewed and assessed with the same rigor as any financial portfolio. The span of time over which human effort is applied to convert capital to an intangible asset requires a lot of attention. We do this through continuous governance, to align operations with financial intent. These mechanisms allow us to continuously ask whether an investment is still viable, or whether it is being operationally impaired, or has lost business justification. This is no different from what we do with investments in a financial portfolio. This is a subtle but critical difference with traditional IT: we're not trying to "meet plan", we're constantly assessing whether an investment is viable and, if not, what we can do without having to go hat in hand back to an investment committee to ask for more capital.

But there's a difference between mechanical governance and investing. Too often, IT portfolio management is staffed with little more than project reporters. Continuous governance is only effective if we have activist investors: people experienced with technology investments who not only scrutinize the data but manipulate it, reframe it, challenge it, supplement it by getting their own, and interrogate the people behind it. There's a fine line between fulfilling a duty of curiosity and just plain meddling, so think before you act(ivist). Take cues from successful activists (one could do much worse than to do your homework as thoroughly as David Einhorn), engage outsiders as board members for investment governance, and above all challenge silence and rubber-stamping.

Portfolio Management

Our strategy, then, is to separate strategic IT into an investment arm, and manage it like an investment portfolio: inception flow that continuously screens and revisits investable opportunities, have a diverse and hedged portfolio of small capital investments, bringing continuous governance and activist investing practices to bear on those investments, and rebalancing the portfolio when necessary.

In general, this is how IT portfolio management should be practiced.

Doing these things gives IT investments a robustness they don’t typically have:

  • We continuously assess new investment opportunities.
  • We have continuous assessment of the viability of in-flight opportunities.
  • We have a pool of funds out of which we can fulfill IT investment activity (an expectation for what we’ll spend on “human effort”).
  • It makes capex more liquid (accessible at a more coarsely grained level), protecting any expectation we set for payroll funding out or capex and reducing the risk of a solvency (a/k/a “capability”) crisis should several projects be suspended (the equivalent of our “tier 1 capital” of IT).
  • It decouples the budgeting decision from finely-grained (and inaccurate) project planning exercises, and roots our budgeting in value as opposed to cost.
  • We can link the financing of the investment opportunity to the investment itself (e.g., we may raise capital specifically to fund a tech investment if we think it represents a major business opportunity or we need to stave off a threat to our business), and feed that directly into our portfolio management.
  • We talk in financial terms and solve problems of the firm's capital allocation, instead of asking the CFO to talk in operations terms and solve (and often, over-simplify) IT's operational problems.
It’s worth looking at pure-play software investing as a useful comparison to captive IT investing. Generally speaking, software firms have low capital intensity (lower now especially with cloud) and little debt (the volatility of tech makes financing via fixed income instruments unattractive). They also tend to throw off copious amounts of cash (e.g., Microsoft, Google, etc.) This gives tech firms several degrees of freedom that firms in other industries simply don’t have.

People accustomed to the low-debt-high-cash tech investing environment tend to bring the same set of expectations of captive IT departments. Those expectations are well intentioned but wide of the mark, as illustrated in previous posts: because IT is seen by the business as part of operations, it is subservient to, not a component of, the financing demands of the business.

As I stated at the beginning, the fundamental concept is to have IT separate its investment activity from the utility services it provides. That seems like a conversational non-starter. But in most firms, there's a pretty good business case for doing that.

To put things in perspective, if the entire $350m discretionary IT investment [of this firm] had been retained as profit instead of spent on projects, the company’s earnings per share would have risen, creating more than $5bn of additional shareholder value.

Richard Bhanap, Managing Director, KPMG Europe writing in the Financial Times
A board doesn't have to invest in the business through IT. It can use capital to retire debt or buy back shares, invest in other securities, buy other companies, or make a dividend payment to shareholders. As Mr. Bhanap points out, when a company does invest in IT, those investments have a very high standard to meet. We lose sight of that standard when Strategic IT is thought of as "operations" as opposed to "investment". IT stands to benefit by taking on responsibility for investment performance.

Decoupling Strategic IT from operations, and instead casting it as an investment arm, gives us an opportunity to get Strategic IT out of the annual budgeting cycle and into an investment cycle. Doing that creates a more conducive atmosphere for Agile IT.

As a post-script to this series, we'll look at IT portfolio management - and what we're really asking IT to do.

Updated 29 December 2011