Vertical Integration in a Rapid World

I have long been a student of organizational structure. In general, I've been a proponent of specialization and laser focus. This works against the concept of conglomerates specifically and vertically-organized enterprises generally. A recent Wall Street Journal article highlighting several recent examples of vertical integration piqued my interest. Just why is it that vertical integration seems more compelling today than it did even five or ten years ago? What has changed in the environment to have caused the perceptions of many to do a 180? Is this a rational adaptation to a different landscape or a costly fad that will invariably run its course?

Vertical integration has often been linked with monopolists seeking to exercise control over a particular product or market, e.g., Andrew Carnegie and steel in the 1850s, Henry Ford and automobiles in the 1900s. From mining operations to refineries to ships and rails to factories and distribution, these companies controlled every part of the their supply chain. They overpowered their supply chains with capital, and barriers to entry were high. Starting a new steel company was no mean feat, and competing against Henry Ford wasn't a picnic, either. But over time, as these industries globalized, the value of each part of the supply chain shifted. Japan became a powerhouse in steel from a processing perspective, creating high-quality steel with few defects at low cost. But they didn't have control over the raw materials supply chain. Technology and quality management became the key sources of differentiation, and the US steel companies that were slow to adapt got crushed. A similar phenomenon happened with the Japanese and the auto industry, where they didn't control the bottom layers of the value stack but used technology, process engineering and customer focus as sources of competitive advantage. In the face of superior technology and control processes, the power of vertical integration withered.

Fast forward to today. We're seeing several examples of the return to verticalization, including those cited in the WSJ article: Oracle, Boeing, HP, and Apple. The general knock I've had against these kinds of moves is that a company has a core competency, and when it strays from that competency it sub-optimizes. For example, can a company really design and manufacture the best hardware AND software? Can it design and manufacture the best printers, communications equipment AND run a world-class consulting business? Wouldn't it be better to put all of one's efforts into a particular area, achieve market dominance and high profit margins, and dividend the cash out to shareholders rather than spending it on acquisitions to achieve vertical dominance? Certainly over the last 30-40 years the pendulum had swung towards specialization, as the vertically integrated companies got picked apart up and down the value stack: there were always companies better, stronger, faster than members of a vertical organization. But something has changed. In a word: speed.

The world has flattened. Supply chains are global and fragmented. Information dissemination happens at lightening speed. Customer preferences drive design and not the other way around. Think about the impact Apple has had by controlling the user experience, a seamless integration of hardware and software. This is markedly different than the Dell/Microsoft/Intel experience. Apple is selling not just a product but an experience, an image. Dell is selling a bundle of features. And Apple is able to achieve this partly because of vertical control of its value stack. Dell is a procurer and an assembler. And they are very good at it. But Apple's tight integration laid the foundation for a host of add-on hardware and software solutions that augment the core experience. Dell simply can't go to these places because it lacks the holistic perspective and control. Assuming perfect access to all materials in its supply chain, might Apple be able to deliver its customer experience better and more cheaply by simply focusing on software and product design than it does today? Sure. But given that perfect access doesn't exist and that speed is critically important to adapting to changing customer preferences, does vertical integration create a kind of option value that a more fragmented supply chain lacks? Undoubtedly.

Historically specialization has conveyed perceived option value, where the best suppliers can be tapped at all times and with weaker suppliers being replaced in the name of ruthless efficiency. But I believe option values have flip-flopped. Specialization may, in fact, represent a short option position, as scarce resources can be parceled out by sharp suppliers to the highest bidder, while those with vertical control can respond and react in real-time to changes in market conditions. Might the pendulum swing back in the other direction? It always does. But might vertical integration be in vogue - and the rational and adaptive approach to best serving customers and maximizing profits - for the next few decades? I'd say so. And I have to admit I never thought I'd say that...

Rethinking The Wall Street Business Model (Part 1)

"Too Big To Fail." "Shrink Wall Street."" Ban credit default swaps." These are just a few of the themes dominating the discussion around the Wall Street business model. They all, unfortunately, miss the point. Size, scale, and instruments that properly used help manage risk have their benefits. Lost in the fallout of the financial crisis is the reason why Wall Street exists: to facilitate capital formation and to provide tools for efficient capital allocation. These are customer-focused activities. This cuts across the Wall Street firm, touching underwriting, credit, M&A, security sales and trading, derivatives, foreign exchange and asset management. I'd argue that these business lines are appropriate for the Wall Street firm and really do help customers, be they corporations, municipalities, sovereigns or institutional investors, achieve their objectives. The problem is that both regulators and risk managers have not kept pace with the increasing scale and complexity of the 21st century Wall Street firm, leading to the dramatic (over) reaction to the financial crisis by the US Government and the populist backlash from ripped-off US taxpayers. Further, the role that ratings agencies have come to play in the capital formation and asset allocation process must also be considered, because without them the recent crisis could not have happened. And this chaos has opened the door for opportunistic, PR-centric intellectual lightweights and politicos to foment movements around new regulations that will hurt - not help - capital formation and market efficiency. In short, it is a mess. But some reason needs to be brought into the discussion - and fast.

First, which elements of today's model don't fit and should be shut down or hived off? Then, what needs to be done to ensure that the model functions as intended? My over-riding goal is to provide customers with the products and services they want without promoting the privatization of profits and socialization of costs. Somewhere along the line we got off the rails, and it is easy to point fingers, e.g., ill-informed and simple-minded regulators, greedy and opportunistic Wall Streeters, incompetent and money-grubbing rating agencies, etc. Bottom line, we need to move beyond the finger pointing and towards real solutions. Here are my initial thoughts of what needs to be done, with an eye towards practicality and reason:

Idea #1: Separate proprietary trading operations from Wall Street firms

When thinking about Wall Street, it is important to remember its core mission: to facilitate capital formation and provide tools for capital allocation. Internal proprietary trading operations do not fall under either category. They are, in essence, subsidized hedge funds with an implicit Government guarantee. Artificially cheap financing costs. Less transparency than their independent hedge fund counterparts of like scale. These operations are readily separable from the customer-driven business. There is simply no rational reason why they should exist as an appendage of a Wall Street firm. Move them out and make them compete in the free market with their independent peers. Note, however, that this does not mean that all proprietary trading risk is wiped away on Wall Street. Desk traders as part of the main sales and trading operation will always take proprietary positions, making markets and taking views. This is a far cry from the separate, off-trading floor synthetic hedge funds run across Wall Street (like Andrew Hall's Phibro, which was recently split off from Citigroup, or my former employer, DB Advisors), and are part of the customer-facilitation business.

Idea #2: Push over-the-counter assets onto exchanges

This is not just limited to credit default swaps. Most derivative contracts. Most cash bonds. Even many larger syndicated corporate loans. There is no good reason why such assets shouldn't be listed and traded in a public forum. This would help with liquidity, transparency and risk capital weighting. This would also assist with the overall risk management of the firm. Many assets have been slow to migrate to exchanges because - surprise - transparency and liquidity tends to drive down bid/offer spreads, making them a less interesting proposition for those standing in the middle of these deals, e.g., the Wall Street broker/dealer. Trading volumes should somewhat mitigate spread compression, but the benefits to society of moving previously opaque assets onto exchanges shouldn't be minimized. This is a no-brainer. 

Idea #3: Eliminate sell-side payments to rating agencies (and perhaps the agencies themselves)

I'm including rating agencies in the Wall Street discussion because they are inextricably linked. Paying for favorable research is a non-starter in the equity business. Why should it be any different in the fixed-income world? The way the rating agency industry has grown up is fraught with conflict and must be changed. Is rating agency research valuable? Let the market decide. Insist that the buy-side pay for it. If the very concept of quasi-sanctioned ratings falls by the wayside, and it becomes more akin to the buy/sell/hold of high-quality equity research, then two things will happen: (1) value-added research providers will emerge to compete with the rating agencies, as firms will fill the information vacuum once headline ratings are eliminated; and (2) the buy-side will have to get back to basics and do real research, without offloading their fiduciary duty to the rating agencies. Only good stuff comes out of this change. Sure, pension funds and endowments across the globe will have to rewrite their investment policies to eliminate allocations tied to ratings, but then the brainless exercise of filling these allocations will stop and be replaced by bona fide research. Unlike Wall Street, the rating agency business is one that really need not exist. Stop the gravy train and make the buy side pay for value.

Idea #4: Revisit risk-weighted capital methodologies and move towards a mark-to-market framework

In a world where Wall Street assets are far more liquid and transparent, but where assets are far more correlated than previously imagined, a new view of risk management and capital provision needs to emerge. Wall Street firms will principally have two types of assets: exchange-traded and non-exchange traded. Exchange-traded assets will each attract their own risk capital provisions based upon liquidity, volatility and float, with a portfolio-wide benefit given for some measure of imperfect correlation among the asset classes (though with correlation matrices that are informed by fat tails and black swans, which we know are extremely fat and not so rare). These assets will always and at any time be marked-to-market. The non-exchange traded assets are more complicated. As I've written previously, I believe these assets should be marked-to-market unless they are (a) intended to be held to maturity AND (b) the firm has term financing in place to be able to carry the asset until maturity. There can be no 30:1 levered balance sheets aren't almost entirely marked-to-market; this problem became immediately apparent in the wake of the market meltdown. "You mean [name your favorite Wall Street firm] can't finance itself overnight??" This should never happen, yet it did. It shouldn't happen again.

Idea #5: Give traders an equity interest in their strategies

The compensation culture on Wall Street is severely messed up. Trader payouts look like a long call option: lose your salary on the downside but get a percentage of profits fueled by a massive balance sheet and cheap capital on the upside. And with a calendar-year orientation driven by the annual bonus cycle, there is motivation to swing for the fences to lock down that "career year," or to swing for the fences when you are down since, hey, what do you have to lose beside a few hundred grand of base salary? I know it sounds crass, but this is reality. Sure, clawbacks can help address some of this asymmetry, but overly complex and punitive pay structures will cause the great traders to all move to hedge funds, leaving Wall Street the victim of adverse selection (some would argue this already happens today). But what about literally creating a trading account for each trader than can rise and fall, where only a portion of the year's gains can be withdrawn with the balance remaining invested in the trader's strategy? One of the big downsides of trading on Wall Street and not at a hedge fund is that you start at -0- at the beginning of each year, while at a hedge fund you get the benefit of compounding capital, e.g., I get to keep my capital account and compound off that higher base each year. Over time, the power of compounding drives many traders to hedge funds, but there is no reason why such an alignment of motives shouldn't exist on Wall Street. Wall Street's shareholders should want this, too, because traders will begin thinking long-term, like their better hedge fund brothers and sisters. Shifting from an asymmetric payout culture to an entrepreneurial hedge fund culture would help with risk management as well, smoothing returns and generating more rational decision-making over time. Revolutionary, yes. Impossible, no.

This is simply the beginning of my thoughts on this theme. I'd love to hear your ideas, too. I'll be sure to incorporate your thinking into my next installment.

"Social Leverage" in Venture Capital

I will soon be participating in a panel at Defrag titled "Is Social Leverage the next big thing for VCs?" with my friends Fred Wilson, Howard Lindzon, Brad Feld and Jim Tybur. This is an interesting question that can be interpreted a few different ways, so I thought I'd put a stake in the ground to spur my panel-mates to challenge my perspective.

The venture investing business is, without question, a social business. Working with entrepreneurs. Identifying good co-investors and advisers. Plumbing one's rolodex to help make connections. Cultivating potential business development opportunities. However, there are elements of venture investing that sometimes work against this social nature, e.g., scarce capacity in a "hot" deal, leading VCs to be quite anti-social and to block other participants. While I lack the data to back my thesis, my belief is that in true early-stage venture investing the value creation of an investment syndicate (assuming the co-investors are truly value-added) exceeds the value give-up of sharing scarce investment capacity. This is one aspect of "social leverage," as the non-linear increase in contacts arising from a right-sized syndicate can substantially de-risk an early-stage investment. I have put this into practice in much of my early-stage investing, and it has worked as expected: co-investors with domain expertise and a wealth of industry-specific contacts can drive tremendous value to a start-up, especially in its early, formative, high-risk period. Help with recruiting. Identifying and gaining access to early adopter clients. Different product use cases to help chart strategy. These are just a few ways in which getting a group of super smart people involved with financial skin in the game can help an early-stage venture. Bottom line: social leverage is alive and well in the venture capital business, provided VCs aren't piggy and are focused on what's best for the business, the entrepreneur and, in the long run, themselves.

Another take on social leverage is as an investment theme. Several examples can be found in my portfolio: bit.ly, StockTwits, TLISTS, TweetDeck. Twitter and Facebook are clear examples as well. These are companies whose value is partly driven by community, where the value of the platform increases in a non-linear way as participation goes up (I would posit that this value function looks like an s-curve, where value accelerates during a period of rapid growth, but then flattens out as network effects have largely been exploited). Now, this assumes that this increase in usage is managed well, from both technology and user-experience perspectives (sometimes we bemoan the growth of Twitter because of this, no?). But there can be little doubt that these companies are facilitating the growth of communities, building affiliations, and promoting social leverage through their platforms, I think this is an investment trend that will continue for some time, as more vertical applications of social leverage emerge to drive a richer user experience to those with common interests, e.g., StockTwits and investing. And more tools will emerge to help monetize these communities in contextually-specific ways, e.g., TLISTS.

So this is my story and I'm sticking to it. Now we'll see what Fred, Howard, Brad and Jim have to say...

Deal With It, Mr. Einhorn

David Einhorn is without question an exceptionally bright man and a very astute investor. However, the latest message being delivered from his bully pulpit, proposing a ban on credit default swaps (CDS), is misguided at best and dangerous at worst. Are his motives for putting forth this radical view pure, or perhaps informed by the complexity of being an equity investor in a world where the entire capital structure can be sliced, diced and priced? I have no idea. But banning CDSs is akin to banning Twitter. Are there some negative outcomes associated with using each of these tools? Sure. But do their overall benefits outweigh their costs? I believe so.

Here are a few extracts from Henny Sender's Financial Times' story on Mr. Einhorn's Letter to Investors:

“I think that trying to make safer credit default swaps is like trying to make safer asbestos,” he writes in a recent letter to investors, adding that CDSs create “large, correlated and asymmetrical risks” having “scared the authorities into spending hundreds of billions of taxpayer money to prevent speculators who made bad bets from having to pay”.

CDSs are “anti-social”, he goes on, because those who buy credit insurance often have an incentive to see companies fail. Rather than merely hedging their risks, they are actively hoping to profit from the demise of a target company. This strategy became prevalent in recent years and remains so, as holders of these so-called “basis packages” buy both the debt itself and protection on that debt through CDSs, meaning they receive compensation if the company defaults or restructures. These investors “have an incentive to use their position as bondholders to force bankruptcy, triggering payments on their CDS rather than negotiate out of court restructurings or covenant amendments with their creditors”, Mr Einhorn says.

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“The reform proposal to create a CDS clearing house does nothing more than maintain private profits and socialised risk by moving the counterparty risk from the private sector to a newly created too big to fail entity,” he notes.

That’s because it is almost impossible to adequately capitalise against such developments. “There is no way a clearing house could demand enough collateral,” he says. “The market can be so big and discontinuous that it is very hard to figure out the correct amount of collateral.”

The crux of Mr. Einhorn's argument is that CDSs, by their nature, are negative tools, e.g., the holder wants the company to do poorly, and will do things to hasten this fact, and that merely putting CDSs on exchanges won't solve the larger problem of taxpayer support for "too large to fail" institutions. 

Are CDS negative tools? Sure. Is shorting stock a negative tool? Certainly. The ability to go long and short creates what I call "positive stress," e.g., it's stressful, but it keeps managements' focused and penalizes poor corporate decision-making. They both provide essential checks-and-balances in the financial system, provided they are not used fraudulently. The mere fact that an instrument is "anti-social" is no reason to ban its use: Mr. Einhorn knows this. And while he might argue that shorting a stock doesn't have as direct an impact on a company's need to enter bankruptcy, it might be that a poorly run company should be in bankruptcy with its assets better deployed by others. Also, the CDS market has been a kind of early detection system for the equity markets, providing a leading indicator of corporate woes before this information has been fully priced into stock prices. Taking away this kind of information hurts everyone, including Mr. Einhorn. And if bankruptcy laws need to be brought up-to-date to reflect the fact that a multi-trillion CDS market has emerged, then so be it. But to merely toss out the information value associated with the CDS market is ludicrous. In fact, I'd argue that the market should be bigger, more transparent and more liquid, which gets to Mr. Einhorn's second point.

Clearinghouses are not a panacea, according to Mr. Einhorn, because the CDS market is too big, their price movements too discontinuous and collateral requirements too difficult to quantify, invariably leading to private profits and socialized costs. One word: Garbage. Think about it this way. As one moves down the capital structure, from senior debt to junior debt to equity, price volatility and discontinuity goes up. Why? Leverage and the hierarchy of claims. A company's equity price can move all over the place while its senior debt trades in a narrow range. It stands to reason, therefore, that CDS should have price movements more stable, e.g., less discontinuous, than equity prices. Do stock prices gap? Yes. Can CDS prices gap? Yes. But because of the seniority of their underlying in the capital structure they should gap less frequently and less violently than stock prices. Yet Mr. Einhorn doesn't want to ban equity trading. What would become of his hedge fund?? The issue is one of liquidity and transparency. Discontinuity comes from opaqueness and thin trading volumes, both of which can be addressed through an exchange mechanism. And this is directly related to the collateral question. As the market becomes more liquid and more continuous, collateral requirements will be increasingly easy to set, far easier than they are today through the daisy-chain of over-the-counter margining arrangements. So at the end of the day, I find Mr. Einhorn's arguments specious and likely self-serving.

As a rule, turning back the clock of innovation is almost never a good thing, and it isn't here, either. Better to harness it and use it prudently than to pretend it simply doesn't exist. Mr. Einhorn knows better, which is why this whole meme makes me very curious...

Barking Up the Wrong Tree

After reading the news, participating in key industry conferences and doing some thinking, I've come to the following conclusion: the regulators - and Congress - are barking up the wrong tree. They would have you believe that the equity markets are rigged, retail investors are screwed and that the market structure is flawed. They would further argue that the equity markets are in need of dramatic new regulation, flash orders and high frequency trading are the root of all evil and that "dark pools" are something promulgated by Darth Vader. I have only two words to say to Congress, the SEC and the White House: Bull. Shit.

There are some problems to be sure, but they are not what the spin-meisters in Washington would have you believe...

Which markets stayed open for business every day in the teeth of the crisis? The EQUITY MARKETS. You know, the ones that are now in the cross-hairs of every member of Congress with a populist agenda in dire need of scoring points with their electorate. The markets that were virtually closed for weeks? The DEBT MARKETS, including the OTC DERIVATIVES MARKETS. Why was this the case? Uh, maybe because the equity markets are EXCHANGE-BASED and didn't have BS entities called RATING AGENCIES that lobotomized decision-making and facilitated hundreds of billions to be deployed in assets investors didn't really understand.

And which entities are receiving the most heat? The exchanges. The least? The OTC derivatives markets and the rating agencies. Why is this?

The exchange players have awful public relations. The come across as ultra-complex, technologically incomprehensible and in league with the reviled financial institutions and hedge funds. And clearly dark pools and high frequency traders fall into this category. Markets go up and markets go down. The main thing that matters is that they stay open, provide access to investors big and small and promote competition. The exchanges have done a masterful job of delivering on this for both institutional and retail investors. But Congress and the White House appear destined to focus on policies that ostensibly focus on the retail investor (though it is arguable as to whether the prescriptives will actually help; they most likely will hurt), though the retail investor has become increasingly less important in the overall scheme of the equity markets. Most retail money is handled through pension funds and mutual funds, effectively institutionalizing much of the potential retail flow. Further, the retail investor has never had better access or cheaper execution than they have today, yet the picture is painted that they are getting screwed at every turn. It just makes no sense.

In every era certain subsets of market participants made investments to gain an edge. Whether it was the stagecoach, the telegraph, cheap silicon, abundant fiber or co-location, innovators with capital have always sought to be one step ahead. It is this inexorable move towards better, cheaper, faster that delivers benefits to all, even if more benefits go to those who made the investments. Should the retail investor get the exact same execution as a smart algo that is the result of millions of dollars of development, leverages (and pays for) co-location and puts enormous amounts of capital at risk? Not in my opinion. If the ultimate goal is that every market participant, regardless of size, amount of investment or capital at risk is in the EXACT same boat, then we'll see what happens to innovation: It will plummet to zero. The populist denizens in Congress and in the White House are pushing towards the lowest common denominator: mediocrity for all.

Why, oh why, haven't the broken OTC derivatives markets and rating agency crimes been aggressively pursued by lawmakers and regulators? One reason: because they are far less sexy than the exchanges and don't DIRECTLY impact the retail investor. Not too many mom-and-pops have purchased a 5 year GM CDS or stop by Moody's for a report on the SocGen CMBS Non-Conforming Pool XII. They are far more likely to have a brokerage account, an IRA or a self-directed 401k. What's more systemically important, banning "flash orders" or mitigating the counterparty risk associated with tens of trillions of over-the-counter derivatives contracts? We already know the answer, since Mr. Geithner and his friends did a back-door bail-out of Wall Street with taxpayer money via the AIG gift. This was due to credit derivative counterparty performance risk, friends, not because they had a lousy stock portfolio that they couldn't liquidate. And why do rating agencies even exist? They have simply resulted in an abrogation of responsibility on the part of investors: THEY are the true WMDs, which is ironic considering Mr. Buffet's long-standing position in Moody's. Yet we seldom hear about this.

Sadly, we live in a world of sound bites, and Congress and the White House have found far better sound bites to attack the denizens of the equity markets rather than the derivatives and debt markets. And as usual, it will be this stupidity that will cost us all, except the Congresspeople who will have pandered to their constituents in order to get re-elected. Someday, perhaps, we'll have a vehicle for measuring the efficacy of elected officials, not on the basis of success in getting their measures through but in the worth of the measures themselves. There will be many perceived winners when Congress and the SEC enact short-term popular and long-term stupid regulation that increases costs (including to retail) and stifles investment. Quite simply, they are barking up the wrong tree.

This is why I seldom blog anymore. Because just thinking about the irrationality and long-term consequences of this stuff makes me sick...