Financial Engineering Run Amok: Macro Hedging Your Career?

Remember where I came from, people: I used to run financial engineering teams. So it may seem a bit weird that I am throwing stones at an approach that purports to offer risk management benefits for the layperson - namely, the use of oil hedging strategies to manage your life/work financial exposures. This strategy is put forth by none other than Mr. Irrational Exuberance himself, Robert J. Shiller, in a recent article in Forbes (June 4th issue). Given digital rights issues (!) I am not able to provide a link but I'll attempt to accurately reflect the big picture here. Before diving in, I am proud to note that Robert and I share an undergraduate alma mater - the University of Michigan. I'm not sure if Robert's love for risk management was seeded at U of M or not - I can tell you that mine most assuredly was not. Other seeds were planted - but that is a post for another time...

Shiller's basic hypothesis is straight out of Finance 101 - if you are going to be consuming something (like oil), and you are subject to its price fluctuations over time (in oil prices), you'd benefit from having some of this in your portfolio (through some financial instrument). Further, some people might be at greater risk to price increases and price volatility of the item in question (like the impact of oil prices on those who work in or around the auto industry and its environs), and should consider having an even greater exposure to this thing in your portfolio. And in the article Robert reviews a variety of different ways of hedging oil price exposure, providing the pros and cons of each. All in all, an interesting academic review. And I'd expect nothing less from a man of Shiller's background and intellect.

On paper, it is hard for me to argue with Robert's theory. It is factually correct on its face. The problem with his approach, however, is that it doesn't take into account the most powerful and insidious of risks - irrational human behavior. This is something that I've written about a lot and witnessed on more than a few occasions. Like individuals buying single stocks because they are so smart and the market is so dumb. Like gamblers making larger bets as they are losing as opposed to shrinking bet size as their assets drop. And these are just two examples of what extensive academic literature has shown is, unfortunately, human behavior. When it comes to economic decisions, we frequently do absolutely stupid things. We just do. And we can't help it. So when Mr. Shiller proposes what is, in effect, an elegantly straight-forward risk management strategy for laypeople I shudder. BECAUSE I KNOW FOR A FACT THAT PEOPLE, IN GENERAL, WON'T BE ABLE TO IMPLEMENT SUCH A STRATEGY IN A LONG-TERM, RATIONAL MANNER. And this doesn't take into account the inevitable basis risk that will occur between oil prices - the hedged asset - and people's wealth. Unless hedging is brutally simple and startlingly straight-forward (like swapping a fixed-rate bond into floating for its term), basis risk and peverse motives (like the desire to unwind a "winning trade" - all of a sudden the risk management rationale goes right out the window) take over. I've seen it with retail investors. I've seen it with ultra high-net worth individuals. I've seen it with Fortune 50 corporations. I've seen it everywhere.

So, bottom line: I believe Mr. Shiller's heart is in the right place. I just think he is somewhat detached from the human condition, something about which he really should know. But my advice to those non-professionals considering his recommendations: think long and hard before jumping in. Because doing the right thing over long periods of time - even if it makes sense at the outset - is awfully hard. In fact, almost impossible.

EA: Backing the Leaders, Feeling the Pain

Catching up on my feeds this weekend saw me stumble over a story that brought back some memories: from the San Jose Mercury News, "EA's fumble: Game maker may have misjudged popularity of Nintendo Wii." This story is, in essence, at least six months old. Even this blogger penned a post over six months ago titled "EA: Why Didn't Wii Focus on Nintendo?" The interesting thing is that I was going out on a limb back in November when I was calling EA to the mat, back when it's stock price was $58 and it was trading at 43x earnings. Fast-forward to today: the stock is trading at $48, having dropped 17% from my original post. One of the principal reasons: stagnant revenue growth, skyrocketing development costs. Why? Having to ramp up development for yet another platform, but one that will be absolutely vital to its growth prospects in the near and medium-term: the Wii.

So this is what the Mercury News had to say about EA today:

Some analysts and investors are beginning to question this upbeat outlook. The biggest problem: the surprising early dominance of Nintendo's Wii in the latest round of the console wars. It's no coincidence, they say, that EA emerged as the top game maker at a time when Sony's PlayStations dominated the game console market. The threat that  the Wii now poses to Sony's dominance is bound to affect EA as well, they say.

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EA officials blame the company's recent problems on the complexity of the transition. Not only has the company been developing games for about 11 different platforms during the transition, but there also are multiple emerging opportunities in the industry, from the growing market for games in Asia to in-game advertising to games for mobile phones, said company spokesman Jeff Brown.

While EA was late to recognize the potential of the Wii and Nintendo's DS handheld, it's been ramping up its development efforts for both, Brown said. Meanwhile, the company has also been investing in many of those new areas of the game business, he said.

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In some ways, EA's troubles aren't unexpected. The transition to new generations of game hardware usually are troublesome for software vendors. That's because they typically invest in developing games for the new consoles long before sales of the machines take off.

But this time, analysts and game makers expected an easier time. Companies such as EA promised to continue to develop games for outgoing platforms longer than they had in the previous industry cycle. Sales from those games as well as for two new handheld systems, Nintendo's DS and Sony's PlayStation Portable, were supposed to help bridge the gap during the shift from older to newer generations of game consoles.

But things didn't work out as expected. Sony's PSP saw limited demand. Although games for Sony's older PlayStation 2 continued to sell, development costs for the new consoles skyrocketed, eating into company profits. And when the new consoles arrived, fewer than expected made their way into consumers' hands because of supply problems, demand problems or both.

For the industry, the result has been a longer than expected transition. For EA, it's meant that sales have grown at an annualized rate of just 1.5 percent over the last three years, its research and development costs have more than doubled during that time period, and its profit has fallen by more than half.

Now compare this to what I had written on November 21, 2006. DId these risks of backing the legacy leaders ever come home to roost, or what?!

However, when a platform technology shift happens (roughly every five years), game developers encounter a rough patch and need to increase diversification by making fewer titles across more platforms. They then wait for the fall-out and watch for the winners to emerge, after which point they revert back to the original operating model. While this is a business that has the capacity to mint cash, it also has the capacity to result in a lot of dry wells. Clearly not a business for the meek.

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So if EA continues its emphasis on Sony it is clearly exposed to the degree of adoption (and supply) of new PS3 consoles. If PS3 flops then what? EA will need to identify and milk another future cash cow. They could look to Microsoft’s Xbox 360, with a current installed base approaching 10 million by Dec 31. Not exactly the 100 million installed user base of PS2, but not too shabby nonetheless. However, if the situation evolves such that the Nintendo Wii becomes the rising star, EA may be in trouble. FYI, the French company Ubisoft has lined up nine titles for Nintendo including that exculsive to the Wii: Red Steel.

Ninendo has forecasted up to 4 million units shipped worldwide and with sharply lower development costs than Xbox and PS3: $5-$8 million per title for the Wii vs. the $15-$20 million for Xbox 360/PS3 platforms. This makes the Wii far more attractive (and less risky) for both developers and publishers. If EA sticks to their PS3/Xbox 360 strategy, they may miss the boat on Nintendo, spending too much in development costs while missing what looks to be a home run console in the Wii. This could dent the next several quarters of EA’s earnings, painting a pretty ugly picture for the stock price going forward.

Ok, ok, so I called this one (or, rather, the internet did). But what about Ubisoft, that company that was well ahead of the pack in putting its chips in with Nintendo and the Wii? They just reported blow-out earnings today. Among the big winners in their current product portfolio? Red Steel, exclusively for the Wii, as mentioned in my post above. As I have noted before, game development is akin to trading, where bet distribution and bet sizing are key to winning. And in the case of EA, while they are working dutifully at playing catch-up, they find themselves deep, deep in the hole with a declining pile of chips in front of them. EA has won before and I am sure they'll win again, but theirs is a tough row to hoe. And it takes time. A. Long. Time.

 

Hedge Fund Asset Pricing Revisited: First; Communicate the Process. Then; Follow the Process. It's That Easy.

People who know me know that I am way into process and control. Define the process. Test the process. Refine the process. Document the process. Communicate the process. Follow the process with rigor and collect data along the way to ensure that the process continues to be both accurate and stable. This is the way it's done. Sounds easy, right? Easier said than done in practice (though why, I'm not too sure). Today's Financial Times carried an article on one of my favorite subjects - valuation of complex hedge fund assets - which is really all about creating an effective, clearly communicated process and adhering to it with religious fervor. While reading the article I had this familiar feeling of deja vu. Where have I read about this illiquid asset valuation stuff before? Hmmm. Oh, that's right. My blog, that's where!

This is not a new issue by any stretch, but FT piece does provide a helpful reminder of how important this topic has become given the proliferation of complicated, over-the-counter derivatives such as CDOs, CDSs, TRSs, and other three-letter acronyms. It is only with clear and effective processes and policies that the continued, healthy institutionalization of the hedge fund business can continue apace. Otherwise, issues of trust and transparency will rear their ugly heads and the inevitable blow-ups will occur, ruining what represents a historic opportunity for the hedge fund industry to grow in a prudent, risk-controlled manner and to take its rightful place in the architecture of institutional portfolios as a core asset class. From the FT:

The valuation of hedge fund assets has risen from nowhere to become a hot-button issue. How to value illiquid instruments is occupying minds inside and outside the industry. On the inside, the Alternative Investment Management Association in March published its Guide to Sound Practices for Hedge Fund Valuation. This followed the International Organisation of Securities Commissions releasing its Principles for the Valuation of Hedge Fund Portfolios. The issue was even on the agenda of a meeting in April of the G7 advanced industrial nations where representatives of leading hedge funds met deputy finance ministers.

This sudden focus is recognition that valuation of the increasingly complex assets used by hedge funds is a big issue for investors. Incorrect valuations can mean investors pay too much for units in a fund, lose out when they sell, or pay too much to managers in performance fees.

Pricing and valuation is only a minor issue in equity long-short funds, where standard mark-to-market techniques are sufficient. But there has been a proliferation of sophisticated strategies in recent years that have required advanced valuation techniques. These techniques are required primarily for over-the-counter derivatives, which are illiquid and therefore not easily priced. Instruments include collateralised debt obligations, credit default swaps, total return swaps and mortgage derivatives, all of which have grown enormously in popularity.

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Complex and illiquid issues are typically hand-priced, involving an evaluator calling the desk of a broker-dealer that makes a market in the security (ideally the primary dealer). Mortgage-related products are often priced using models with analytical data and dealer quotes as inputs. Vendors will often incorporate actual trade data into the models and adjust the model prices in line with any visible trades in the market. This process is clearly far from straightforward.

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Meanwhile, an Iosco committee including US, UK, French, German, Hong Kong and Spanish regulators, as well as hedge funds and investors, proposed nine principles of valuation. The main suggestions were that hedge funds should draw up policies for valuing investments, ensure they are used properly and applied as independently as possible. Valuation methods should also be made clear to investors.

While there are no precise answers to the questions of complex derivative pricing, there can be a precise, clearly communicated process that is followed for valuing such instruments. And this is what will set hedge fund managers free. It is hard to get angry - much less get litigious - if someone tells you the process they are going to follow for handling a complicated problem that is carefully adhered to and logical on its face. No funny business. No single-data point valuation on which NAV and, therefore, compensation is based. Engage several dealers, maybe even rotate among a larger number to ensure fairness and independence, toss out the high and low, document all responses, repeat. To get a sense of how important I believe this issue to be, here are some thoughts I had written last July when discussing how poor illiquid asset valuation can skew NAV and cause a big, big problem for the industry:

But this issue - getting paid on NAV when NAV itself is highly questionable - is a real problem. It looks bad. Real bad. The implications extend beyond compensation. For instance, if you can't arrive at a fair value for an asset, a "thumb in the air" method is used like book value minus an illiquidity haircut. This approach dear friends, is not very scientific and is extremely prone to error. Beyond error, once an approach is used for a particular asset that approach tends to be used again and again and again. This has two potentially adverse effects upon disclosure and compensation: (1) compensation may be overstated because NAV might be much lower that the level reflected in the NAV calculation; and (2) volatility of returns will be understated since this asset, whose value invariably is moving up and down but whose value is difficult to measure, is being valued in the same way quarter after quarter after quarter. This is called autocorrelation. This skews the analysis of fund returns and makes a fair comparision across different firms and different strategies nearly impossible. Does any of this sound good?

And if the industry doesn't take steps to address this issue, my sense is that the issue will be dealt with for them by constituencies they'd rather not deal with (read: the SEC or Congress). It is just too big a problem to be ignored, and the problem is growing every day as more funds pile into less liquid assets for the reasons mentioned above. One way to possibly deal with this is to create a fund with two share classes - one which tracks the liquid assets (and therefore has a calculable NAV) and another which captures the illiquid assets (which does not have a readily calculable NAV). The liquid asset class could attract performance compensation in the same way hedge funds are paid today, which is generally quarterly. The illiquid asset class, however, could be treated much the way private equity compensation is handled today, based upon realization of the value of the illiquid investments. A manager could then report two NAVs, one for each share class. This would seem to restore the original intention of hedge fund compensation model, while providing for a better matching of performance generation and performance payment. This would also be a great PR move for the industry, proactively dealing with an issue before it becomes a PR nightmare.

For those who care, here are some posts I had written previously that also discuss the illiquid asset valuation issue:

• 07/21/2006: Broadening the Multi-Strategy Mandate - Where do Hedge Funds end and Private Equity Firms begin?
• 08/04/2006: Side Pockets - Use or Abuse
• 12/26/2006: Hedge Fund Convergence: Strategy Versus Structure
• 04/30/2007: DE Shaw and Convergence: Putting the Issues on the Table

Sometimes getting the right answer is easy. And notwithstanding the complexity of the instruments at hand, the right answer to the valuation question is simple: clearly communicate and follow the process. End of story.

 

Wallstrip: The Magic is in the Process

I have been cracking up reading the various theories as to why CBS supposedly bought Wallstrip. Explanations abound: it's Lindsay, right? It's all about the talent. Hey, it's hard to create a popular web video show, right? The writing, acting and production needs to really resonate with the audience. Or gee, is CBS really be behind the eight-ball in their creative process if they need to go out and pay a bunch of money for a seven-month old vlog site? The best way to break down the problem: analyze the value stack.

Where exactly are the pressure points in bring a show from idea to release? The answer: it is the vehicle for stringing together the creative writing, the acting and the filming in a seamless, time-sensitive and cost-efficient process. IMHO, it is this process that represents the real IP of Wallstrip. Lindsay, Jeff, Adam and Howard are all key to making this process happen, but it is their collective know-how that creates the value. Believe me, it is not as simple as it seems. This is why CBS made this purchase, to get this know-how and to expand it beyond Wallstrip into a provider of leading-edge web video content. They've got the talent pool. They've got the distribution. They've got the ability to do edgy deals in the contex of a large, old-line organization. This is smart.

The only story I've read in the mainstream media that begins to get at this point was in today's New York Times. The idea for this was, of course, picked up from the web on the VC Ratings blog, which was, in turn, extracted its essence from Fred Wilson's authoritative post on the topic. So there you have it. To the NYT's credit, they got it. And the real answer was on the Web. It's good to be open minded. Get the best content from wherever it resides. And this is the result of the value engine that is Wallstrip.

Taking the Long View: Honda Has it Right

One of the things that really irritates me about the U.S. public markets - and the mind-set of many U.S.-based institutional investors - is an emphasis on short-term results. There are inherent, structural, perverse incentives for corporate executives to do things that maximize short-term results to the detriment of long-term shareholder value. And this is a shame, for investors, executives and the economy alike. And every so often I read a story that flies in the face of this approach, providing an example of a company or companies that eschew short-term thinking and instead choose to take the long view. And I know, I KNOW, this is the right thing to do. I just read one of these stories, and surprise, surprise, the company mentioned is not a U.S.-based enterprise - Honda Motor Company.

In general, Japanese corporations have done a better job focusing on long-term benefits than their U.S. counterparts, particularly in the capital-intensive industries like autos and steel, and the results have been  predictable. But in this case, Honda is bringing their long-term thinking onto U.S. shores, insisting that cars sold into a foreign market are largely made of parts produced in that market. And if this means working with local suppliers in order to up their game to achieve Honda's high standards, then so be it. And if it costs a pile of money in the short-term but stands to create a strong, financially stable partner in the long-term, that is the price of playing the game the right way. I respect this so much, it is hard to put into words. Anyway, here are some interesting elements of the story.

Two years ago the walls were closing in on Anthony Chopp and the other employee-owners of Northwest Tool & Die. The tiny Walker, Mich. manufacturer had just racked up a $1 million loss on $10 million in revenues. It had $5 million in bank debt and owed $1 million more to vendors. Its customers, auto parts suppliers, were ailing. They were turning to low-cost tool shops in Japan, Korea and China for the dies they use to stamp sheet metal into sculptured steel parts for automobiles. "It was a pretty bleak picture," recalls 42-year-old Chopp, who was thrust into the chief executive's job in the midst of the crisis.

Today Northwest is thriving, even as much of the tool-and-die industry continues to deteriorate. Northwest's savior was of a most unlikely sort: Honda Motor. The Japanese automaker took Northwest under its wing, teaching it to more efficiently design and manufacture while steering millions of dollars in new business to it--even though its prices were 50% higher than any of a number of Asian suppliers. Today the new manufacturing techniques have brought Northwest's tool prices to within 15% of the low-cost Asian competitors.

"We took the long view that by working together we could make them competitive," says Timothy Myers, a purchasing executive for Honda of America.

Crazy like a fox, Honda has always been a quirky company driven as much by principle as by economics. It believes in building cars in the markets where they are sold--half of its global sales are in North America--and using locally produced tools, as well. So it made sense to rescue an ailing U.S. company, says Myers. When the tool supplier is situated nearby, he says, communication between engineers is better and cheaper, leading to improved manufacturing and fewer quality problems. "If everything is sourced overseas and shows up in a crate, we haven't really learned anything," says Myers. He has not forgotten that in 2002 a port strike on the West Coast delayed the shipment of important tools needed at a factory in Ohio for the launch of the Honda Element.

One point I plainly disagree with is the author's statement that Honda has been "driven as much by principle as by economics," somehow weakening the economic rationale of their actions. While that may be the case in some decisions made by the Company, that certainly isn't the case here. I believe the decision to prop up a local supplier, teach them how to become competitive, and have them effectively integrated into Honda's production process is manifestly rational from an economic perspective. Honda is creating a stable, local, high quality supply of parts. It is investing in the U.S., something that will endear it to labor unions, local, state and federal governments. It is greater vertical control over its production process without taking on the fixed costs. This is startlingly smart and something that flies in the face of what the U.S. automakers have been doing with their suppliers, namely, squeezing them as hard as possible in order to reduce their cost structures. Yes, lower costs are better, but not if it creates a financially unstable supplier. It can cause labor unrest. It can sour relations with government entities at all levels. In short, it is taking the short view. And it stinks.

Honda is so pleased with its progress that it is adding two North American tool shops to its comanagement program. American companies account for 41% of the tool-and-die business on Honda parts, up from a third before.

Northwest exited bankruptcy court in July 2006. It reported $12.5 million in revenues and a 6% pretax profit margin for the year. Honda accounts for 40% of that business, up from 20% before the bankruptcy. Chopp is aiming for sales of $25 million and a 10% margin within two years. He has won business from new customers, including big Ford and Chrysler suppliers. Its workforce has gone from 46 to 74.

And Chopp is sharing what he learned from Honda with other toolmakers in Michigan, who have formed a coalition in an effort to stop the industry's decline. "If you're not changing, you're headed for extinction," said Chopp. "We started to change too late, and it almost killed us."

So, you can see how Honda's actions have a salutary effect on several constituencies:

• Honda, for the reasons mentioned above;
• Northwestern, the tool-and-die maker assisted by Honda, because they have a new chance at life;
• U.S. auto makers, who have a financially healthy, high quality supplier of parts that they are sharing with Honda;
• The U.S. tool-and-die industry, to whom Northwestern's lessons are being disseminated through a trade coalition;
• Consumers, who will get a steady supply of the cars they demand;
• Employees in the U.S. tool-and-die industry, who won't lose their jobs; and
• U.S. taxpayers, as employed people generally pay more taxes than unemployed people.

The losers in this story? None. Except that it just shines a bright light on the innovative, long-range thinking of Honda versus the U.S. automakers. And that, as a U.S. business professional, is hard to stomach.

Goldman Sachs' TrUE is Truly Golden

So it happened. Oaktree's unique public-while-staying-private offering is now complete. And the results were nothing short of terrific - for Oaktree, for Goldman Sachs, and for the institutional investors that now have another way to access top-shelf product that might not have become available in the absence of such an innovative structure. A few details from today's story in the LA Times are provided below. It is interesting to note that both the tone of the story and the comments of the Oaktree principals are very much in line with my earlier analysis of the strategy:

Los Angeles-based Oaktree and its principals took in more than $800 million selling a stake of about 14% to fewer than 50 other large investors.

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Oaktree, which manages about $40 billion in assets, specifically decided not to offer shares to the public at large. Instead, its stock offering is the first on an exclusive market created by brokerage Goldman Sachs Group Inc.

The idea behind the market is to allow private firms to raise money — and create a way for their executives and employees to cash out some of their wealth in the business — without taking the cumbersome route of going public.

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They said Oaktree's shares, or units, were priced at $44 apiece late Monday and began trading at $50 on Tuesday. Only institutional investors can trade the shares; the general public isn't allowed in.

"In time, we expect to see this [market] employed by a number of premier companies in other industries that wish to access liquidity and outside capital but also to remain private," Marks and Karsh said in the memo. "It makes sense that there be a way for leading companies to accomplish these dual goals."

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If Goldman's market becomes popular, it could present more competition for the New York Stock Exchange and the Nasdaq market as they seek to entice public stock offerings.

"I think it's quite appealing," said David Brophy, a finance professor at the University of Michigan. The greater federal regulatory burdens imposed on public companies since the corporate scandals of a few years ago have raised the cost and hassle of being publicly traded, he said.

"A lot of companies now say, 'What's the point of being public?' " Brophy said.

Although some analysts said Oaktree could have raised more money selling a minority stake in the public market, Marks and Karsh said in their memo to clients that that issue "meant little to us in comparison to the advantages" of staying private.

RIght. So, the issue raised more than expected, as is normal for sought-after newly-issued shares. It traded up on the open like most solid IPOs. The entire issue was soaked up by only 50 institutional investors, resulting in an average of over $15 million in shares per buyer. This is not your your father's retail-driven IPO of yesteryear. And oh, by the way, all of those nasty and annoying  legal, regulatory and compliance issues associated with being public are simply not present. And finally, the clear perception that any economic give-up by the principals by doing a private versus a public deal is well worth it. In sum, what does this indicate? Exactly what I spelled out two weeks ago, that the new issuance market in the U.S. is going to come under pressure - and fast. I have received a few comments from readers who believe that regulations like Sarbox, while a pain, are not a true deterrent to companies going public in the U.S. I have to roundly disagree. And time will tell. But if I were a betting man, I'd wager that the TrUE structure and the inevitable variants will become an increasingly attractive alternative for top new-issue prospects, especially now that Oaktree has broken the ice. The offering was a success and congratulations to all. Except my friends at the NYSE and Nasdaq, whom I assume are shaking in their boots.

AND NOW A LITTLE ON SARBOX

I was pleased to read about the SEC approving guidance to ease Sarbox rules. From today's Wall Street Journal:

The 2002 Sarbanes-Oxley law requires company executives to assess at the end of each year the adequacy of internal controls over financial reporting -- the policies, procedures or activities designed to minimize the chances of inaccuracies in financial reports. The internal-controls assessments, combined with a separate evaluation by outside auditors, have spawned complaints that rules mandated after the Enron Corp. and WorldCom Inc. scandals are too costly and cumbersome.

Under the SEC's guidance, company executives may be able to conduct fewer tests and assemble a smaller amount of documentation to back up their evaluations of internal controls over financial reporting. The guidance gives managers leeway to use their own judgment to identify the areas of their business most at risk of creating financial errors, determine whether controls are in place to address those risks, and then evaluate the operating efficacy of the controls.

This is big, from both cost-saving and time-management perspectives for large companies and from a compliance perspective for small companies. For the first time it seems that Sarbox guidelines might actually be appropriate and achievable for smaller companies, which has certainly not been the case up to this point. Hopefully this will have a salutory effect upon the perception of the U.S. public markets. Because as noted above, we can use all the help we can get.

Ah, Wallstrip, I Knew You When...

So it's a done deal. Wallstrip has been sold to CBS Interactive. Howard has blogged about it. Om has blogged about it (notwithstanding the lousy prognostication of GigaOm readers). Fred has blogged it as well. So what more is there to say, really? Well, I've got a few thoughts of my own to share.

Howard, thanks for asking me to both invest in and sit on the Board of Wallstrip. You built a great team, surrounded yourself with great investors and advisors (Fred, Brad, Mike - the list goes on and on) and really made a go of it in a short amount of time.  You truly know how to leverage networks like none other, and have that perfect mix of humility, arrogance and confidence that makes for a rocking entrepreneur. I love you, man.

Andy Monfried was terrific to work with on the Board. A brilliant marketing guy and just a hell of a nice guy. I look forward to doing more deals with you in the future.

Jeff and Adam, what can I say, our Bright Red boys are now making the Green. Congrats! You taught me a lot about the business; I hope my prattling on about strategy, value stacks, competitive advantage and all that b-school crap didn't put you to sleep too much! Anyway, you are both rock stars and I know you'll create massive value for your new friends at CBS Interactive.

Lindsay, oh Lindsay, what can I say? The way you managed the action in that referees' shirt during the Blackberry Shoot-Out. The way you laughed at me when I tried to explain that the name of my company, Monitor110, was derived from the binary for "6." Ah, those magical moments. Sorry about flicking that rubberband in your eye just before the Shoot-Out. I guess now I understand who had greased my Blackberry just prior to the thumb-off, rendering my performance less than stellar. It was you, sister! Good luck anyway - I know you'll rock the house.

Anyway, it was all a ton of fun and I wouldn't have traded those crazy seven months for anything. Onward and upward - I'll be rooting for you!

An "A Ha" Moment for the BIS: Hedge Funds Really ARE Regulated

Shortly after Germany's call for a voluntary hedge fund "code of conduct" was roundly defeated, the BIS released the results of a year-long study indicating that lending practices geared towards hedge funds have slackened. This then prompted the BIS's call for more intensive monitoring of investment banks' portfolio exposures and more stringent risk management practices. From today's Financial Times:

Evidence that action is needed comes in a report from the Basel-based BIS, saying investment banks’ declining financial discipline is making them more vulnerable to future turbulence. It says the underlying problem is that banks are competing fiercely to win business from the hedge fund sector, which has expanded greatly this decade.

Consequently, the BIS warns that regulators may need to press hedge funds and investment banks to reveal more data about their market activities, and relationships. And it urges banks and hedge funds to step up their level of stress-testing, to cope with the accelerating pace of financial innovation in areas such as derivatives.

“There has been some erosion of counter-party discipline [among banks] recently,” warns the report, which was drawn up by the Financial Stability Forum, a committee of international regulators organised by the BIS, and released over the weekend.

It adds: “This complements other signs of complacency about risks in markets . . . such as the weakness of covenants in credit contracts that could impose significant challenges for market participants”.

Hey now, BIS. You are on the right track. Banks lend to hedge funds. Banks are regulated institutions. Banks should be able to provide data indicating their risk management practices and a granular review of their portfolio exposures. In fact, I know that banks are asked to produce this information as I've sat through many of these meetings over the years with various regulators. This is what regulators are supposed to do. Regulate. But in order to do so effectively, they need to ask the right questions. Which means really understanding the industry you are regulating. As I've noted previously, the SEC has been doing a much better job of understanding hedge fund risks over the past five years. Whether banking regulators have been keeping up with the rapid changes in the alternative investment landscape I'm not so sure. But in any event, the opportunity exists to proactively manage systemic risks through the effective monitoring of regulated institutions (read: prime brokers), namely, those which are providing the lion's share of credit for hedge funds.

The other piece of the puzzle is really being on the leading-edge of hedge fund investment practices and strategies. And likely the best way to stay in the information flow is to do what the FSA does, which is to develop dialogues with the largest and most influential hedge funds in their jurisdiction. Rather than providing incentives to be evasive and withholding by virtue of heavy-handed and illogical regulation, the FSA approach encourages the kind of voluntary transparency that the German regulators would like to hit you over the head with. Between having an insider's view of the market through light-touch regulation of hedge funds and the sheer power to impact lending practices through the oversight of banks and prime brokers, the BIS, FSA, SEC et al should be in pretty good shape. And now if they'd just put their heads down and focus on doing this in the best way possible we could get on with it and stop the never-ending tug-of-war across borders and regulatory bodies. This is what would really protect those whom they purport to be protecting - and not simply politicians' jobs.

Me on Reuters TV Discussing Halo 3: Financially Successful? Likely Yes. Transformational? Definitely Not.

I was recently interviewed on Reuters TV concerning a topic I love: gaming, and specifically the new release of the Xbox 360 game Halo 3. What about the game? Is this just the ticket to help the Xbox 360 cross over into the mass market? And what about the Xbox 360 media center strategy anyway? Does it have legs? These were some of the questions posed to me by Jeanne Yurman of Reuters. Though I have provided a link to the clip, the two key points I made during the interview are:

1. Halo 3, while likely a very successful game that will be sold into the existing installed base of mature, hard-core Xbox 360 gamers, is not going to help Microsoft cross the chasm into the mass market. First of all, the game is an M game. A mature game, a violent game. This is most decidely not a game for the whole family. Contrast this with Nintendo, where most of the games are rated either E or T and with much broader appeal. Further, unlike its predecessor Halo 2, the Halo 3 game is not backward-compatible, only being able to be played on the Xbox 360 console. This limits its initial target audience to around 10 million Xbox 360 console owners, versus the 30 million that are available to Halo 2. Neither of these are helpful facts if "mass market" is truly the objective. And I certainly don't buy the argument that the Halo 3 game itself will drive new console sales. The game has gotten OK reviews and I am confident it will sell well to existing Xbox 360 loyalists, but beyond that, I am neither a dreamer nor a believer.

2. The Xbox 360 media center strategy has been discussed ad nauseum on this blog and others. And there are certainly differences of opinion on the likely success of this strategy. My position remains: the mass market will not be willing to pay for an all-in-one home entertainment solution, and certainly not one which is first and foremost a gaming console. They will buy consoles to play games at home, play games with others and maybe a little game-related social networking on the side. Might I be wrong? Of course. But this is one hell of an expensive bet to make, and one that has some ugly historical precedence in the form of the Sony PSX.

Anyway, that's it. I hope you find the clip interesting. I have so much more to say and so little time... More later.

IA To Barron's on Dividends: Let the Market Decide

Dividend strategy, among the most contentious of capital structure policy issues and one about which I've written before, graced the cover of Barron's this weekend. The thrust of the story: that dividend payouts are too low and that buybacks are overused. The story, penned by Andrew Bary, is both well-written and well argued yet misses an important point: that the market - namely, institutional investors - appears to be pretty comfortable with corporate financial policies, at least on an aggregate basis. Sure, there are isolated circumstances where institutional shareholders may clamor for higher regular payouts, but in general, the market is trading pretty well given current corporate behavior. And I don't really buy the argument put forth by Henry McVey of Morgan Stanley concerning the impact of retail demand for dividends:

"A lot of corporations are missing the seismic shift in retail demand for yield," says Henry McVey, chief investment strategist at Morgan Stanley. As tens of millions of baby boomers start retirement, the demand for yield-oriented investments will climb. McVey notes that Americans over 65 have equity portfolios with an average yield of 2.6%, versus 0.8% for those under 65.

Much of this money is going to be run by institutions, not by retail, so I'm not really sure if this "seismic shift" really matters. I think not. And while I'm at it, I also don't really buy the following argument governing the motivation of corporate-sponsored buybacks:

Corporations are wedded to big buybacks because executives believe that repurchases are the best way to lift share prices. And higher prices enrich corporate managers who have lush stock-option packages. Individuals, meanwhile, can benefit from buybacks to the extent that they defer paying capital gains.

Corporations like buybacks because they are flexible, can be used to soak up short-term excess cash as well as to facilite a more optimal capital structure, and because of the signaling effect they can have on management's view of business prospects. I don't think corporate managements really believe that institutional investors are as dumb as Mr. Bary would have you think. Given my knowledge of corporate finance departments and their decision-making processes, I am pretty confident that the reasons I raised for why buybacks are used are more on point, IMHO.

So while we can prattle on about what should and should not be, the market is saying something: that the current dividend vs. buyback policy is just fine, thank you. And while we can debate the point on a theoretical basis, the fact that the two strategies are tax-neutral and that institutions seem to like the discretionary and signaling aspects of buybacks means that things are unlikely to change. Until institutions begin stand up and begin voting with the pocketbooks, that is. Which means a change in the market. Which is the way things should be, not the way some people think things should be in the financial media eco-chamber. Let us always remember: Mr. Market rules, now and forever.

More Evidence of the Ravages of Sarbox: U.S. Private Placements Overtake IPOs

The regulatory regime governing the U.S. equity markets is in trouble. Deep trouble. I've written about this extensively, most recently in a piece concerning Goldman Sachs' new private market for institutional investors, GSTrUE. In brief, I concluded that any regulatory regime that pushes blue-chip potential issuers such as Oaktree Capital Management to avoid going public has fundemental problems. I felt pretty confident in my logic and my conclusions. And just yesterday the Financial Times ran a story that only bolsters my arguments with these fascinating and damning statistics:

Straight public equity offerings on the three largest US stock exchanges - the New York Stock Exchange, Nasdaq and the American Stock Exchange - raised $154bn last year, while offerings involving so-called 144A private placements raised $162bn.

It marks the first time deals involving private capital raisings have raised more than basic public offerings. In 2005, when IPOs on the three largest exchanges raised $147bn, deals with private placements raised just $101bn.

The story then goes on to discuss many of the same issues I raised in my post earlier this week, driving home the dampening effect that Sarbanes-Oxley is having on the perceived attractiveness of the U.S. public equity markets:

Companies, particularly from outside the US, view such private deals as a way to avoid burdensome Sarbanes-Oxley legislation and gain quick, cheap access to US capital markets without the need to even register securities with the US Securities and Exchange Commission.

And, apparently, I'm not alone in my concerns or of the potentially tectonic effect that GSTrUE and other private pools of liqudity could have on U.S. exchanges; the Nasdaq itself is looking to launch an automated market to handle the trading in these new private offerings:

It (the increase in private placements) also comes as Nasdaq, the second largest US stock exchange, prepares to launch an automated market dedicated to such private placements.

Bob Greifeld, Nasdaq's chief executive, said the launch of the new platform, planned for June, could be "the most important development for the equity market since 1971 [when Nasdaq was founded]".

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Nasdaq's Portal and the Goldman System, known as TrUE, will be exclusively available to institutional investors.

Such institutions are increasingly the dominant player in the global trading landscape, serving as the top stock holders for many leading public companies.

This final point, a point which I raised in my earlier post, is absoutely critical when assessing the magnitude of the threat posed by these alternative exchanges. The retail investor is not the driving force in the equity markets here or abroad, and given the structure of U.S. regulatory doctrine once one crosses into the realm of the "accredited investor" there is much one can do on a private basis. Like start a private exchange. Or many private exchanges. If GSTrUE is successful, as I expect it will be, is there any doubt that Morgan Stanley and the like are close behind? And with the great leap forward in low latency trading technology, what is stopping a flow aggregator like Nasdaq or any ECN from pooling the deals originated on these private exchanges and enabling them to be traded more broadly? In fact, I am almost certain that this is how it will play out. So, to recap, if:

• You have a massive pool of institutional liqudity in need of high-quality product; AND

• You have a sea of high-quality companies that would like liquidity but are put off by the regulatory demands of going public in the U.S.; AND

• You have innovative investment banks structuring these early deals between high-quality issuers and high-quality, leading-edge investors willing to buy a new and untested product; AND

• You have ECNs with capacity that can pool flow across these private exchanges and centralize trading, clearing and settlement in order to broadly and efficiently distribute product; THEN

• You get a withering U.S. new issues market that will slowly and inexorably die on the vine.

I know this isn't pretty. But I'm not sure that there is a more likely scenario than the one I just painted. Congress and the SEC would wake up and dial back Sarbox. And that would help. But the question remains: will it be too little, too late?

Nintendo Wii: A First Six Months for the Ages

From an investor standpoint, the Wii represents financial and strategic nirvana for Nintendo, a phenomenon about which I've written on several occasions. Some of the reasons for this nirvana-like state are as follows:

• Low sales price
• Mass-market appeal
• Leverages wealth of existing cross-market IP, i.e., Mario and Donkey Kong
• High margin on console sales
• Comparatively low game development costs
• Lower risks for third-party developers, e.g., due to costs and rapid growth in installed base
• Fun platform on which to engage and excite developers, e.g., Wiimote and portabililty
  
• Adequate supply upon launch
• Viral word-of-mouth sales growth

Given my deep interest in the "console wars," I was interested to read a post by Blake Snow over at Infendo yesterday which quantified the first six month U.S. sales figures for the last generation and current generation consoles of Nintendo, Sony and Microsoft. He included this very interesting chart as an exhibit to his eye-opening post.

 

Blake then goes on to ask a very interesting question concerning what the market really wants, especially given the empirical data at our disposal:

So do people want “next-gen” or “different-gen”? Nintendo says they want the latter and so do initial U.S. console sales. Assuming history repeats itself, the 360 and PS3 will end up in a distant second and third place with Wii perhaps outselling the PS2’s unprecedented 115 million worldwide units. What does it all mean? It means fans of motion-controls can expect to see a boatload of good games with fewer titles gracing “real next-gen” platforms. I feel like I’m taking crazy pills!

Different-gen or next-gen? I'd tend to agree with Blake, and it appears that the market supports this view. Just because something is loaded with features, does that mean it will necessarily sell better than something more spartan, but which provides a more enjoyable user experience? I think we know the answer to that question. One need only look at today's console wars, or perhaps Sony's legendary flop the PSX to see that feature mania and whiz-bang are not what sells product, at least on a mass-market basis. Enjoyment does, of which features are only one small part. Whizzy graphics, sure, but is it easy to use? Are the games easy to learn? Are the games fun to play with others? Oh, and what about value? Is my cost of entry high or low relative to the fun I'll have playing the game? Because of its superior fun/cost ratio, the Wii has been the answer for most of the mainstream game players, and even some hardcore gamers who want a second console to mess around with that provides a materially different user experience than the button-mashing "high-end" Sony and Microsoft offerings. And while I'd love to see the global numbers, I think the U.S. is a pretty good representation, especially given what we know of the Wii's run-away success in Japan and the struggles of both PS3 and Xbox 360 in that core gaming market.

Now I'm not sure if the Will will surpass the legendary success of the PS2 over its life. 100 million+ consoles is pretty hard to beat. That said, Nintendo has built a remarkably profitable, exciting, fun-filled platform over the past 6-7 months, and is only gaining momemtum both in console sales and excitement across the third-party developer community. I'm glad Blake created a picture to help put the Wii's early success into perspective. Because a picture is worth 1000 words, and in this case the picture is speaking loud and clear: Go Nintendo.

A "Voluntary Code of Conduct" for Hedge Funds? It's Face-Saving Time in Germany

Poor Germany. Why are their regulators so consistently out-of-step with their cousins, the FSA in the UK and the SEC in the US? Their urge to regulate industries - especially those they don't understand -  has become the ultimate indicator of future growth. When private equity firms started becoming more active, and Europe became a center of growth for PE-driven deals, German regulators referred to PE professionals as a bunch of "locusts." And what happened? The growth in private equity assets under management exploded to unprecedented levels. And when German regulators started banging the drums for greater transparency and disclosure from "dangerous hedge funds," you could be certain that hedge fund assets were going to go through the roof. Which they have. In each case German regulators have stood apart from those in the two largest centers of finance, the US and the UK, and have looked pitifully weak, ineffective and lacking in power and influence.

So what we have this week is an attempt by Germany, with support from ECB President Jean-Claude Trichet, to put into effect a "Voluntary Code of Conduct" governing hedge fund disclosure and transparency. In short, a face-saving measure for Germany. Because if they had any less face, they'd be lacking a head entirely.

From today's Financial Times:

A proposed voluntary code of conduct for hedge funds is winning increasing backing around the world as a way of controlling risks created by the fast-growing industry, according to Jean-Claude Trichet, president of the European Central Bank.

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Germany has long been pushing for measures to boost transparency in the hedge fund sector but the UK and US have resisted proposals that might involve unnecessary regulation. Mr Trichet's intervention offers Berlin powerful backing as it seeks agreement by the end of the year.

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A voluntary code could, he said, cover risk management within hedge funds and the exchange of information between funds and their bankers and between funds and their investors.

"I trust that in a number of areas we can proceed very much through the way of such voluntary codes," Mr Trichet said.

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The ECB has been among the global financial institutions most vocal in warning about possible risks created by hedge funds. Its last financial stability report, released in December, warned that in their dealings with hedge funds "the prime brokerage businesses of banks have continued to test the boundaries of their risk appetite and prudence in risk management".

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But amid scepticism in the US and Britain, senior German finance ministry officials said the proposal has been removed from the final communiqué to be agreed at this weekend's two-day meeting in Potsdam.

So, notwithstanding JC Trichet's support, it is pretty much acknowledged that Germany is not a thought-leader in financial services regulation. In fact, it is having a hard time gathering support for voluntary hedge fund guidelines that have a fraction of the teeth of what they'd really like to see. They've boxed themselves into a corner, and they're getting crushed.

An even harsher view of Germany's position is offered by the International Herald Tribune in a story titled "Germany fights lonely battle to rein in hedge funds:"

Germany will make a last-ditch effort Friday to persuade the world's top economic powers to tighten their grip on hedge funds and private equity firms.

But even before these countries' finance ministers convened at a Group of 8 meeting, the push was being written off as futile - illustrating Germany's isolation in its desire to rein in the booming industry.

In the run-up to a two-day meeting near Berlin that will begin Friday, the United States, Japan, Britain, and Canada - where the bulk of hedge funds and private equity firms are based - have signaled their desire for a hands-off approach toward regulation.

"Central banks and other regulators should resist the temptation to devise ad hoc rules for each new type of financial instrument or institution," Ben Bernanke, chairman of the U.S. Federal Reserve, said in a speech this week.

Henry Paulson Jr., the U.S. Treasury Secretary, has said he would skip the meeting this weekend altogether because of a heavy workload.

Other members of the club - France, Italy and Russia - have given little or no public support to Germany's effort.

Their stance is an embarrassment to Germany, which has made increased transparency of the industry a top priority in its role as the current president of the G-8.

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Ouch. When you've got Ben Bernanke talking smack and Hank Paulson blowing you off, you know you've been marginalized. I just don't know what it will take for German regulators to wake up to a simple fact:

The key issue with oversight of the hedge fund industry is the management of systemic risk, not single-fund risk, and that this oversight can be performed through a review of and data from institutions that are already regulated.

I've written about this in excruciating detail on a number of occasions, but for some reason it is clear that Germany's leaders and the BaFin just aren't reading my blog. Too bad. Hopefully, at some point, they'll ingest some of these insights and join the rest of us on this planet.

FYI, some of my earlier posts on the this and related topics are as follows:

• 02/23/2007: The Presidential Working Group on Hedge Funds Has Been Reading My Blog! Amen.

• 02/12/2007: The G-7 on Hedge Fund Risk: Politics Abound, But Getting the Right Answers

• 01/30/2007: "Implicit" Hedge Fund Regulation: Moving in the Right Direction

• 01/09/2007: Who Says Hedge Funds Aren't Regulated?

• 07/27/2006: Do Hedge Funds Give Rise to Externalities?

• 07/16/2006: Much Ado About Nothing - the Hedge Fund Regulation Debate

A Blogging Manifesto

Cosmic Questions

What is it about blogging that turns me on, both in my own writing and in the writing of others? Why is it that certain blogs really irk me, while others strike just the right tone and cement my avid support? Why is it that some of my posts achieve broad readership and get picked up far and wide, while others, some of which I like a great deal, get read by only my most hard-core followers? And just to add a little more spice to this introspective rant, how much of my blogging is the result of pure narcissism versus my deeply-felt desire to share my domain expertise and perspective with a larger audience? These are not easy questions. And I feel almost naked asking them of myself. But I am having my own little mid-life blogging crisis and I want to use my writing as a vehicle for getting some answers. Right now.

Why I Blog

So let me start with the most basic question: why do I blog? Because my guess is that by answering this question, I will find the seeds of the answers to all the others. So the results of my Freudian "free association" exercise, following the form "I blog because...," are as follows:

1. I like to write
2. I like to be read
3. I like to read what I write because it is a window into my heart and my brain
4. I like it when people say "When I read your writing, I can hear you speaking"
5. I like the peace I feel when writing
6. I like the passion I feel when writing
7. I like to share my knowledge and experience with others
8. I like the recognition
9. I like the feedback
10. I like the connection to my audience
11. I like the challenge of writing something that people care to comment on and link to
12. I like seeing my Technorati/StatCounter/Feedburner numbers going up
13. I like to feel more hip than a normal Wall Street guy
14. I like being viewed as an expert
15. I like the new friends and colleagues I have made
16. I like the deals I've been shown, some of which I've invested in
17. I like to feel as one with the online world

Getting Introspective

I'm sure there are other reasons but I think this is a pretty good list. Looking at the 17 items it certainly answers a lot. What turns me on? See 1 through 17 above. Narcissism vs. desire to share? Some of both to be sure. And I'm ok with that. But what about those posts I write that get little pick-up, notwithstanding the fact that I think they're great? Oh, does that bug me! I can't help it. Why doesn't anyone like my stuff on creative destruction? Come on, folks. It's good stuff! At least to me. And that should be ok, right? Why does every post need to get picked up and spread all over? It shouldn't matter. As long as the writing is good, the points made relevant and that I feel good about it. I'm not sure I'm mature enough to feel that way, but I guess I'll try. Oh, and what about that practice of checking my page views multiple times a day. Who cares, right? But I'm always interested in both how many people and which people are reading my stuff. It's an addiction. Kind of like the Blackberry. And both habits are tough to shake. I'm trying to be more grown-up about this. But there is a certain excitement to being read and impacting the way people think about things. This is what really gets me off. Being an influencer. And influencer as the result of my ideas and my ability to communicate them, not my aesthetic tastes. Hmm, this explains a lot.

Getting to the Root of it All

So what really bugs me about other's blogs? Poor writing. Bad spelling. Weak analysis. "Safe," non-challenging positions. Simple aggregation without analysis. Cluttered, distracting pages. These are some of the hallmarks of sites that I find difficult to read. That said, there are exceptions to this rule. My friend Fred Wilson has a sickly-cluttered blog that takes too long to load because of its "widget farms."  But I enjoy A VC and read it every day. My other friend Howard Lindzon spells like crap and could take a course in modern English, but I enjoy his content and his firm stances on stocks, issues and people. So, as with most things in life, it is not simply black-and-white. But what Fred and Howard's blogs have in common relates to the quality of the content and the passion with which that content is delivered. I am apparently willing to look beyond cosmetic annoyances to get to the meat of the issue. This is good insight. Nice to know I'm not totally superficial, eh?

A Blogging Manifesto

In light of these conclusions, I'd like to put forth my own Blogging Manifesto. This may not work for you, but it does for me.

#1: Write with passion

#2: Write well

#3: Take a position - always

#4: Think about what your audience would like to read, but don't be limited by it

#5: Don't be obsessed with your readership; if your blog is good, they will come

#6: Leverage your experiences and domain expertise in your writing

#7: Be able to back up opinion with fact and cogent arguments

#8: Excellent content can make up for a lot of cosmetic annoyances

#9: Blog to live, don't live to blog

#10: Have thick skin; if you're not pissing anyone off and being criticized, you're probably not writing with enough conviction

So that's it. Take it for what it's worth. I hope you enjoyed the post, because I enjoyed the process of writing it.

Marketing-Push vs. Evangelism-Pull: Microsoft/Sony vs. Apple/Nintendo

Which is better - spreading your product gospel through slick marketing campaigns or having your own customers doing the talking for you? I think the answer is pretty clear. But what about the breadth of your product's reach? What if you have a loyal, passionate following of hard-core users but you want to expand beyond this core? Don't you run the risk of alienating those core users as your product becomes increasingly mainstream? And is this a problem, or simply a natural and expected evolution following the product life cycle? These are just some of the thoughts that went through my head upon reading an interview with Shane Kim, Head of Microsoft's Game Studio, by Dean Takahashi, author, blogger and writer for The Mercury News. One Q&A in particular prompted my own questions about marketing strategy and customer-driven product evangelism (the bolding is my own):

Q: I (Dean Takahashi) talked to Peter Moore recently. He said we will have an answer to the approachability of the Wii in the next three to six months. I asked him if that meant you are doing mass market games. He said no. It would be a combination of things. Is this part of your strategy?

A: First of all I wouldn’t say it is an answer to the Wii. That sounds way too reactive. While Nintendo is enjoying a lot of early success with the Wii, for us, part of our strategy has always been to appeal to expand beyond the core gamer. That goes back to our primary objective to win this generation. We know from prior experience that you don’t win the generation just by winning the core. If we want to win this generation, we have to expand beyond that. Now is the right time for us to do that. The first two holidays were really about competing for the core gamer. I agree with Peter it is not just one thing. It is an end to end strategy to appeal to a broad audience. It’s not just about content. It’s not about how you market the platform. You have to do all those things if you want to reach a broader audience. That will be a challenge for us because we have been so strong with the core gamer. It’s been part of our strategy all along.

Wow. There is a lot going on here. Let me try and parse the language to identify some of the key issues:

1. Being reactive is bad
IA question: but reactive to whom?

• Isn't being reactive to the needs of your market good? Isn't this called being customer-centric?
• If a competitors' strategies are working and yours are not, is there shame in being reactive (which entails being humble, learning and listening, which is not necessarily a core competency of many of those involved in gaming)?

2. Winning the generation means moving beyond the core

• It is conceivable that a successful console strategy could be built around the core - as long as you don't spend billions building it.
• Figuring out how to "cross the chasm" is essential in positioning the early sales strategy, lest you be pigeon-holed as a hard-core application.

3. A winning strategy is built off of success in selling to the core

• Nintendo's success with the Wii would indicate that this isn't necessarily true.
• You might actually develop a strategy and product that is not well-suited to the broader audience if you initially cater to the core, whose requirements are likely very different (and more costly).

4. Appealing to a broader audience means delivering an "end-to-end strategy"
IA question: an end-to-end strategy to appeal to a broader audience involves precisely what?

• Does end-to-end mean offline/online/gaming and media?
• If so, the Wii's low-end entry strategy that can subsequently be upgraded is a much lower risk, lower cost way of building an installed base which can be upsold later, no?

5. Appealing to a broader audience will be a challenge due to strength with the core
IA question: but why? Due to concerns over alienating the core or the difficulty in moving beyond the perception of being a hard-core application?

• Is the core essential to your DNA, i.e., not simply as a stepping-stone to a broad market strategy?
• If the core is essential, how do you lower the price/feature point to a level that represents an attractive value proposition to the broader audience but doesn't alienate the core?

An interesting point to note about Nintendo is that its "core," unlike Microsoft and Sony, is not in its user base but in its IP - namely, its stable of timeless characters. Mario. Zelda. Donkey Kong. Characters who have had appeal across generations and have acted as the glue of the Nintendo franchise. This kind of core - a mass-market, family-friendly core - is invaluable. And is something possessed by neither Microsoft nor Sony. An interesting post discussing Xbox 360's keys to victory offers some insight into how the Xbox 360 can compete for the mass-market against Nintendo:

5. Broaden the audience with more family-friendly IP

If Microsoft wants to be able to compete with Nintendo for the family-friendly market, it not only needs to bring down the price of the core package, but it's got to introduce more kid-oriented IP, whether through its own studios or licensing partnerships with third parties. Rare's Viva Pinata and Banjo Kazooie may help, but the 360 is still very much a hardcore gamer's machine and is dominated by hardcore titles like Gears of War, Crackdown, Ghost Recon, etc.

This, however, is an area where Microsoft's Xbox Live Arcade service can give the 360 a leg up. XBLA already has a good portfolio of titles for people of all ages and it's only going to continue to grow. MS recently announced that they have 6 million Xbox Live members, but how many of these are actually gold-level, paying members, let alone people who pay to download Live Arcade games? If MS wants to make the 360 more appealing to a broader audience, not only should Xbox Live be made free, but Xbox Live Arcade should offer an ad-supported type of service that lets users play games for free – similar to what GameTap just announced.  This would likely go a long way toward getting more "soccer moms" and their children interested in the 360.

Interesting stuff. My belief is that while Dean's interview was with respect to the Xbox 360, a similar conversation could have been had with Sony product management regarding the PS3. Both consoles are currently in the midst of an identity crisis, having their legions of loyal fans but having a hard time breaking into the mainstream. A high price point. Consoles loaded with features that reflects a far grander strategy than simply gaming. In short, a high-risk strategy that is heavily dependent upon changing market perceptions about a gaming console's use and the features and functionality desired by the broader market.

But even more importantly, the issue to me is that Microsoft and Sony have to convince the recreational gamer of at least one of two things in order to buy their products:

1. The features and functionality over and above those of the Wii are worth paying for
2. The console should be viewed not simply as a gaming tool but as a multimedia vehicle in the living room

These are hard things to convince people of. If I'm not a hard-core gamer do I really care about all the bells-and-whistles of the Xbox 360 and the PS3? Probably not, and certainly not to the tune of $200-$300 more than the Wii. And what about the box-in-the-living room argument? I think this approach kind of sticks them in no-man's-land. The multimedia consoles are still expensive - period. There is no getting around this. So is the broad market going to lap this up? Hmmm. Risky bet. And what if the money isn't really the gating issue, would the monied multimedia buyer choose to use their gaming console as their multimedia portal? I'd strongly doubt it. So I'm not sure where this puts Sony and Microsoft in this quest for the mass market. That said, there is one thing that could surely drive sales if only it happened: viral word-of-mouth selling by existing customers, the kind that gets people to the store tomorrow because they just have to have what their friends have. Now this can either be a faddish thing or an evangelical thing, and I'd posit the difference between the two as being:

• Faddist: I observe something an influencer has. I think it's cool. I get that thing. But once that thing is no longer cool I move on to the next cool thing.

• Evangelist: An influencer whom I respect has something cool. They tell me about it. They show it to me. I trust them. I buy the thing. I like the thing. I then become an influencer and tell others about the thing. And so on...

If you are Tommy Hilfiger, you were a prep-school fad phenomenon. It's appeal spread like wildfire. Stores were built, specialty boutiques in high-end department stores were constructed, the advertising machine kicked in and distribution quickly moved mass-market. The early-adopter cool left the brand, but by then it had become firmly mass market. They engineered the transition extremely well. But the road is littered with brands that had a rapid ascent, only to peter out after the transition from fad to mass-market didn't take. Wrong messaging, wrong product, inadequately capitalized, bad management - there are a litany of reasons for these failures. But there is fundamentally greater risk when one is reliant on marketing-push versus evangelist-pull, because it sets a higher bar for being convinced then if one is "sold" by an evangelist. Because you trust an evangelist. They are your friend and/or someone whom you respect.

Nintendo and Apple products are being effectively pushed by evangelists. Sure, slick advertising augments these more organic efforts, but make no mistake: in general, people that own Apple products love them and talk about them. Frequently. The same with Nintendo and the Wii. I just can't get people to shut up about these products. But I can't say the same for Microsoft and Sony, notwithstanding how cool or slick their graphics are or how many features and functions their consoles have. Either I don't know the people that are the evangelists (notwithstanding the fact that I know dozens of people that have the Xbox 360 and the PS3, yet never evangelize to me about them) or they are just not into spreading the gospel. And this is a problem. And raises risk. The holy grail is to have millions of evangelists out there pounding the pavement for you, completely unpaid. They are the best sales, marketing and PR force money can't buy.

From the Mailbag: The Valley vs. The Street - Where to Start?

Is the Valley the only place to do a start-up? And what about New York, anyway? Now this is a question I've been asked more than a few times over the past two years, and as time goes by I feel better able and more qualified to answer it due to my own start-up and investment experiences. So the catalyst for this post was this recent email from an IA reader:

My name is [let's call him S. Valley] and I'm an internet entrepreneur in Palo Alto. I was referred to your post on the shift from Wall Street to Main Street and I very much enjoyed your thoughtfulness. A good friend formerly at a hedge fund is now starting his first internet company and going through a similar transformation, loving most of it along the way...

I noticed you have stayed in New York. This friend and I have had a spirited debate about whether starting his company in New York is a significant disadvantage. I've argued, for not entirely objective reasons, that anywhere outside of the Bay Area is more plausible but still handicapped for an internet company. I'd be curious on your view of this...

Now, myself and Mr. Valley engaged in a little email tennis around this topic, the contents of which I will share with you, my patient and loyal IA readers. This response, from me:

Hi S. Valley. Yours is an oft-asked, provocative question. I should blog the answer (and maybe I will), but my punch line is that it depends on the nature of the company and the nature of the customers. Sure, there are base level resources that need to be present (i.e., access to talent, access to angel and VC capital), but I'd argue that a financial services Web 2.0 application is better started in New York than it is in the Valley (though I'm sure Peter Thiel would disagree). Massive access to talent. Close to customers. Seasoned and well-heeled angels and VCs. But for a CGM start-up, the Valley is probably a better place. So, in short, I think it depends. New York has come a long way, to be sure. But it ain't no Valley, either.

Well, and Mr. S. Valley's response:

I would agree that New York has caught up. In his case, his service will target consumers and my argument has been that the engineering, adviser, and VC resources for consumer internet startups are richest in the Valley by probably 3-4x anywhere else. His counter-argument is that a high-quality startup in the smaller bowl of NYC can draw the top talent, which in most areas is comparable...

I do love that the production costs for internet have lowered and distributed so much that nearly anyone anywhere with a great idea can bring it to reality. What I don't know yet is how much the fuzzy value of relationships and face-to-face interactions can be ported. I've felt these facilitate trust and value development beyond any other communication method...

So there you have it. But I'd like to address a few issues that weren't specifically raised in either the question or my response. And just be clear, notwithstanding the fact that I am a New York denizen I am trying to look at this issue in a fair, open and dispassionate way. Believe me, ok?

1. Intimacy among entrepreneurs, VCs and University ecosystems: My perception is that both the Bay Area and Boston are much more evolved than New York in the way technology and IP is transferred among these constituents. And this is a shame. Because the greater NY area is home to some of the finest institutions of higher learning in the land. We are just not quite good enough yet at making sure breakthroughs in the lab make it to the marketplace. This will evolve over time. But New York is far, far behind its East and West coast start-up cousins.

2. Breadth of the angel ecosystem: This is a place where New York has made huge strides in the past few years. As a member of New York Angels and as an independent angel investor I have seen tremendous activity among experienced, value-added individual investors in this City. But one thing NYC lacks is the breadth and depth of successful entrepreneurs who have made their big money on their own deals and are now recycling their wealth into new, exciting start-ups. This has the dual benefit of keeping these extremely talented entrepreneurs engaged and invested in the successes of the future together with providing a large pool of investable angel capital from which to draw. New York has not yet had the magnitude of big entrepreneur pay-offs to rival the Peter Thiels and Reid Hoffmans of the world.

3. VC integration into the entrepreneur community: Big VC/entrepreneur schmooze-fests. Networking events. Start-up business plan contests. These are all good ways to solidify the closeness of a region's start-up ecosystem. Both the Bay Area and Boston have historically done a really good job of this, while New York is more nascent in its efforts. That said, my friends at DFJ Gotham Ventures are hosting a venture challenge at Columbia Business School (my alma mater) that is just the kind of thing that gets the juices of young entrepreneurs flowing. Real cash ($250k+ of funding). Real feedback. A real stage on which to shine. This is good stuff. New York needs more of this.

4. A culture of winning the start-up lottery: It is just a fact that the Bay Area and Boston have many, many more examples of start-ups reaping those mythical 100x payoffs than New York. And this is ok, because New York will get there. But until this happens, New York will still be a Second City of start-ups, because nothing speaks like success. Success breeds success. Success attracts dollars. Success attracts the best talent. It creates a barrier for other ecosystems to take hold. Not that it can't happen, because it will. But it just takes time. And New York simply isn't there yet, IMHO.

In short, I Love New York. But I also acknowledge that it is not yet the #1 place to do a start-up. My partner, Jeff Stewart, argues that NY is better for start-ups because of its Selling Fields.  It may be for some applications and businesses, but it is not there yet, IMHO. But I love being the underdog. Because just when you least expect it...