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, 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.