Monday, January 19, 2009

Are Blasts from the Past Afoot?

Hyperbole to the contrary notwithstanding, the terrorist attacks on 9/11 did not change everything. Likewise, the Panic of 2008 will not change the fundamental facts of business. It may, however, dramatically change its face. In a topsy-turvy post-panic world your company’s biggest competitor might be a nimble newbie or a lucky small fry in just the right place at just the right time. The successful manager will know, as the Chinese do, that crisis spells opportunity as well as peril.

Some industries, like publishing, may be completely transformed in the next few years. Long on the ropes, newspapers and book publishers face dramatically declining revenues and a slew of new competitors, from bloggers to web videographers, free of traditional publishers’ costly overhead and antiquated distribution systems. Even college textbooks, long among the fattest of cash cows, may come under pressure from radical new business models like that of Flat World Knowledge, which claims it can make an adequate profit by giving textbooks away for free, online, without relying on advertising. Other long sagging and lagging industries, including construction, healthcare, higher education, and real estate, are also ripe for change.

The demise of the big investment banks has the potential to upend corporate finance, returning it to its roots. Startups may stay private longer and then go public via a direct public offering (or “OpenIPO”) facilitated by WR Hambrecht and Company instead of a traditional initial public offering underwritten by a bulge bracket investment bank. Direct public offerings were the norm in the United States before the Civil War and could become so again. Unlike intermediated IPOs where investment bankers set the selling price, modern DPOs use an auction process to discover the price at which all the offered shares will be purchased. The issuer is therefore never stuck holding unwanted shares and first day “pops” in the aftermarket are almost unheard of. DPOs are also considerably cheaper for issuers than IPOs.

Bond issuance and merger finance may also undergo major changes. Private placements have been an important part of corporate finance since the securities regulations of the Great Depression. In coming years they may become even more important because they will be easier for the remaining investment banks, small niche players called boutiques, to arrange than full blown public offerings. Boutiques will continue to offer M&A advice, but corporate law and accounting firms and commercial banks will certainly enter the vacuum created by the exit of the major investment banks.

For bank credit, smaller businesses may find it easier to turn to their local community banks or smaller regionals than to wait for the big boys’ balance sheets to improve. Community banks were largely untouched by the subprime mortgage mess and stand ready to lend to solid local businesses. Also, trade credit will probably make a comeback as businesses sitting on stashes of cash or with access to relatively cheap sources of external finance find it prudent to keep key suppliers or distributors afloat. As in the nineteenth century, credit may again cascade through the channels of trade, from the biggest, best, and oldest companies through their most important customers, clients, and suppliers to the small, weak, and new.

Insuring businesses against risks may also change in the next few years. Insurance companies did not take a direct hit from the subprime debacle – AIG failed due to risks taken at the holding company level, not because of losses at its operating companies. Nevertheless, the panic of 2008 clearly stressed many insurers already facing competition from new alternative risk transfer mechanisms (ARTM), including catastrophe and death bonds. Investors see much value in such bonds because they offer good returns that are not correlated with other financial markets, a clear virtue when almost everything else is down, as at present.

Adam Smith, Profitability, and Efficiency

“It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own self interest,” Adam Smith wrote in The Wealth of Nations. “We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.” True enough. The self-interest of profit maximization does keep us fed, clothed, sheltered, entertained, and much more besides. But profitability and economic efficiency are not always the same thing, and it is the latter that ultimately aids society. Profits, after all, can stem from sources other than efficiency, like rent seeking or market power, that are social bads.

For the last three decades or so, the general consensus was that markets could do no wrong and governments no right. Increasing numbers of people now realize, however, that some government agencies are economically efficient and some private businesses are not, though they may have been profitable for awhile. What matters, we are coming to realize, is not who owns or runs an organization but rather the structure of the market it operates in (competitive or monopoly at the extremes) and the degree to which internal incentive structures are aligned with the organization’s goals, as in the two by two matrix below.

Stereotypically, businesses inhabit the upper left quadrant, where competition and a high degree of internal incentive alignment ensure efficiency, while government agencies dwell in the lower right quadrant, the inefficient victims of monopoly and incentive misalignments. Some government agencies (and non-profits too), however, compete with other governments and/or private sector firms and have decent internal incentives. Think, for example, of the post office. Stockholder owned investment banks, by contrast, operated in markets that were less than fully competitive and had flawed internal incentives. Due to their market power and incentives they were profitable for a decade or so but ultimately their inefficiencies caught up with them, leaving society with the bill.

In the coming months and years, the government is likely to try to extend its purview, to regulate more aspects of the economy more thoroughly than hitherto. It may also try its hand at mortgage banking (via the remnants of Fannie and Freddie), commercial banking (via the Federal Reserve’s new lending powers), and maybe even automobile production. (If that sounds far-fetched, few before 1970 would have believed that the federal government would operate an extensive passenger railroad system for over three decades.) Rather than outright opposing such endeavors, American businesses would do well to use their expertise to try to move them as close to the upper left quadrant as possible. They would do well to try to move their own businesses in that direction as well, to fight their natural proclivity to create short-sighted incentive schemes and to strive for more market power. What ultimately matters for the economy is not jobs or profits but creating more output from the same input.

Partnering with Regulators

Traditionally, American businesspeople considered regulators a foe to be avoided, co-opted, or, if possible, vanquished. That’s the wrong attitude, especially in the current environment. As Lord Melbourne (William Lamb, 1779-1848) once said, “Those who resist improvements as innovations will soon have to accept innovations that are not improvements.”

Regulators, good ones anyway, curb business’s worst excesses. Where business seeks market power, regulators strive for competition. Where business yearns for high returns, regulators desire systemic safety. Rather than butt heads time again, regulators and the regulated ought to sit down as partners and figure out how both sides can achieve their goals.

Possibilities abound but compensation reform holds supreme promise. From the corner office to the mailroom, people usually do precisely what they are incentivized to do. Tell a pastry chef he can eat his mistakes and you’ll soon have a fat guy in the bakery. Pay workers by the hour and you will have to supervise them much more closely than if you pay them by the piece. Give a CEO stock options and the stock will rise, hopefully due to increased efficiency but quite possibly because of accounting shenanigans.

Companies that get the compensation question right thrive. Consider Guardian Life Insurance Company of America (GLICA), a successful mid-sized mutual life insurer in an industry now dominated by joint stock giants. Although owned by its policyholders, GLICA did not become a stodgy mutual dinosaur because its general agents, firms that sold mostly Guardian products, played the same role that large blockholders play in the governance of stock corporations and basically browbeat Guardian’s management into remaining competitive. GLICA’s managers also devised a long-term incentive program for themselves, which pays off handsomely upon retirement, thus closely aligning their interests with those of their policyholders.

Conversely, business history is littered with the corpses of companies that got the compensation question wrong. Bear Stearns, Merrill Lynch, Lehman Brothers and the other investment banks that stumbled during the financial crisis of 2007-8 are the most recent major examples. Traditionally, investment banks were partnerships. With their all at stake, the partners took small risks while building equity for the long haul. After the investment banks went public, however, managerial incentives changed dramatically. The game then became to earn big returns and gigantic annual bonuses by taking huge risks, stockholders and other long term stakeholders be damned.

It should be an invariable rule of business never to pay anyone until the ultimate consequences of their contribution is clear, when economic profits are actually accrued rather than mere accounting profits booked. Paying mortgage originators full commissions at closing has failed seven straight times in U.S. history. Instead, originators should be paid over a period of five or seven years, and only for mortgages that are not in default. (Analogously, life insurance agents receive their commissions over years to incentivize them to sign up good risks.) Similarly, managers should be incentivized to attain, and then maintain, their stock price target, not merely to puff up the stock for a fleeting moment.

Businesspeople generally concede these points but counter that competitive markets for talent preclude them from deferring much compensation for long. The best people, they claim, would flee to competitors willing to pay up sooner. Here is where a strong partnership with a good regulator can work wonders. Businesses should sit down with their regulators and come up with incentive compatible compensation structure guidelines for every major job category in their respective industries. The regulators should then enforce those guidelines so no company can complain about being at a competitive disadvantage. Where appropriate, the regulators should seek international cooperation. Most importantly, they need to watch out for attempts to find loopholes and changing industry conditions. To ensure that they remain attentive, regulators ought to think long and hard about their own incentive structures.