Breaking Bonds

Warren Buffett has famously said that:

It’s only when the tide goes out that you learn who’s been swimming naked.

One of several truths captured in this maxim is that when things are going well, we hear all sorts of interpretations that project glory onto the swimmer.

In that vein, you often hear in professions that dole out high compensation that the pay is a reflection of education, skill, hard work, and scarcity of talent.  It’s interesting how often an equally or more compelling story can be told that comes down to a market failure resulting from information opacity and asymmetries, that can be cured, as I have explained in prior posts.

In Buffet’s terms, while the tide is in, the waves prevent us from disputing the truth of self-congratulatory explanations, because they obscure our vantage point as to where the value is generated, whether in market failures or the market actors. The waves in what I am talking are the opacity and crimps in information flow.

As an important example, let’s talk about bond trading at investment banks.  As the New York Times reports:

Bond traders have long defined Wall Street’s swagger and, in good years, generated a major share of its profits. Now, though, an upheaval is taking place in the bond business that is wiping out billions in profits and thousands of jobs.Wall Street banks like JPMorgan Chase, Goldman Sachs and Credit Suisse managed to keep their grip on the bond market in recent years, amassing huge inventories of bonds for clients and trading them mostly in private over-the-phone transactions.

But tighter regulations being enacted this year and new electronic trading technology being rushed to market are threatening to permanently constrain this bastion of big bonuses and risk-taking.

“It was a rock solid kind of career not too long ago,” said Lou Ricci, a co-founder of The Hagan-Ricci Group, a head-hunting firm. “You give me a really good bond trader right now, I probably can’t find them a job.”

The opaque waves have receded with the better information flow enabled by electronic markets, so that the market is not reliant on a few people stockpiling information and transmitting it only via phone calls.  As a result:

Analysts expect that the changes ahead will largely mirror what happened to stock trading a decade ago, when a combination of regulations and new technology transformed buying and selling stocks into a more automated business. That shift reduced staffing levels by 35 percent and compensation by 45 percent, according to recent research..

So the “value” came from the tight hold over the information, rather than the virtues of the bond traders.  This is a cautionary tale for professions and an opportunity for others.

Sean Parker: Chasing Creation Rather Than Perception

Thoughtful comments from Sean Parker in Andrew Ross Sorkin’s column in the New York Times, on the difficulty of being a repeat entrepreneur:

He asks:

How can you as an entrepreneur that’s had success, has a reputation, ever build the courage to go and do something again? Most entrepreneurs don’t remain entrepreneurs. It’s just too psychologically draining to have to constantly start over.

Consequently, there is a move for those entrepreneurs to venture capital.  He saw his own move in that direction as a “total cop-out,” explaining:

You have a whole portfolio, you only focus on your successes, you ignore your failures and you get to continue looking like a player, but you’re ultimately not in control of anything.

Everything is probabilistic, nothing is deterministic, so you never have that satisfaction of knowing that you’re in control of an outcome. So you spend all of your time managing your reputation, managing your relationships and you spend almost no time thinking creatively or doing the things that an entrepreneur is good at doing.

The last distinction between spending your time creating something versus shaping perceptions of yourself seems to be worth keeping in mind, whatever you happen to be doing.

Vision at the FCC, Finally

My friend, FCC Commissioner Ajit Pai delivered his first major speech as a Commissioner yesterday in Pittsburgh.

One of the measures he proposes is establishing an Office of Entrepreneurial Innovation, charged with reviewing proposals for new technologies and services on a faster track than before:

Some might ask: Why do you need to create a new office to do that? Well, existing Bureaus and Offices at the FCC have many responsibilities, and handling petitions for new technologies or services is but one task among many. But if we create an Office of Entrepreneurial Innovation, shepherding proposals for new technologies or services through the FCC will become an institutional priority and send the right signals to the marketplace. Entrepreneurs need an advocate at the FCC—one that will hold us accountable if we delay, rather than decide.

This shouldn’t be a big deal, but it is.  For the decade or so I have been more than casually aware of the FCC, the language of the FCC is the language of Washington bureaucracy and dividing the spoils of big company rents.  This from the agency that ultimately regulates our — as entrepreneurs and users — access to the Internet, whether it is our wireless data, broadband access, or the ability of content to flow freely over the wires, and is supposed to be watching over some of the companies that are privately regulating these key elements of the Internet ecosystem.

In this context, Ajit’s speech, and bringing in the interests of entrepreneurs to the mix, is leagues more visionary than what we normally hear from our FCC Commissioners, usually reporting on the inside baseball of Capital Hill and K Street, focused on dividing on the fruits of innovation, instead of focusing on supporting the birth of the technologies of tomorrow.

Another hint of hope in the speech concerns something that Yochai Benkler, Fred Wilson, and I have been blogging about: innovation sandboxes as a core feature of spectrum policy, instead of the overemphasis on spectrum auctions.  The edge is where true wireless innovation starts, and more innovation is necessary as the wireless players squeeze users access to the Internet (explained in this post).  Ajit mentions that there is a place for unlicensed use of spectrum, although he needs to elaborate, as there still seems to be a bias toward incentive auctions in his remarks.

That said, if there is a President Romney, look for one of the few bright spots of that result to be FCC Chairman Ajit Pai.

Tech Cubism

In 1907, Braque and Picasso met and formed an intellectual and creative partnership to overturn the art of the 19th century.  They took inspiration from certain existing artists and traditions — from what was in the air at the time — but then jumped off from that determined to shatter existing notions of representation.  They succeeded and set twentieth century art in a completely new direction.

This seems the right attitude to adopt wherever: it’s high time to employ tech to bury the assumptions, conceits, and trends of the last century.

Be A Missionary, Not A Mercenary

Thirteen years, I ran into Vinod Khosla at a conference, and jumped on the opportunity to pitch him on what we were working on at the time.  He politely listened to my pitch, thanked me, but when I persevered gave me a glare of serious disapproval for pushing on.  Nonetheless that remains one of my most memorable career experiences.

The reason why is because he is among the most stalwart defenders of the very bold entrepreneurial vision – a zealot as he describes himself on Twitter.  One of my early posts on this blog is worth revisiting.  There he explains how he is looking for black swan investments:

“I am only interested in technologies that have a 90% chance of failure but, if they do succeed, would change the infrastructure of society in some radical way.”

You need vision and faith to find those because:

“But these things aren’t predictable.  Forecasting is based on assumptions, and technology changes these assumptions. I never compute returns. If you start forecasting cash flows, you lose innovation, you lose instinct. You average yourself down to mediocrity.”

Today, on a New York Times blog post, Khosla writes an opinion piece again defending bold entrepreneurial vision.  It starts:

Some people seem to think that getting acquired should be the highest aspiration for an entrepreneur in Silicon Valley. I disagree vehemently.

In fact, I think that mindset does a disservice to the entrepreneurs in Silicon Valley and around the world. This is exactly the wrong way to think about building a start-up not only because it develops the wrong company culture, but on a large scale it can poison the unique and innovative ecosystem that has developed in Silicon Valley over the past 40 years.

You want missionaries, not mercenaries – passionate, maniacally-focused founders who believe in a vision. Founders like this draw the most gifted and passionate employees, who maximize the chance of success, even if they ultimately fall short of their initial goals and get acquired.

There are of course mercenaries and people setting up for “acqui-hires” in the valley as well, but that is not what Silicon Valley’s special sauce is about.

In my view, it’s irreverence, foolish confidence and naivety combined with persistence, open-mindedness and a continual ability to learn that created Facebook, Google, Yahoo, eBay, Microsoft, Apple, Juniper, AOL, Sun Microsystems and others.

Here’s to Vinod Khosla and missionaries, motivated by going big, not by selling out and going home.

Credit or Cash (Flow)? Which Game Is Being Played?

This week, I read this passage in the Economist:

This in turn sparked huge and occasionally destabilising flows of cross-border capital and a massive burst of credit creation. Total credit in the American economy passed $1 trillion in 1964; by 2007, it had exceeded $50 trillion.

This debt explosion showed up not in consumer prices but in asset prices, notably in property. The cycle was self-reinforcing: banks lent money to people to buy property, causing prices to rise, making banks more willing to lend, and so on.

It got me to thinking.  To understand the modern economy, you have to account for the general uptrend in availability and cost of credit as described above.  The fact that the supply of money has an effect on valuation of assets is simultaneously obvious and also deeply strange and unsettling in highlighting that the notion of valuation is inherently unstable.

To see why, let’s step back and think of valuation.  In simplest form, valuation is simply where supply meets demand, but the precursor question to that is how are the supply and demand functions set.  Among the approaches to valuation, let ‘s talk about two.

The first is a function of the discounted cash flows of the specific asset to be valued; the second is driven by the ease and availability of credit in the economic generally.  Where it gets interesting is when these two co-exist for the same asset and/or where there are both financial buyers (who are relatively indifferent to the asset other than as a store of value) and physical buyers (who will use the asset).

The most obvious place in our everyday lives where this is true is with housing.  One method of deciding a fair price to pay is figuring out the sum of discounted cash flows of what you could get (or would have to pay) if you rented the place.  Alternatively, you can just figure out what you can pay for something you like: the lower the interest rates are and the more credit is available, the more debt the buyer would be able to handle and the more she can pay.  The latter approach — considering what we could pay versus what we would rent it out at — wins out more in our economic culture.

In one sense, one can say it doesn’t matter which approach wins, as long from an individual level the risk is appreciated.  But, if you pay more than a home is worth from a rent/cash flow perspective because of a credit boom, then when the credit boom is over, you might find yourself deep underwater.  That’s where we are today and have been for the last five years in the economy.  So, the rub is that it does matter from a societal perspective, because distortions in valuation can have a serious aggregate economy-wide impact when they are way out of whack.  In other words, serious trouble can result if the game changes.

With the historical growth in credit, the credit approach to valuation seems to be more and more dominant in our economy, even beyond property.  The leverage needs a place to go.  For more and more markets, there seem to be both physical users as well as financial investors looking at the same asset.  What may have been at one point actual physical markets with a little bit of hedging are becoming deeper financial markets.

You see this play out in oil, coffee, food stuffs, private equity (the market for companies), in addition to real-estate.  More and more, such markets that, in the past, were driven by fundamental supply and demand from physical users are flooded with money from non-physical user investors.  These latter users are playing a different game — they are not necessarily concerned whether the underlying physical markets justify a valuation, but instead interested at their entry price and the attractiveness of the exit price.

On one hand, this is a problem in that it causes issues for buyers who need the physical goods.  So, why should individuals pay more for coffee or gas because of “speculators?”  On the other hand, those speculators/investors would argue that they are adding liquidity to the market, and give physical users a way to hedge and transfer some pricing risk.  These are not just problems for little people, filling up their gas tanks or paying an extra nickel for their cup of coffee: big companies regularly complain about speculation in their input markets.  For examples, airlines have been screaming about oil markets, and Starbucks has been complaining about the market in coffee beans.

These are real and hard questions.  This post does not answer them.  But here’s the lesson as players in non-financial markets.  It’s important to know what game you are playing — when you are selling or purchasing something, is the market being driven by cash flows, credit, or something else.  If you’re going to have to sell the asset, are the rules of valuation in the market going to change?  Are the valuations suggested by underlying cash flows and credit so out of whack that there is a lot of risk that things might readjust during your time frame?

These are important questions to consider because if the game changes on you, you can end up being the one played.

Amazon Instant

On launch, one of the biggest hurdles that Amazon encountered in its business was the lack of immediacy — the time between desire and delivery led to lost sales.

A core part of its business strategy since then can be seen as trying to eliminate this friction, erasing that lag between want and have, making it almost instant.

Where a good can be transferred into something digital, Amazon has invested to do that.  Most successfully, you have the Kindle and e-books.  Amazon also delivers music and movies digitally, and is trying, with only mixed success so far, to have the Kindle Fire be the hub for that.

For those goods that will be physical, the Amazon logistics, primarily in the form of Amazon Prime, have made two-day delivery the expectation.  Increasingly, in some markets like New York, sometimes one has the mind-bending pleasure of getting goods on the same day without having paid extra, and Amazon is building more local warehouses around the country to make this an even more regular occurrence for customers.

Amazon has the edge in prices, and in customer experience.  The closer it gets to achieving its instant strategy, it gets almost  unstoppable, having eliminated one of the primary remaining reasons to walk into a brick and mortar retailer.

The Red Aristocracy And The Price of Business In China

Following up on my post on China, the FT today has an amazing investigation into the massive scale and tawdry manner of “princeling” looting.”  It’s worth reading the article, and particularly looking at the graphic which links the money to members of the Politburo and other officials.

The Who?

No formal charges of corruption have been levelled against anyone in the family, and senior advisers to the leadership say they believe the case against Mr Bo and his wife will not dwell on how they grew so rich. This is mainly because the party is concerned about drawing attention to wealth amassed by other leading families, revolving around a core of about 100 military and civilian households.

An investigation into the activities of other political families reveals a web of vast and tangled dealings similar to that controlled by the Bo family. Virtually every member of the party’s nine-member politburo standing committee, the elite group that rules the country, has relatives involved in businesses that rely heavily on state approvals and support…

“In the 1990s most senior leaders at least tried to moderate their princelings as they got rich but now there is almost no restraint and it has got out of control,” says a leading Chinese financier with close ties to the party leadership. “This is the single biggest test of the legitimacy of the party…”

“The longer you stay in China the more you realise that everything is controlled by a couple of hundred powerful families,” says one veteran foreign diplomat who specialises in elite Chinese politics. “You also realise that most major foreign companies are trying to hire the sons and daughters of Chinese officials so they can get access and do business.”

The How

However, the chief executives of three multinationals with decades of experience operating in China told the Financial Times that engaging relatives of senior officials as consultants or as joint venture partners was standard practice – and, in fact, vital in many industries. They said these princelings usually preferred to hold stakes in joint ventures through a holding company in Hong Kong or the Caribbean, where Chinese anti-corruption investigators cannot find them.

Consulting fees are often paid in places such as Dubai or Hong Kong, and agreements are frequently written on red paper because photocopies or scans show up black, making it harder for them to be circulated widely, these people said. In some cases, these relatives are introduced as highly paid consultants at the end of the negotiation process, and their sudden appearance is usually taken as a sign that the deal will go ahead.

These chief executives and others said that, as China’s economy has grown and the opportunities for enrichment have multiplied, it has become much harder for foreign companies to recruit or gain access to the relatives of the most senior officials. “These days, a foreign bank would be lucky to get a kid whose father was a vice-minister,” said one senior executive at a western bank in China. “The big families want to go into private equity or do business themselves be­cause that’s where the real money is.”

Sort of begs another question then:  When the scale of the corruption is epic and brazen and the information is increasingly out there such that the FT is reporting on it, what happens next?

Let Them Drink Oil

To follow-up on my views on oil from a few days ago, let me describe a scary reality and a hopeful prospect of our efforts to free ourselves from the grip of OPEC.  In order to “let [their populations] eat cake,” the oil countries have, by and large, been spending money on benefits to their population to mute dissent.  Like, in our domestic situations, where states ramped up pensions when tax revenues spiked on the assumption that times would always be good, this has left the oil states dependent on high oil prices.

According to this week’s Economist:

The country’s oil minister, Ali Naimi, has said that $100 a barrel is fair. The Saudis are reckoned to need $80-85 a barrel to maintain a programme of lavish social spending designed to avoid an “Arab spring” in the kingdom. Iran, Iraq, Algeria and Venezuela rely on an oil price above $100 to keep spending on track and want the Saudis to cut production more.

The OPEC countries are telling us where they need the oil price to be.  It is no longer sufficient to have oil selling at $2o a barrel, $50, or even $75.  In today’s oil market, production and disruption in OPEC countries is the primary driver of prices, and within OPEC, Saudi Arabia, as it has the most spare capacity and reserves in the world, is the ultimate price kingpin.

The social spending pressures to placate their populations are not going away.  Thus, to the extent OPEC/Saudi Arabia retains the price-setting power, we are never going to pay less than we pay today for oil.

This makes it all the more important that, as I describe in the prior post, we reduce our dependence on OPEC.  There are three aspects of that: first, buying less oil altogether by cutting consumption; second, buying the oil we do from outside OPEC; and third, through those actions, changing the supply that acts as the price-setter in the market to pull the price down.  Since oil is a global market, for the oil we need even after we cut consumption, we also don’t want to be paying current prices.  The hope has to be that the ability to procure oil from outside OPEC by the United States, one of the world’s biggest oil consumers, will have the consequence of reducing the influence of OPEC and Saudi Arabia on those prices.

Amazon’s Farm Team

Amazon, far from its creation story as a book seller, is the closest thing we have to a Google for Shopping.  Because of its own success with online retail, and superior provision of all elements of selling and fulfillment, it empowers entrepreneurs to use the Amazon platform for sales in competition with Amazon itself.  Amazon makes money from the sales, without taking the risk of the profitability of sales, so for some investors, this is going to be the better business model.  For consumers, Amazon is a one-stop shop to see products being sold by many retailers in competition with each other and Amazon.  This FT article has a good overview of the model.

But there is a further ingenious benefit as the other retailers act as a “farm system” for items that Amazon does not sell yet.  If Amazon sees that a retailer on its platform finds a blockbuster, Amazon can start selling the product directly, using its scale to presumably get better terms than nearly anyone else.  It’s sort of like a Triple A team which scores with an unexpected slugger, and as a reward, the affiliated major league team snatches the slugger up.  Fast copying is the nature of retail, but what an arrangement!

It’s somewhat analogous to what happens generally with platform industries as platforms and their customers clash as platforms inevitably expand their scope as they see successful business models built on them.

The interesting question is understanding what contractual restrictions and Chinese walls protect the businesses where it’s not the retail sale platform, but instead AWS.  For example, how much does Amazon learn about the video streaming business or the music subscription business from hosting Netflix and Spotify that it can use up to build up its own directly or adjacent competing businesses?