Bosses at troubled companies say they want growth through innovation. They prefer growth through girth.

The headlines are heavy with iconic companies that have hit the skids recently, from Starbucks, to Boeing, to Intel. All have relatively new CEOs, each of whom has said that their respective company's path to salvation lies in returning to their roots, to once again be a coffee shop or an engineering firm. The assertion is that by going back to basics, they can regain the crown of leadership in their respective markets.

The problem is, there is no going back. The combination of circumstances that created the conditions for rapid growth and market dominance are long gone. The socio-economic factors have changed. The regulatory environment has changed. The key technologies have changed. The supply chain has changed. The competitive landscape has changed. Don't bother with the flux capacitor.

What those bosses are really saying, of course, is “we need a do-over.” But there is no do-over. Not only are years of financial engineering not easily un-done, they created a financial burden that operations have to carry by generating copious free cash flow. Sorry, but no matter how desperate the situation, the new CEO is not the William Cage figure in the Edge of Tomorrow.

While the Starbucks and Boeings grab the headlines at the moment, there are many once iconic companies that backed themselves into a corner by starving operations to feed the balance sheet. Time ran out, old management was shown the door, new management is ushered in.

This is the playbook that new management follows.

The first step is to alleviate immediate financial pressures, starting with the balance sheet. This means any or all of: maxing out credit facilities, selling assets, raising cash through equity sales, taking the company private, breaking up the company, and in the extreme filing for bankruptcy protection. Investors may win (a company breakup can work out well), investors may lose (dilution of equity), and investors may get wiped out (common equity is valueless in bankruptcy).

Fixing the balance sheet buys time, but not a lot of time, so the income statement needs to be shored up as well. Quality problems? Losing customers? Margins too thin? The playbook here is well established: simplify operations, promote quality above all other metrics, reduce contractors and staff, cut discretionary costs, slash prices, over-reward customer loyalty, etc. The good news is, customers mostly win. The bad news is, employees mostly lose, as they will face perpetual cost cutting efforts ranging from the structural (opportunistic terminations) to the petty (workplace surveillance).

Which brings us back to the CEO statement that “we need to become who we once were”.

Unless there are high-value trophy assets, or a large portion of the debt can be saddled onto divisions spun off, the financial stabilization effort will leave a balance sheet that is out of proportion with the income statement. That is, the balance sheet is structured for a company with higher sales growth and stronger cash earnings. Before it does anything else, the company must face the fact that financial stabilization isn’t going to return the capital structure to what it was before all of the financial engineering happened.

That has serious repercussions for operations. Recapturing lost competence only solves the growth problem if the core business can once again be a growth business. This is the fundamental hypocricy of CEOs trafficking in "back to the future" statements: the core business has to be a growth business or returning to core competencies solves nothing. Absolutely nothing. And they know it. Being good at what you used to do well will staunch decline, but it offers no guarantee of a return to growth if there’s not much growth to go round. It is also worth pointing out that the “we need to become what we once were” statement also masks the actual objective: it isn’t to be the pre-eminent firm in the market the company made its name at, as much as it is to resucitate the income statement to a point that the balance sheet makes sense again.

If the core market is slow- or ex-growth, the go-to strategy is to capture a greater share of total customer spend, a.k.a. “revenue grab”. The opportunities here include extending the brand by selling adjacnet products and services (e.g., as GE famously expanded from selling nuclear power plant technology to servicing nuclear power plants in the 1980s). Another is selling against type: where a company once differentiated from its competition by refusing to sell what it derided as low-value offerings, it will cheerfully sell anything and everything because every dollar of revenue is now the same. Yet another opportunity is predatory monetization: charging for things that were previously given away for free (e.g., whereas once upon a time, all economy seats were priced the same, those near bulkheads or the aisle cost more than seats in the middle).

None of these alternatives are revolutionary. All have the advantage of not being “bet the business” pursuits. Which is helpful, because the balance sheet limits the investment the company can make in pursuing any growth opportunities. All of these can be pursued through partnership and small acquisition, as opposed to organic development; this jumpstarts capability, minimizes cash outlay, and promises faster time to return.

Yet none of these are truly growth strategies in that they open new markets or compel buyers to spend where they had not spent before. They are only growth strategies because they assume that customer income statements are growing: growth in wallet share creates exposure to growth in customer income statements. Restated, as aggregate customer topline grows, aggregate customer expenses grow, and a greater capture of customer spend leads to growth. It’s growth by girth, not by invention, innovation or creativity.

The intermediate-term success of this strategy is a return to modest growth and sufficient cash flows to make its interest payments and modest - if only occasional - dividends. These are not steps that will help the company regain its lost edge. Just the opposite: they signal capitulation that it will never regain that edge. Its long-term success is either to be acquired (a possibility because inflation increases revenue and simultaneously reduces the debt burden), or to be in a position to grab more revenue should a competitor stumble or outright fail.

To become what the company once was - a company that made its own growth by obsoleting its own products and services (why keep that 286 PC when you can have a Pentium? Why fly a fleet of 707s when you could fly a fleet of 747s? Why keep using that old phone since it can’t keep a charge anyway?) - requires both a capacity for innovation and a growth market. Yes, I just wrote “the company makes its own growth” because it does so by proxy. Technological advances bring new consumers into the market: personal computer manufacturers expected to sell more PCs once they had more powerful CPUs that could solve more complex problems; airlines expected to fly more passengers once they had more planes and larger planes to drive down costs in the post-deregulation airline industry.

A cash strapped, debt laden business is an unlikely candidate to invent the market-creating technologies of the kind that brought it to prominence in the first place, if for no other reason than a company pursuing revenue grab is focused on yesterday’s growth markets and is therefore poorly attuned to tomorrow’s. That is not to say it is utterly hopeless, but that the path back to growth markets isn’t going to be self-directed. Finding the way back into a growth market requires that the company be quick to recognize, implement and operationalize something new. But that, too, requires balance sheet leeway that, depending how dire the straits it finds itself at the start of the retrenching cycle, will limit its ability to spend on the R&D necessary to innovate. This is the cundrum of retrenchment: while fortifying the balance sheet is unavoidable, the resulting fortress imprisons cash flows and, ultimately, the income statement. Add - well, subtract - labor severed during retrenchment and the disengaged labor that remains, and it is highly unlikly that a fallen icon will return to the vim and vigor of its go-go days.

The retrenching company needs balance sheet and operational restructuring. It will then look for easy money anywhere that it can extend its brand and monetize its offerings. It will hope to buy time for inflation to work its magic on the debt burden and the topline, and to be ready for a competitor to stumble. That is the definition of success.

While a nice sentiment, nothing in this playbook benefits from the business returning to what it used to be. Because success of the grafted-on rescue management isn't "to win", it is "not to lose."

The yield curve is inverted. Tech's problem is asset price inflation.

The business of custom software development is, at its core, an asset business. Software development is the business of converting cash to intangible assets by way of human effort. Plenty of people opine about how important human labor is to software, and of course it is. Good development practices reduce time to delivery and create low-maintenance, easy-to-evolve software. What labor does and does not do is extremely important to the viability of software investments.

But software is an asset, not an operating expense. If there is no yield on a software asset, investing in software is a bad use of capital. No yield, no capital, no cash for salaries for people developing software. Money matters, whether or not we like to admit it.

This is a stark reversal for tech. When money was cheap and abundant as it was for over a decade, tech had the opposite problem: no yield, no problem! When capital wasn’t a constraint, the investment qualification wasn’t “what is this asset going to do for us” but “what are we denying ourselves if we don’t try to do something in this area.” Trying was more important than succeeding.

There are those who want to believe that financial markets are unemotional, but they are not. Momentum is a crucial factor in finance. Momentum is what gets investors to pile into the same position. Momentum turns a $100k plot of land into a $2m real estate “investment”. Momentum is an emotional justification in that the rationalization is hope, not fundamentals.

Tech rode momentum for a long, long time. Before COVID, the story that built momentum for tech was disruption. During COVID, the story was tech as a commercial coping mechanism. Momentum put abundant amounts of cash into the tech sector. Abundant cash inflated more than just salaries: it also inflated technical architectures and solution complexity. Money distorts.

That momentum has run its course. Tech is reaching - grasping - for any growth story. To wit: GenAI here, there, everywhere.

There are two winning hands in momentum trades: “hold to maturity” and “greater fool theory”. The prior requires a lot of intestinal - not to mention free cash flow - fortitude. The latter requires finding somebody foolish enough to spend as much (and ideally more). Nearly two years of contraction in the tech sector indicates a shortage of greater fools. Yes, some subsets of tech still command premium pricing; suffice to say there is no rising tide lifting all boats, and has not for quite some time.

Tech rode the wave of price inflation. The yield curve indicates that the wave has crested.

The era of ultra low interest rates is over. Tech has painful adjustments to make.

Interest rates have been climbing for two years now. The Wall Street Journal ran an article yesterday with the headline the days of ultra low interest rates are over. Tech will have to adjust. It’s going to be painful.

When capital is expensive, we measure investments against the hurdle rate: the rate of return an investment must satisfy to exceed to be a demonstrably good use of capital. When capital is ridiculously cheap, we no longer measure investment success against the hurdle rate. In practice, cheap capital makes financial returns no more and no less valuable than other forms of gain.

There are ramifications to this. As fiduciary measures lapse, so does investment performance. We go in pursuit of non-financial goals like "customer engagement rate". We get negligent in expenditure: payrolls bloated with tech employees, vendors stuffing contracts with junior staff. We get lax in our standard of excellence as employees are aggressively promoted without requisite experience. We get sloppy in execution: delivery as a function of time is simply not a thing, because the business is going to get whatever software we get done when we get it done.

Capital may not be 22% Jimmy Carter era expensive, but it ain’t cheap right now. Tech has to earn its keep. That means a return to once familiar practices, as well as change that orchestrates purge of tech largesse. Business cases with financial returns first, non-financial returns second. Contraction of labor spend: restructuring to offload the overpromoted, and consolidation of roles or lower compensation for specialization. Transparency of what we will deliver when for what cost, and what the mitigation is should we not. An end to vanity tech investments, because the income statement, much less the balance sheet, can no longer support them.

Some areas of the tech economy will be immune to this for as long as they are thematically relevant. AI and GenAI are TINA (there is no alternative) investments: a lot of firms have no choice but to spend on exploratory investments in AI, because Wall Street rewards imagination and will reward the remotest indication of successful conversion of that imagination that much more. Yet despite revolutionary implications, AI enthusiasm is tempered compared to frothy valuations for tech pursuits of previous generations, a function of investor preference for, as James Mackintosh put it, profits over moonshots.. Similarly, businesses where there is a tech arms race on because innovation offers competitive advantage, such as in-car software, it will be business as usual. But these arms races will end, so it will be tech business as usual until it isn’t. (In fact, in North America, this specific arms race may not materialize for a long, long time as EV demand has plateaued, but that’s another blog for another day.)

Tech has had the luxury of not being economically anchored for a long time now. If interest rates settle around 400 bps as the WSJ speculated yesterday, those days are over. The adjustment to a new reality will be long and painful because there’s a generation of people in tech who have not been exposed to economic constraints.

This is the Agile Manager blog, as it has been since I started it in 2006. Good news, this change doesn’t mean a return to the failed policies of waterfall. Agile had figured out how to cope with these economic conditions. Tech may not remember how to use those Agile tools, but it has them in the toolkit. Somewhere.

That said, I also blog about economics and tech. If the Fed funds rate lands in the 400 bps range, tech is in for still more difficult adjustments. More specifically, the longer tech clings to hopes for a return to ultralow interest rates, the longer the adjustment will last, and the more painful it will be.

The ultralow rate party is over. It’s long past time for tech to sober up.

The Credit Cycle Strikes Back

A few months ago, I wrote that the capital cycle has become less important than the tech cycle. I’d first come across this argument in a WSJ article in 2014, and, having lived through too many credit cycles, it took me some time to warm up to it. The COVID-19 pandemic laid this out pretty bare: all the cheap capital in the world provided by the Fed would have done nothing if there wasn’t a means of conducting trade. Long before the pandemic, tech had already made it possible to conduct trade.

Capital has flexed its muscles in recent months, and the results aren’t pretty. The Fed has raised interest rates and made clear its intention to continue to increase them to rein in inflation. The results are what you’d expect: risk capital has retreated and asset values have fallen. Tech, in particular, has taken a beating. Rising inflation was limiting household spending on things like streaming services, abruptly ending their growth stories. Tech-fueled assets like crypto have cratered. Many tech firms are being advised to do an immediate volte-face from “spend in pursuit of growth” to “conserve cash.”

But this doesn’t necessarily mean the credit cycle has re-established superiority over the tech cycle.

Capital is still cheap by historical standards. In real terms, interest rates are still negative for 5 and 10 year horizons. Rates are less negative than they were a year ago, but they’re still negative. Compare that to the relatively robust period of 2005, when real interest rate curves were positive. Less cheap isn’t the same as expensive. Plus, it’s worth pointing out that corporate balance sheets remain flush with cash.

Any credit contraction puts the most fringe (== high risk) of investments at greater risk, e.g., a business that subsidizes every consumption of its product or service is by definition operationally cash flow negative. Cheap capital made it economically viable for a company to try to create or buy a market until such time as they could find new sources of subsidy (i.e., advertisers) or exercise pricing power (start charging for use). If that moment didn’t arrive before credit tightening began, well, time’s up. Same thing applies to asset classes like crypto: when credit tightens, it’s risk off as investors seek safer havens.

The risk to the tech cycle is, how far will the Fed push up interest rates to combat inflation?

Supply chains are still constrained and labor markets are still tight. Demand is outstripping supply, and that’s driving up the prices of what is available. Raising rates is a tool for reducing demand, specifically reducing credit-based purchases. Higher interest rates won’t put more products on the shelves or more candidates in the labor pool. If demand doesn’t abate - mind you, this is still an economy coming out of its pandemic-level limitations - inflationary pressures will continue, and the Fed has made clear they’ll keep increasing rates until inflation cools off. With other shocks lurking - a war in Europe, the threat of food shortages, the threat of rolling electricity blackouts - inflation could remain at elevated levels while capital becomes increasingly expensive. Of course, sustained elevated interest rates would have negative consequences for bond markets, real estate, durable goods, and so on. The higher the rates and the longer they last, the harder the economic landing.

That said, tech is the driver of labor productivity, product reach and distribution, and a key source of corporate innovation. The credit cycle would have to reach Greenspan-era interest rates before there would be a material impact on the tech cycle. And even then, it’s worth remembering that the personal computer revolution took root during a period of high interest rates. Labor productivity improvement was so great compared to the hardware and software costs, interest rates had no discernible effect.

The credit cycle is certainly making itself felt in a big way. But it’s more accurate to say for now that capital sneezed and tech caught a cold.

Crowding Out

Tech has had a pretty easy ride for the last twenty years. It only took a couple of years for tech to recover from the 2001 dot-com crash. In the wake of the 2008 financial crisis, companies contracted their labor forces and locked in productivity gains with new tech. Mobile went big in 2009, forcing companies to invest. Then came data and AI, followed by cloud, followed by more data and AI. The rising tide has lifted a lot of tech boats, from infrastructure to SaaS to service providers.

The ride could get a little bumpy. Five forces have emerged that threaten to change the corporate investment profile in tech.

1. Labor power: workers have power like they've not had since before the striking air traffic control workers were fired in the early 80s, from unions winning COLAs in their labor agreements to the number of people leaving their jobs and in many cases, leaving the workforce entirely. Labor is getting expensive.
2. Interest rates: debt that rolls over will pay out a few more basis points in interest rates than the debt it replaces. Debt finance will become more expensive.
3. Energy inflation: energy prices collapsed before the pandemic, only for supply to contract as energy consumption declined with the pandemic. It takes longer for production to resume than it does to shut it off. True, energy is less a factor on most company income statements than it was fifty years ago, but logistics and distribution firms - the companies that get raw materials to producers and physical products to markets - will feel the pinch.
4. Supply chain problems: still with us, and not going away any time soon. Sanctions against Russia and deteriorating relations with China will at best add to the uncertainty, at worst create more substantive disruption. By way of example, the nickel market has had a rough ride. And there has been increasing speculation in the WSJ and FT of food shortages in parts of the world. As companies stockpile (inventory management priorities have shifted from “just in time” to “just in case”) and reshore supply chains, supply chain costs will rise. Supply will continue to be inconsistent at best, inflationary at worst.
5. Increase in M2: adding fuel to all of these is a rise in M2 money supply. More money chasing fewer items drives up prices.

All of these except for interest rate rises have been with us for months, and we’ve lived with supply chain problems for well over a year now. These factors haven’t had much of an impact on corporate investment so far, largely because companies have successfully passed rising costs onto their customers. Even if real net income has contracted, nominal has not, so buybacks and dividends haven’t been crowded out by rising expenses.

But the economy remains in transition. Many companies are starting to see revenues fall from their pandemic highs. While rising interest rates may cool corporate spending, it has to cool a great deal to temper a labor market defined more by an absence of workers than an abundance of jobs. With real wages showing negative growth again, it will become more difficult for companies to pass along rising costs. Rising resistance to price increses will, in turn, put pressure on corporate income statements.

Of course, this could be the best opportunity for a company to invest in structural change to reduce labor and energy intensity, as well as to invest for greater vertical integration to have more control over upstream supply, with an eye toward ultimately changing its capital mix to favor equity over debt once that transformation is complete. That’s a big commitment to make in a period of uncertainty. Whereas COVID presented a do-or-die proposition to many companies, there is no cut-and-dried transformational investment thesis in this environment.

What does it let us do that we couldn't do before?

In the past year, activist investors have pushed for retailers like Macy’s and Kohl’s to separate their eCommerce operations into separate listed entities. The argument goes that eCommerce retail growth is rapidly outpacing bricks-and-mortar business growth, and saddling a high-growth business to an ex-growth legacy company depresses enterprise value. Separating them into two listed entities liberates the trapped value and allows investors to benefit: the eCommerce business for growth, the bricks-and-mortar business for its stable (if declining) cash flows, real estate holdings and intellectual property (e.g., brand) value.

Not so fast. There are counter-arguments to making this separation, and not just that a growing eCommerce division covers up for a struggling traditional retail operation.

Principal among the arguments for keeping the business whole is that even with - and perhaps especially because of - COVID, there’s a strong argument that the omnichannel strategy is the strongest hand to play. Omnichannel requires a seamless customer experience that independent eCommerce and physical store legal entities will struggle to curate. It stands to reason that what is good for the brick and mortar business is not necessarily the same as what is good for the eCommerce business, and vice-versa. Having eCommerce and brick-and-mortar working independently - if not at cross-purposes - will do little to harmonize the customer experience, not helpful at a time when doing so is deemed essential to survival.

An extension of this argument is that an omnichannel strategy doesn’t distinguish among channels, so separating the two - and thereby creating a distinction between them - is solely an act of financial engineering. Assessed as a financial act, the obvious question is, who wins? The consultants, attorneys and banks that collect fee income from the separation are clear beneficiaries: they’ll collect their fees regardless the outcome. Investors may or may not win out, as bond and equity prices in both legal entities may plummet after their separation, but at the start they will have no less value than they do today plus upside exposure through clearer value realization paths. Unfortunately, it’s hard to imagine how the pre-separation business itself gains from the separation: does it stand to reason that even more formalized organizational silos, redundant corporate overhead functions, and executives with polarized incentives are customer-value generative outcomes?

This flare-up in retail is interesting because it is the latest incarnation of a long-lived phenomenon of companies touting a change in their capital structure as a strategic initiative. I first wrote about this almost nine years ago. At the time, activist investors were attacking tech firms to create new classes of preferred shares or issue new bonds solely for the purpose of extracting cash flows from operations for the benefit of investors. But it wasn’t just an outside-in phenomenon of investors pressing tech firms: Michael Dell had at that time proposed to take Dell private, which did soon thereafter. With only wolly words to describe the justification for going private, it raised the question, what can Dell do as a private company that it cannot do as a public one?

The current kerfuffle in retail allows us to ask this question more broadly. Changing capital structure is no different from any other use of corporate cash, be it distribution of dividends, to replatforming operations, to simply strengthening the credit rating. Those bankers, lawyers and consultants don’t come cheap. The question is, what does it let the business do that it couldn’t do before?

With the benefit of hindsight, we know that Dell the publicly listed company became Dell the private equity fund. Among its acquisitions was EMC, and in particular EMC’s stake in VMWare, a position so lucrative that when Dell went public again in 2018 the implied value of the business excluding that holding was effectively nil. Dell the public company could have acquired EMC; publicly listed tech companies make acquisitions all of the time. What going private let the business do that it couldn’t do before was to concentrate ownership, and subsequently the returns from those acquisitions, in fewer people’s hands.

In the retail sector, the answer is not necessarily so cynical. Saks made the split into separate bricks & mortar and eCommerce legal entities earlier this year. In the words of the eCommece CEO, as quoted in the WSJ this week, both businesses benefit overall because they don’t have the same dollars chasing conflicting investment opportunities exclusively in an IRL and online realm, the eCommerce business has expanded its eCommerce offerings and reach, the brick and mortar business has better integration with eCommerce than it did before, and eCommerce now has an employer profile attractive to tech sector workers. In short, to destroy a longstanding phrase, by being two entities, the Saks eCommerce CEO argues that the sum of the parts is greater than the whole could ever have been. The CEO argues that the separation lets Saks do something - probably many somethings - it could not do before.

This, in turn, begs the question why.

There’s a quote attributed (quite probably erroneously) to the late Sir Frank Williams of the eponymous Williams Formula 1 team. When asked whether he approved of a proposed change to the race car, the legend is that his only response was, “does it make the car go faster?” It’s a deceptively simple question, one that I long misunderstood, because I took it at face value. Engineers can do any number of things to make a car go faster that also make the car less reliable, less stable, incompatible with sporting regulations, and so forth. While the question “does it make the car go faster” appears a simple up-or-down question, it actually questions the reasons behind the proposed change. How does it make the car go faster? Why hasn’t anybody thought to do this before? In answering those questions, we find out if the proposed change is clever, or too clever by half.

And that’s the question facing traditional retail. A commercial restructuring that alleges it creates value for the business (that is, not just investors) flies in the face of conventional wisdom. Sometimes that conventional wisdom is correct: Dell shareholders who accepted something less than $14 / share in 2013 lost out on a quadrupling of the enterprise value over an 8 year span (and no the S&P 500 didn’t perform quite that well over that same timeframe). But then, as John Kenneth Galbraith pointed out, conventional wisdom is valued because it is convenient, comfortable and comforting - not because it is necessarily right. Perhaps Saks and parent HBC are onto something more than just financial engineering, if in fact separating eCommerce from bricks & mortar let them do something they could not do before.

Is the Tech Cycle More Important than the Fed Cycle?

In 2014, Andy Kessler wrote an intriguing op-ed in the WSJ, positing that beginning in the last half of the 20th century, the tech cycle had replaced the Fed cycle as the engine responsible for economic growth.

His argument went like this. Historically, the economy ran in 4 year cycles. Initially, cheap capital stimulated business investment and employment, which spurred spending, but increased spending eventually brought inflation. Inflation meant prices of goods rose and eventually tempered demand; lower demand meant inventories climbed, causing companies to slow the rate of production. Lower production forced companies to lay off workers, while the Fed raised interest rates to tame inflation which culled business investment. As inventories depleted and inflation abated, the cycle started all over again. Many interpreted this as the Fed cycle of interest rate adjustments. As it was once said, the Fed brings the punchbowl to the party before the guests arrive, and takes it away once the party heats up.

Seven years ago, Mr. Kessler pointed out that economic cycles are much longer today than they once were and attributed this to the tech cycle. His basic argument was that each new generation of tech - in his narrative (a) mainframes, (b) personal computers, (c) early internet, (d) mobile / cloud - had a greater influence on the longevity and vitality of economic performance than anything that the Fed did. The technology enabled changes in business models that made them less susceptible to traditional forces. His case study was that supply chain integration meant less inventory buildup, which meant less volatility, and subsequently longer cycles.

It’s a very intriguing proposition. I’ve wrestled with this from a few different perspectives. Yes, undoubtedly, new generations of tech have changed business models, making companies less vulnerable to the broader business (and subsequently capital) cycle. Technology has also increased worker productivity, which reduces labor intensity, which means less labor volatility when things slow down. Yet at the same time, quite a few tech firms have shown themselves to be vulnerable to the business cycle. To wit: the Fed cycle matters a great deal to tech firms dependent on benign credit conditions. Tech has no special immunity that way.

The traditional economist in me has two problems with Mr. Kessler’s argument. First, the “tech disruptor” mantra ignores financial orthodoxy - not to mention the over-abundance of other would-be disruptors - at its peril. It tends to be a self-referential argument that “tech is disruptive and is therefore ascendent.” Which is true, until the tech in question runs out of money or ends up in a bizarre stasis where a bunch of tech disruptors with overvalued equity deadlocked in internecine warfare, each simply waiting for all the others to run out of cash before they do. Second, long wave theory tends to read like narrative fallacity, something that Nassim Taleb specifically warned about. Nikolai Kondratiev was clearly onto something, but how much of a long-wave cycle is cherry-picking data points to fit a narrative rather than the data itself exposing the narrative?

That said, capital makes itself irrelevant when it is so cheap and so abundant for so long, as it has been for decades now. The traditional economist in me is an idiot for clinging to a set of parameters that have made themselves irrelevant to a broader set of trends.

That’s a long preamble to say that Mr. Kessler’s 2014 argument has contemporary relevance in light of economic performance during the COVID-19 pandemic.

The Federal Reserve’s response to the pandemic in 2020 was to apply the playbook it developed in response to the 2008 financial crisis: (a) expand the balance sheet through bond buying (this Fed page is representative of the period, look at the second and third columns); and (b) increase the money supply. Theoretically, cheap capital would mean that businesses and consumers would have no reason not to invest and spend.

But those businesses and consumers couldn’t invest or spend if they didn’t have the means of investing or spending. Traditional ways of working were analog, requiring people to conduct business in person. Fortunately, the technologies had long existed for commercial activity to continue despite people being unable to leave their homes. The existence of those technologies wasn’t just serendipitous: the fact that productivity tools enabling a remote, geographically distributed labor force to work collaboratively existed at all fits Mr. Kessler’s point that the tech cycle had far greater influence on economic performance during the pandemic than anything the Fed did. While some sectors of the economy did fall off a cliff (e.g., air travel, hospitality), most carried on. And despite the fact that the pandemic has been going on for nearly 21 months now, S&P 500 earnings are very strong. Without the technology the entire economy would have fallen off a cliff no matter how much money the Fed printed.

The pandemic also exposed winners and losers. Not created, exposed. Pre-pandemic, the tide in customer interaction, whether B2C or B2B, was already moving toward digital channels. The companies caught without viable digital channels were losers during the pandemic. The justification for digital channel development during the pandemic - and true right up to today - has less to do with beating the hurdle rate for investing capital, and more to do with simply staying in business. Sure, the decision to invest is easier to make when interest rates are meaningless, but it isn’t interest rates that make the investment in digital channels compelling. Survival makes them compelling.

The concern today - October of 2021 - is whether or not the Fed cycle has finally become inflationary. I write “finally” because Fed policy targets 2% personal consumption expenditure inflation, and PCE inflation has by and large fallen short of that target since 2008. In recent months, inflation has not only topped that 2% target but run a few laps round it. In the traditional Fed cycle, the measured policy response would be to raise interest rates, which will cool economic activity and bring an end to the cycle.

But how will this play out?

Let’s look at the drivers. Inflation, twined with a labor participation rate plumbing depths not seen since the early 1970s, is creating pressure for real wage increases. After decades of losing, labor is having a moment (link to blog). Unionized workforces are on strike. Amazon may have to increase warehouse labor comp.

Historically, the Fed response would be to increase interest rates aggressively to tame inflation. Yet markets are still pricing the Fed funds rate to rise only to about 1.20% by 2026. That might seem a huge jump from the 0.06% the Fed funds rate stands at today, but by historical standards 1.18% is ridiculously cheap capital, not the kind of rate that discourages spending. That means markets expect capital to be cheap (and therefore abundant) for the foreseeable future.

As labor costs rise, companies will look for ways to increase labor productivity so they can reduce labor intensity of operations. Labor productivity comes from increased tech density. Drones, robots, distributed ledger technology, vehicle electrification, and many more technologies will be the drivers of that labor productivity. If capital is cheap, the hurdle rate is low for productivity-enhancing investments. And even if the Fed upped interest rates much higher to tame inflation, corporate balance sheets are awash in cash. A lot of companies simply don’t need to raise capital to finance new investments.

Inflation may persist into 2022, and even beyond. But Mr. Kessler got it right in 2014: it won’t be the Fed that determines how the economy performs in this cycle, it will be tech.

What Can You Do With Less?

In the heady days of the dot-com boom, it became common for investors to challenge would-be entrepreneurs with the question, “what can you do with more?” To the aspirant (and typically struggling) startup, the question was profound, if for no other reason than they were buried in the realities of trying to keep their own narrow universe from imploding on itself.

The question is still asked today, just in different ways. For example, the Wall Street Journal recently profiled the relationship between Masayoshi Son of Softbank and Adam Newmann of WeWork, specifically how Mr. Son prodded Mr. Newmann to pursue ever more ambitious goals in 2018. That ambition culminated in a goal for WeWork to grow revenue from $2b to over $350b in 5 years (making it larger than Apple), a mooted valuation of $10t (making it equal to about 1/3rd the total market valuation of all US equities), and a pitch for $70b in financing. It was certainly more; although, what actually followed was certainly less.

While the question remains the same, the question behind the question is not. A quarter of a century ago, it wasn’t clear what tech companies would succeed, and what success would look like, if in fact any would succeed at all. Spending more in the pursuit of success was a way to have less dependency on serendipitous technology and market phenomenon in the pursuit of what everybody knew was the future. Owning more of the value chain, spending more on marketing and awareness campaigns, signing up more partners, and so forth were ways to project influence over the things out of one company’s direct control. From a finance perspective, this was small beer: the price to try everything and fail wasn’t a whole lot more than the price to try a few things and fail.

Today, if every business must be a digital business, the question of success or even survival is not what is being put to the test. Instead, it is a test of one’s of ambition: if the future of [insert your industry name here] is digital, the question isn’t whether [insert your digital strategy here] has the potential to succeed or not, but whether it will become the dominant digital path in its industry or just an also ran that becomes a footnote in history. You must think bigger than a digital strategy: what are you going to do to impose your vision of the future on the commercial and non-commercial ecosystems relevant to your future? “What could you do with more?”

In rapidly growing markets, there is some wisdom in this. Industry lifecycles are characterized by relatively short periods of rapid growth pursued by hundreds of equity financed competitors that are followed by long periods of slow growth dominated by a handful of oligopolistic market participants sucking cash flow from operations to service debt, finance buybacks and pay dividends. An overwhelming majority of the small competitors that exist during the rapid growth phase won’t survive and the small ones that do won’t matter much. As Larry Ellison pointed out years ago, “The No. 1 software company in every segment makes all the money. We never buy anything where it doesn‟t put us in the No. 1 position or get us in such a strong No. 2 position that we think we can get to No. 1 very quickly.” When a clear market opportunity emerges, the stakes are very high indeed.

Of course, not all tech is about potential for world domination. Sometimes it is about utility. Utilities - think electricity, water, and the like - are taxes on a business. As we saw a couple of months ago, one of the overriding questions that dogs utility tech investments is, “do we have to do it now?” Another is, “what could you do with less?”

This latter question can be responded to as an appeal to value more than to cost. Even within the most mundane of utility tech opportunities are innovations, sometimes small, but innovations nonetheless that are legitimate sources of value. While many (if not most) utility tech investments will never have a comprehensive value proposition, often they can be unpacked so that the utility investment can lead with value realization. Decoupling legacy technologies through APIs and abstraction layers allows for creativity not just in how utility tech is delivered, but how fundamental business problems can be solved. When successful, a utility tech investment can be reframed from a single all-in commitment to a series of investment tranches that deliver both near-term value and long-term utility. When we do this type of analysis, we very often find there is quite a lot that can be done with less.

This draws a great deal of ire, of course. Enterprise IT doesn’t much like requesting a little more funding for the same initiative year after year after year, much less the specter of a long-lived hybrid tech landscape resulting from only partial modernization. Tech vendors prefer large commitments from their customers before they will offer discounts or commit top people. And, this appears to legitimize the lack of confidence that corporate capital allocators have in an IT function’s competency.

But when the relationship between enterprise IT and the rest of the business is characterized by low trust - still all too common to this day - it behooves IT to meet the trust deficit head on. Doing so demonstrates good stewardship of capital and provides transparency into why and how IT spends that capital. It also makes utility tech spend far less self-referential (I still see “we’re moving to the cloud because the cloud is better” as a business case justification) and far more aligned with business goals. And leading with value while asking for tranches of “less” is not an acknowledgement that IT isn’t trustworthy as much as it insists on a high-trust partnership with business and IT on achieving the outcomes. IT doesn’t get a blank check to do tech things, but then neither does the business get anything it might ever want. Both are equal partners in shared outcomes, and partnerships cannot function without trust.

“What can we do with less?” is a good question to ask. Because sometimes, less really is more.

Is There a Business Case for Utility Tech Investments?

Last year I wrote a piece on legacy modernization initiatives. Among the points I made was that legacy modernization is at best a break-even proposition: modernization is simply trading something old for its modern counterpart, getting the same capabilities in return. Of course, there are first order benefits to legacy modernization. Additional or more comprehensive capabilities that come standard with a new COTS product; lower labor intensity and less dependency on costly knowledge workers required to sustain legacy assets; and reducing systemic fragility (e.g., production downtime) are all very real economic benefits that have P&L impact. But by and large, these benefits at best cover the costs for a modernization effort: the new assets will come with a cost to acquire and customize, a cost to migrate, a cost to integrate with other systems, and annual costs to maintain, support and evolve. Software ain’t cheap to buy, implement and live with.

But one thing I did not point out in last year’s blog is that a legacy modernization - even a sweeping one - falls into the category of utility tech not value-generative tech.

A value-generative investment is a roll of the dice that, say, a new market opportunity can be developed or a cost efficiency can be made where none was possible before. There is some uncertainty whether a market opportunity can be converted or a cost efficiency can be realized because of factors outside of anybody’s control: that buyers will see the company as a provider of a new category service it has never offered before, that a problem space is sufficiently consistent enough to allow for systemic improvements, that the technology exists to perform the task in the environments and conditions where it must perform, and so on. A value-generative investment is the pursuit of something that may not have been necessary or possible, and therefore could not have been done before. A value-generative investment is an exercise in deploying risk capital through IT in the pursuit of extraordinary benefit that yields competitive advantage.

This does not describe legacy modernization. Investments in utility capabilities are the pursuit of improvements in the way things are done, because at present they are inadequate by contemporary standards. The risks in a legacy modernization investment are entirely to do with execution of the investment itself, not how well the investment performs post-production. For legacy modernization benefits to be realized, the assets must be built to be reliable and low-maintenance; and customization, conversion and cutover costs must not spiral out of control. The proximate causes for utility investment failure are all within the confines of the execution of the investment itself: that the people doing the work are competent in the domain and technologies; that there is low staff turnover for the duration; that the team is not creating an entire project phase of execution (in the form of unanticipated late-stage integration and testing) to solve problems entirely of its own making; and so forth. True, there are unknowns in the business domain and in the legacy systems, and such uncertainty does create the risk for costs to increase. However, uncertainty of this kind is generally covered by cost contingency in the investment proposal. Even in the extreme cases where legacy assets are completely unmaintainable, legacy system modernization is still the replacement of one known domain of capabilities with another.

The nature of the uncertainty in the investment matters because it changes the nature of the capital allocation question put to an investment committee. For value-generative investments, the investment committee is asked whether it wants to gamble some of the firm’s capital in the uncertain pursuit of extraordinary benefit. By and large, only the investment capital itself is at risk, because an investment committee can terminate an underperforming value-generative investment with little reputational and operational blowback. However, for utility investments, the investment committee is asked whether it wants to tie up corporate capital for an extended period of time to improve the quality of services within the firm. Utility investments tend to be all-in commitments, so the investment committee is also underwriting the risk that additional capital will be necessary and that it will be tied up for a longer period of time to make good on the modernization investment.

Hence these are two very different types of capital allocation. One is to bet some pocket change at a casino table with something less than 100% expectation of a full payoff, and perhaps any payoff at all. The other is to prepay for two years for a health club membership in the anticipation that regularly using the health club will result in lower insurance premiums. In capital terms, the prior is equity, the latter is debt.

The justification for each investment is markedly different. The upside potential - however remote - for a value-generative pursuit will eclipse its cost. The upside potential for a utility pursuit will be break-even at best. Even the most thorough of cost-benefit analyses will not make a utility investment a no-brainer. Look, even a value-generative pursuit that fails yields a good story for the CEO to tell the board, provided it wasn’t an outsized gamble of scarce corporate funds. But many a C-level exec has been fired for cost overruns on utility investments.

A compelling value-generative tech proposal gets the investment committee to ask, “we accept the possibility, how probable is the payoff and how long is the window of opportunity?” Yet even the most compelling utility tech proposal gets the investment committee to ask, “we accept the need to do this, but do we have to do this right now?”

The question that a cost-benefit analysis for a utility tech investment must frame is, “why should we do this right now?” We’ll look at what that analysis consists of in a future post.

The Financialization of Disruptive Technology

It's fashionable to champion an investment-oriented model for software development, particularly around exploratory opportunities. Allocate risk capital, run experiments through software, learn what works and what doesn't work, re-focus, rinse, repeat, reap rewards.

I've been a proponent of companies doing this for a very long time. It twines the notion of devolved decision making with thinking of IT as an investment rather than a cost. Invest in what you know paid off handsomely for Peter Lynch. "Continuously adjust your investment position based on what you learn" seems an apt mantra for today's world. Organize for innovation, re-acquire lost tribal knowledge, challenge - but respect - commercial orthodoxy, and constantly re-apply what you learn to change the rules of engagement in an industry. Every day you're in business is a day you're able to bring the fight, and this is simply the new way of bringing the fight. Better figure it out.

What if this is not a viable strategy?

I've danced around this question for the past 7 or 8 years, challenging the invest-for-disruption premise from a lot of different angles. Among the problems:

1. The labor density of new ideas has risen nearly 3x the rate of inflation. As the FT put it, that implies it is getting harder to find new ideas.
2. Investment yields are highly concentrated. There are a plenty of analyses to show that a small percentage of investments yield the majority of the gains. A recent FT Lex article on biotech investing drives the point home: "A 20-year study found only one-fifth of exits were profitable. Just 4 per cent of investments made half the returns." Picking winners is hard.
3. Regulated industries are unappealingly complex, but those complexities exist to protect consumer and provider alike. Denying, ignoring, or circumventing market sophistication results in bad outcomes for everybody: investors are subject to cycles they thought they were immune to, customers get robbed, and in the end management takes the same path their orthodox predecessors did decades ago.
4. Cheap capital makes it easy for anybody to enter the innovation game. The multitude of companies competing to offer home meal kits and ride-hailing show there are no barriers to entry. Unique ideas aren't unique for very long, and the economics of exploiting them are much shorter lived.
5. Deep pocketed investors make it expensive to stay in the innovation game. The WSJ has pointed out quite a few times that We Company, Uber, Tesla, and many other firms subsidize every customer transaction with investor capital. And as this graphic illustrates, that is an extraordinarily expensive investment proposition.

The whole point of the portfolio model applied to captive technology investing was to avoid taking a long position in any one thing. That created nimbleness at the portfolio level such that capital - and the knowledge workers that capital pays for - could be rapidly redeployed to the best opportunity given our most current information. This took advantage of a unique characteristics of software vis-a-vis its industrial (hardware) predecessors: real-time adaptability. Whether it was the accounting department building tools in Visicalc in 1982 or a team of developers creating the company's first e-commerce site in 1997, the ability to rapidly deploy a new capability in software created an operational differentiator. Manufacturing changes took years. Organizational changes took months. Software changes took minutes.

That meant that software had the potential to be lower-case-i-investing: we knew in the early 1980s and again in the late 1990s that applied adaptable cheap technology could create incremental efficiency gains and therefore advantages. The formula was to exploit the adaptability of software and expedite its application: get new code changes deployed every month, every day, every hour when possible. As an operating phenomenon - that is, as it impacted day-to-day operations - this offered tremendous potential for competitive advantage: land punches left, right and center at an alarming rate and you put all your competitors at a disadvantage.

Yet per the above, software is no longer strictly an operating phenomenon. It's a financial phenomenon. Software is now upper-case-I-investing: all positions are long positions, and the stakes are winner-take-all. The incremental nature of the portfolio model has more to do with trench warfare in World War I than it does with sustainable competitive advantage. These are wars of attrition.

I've chronicled this phenomenon over the years, and over the course of that time have written up simple playbooks for strategic responses: i.e., the incumbent-cum-innovator and late movers. These are appropriate as far as they go, but incomplete once the tech has been fully financialized. If the tech business has been fully financialized, the playbook has to reflect the influence of the finance, not the tech.

The Tortoise Strategy

Three years ago, I wrote that the unstoppable forces of Fintech were running into the immovable force of financial orthodoxy. Specifically, the technology cycle wasn't enough to overcome the credit cycle for peer-to-peer lending firms, which were resorting to selling their loan portfolios to traditional lenders, becoming buyers of last resort themselves when no buyers emerged, and offering deposit insurance for lenders.

Earlier this year, I wrote that incumbents had advantages - specifically, access to greater amounts of patient capital - which they can parlay in a multitude of ways to co-opt a would-be disruptors business: make the disruptor financially dependent by becoming one of their biggest customers buy buying their products (e.g., loan books originated by peer-to-peer lenders), licensing their technology, or investing in their business and getting board seats.

Last month, I wrote that being a late mover can be less financially ruinous than being an early mover. A fast-growth business with low barriers to entry attracts a lot of competitors who burn increasing amounts of capital chasing each other's customers more than new ones. Patience and playing to strengths is a better response than betting the balance sheet in an unfamiliar casino.

This week, the Financial Times ran an interesting article on the trials of peer-to-peer lenders. Finding lenders is hard, and finding borrowers is proving even harder. Incumbent banks have lower costs of capital, which allows them to lend at lower rates. In periods of economic uncertainty or downturn, banks offer safety to cash-holders in the form of insured deposits.

What does the FT article recommend? That the survivors will be those who follow a "tortoise" strategy:

That means working with investors with a low cost of capital [...], and avoiding yield-hungry hedge funds. It means not reaching too hard for high returns, which will become high losses in a recession. It means sticking to niches with good borrowers, who are too hard for big banks to serve. Finally, it means not spending excessively on marketing.

All this, of course, implies slow growth: hence the tortoise. But the hares are set for a very nasty couple of years.

'Tis better to arrive late than not to arrive at all.

Late Mover Advantage

Many years ago, I worked with a company that helped big pharma companies distribute free medical samples to doctors. Having pharma products on-hand is a convenience for doctors and patients alike, mainly because a doctor can initiate immediate treatment for a patient. Having pharma products on-hand is also good for big pharma, as starting somebody on a medication is highly likely to lead to a prescription. So pharma manufacturers were motivated to avail free samples of medicines to doctors.

It's a regulated activity. Doctors can only get medicines appropriate for their practice (e.g., a pediatrician cannot get free samples of Cialis) in limited quantities for specific lengths of time (usually every x number of days). Pharma companies keep track of which doctor got what product on what date. Because doctors exhaust their supply of free product within the allocation time frame, doctors create standing re-order requests. The pharma company decides whether or not to fulfill a doctor's reorder request primarily based on when the last order was fulfilled and the quantity supplied. A pharma manufacturer would not supply more free product to a doctor who had received the maximum volume just a week ago if the reorder window is 21 days.

Because doctors obtain pharma samples from multiple manufacturers, a lot of intermediaries popped up to provide a consolidated service. The value prop of the intermediary was that a doctor need only visit one site to replenish samples from multiple drug manufacturers. Again, because doctors exhaust their supply of free product every few weeks, they were encouraged to set up recurring orders through the intermediary, so a doctor might request multiple products from multiple manufacturers with different replenishment rules. The intermediary made money by charging the pharma company for each free sample request they fulfilled. The pharma company treated it as a marketing expense, effectively treating these intermediaries as a channel partner and paying them a commission. The volume aspect made every doctor acquired very valuable indeed.

The theoretical market numbers were eye-popping. Just one of the big pharma firms measured the total product value they gave away in the form of samples, coupons and vouchers to be nearly $2 billion through all channels of distribution. At the time there were about a dozen or so bulge bracket pharma firms. The free pharma product business was big business indeed.

The company I was working with had a division that was one such intermediary. It was supposed to be a growth business in the portfolio: as mentioned above, pharma samples were a big business and the order volume had plenty of room to grow. But the performance was never all that impressive. When intermediaries made enough mistakes (e.g., process the reorder too early or not at all and doctors don't replenish their sample stock in a timely fashion), and the doctors will sign up with another intermediary. Since the pharma companies were the ones managing the replenishment data (what doctor received what product in what quantity on what date) and enforcing the replenishment rules, and since the pharma companies had no exclusive distribution agreements with any intermediary, a doctor could set up the same reorder profile with a dozen different intermediaries. The first intermediary to process the reorder successfully won the business that day. And, not only were there lots of intermediaries competing for the same business, the pharma companies operated their own direct-to-doctor channels as well - and distributed the bulk of the product that way.

Being a crowded field, intermediaries had no pricing power with the pharma companies. By way of example, at the time the internet travel booking business had a take rate of somewhere between 5 and 10% of the value of the travel services they were selling; intermediaries had a take rate of a tiny fraction of a percent of the value of the product order they were submitting.

In short, there was no customer loyalty, no vendor exclusivity, and no pricing power in this business. There was a market, but no obvious winning strategy. Infrequent site visits meant that user experience wasn't going to provide an edge. Orders duplicated across multiple intermediaries meant that even the smartest algorithms and the fastest technology would provide only a fleeting edge as competitors would quickly catch up. Acquisition wasn't an option as every seller would demand too high a price for little value in the form of assets or cash flow. Industry consolidation would simply formalize the value destruction that had already taken place but not been accounted for.

An intermediary couldn't crush the competition with customer love, innovation, tech firepower, or scale. They were in a state of mutually assured destruction. The only strategy was to hope that your competitors ran out of cash before you did.

Recent analyses in the financial press on the ride sharing, home meal kits and food delivery industries got me thinking about that company again. They compete in crowded fields amid the challenges of low switching costs, low margins, little differentiation, and no customer loyalty. As the Wall Street Journal put it, these companies are now engaged in "a land grab for overlapping customer bases". Every ride from Lyft and Uber is still subsidized by investor capital. There wasn't enough of a market for home meal kits to support the number of firms competing for it.

The Journal makes the point that the would-be disruptors in home meal kits have done more to disrupt one another than they have to established players in retail food, and that's an important point. That these firms are "disrupting" in a different competitive landscape to their technological forebears: building a business at the expense of sleepy competitors in legacy industries (as firms such as Amazon and Expedia benefited from in the 1990s) is much different than trying to do so with evenly-matched competitors.

This casts doubt on the investment case. The long play for all of these companies is winner-take-all: all the chips go to the last player standing. Reuters Breakingviews estimates that the total current market cap of food delivery firms prices in optimistic growth, profitability and value multipliers. Breakingviews goes on to point out that an "... optimistic ending would be one firm knocking out rivals and boosting its pricing power. A more likely one may be that valuations, far from getting hotter and rewarding venture capitalists, grow cold." And what if it isn't a contest worth winning? Groupon won the online coupon competition. It didn't work out too well on a total-return-on-capital basis.

As mentioned above, I've seen this movie before. The Journal article was titled "Mutually Assured Destruction in Silicon Valley." That's apt.

The chattering classes and management consultants advocate for incumbents get into the disruption game themselves. It's certainly good for the pontificators and suits if the incumbents do, because it generates clicks on articles and contracts for services. But doing so asks established firms to enter into very expensive gambles that don't play to any of their strengths, and may offer no payoff whatsoever. Pundits and consultants are very good at spending other people's money - on themselves. Incumbents need to concentrate on their strengths, not their weaknesses.

The incumbent's response to disruption in financial services offers some insights. Clearly, Fintech has had an impact: things like loan origination are far more efficient at banks today than they were just a few years ago. But the disruption storyline in finance is far more muted, in large part because of the way the incumbents responded to it. Incumbent financial services firms didn't try to enter as competitors to the startups, but employed a combination of tactics including infiltration (experienced bankers dominate FinTech boards), co-option (licensing and integrating new technology), and economic might (buying loan books). It should come as no surprise that today, FinTech lenders look more like banks than banks look like FinTech lenders.

Rather than taking a high-risk position well outside of a firm's comfort zone and competencies, patience can be a better strategy. Enter into non-exclusive partnerships and licensing deals and lightly finance the entrants to encourage competition, penetrate their boards to influence their strategy, and alter their book of business to make them economic dependents, all while cleaning up your balance sheet to have more equity and less debt. The incumbent that can do that will have a stronger risk footing when the time is right to strike in changing market dynamics.

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.

The Value Myth

When we think about value, we think in terms of hard measures like increasing revenue or decreasing cost, or soft measures like increasing customer satisfaction or reducing customer friction. This all sounds great, but we know in practice that value is not as concrete as we would like to believe: projections are conjecture, there are multiple forces at work that determine the result we get, and counterfactuals can't be proven to know for fact whether we'd have been better off doing something different or nothing at all given how circumstances played out. Good as it might be that value allows people to relate their actions to hoped-for outcomes, it is naive to think that the outcomes will result from the sum of the actions that we take. Business is far more complex and far more messy.

Saying otherwise is disingenuous, because it gives business a theoretical tidiness that it simply does not possess. Perhaps this is inevitable when non-business people like program managers (coordinator-administrators) and developers (engineer-nerds) traffic in business concepts (finance). Whatever the reason, it isn't helpful if tech wants to be taken seriously by the professionals - particularly the finance professionals - who run the business. Showing a direct line-of-sight from tech or process to business outcome sets up tech to get played and manipulated. Going from tech to business value in one step is a short-cut to being relegated by the board; it is not a path to business relevancy.

In this series of posts, I've taken a different tack, focusing on value and worth as behavioral rather than economic concepts. It stands to reason that if value and worth are in the eye of the beholder, their definitions will be heavily influenced by individual biases. Success of any business initiative comes down to behaviors, so the better we understand those the better we understand the complexity of what value really is in a complex business context.

Value is different things to different people for vastly different reasons. Consider insurance claims. During a storm, high winds blow a tree down and onto a house, collapsing a section of the roof. Insurance adjusters don't care about the aesthetics of different colored roof shingles used in the repair. The adjuster only cares that the roof is repaired and the house won't be taking on ballast the next time it rains. The insurance adjuster is under orders to repair the house with minimum impact to the insurance company's cash flow, and is therefore focused on the utility (which is easy to quantify), not the aesthetics (which are not). That the first thing any prospective buyer will point out is that those green roof shingles clash with the existing gray roof shingles appears nowhere in the adjusters "cost of repair" spreadsheet: whether green or gray or fluorescent pink, those shingles will keep out the rain and the snow and the critters. For the insurance company, the asset they insure was repaired with minimum impact on their cash flow.

The same applies to tech. An engineer infatuated with the tech stack supporting a hopelessly implemented feature set. A user clinging to an interface backed by an impenetrable monolith of code. The CFO who is tone deaf to responsiveness and excessive defects, solely because of the price. Try as we like to frame "business value" as an absolute, in practice it is a relative concept, interpreted and reconciled to the motivations and desires of each individual in the value chain. What gets measured is what gets managed, so "business value" becomes the means through which individual value is realized: we need this over-hyped cutting-edge tech stack because it will help us deliver it faster; how conveniently coincident that experience with that over-hyped cutting-edge technology flatters the resumes of the people working on it.

This creates cascading re-interpretations and re-assertions that smother value, ironically justified by the pursuit of value. A firm I audited years ago had, some months prior, formed a cross-functional committee of tech, business and finance to choose a mobile development toolkit. Business believed it needed a mobile solution, tech aspired to create one, but the board didn't share in the enthusiasm. In the end, finance won out, choosing the tool that cost the least but that tech found unstable and yielded software solutions the business didn't much care for. The tool was never used. Instead, developers rolled their own frameworks and infrastructure, below the radar of the CFO and with a wink-and-a-nod agreement with their business partner that they would do so. The purchased framework had negative value to its intended constituents, to a point that tech believed there was more value (and with the complicity of business in the decision, to the business as well) in creating proprietary development infrastructure. Whether spending twice for infrastructure was tech rescuing the "value" jeopardized by a crap product, or tech being intransigent and subversive to the board's agenda, all depends on your definition of value under the circumstances.

We don't win the triple crown of value all that often. Marketing doesn't appreciate losing the pricey boutique firm they could talk to each and every day, but tech looks like stars to the CFO for sending the work to a cheap offshore supplier. The CIO doesn't like being held hostage by employees who used an obscure tech stack in the name of getting something done "faster", only to be making it debilitatingly expensive as they exit the firm and go into private practice. Eliyahu Goldratt pointed out the tradeoff of local optimization for systemic optimization a long, long time ago. Local optimization infiltrates every value calculation, in temporal ways that defy models of value.

We want to believe that "value" is an absolute measure of something that improves the condition of the enterprise: In unitate es virtus. But we know that people have different interpretations and goals that materially impact the business outcome, so value is a weighted sum of disparate, unexposed agendas. The larger the enterprise, the more complex the calculus.

Value is money, and where there is money, there is politics. With that in mind, value is perhaps best understood as something Mike Royko taught us about the fundamentals of politics many years ago: Ubi est mea?

"Where's mine?"

Questions of Value

In March, we looked at questions of worth. This month, we look at "questions of value".

In the dictionary, value is defined by worth, and worth is defined by value. Why ask the question twice? Because even if they refer to the same thing, the words mean different things in different circumstances. In economic terms, "worth" refers to stored value, such as accumulated financial reserves (one's "net worth") or the price we're willing to pay to replace something we already own. We use the word "value" in reference to economic (or other) power unleashed by something that we have or do. An object has sentimental "value" to which we ascribe an inexplicably high economic "worth". An investment in a truck yields economic "value" on the income statement well above the worth we ascribe to it on the balance sheet, because without it we couldn't achieve delivery efficiencies.

Value traffics in moving, worth in storage.

Value is what we're willing to pay for something in exchange for the returns that it provides. We value cars for reasons ranging from their resale value to the status we think they project to the friends and strangers who see us driving it. We value houses for the school districts we can put our kids in, the relative price of houses nearby, their convenience to how we live and make our living, and the status that living in that post code conveys.

In software, we want to make decisions about where we invest based on value. But because we can't predict the future, value is conjecture. This forces us to ask: what defines value? And who defines value?

Value, like love, is a many splendored thing. There is value derived from features, there is value derived from construction, and there is value amplified from not spending too much. An asset that does many things, is low maintenance, and costs little will be higher yield than one that does few things, is high maintenance, and costs dearly. The problem of defining value is the problem of projection because there are no absolutes in those projections.

This creates a bit of a problem, because value is a future-tense term, and we can't know with much certainty what the most important characteristics are to realizing that value. This becomes a big problem when we want to "buy for value". Worth is bankable, if vulnerable to erosion; value is in the eye of the beholder and may never materialize.

Consider a house. Buyers define all kinds of evaluation criteria, things like proximity to public transportation, newer appliances, and rooms and layout that accommodates their possession and lifestyle. But a house is a building and its utility is a function of its construction as much as its design. Since most home buyers aren't carpenters or plumbers or electricians, they're not able to judge quality of the build. They rely on the opinions of experts. Hence we have inspectors, who are licensed in most states and built into residential contract law to provide their expert opinion on the house.

Selection criteria and expert opinions only go so far, though. A homeowner doesn't really know if a house is what they want until they've lived in it for a while, and besides, some of their criteria will be contradictory and some of their priorities will be out of order. Inspectors have limited expertise with building codes, practices and materials, and they're only spending a couple of hours looking over the carpentry, masonry, electrical, plumbing and mechanical of an entire building that took hundreds of person days to build. For all the sweating and scrutiny, at best our opinions tell us that we shouldn't buy something; they don't necessarily tell us specifically why we should. All house purchases are compromises, and in the end, the purchase is made for substantially - perhaps even largely - emotional reasons, and complex ones at that.

This applies to all kinds of purchases where "value" is a factor. Like cars: we develop criteria (seats, storage, zero-to-sixty speed), poll experts (trade press like Consumer Reports and Car & Driver), but still make a decision that is partially - even largely - informed by emotions. Look, it's got four doors, space for the kids & clubs, it's fuel efficient, and will you just look at those shouty rims?

Questions of value become even more conflicted when multiple stakeholders have different ways in calculating value, and ambiguous authority in setting it. We'll take a closer look at that next month.

Questions of Worth

Price is the critical determining factor in purchasing decisions. If I want a new case for my tablet, and I know the case that I want, it's worth a considerable amount of my time to find the lowest price on offer for that case. A penny saved and all that.

Utility purchases are driven by price sensitivity. If I can't really say one product is a premium offering to another, I'll go cheap at the sales. I need calories after I run, a breakfast bar will do, I don't need a designer breakfast bar.

While I was writing chapter 3 of my book, Activist Investing in Strategic Software, I spent time researching the rise of centralized procurement departments in the 1990s. De-centralization in the 1980s created inefficiencies in cost management: it wasn't uncommon to find that one division was paying far more than another division for an identically skilled position supplied by the same vendor. Centralized purchasing found efficiencies by standardizing roles and position specifications and granting preferred partner status to contract labor firms. In theory, standardized buying lifted the burden of negotiation from individual department managers and found cost efficiencies for the company. Buyers could more atomically define what they were buying, sellers swapped margin for volume.

And tech labor became a utility.

Procurement's ascendance didn't create industrial IT (there were already willing buyers and sellers of narrow skill-sets), but it certainly threw copious amounts of fertilizer on it. Within a few years, we saw significant expansion of contract labor firms (or "services", or "consulting", whichever you prefer): firms like Accenture and Infosys grew rapidly, while firms like IBM ditched hardware for services. Buying became an exercise in sourcing for the lowest unit cost any vendor was willing to supply for a particular skill-set. Selling became a race to the bottom in pricing. In this way, tech labor was cast as a utility, like the indistinguishible breakfast bar mentioned above.

In captive IT, the notion of a "knowledge worker" that came to prominence in the 1980s was stampeded by the late 1990s. Knowledge workers are a company's primary labor force, but through the miracle of standardization, tech people became collections of skills, and subsequently interchangeable go-bots. By extension, tech became a secondary labor force to clients. Labor extracted rents from the client for which it toiled, but labor had no equity in the outcomes that it achieved. Tech labor was wage work. It might be high-priced wage work, but it's wage work none-the-less.

With all cash and no equity, employees now had clear rules of the game, too. Certifications became the path to higher salaries. It didn't matter whether you were competent, Sun certified you as a Java developer, Scrum Alliance a Scrum Master, PMI a Project Manager, any employer a Six Sigma blackbelt. In exchange for minor rent extraction by agencies exploiting an industrialized labor market, buyers received 3rd-party reinforcement of their contract labor model.

With all the ink being spilled on subjects that managers of enterprises like to traffic in - things like Agile delivery, product organizations, platforms, disruptive technologies, and the idea economy (obviously, some more meaningful than others) - it's difficult to understand how companies still choose to source labor like it's 1997. The people I need to build long-lived products on my-business-as-a-platform-as-a-service using emerging technologies don't fit any definition of standard procurement. These aren't left-brain skills, they're right-brain capabilities. If you buy the cheapest knob-twisters that money can buy, how could you possibly have any expectation for creative thought and innovative output?

At the same time, it isn't that surprising. Procurement sources all kinds of contract labor, from executive assistants to accountants to recruiters. Yes, technologies like Office, SAP and LinkedIn are fantastic, but they're not exactly the equivalent of serverless in tech. If the bulk of the labor you source is check-the-box, why would you expect - or more to the point, how could you be expected to comprehend - that tech is unique? Accounting is, well, accounting after all. It's not a hotbed of innovation. In fact, it's usually bad news when it is a hotbed of innovation. "Innovation" in tech is - particularly for non-tech manager / administrators - just a buzzword.

In enterprises with dominant procurement functions, "worth" is a function of "cost", not "outcome". If we rent labor on the basis of how much a unit of effort denominated in time will cost, the "worth" of a development capability is the sum of the labor times its unit cost. We therefore value scale because we assume productivity is an implied constant. If we don't understand sausage-making, we simply assume that more gears in the sausage-making machine will yield more sausage. We fail to appreciate the amount of energy necessary to drive those gears, the friction among them, and the distance those gears create between hoofed animal and grill-ready skinned product.

Thus we end up with a payroll of hundreds doing the work of dozens.

Our economic definition of "worth" precludes us from understanding what's going on. We have the labor, so it must be some sort of operational deficiency. We look to process and organization, coaches and rules. All of which is looking in the wrong place. We're not a few coaches and a little bit of process removed from salvation. We staffed poorly, plain and simple.

What a development capability is "worth" has to be correlated to the value it yields, not metered effort or even productive output. Something isn't "worth" what we're willing to pay for it, but what its replacement value is to provide the same degree of satisfaction. If we're getting the output of dozens, we're willing to pay for dozens. The capability of high-yield dozens will be more dear on a unit cost basis. But clear accounting of systemic results will favor the cost of polyskilled dozens over locally optimized low-capability monoskilled masses.

This is the economics of "worth".

Ecosystems and the Energy Source of Last Resort

It's fashionable for a company to proclaim itself an ecosystem. A mobile phone company makes handsets for users and curates an app market place for developers. The virtuous cycle of an ever increasing collection of apps motivating an ever increasing population of consumers. They have the benefit of steady cash flows from existing customers and constant growth from new ones attracted by an increasingly complex array of products. There are a number of self-proclaimed commercial ecosystems, ranging from online lending to conglomerates of retail, credit and loyalty.

Markets are kind of like ecosystems in the way participants reinforce one another. Buyers and sellers come together in sufficient numbers to perpetuate a market. As more buyers emerge, more sellers offer their wares in the market, which attracts still more buyers. An increase in the number of buyers triggers more complex and diverse products, making the ecosystem more interesting, if not more robust. To wit: demand for tomatoes triggers cultivation of different varieties, some of which are resistant to disease or insects that others are not, increasing the resiliency of the lycopene trade.

Ecosystems aren't inherently complex: a simple terrarium consisting of a lamp, dirt, water and seeds will yield plants. Commercial ecosystems aren't complex, either. We can stand up marketplaces for mobile phone software or money lending or property investing. In doing so, we hope to encourage people to risk their labor by writing software they hope people will buy, or their capital they hope will find a worthy investment. With the right marketing and promotion (i.e., fertilizer) we might attract ever more buyers and ever more sellers, creating a growing and ever-increasing community.

One thing an ecosystem needs to survive is a constant supply of energy. The sun provides an uninterrupted supply of energy to the Earth. It can be consumed immediately (e.g., through photosynthesis). It can also be stored: liquefied dinosaurs are effectively stored energy that originated with the sun. Energy from the sun can be concentrated in many other forms, and accessible to parts of the planet when they're directly exposed to it. This allows formation of more complex life and lifestyles. Some spot on the Earth may suffer drought or fire or some other disaster that wipes out the basic plant life that supports more complex life forms, but the constant energy from el sol means that a devastated area has a source of energy it can draw on to re-develop.

In commercial ecosystems, capital is energy. Markets are highly vulnerable to periodic contractions of liquidity. Both asset classes and tech products fall out of favor, destroying the fortunes of sellers quickly (bank equity values in 2008) or slowly (Blackberry software developers from 2008 onward). Turn off the lamp and the terrarium becomes barren.

Markets require a constant supply of capital in the same way that ecosystems needs a constant supply of energy to survive volatility and seizures. In financial markets, there are market makers who guarantee a counterparty to every trade and buyers of last resort who provide liquidity in the event of a sudden seizure of market activity. It's the latter - the Federal Reserve and the European Central Bank buying sovereign and commercial paper as well as lending to banks with the expectation that they will do the same - who act as the constant supply of energy that keeps commercial ecosystems functioning. Markets will surge and markets will plunge, but it is the "energy source of last resort" that sees markets through the peaks and troughs.

Economic cycles - credit or tech - aren't new phenomenon. When they turn, they expose the fragility of the businesses at their mercy. Late last year, lending marketplaces found themselves with plenty of loans they could write but fewer willing to buy them. The solution they turned to was to introduce a buyer of last resort, initially in the form of banks and eventually in the form of investment vehicles they created themselves.

Any self-proclaimed ecosystem without a backstop buyer - that is, without a constant and reliable source of energy - will be at the mercy of commercial cycles. Mr. Market will not hesitate to turn off the terrarium lamp when the cycle tells him to do so. Once off, he is not so willing to turn it on again. But he might not reach for the switch for the first place - and might very well be first to harvest green shoots after a devastation - as long as there is an energy source of last resort.