September 2016 – Escondido Framework

Lessons from the misfortunes of Deutsche Bank and Twitter

“John Gapper has written today in the Financial Times about the problems facing Deutsche Bank and Twitter, very different companies but both coincidentally valued at about $16 billion and, but for different reasons, facing an uncertain future. He describes them as both lost in the past and argues that “unless a company finds a way to diversify and expand beyond its core business, it gets stuck”. He makes a good case for the first part of his diagnosis. The second, while well argued about the particular positions of Deutsche Bank and Twitter is far from true as a generalisation in that the both the commercial and non-commercial worlds are full of organisations that have thrived and survived without either diversify or expanding, but who have at least adapted.

The point he makes about Deutsche Bank concerns failed diversification and poorly conceived and executed expansion. He writes: “The obvious lesson from Deutsche’s experience is not to lose touch with your roots. “It strikes me that a lot of banks have lost a sense of what made them special in the first place,” says Chris Zook, a partner of Bain & Company, the management consultancy. The bank’s corporate business is outweighed by retail banking and securities trading, neither of which is doing well….. From early on, Deutsche decided that its founding mission — to challenge the hegemony of UK banks in financing foreign trade in the late 19th century — was too small a niche. But expanding into retail and small business banking, as it did after being reconstructed in 1957, was tricky.”

He describes the problem of Twitter as being a victim of the niche in which it was conceived, the 140 character SMS defined tweet, that now is on the slide and any enhancements are proving insufficient to cope with competition. He contrasts this niche definition at conception with the vision of Jeff Bezos who: “astutely started a business that was neatly defined yet had equally clear room to grow. He entrenched it in the public’s mind as an online bookseller before expanding into other products”. Gapper is conveniently ignoring Amazon’s first mover advantage. It is hard to remember now, but it was founded in the earliest days of the world wide web, in 1994, whereas Twitter only came into existence in 2006, when the internet was much further evolved and Facebook, for example, was already two years old.

Gapper contrasts Twitter with Facebook pointing out that it was restricted when first launched, with strict rules about who could befriend users, but Mark Zuckerberg was able to widen its scope by adding videos and messaging relatively early and with a strong revenue model that allowed him to generate both investment and cash that allowed him to buy businesses like Instagram and WhatsApp to neutralise competition both by taking competitors out an enhancing the core service offering.

So what does Gapper think will happen next to these two: “Deutsche now wants to turn back to something closer to its origins, rebalancing towards corporate finance and asset management with less of the expensive grandeur of investment banking. Twitter seems more likely to take shelter within a bigger company”. This first option appears doable, and actually gives the lie to Gapper’s opening argument about diversification and expansion and, if not “sticking to the knitting” is returning to the knitting. In Twitter’s case, it appears that the only hope is finding another company who can replace the company’s interface with the external financial market with a hierarchical relationship to a group HQ and, if there are indeed value creating opportunities for a new parent, something that provides enough sustainable value in the broadcastable message of less 140 characters and audiences that seem fickle and ephemeral to justify an price that provides some sort of return to the existing shareholders.

Footnote: Gillian Tett reports in FT 30th September that Deutsche Bank paid staff 4bn euros in bonuses in 2006 and 2007 and 2bn in 2008.

Highlights from October 2016 Harvard Business Review

My two picks from the latest Harvard Business Review relate to two Escondido Framework themes: the way that executive teams have been the beneficiaries of the misunderstanding by shareholders (or, rather, their representatives on remuneration committees) of what motivates them and how the relevant market relationships work; and the need to think about employees as customers.

An article titled “Compensation, the case against long-term incentive plans” reviews the work of Alexander Pepper, set out in his book “The Economic Psychology of of Incentives: New Design Principles for Executive Pay (Palgrave Macmillan 2015). Pepper documents how pay for performance incentives, and Long Term Incentive Plans in particular, fail to work as proponents expected. The four reasons are summarised as follows:

Executive are more risk-averse than financial theory suggests
Executives discount heavily for time
Executives care more about relative pay
Pay packages undervalue intrinsic motivation

HBR’s review of Pepper’s work, in its Idea Watch section, comes not long after news broke in London on 22^nd August that Woodford Investment Management was to scrap all staff bonuses, based on the belief that ‘bonuses are largely ineffective in influencing the right behaviours.’

The second article of interest is an article by Cheryl Bachelder, CEO of fast food franchise Popeyes: “How I did it…… The CEO of Popeyes on treating franchisees as the most important customers”. It’s not so much the lesson expressed in the article’s title that excites me, but an extract in the middle of the text that takes the message a stage further, recognising staff as customers:

At one point in my career, I was touring restaurants to talk to team members about the importance of serving guests well. I met a young man who was not excited about my “lesson”. He asked who I was. “I’m Cheryl,” I said. “Well Cheryl,” he said, “there’s no place for me to hang up my coat in this restaurant, and until you think I’m important enough to have a hook where I can hang up my coat, I can’t get excited about your new guest experience program.” It was a crucial reminder that we are in service to others – they are not in service to us.

How to build a business that last 100 years?

The Boston Consulting Group’s latest BCG Perspectives brings a TED talk from one of its partners, Martin Reeves, titled “How to build a business that last 100 years”. His thesis is that we should look to lessons from biology to create lasting businesses. He links the failure of businesses to survive – pointing out that the average US public company has a life of only thirty years and probability that any public US company will still be around in five years’ time is only 32% – to a “collapse of the corporate immune system”.

He explains that human immune system, and indeed all successful biological systems from forests to fisheries, and indeed such long lasting social systems as the Roman Empire and the Catholic Church, display six characteristics:

redundancy (“millions of copies of each component — leukocytes, white blood cells – a massive buffer against the unexpected”),
diversity (“not just leukocytes but B cells, T cells, natural killer cells, antibodies”),
modularity (“the surface barrier of the human skin….the very rapidly reacting innate immune system…..the highly targeted adaptive immune system……if one system fails, another can take over”),
adaptivity (“able to actually develop targeted antibodies to threats that it’s never even met before”),
prudence (“detecting and reacting to every tiny threat, and furthermore, remembering every previous threat, in case they are ever encountered again”),
embeddedness (“in the larger system of the human body, and it works in complete harmony with that system, to create this unprecedented level of biological protection…… if one system fails, another can take over, creating a virtually foolproof system”).

He explains that along with and as a consequence of these characteristics, biological systems are complex and can seem inefficient, in contrast to the instincts of most managers and what is taught in business schools and preached by consultants.

Reeves continues by applying these lessons to examples of corporate failure. His first is the tragic loss of independence of Kongō Gumi, builder of Japanese temples for 1,428 years and managed by members of a single family until it forgot the principle of prudence, borrowed heavily to finance real estate purchases in the 1980s and was finally liquidated in 2006 and its assets sold to a large construction company.

Shitennoji Temple, built by Kongō Gumi (578-2006)

He then contrasts the collapse of Kodak with the successful adaptation of Fujifilm, which used its capabilities in chemistry, material science and optics to allow it to diversify into sectors outside photographic film, surviving “because it applied the principles of prudence, diversity and adaptation”. He also cites the success of Toyota in surviving a devastating fire in the only plant which supplied it with valves for car-braking systems. He describes Toyota’s ability to work collaboratively with its suppliers to repurpose production as an application of “the principles of modularity of its supply network, embeddedness in an integrated system and the functional redundancy”.

I am sure that there is something in Reeves’ argument, but some of it is contrived and overall it would be more compelling if some of the example illustrated his six principles more comprehensively, rather than only illustrating one or two.

Certainly Kongō Gumi’s demise reflects a lack of prudence – but the most extraordinary aspect of the story is that it had survived for as long it did, which may reflect the lack of underlying change in the Japanese temple market over almost a millennium and a half. To quote Business Week’s report on its demise:

“To sum up the lessons of Kongo Gumi’s long tenure and ultimate failure: Pick a stable industry and create flexible succession policies. To avoid a similar demise, evolve as business conditions require, but don’t get carried away with temporary enthusiasms and sacrifice financial stability for what looks like an opportunity. These lessons are somewhat contradictory and paradoxical, to be sure. But if sustained success came easy, then all family businesses would have a 1,428-year run.”

The Fujifilm example illustrates the benefit of diversity in a portfolio, but says nothing about the photographic film enterprise itself. Fujifilm’s survival represents the success of a corporate parent in managing a portfolio (ie the business of managing businesses), protecting the interests of a top management group, but says nothing about the business unit that brought together employees who worked in factories producing film, the customers that constituted the channel to the camera owner, or its suppliers. Essentially, as technology moved on, the “virtual space” between the various market interfaces disappeared and nothing that could be done to protect this enterprise. Its corporate shareholder – the Fujifilm group company – had elected to redeploy the cash flow into other businesses because the ultimate shareholders were either not in a position to, or chose not to, intervene.

Toyota is celebrated for how it manages itself supply chain and the nature of these relationships, but the fact of its ability to bring brake valve production on-line quickly illustrates only three, and possibly only two (given that it explicitly did not have redundancy in its supply chain given that it maintained a single source for these components), of Reeves’ biological system characteristics.

Considering Reeves’ argument and his examples and relating them to the Escondido Framework model of the firm, I certainly concur with three of his principles: adaptivity, prudence and embeddedness. I get redundancy, although not quite as he defines it, but at least that bit of spare capacity, underused resource, or financial headroom. But the need for and appropriateness of modularity and diversity must depend on the circumstances, and sometimes are in conflict.

Timeless themes in Galsworthy’s “Strife” (1909)

My mother in law and I have resolved the problem of the deadweight loss of Christmas (Joel Waldfogel, American Economic Review, December 1993) by giving each other a night out at the theatre, accompanied by her daughter/my wife. Whether last night’s trip to see “Strife” at the Chichester Festival Theatre was her gift to me or mine to her doesn’t matter, it was a great production and my first exposure to John Galsworthy’s insightful exposure of the fallacy of mindless short term focus on shareholder value, the importance of recognising the constraints on the firm of public opinion, and the pressures on the trade union to serve its long term interest over the pressures of the interested parties in the immediate dispute. Furthermore, themes on hand around corporate governance, the tension between external directors and a dominant shareholder chairman, and on the other (in the context of the current junior doctors’ dispute and the tensions within the British Medical Association) between the professional leadership of the trade union and the intransigent leader of the local workers’ committee, have a resonance in 2016 every bit as powerful as they may have had when the play was first performed in 1909.

Wikipedia provides a useful synopsis:

The action takes place on 7 February at the Trenartha Tin Plate Works, on the borders of England and Wales. For several months there has been a strike at the factory.

Act I

The directors, concerned about the damage to the company, hold a board meeting at the home of the manager of the works. Simon Harness, representing the trade union that has withdrawn support for the strike, tells them he will make the men withdraw their excessive demands, and the directors should agree to the union’s demands. David Roberts, leader of the Men’s Committee, tells them he wants the strike to continue until their demands are met, although the men are starving. It is a confrontation between the elderly company chairman John Anthony and Roberts, and neither gives way.

After the meeting, Enid Underwood, daughter of John Anthony and wife of the manager, talks to her father: she is aware of the suffering of the families. Roberts’ wife Annie used to be her maid. She is also worried about the strain of the affair on her father. Henry Tench, company secretary, tells Anthony he may be outvoted by the Board.

Act II, Scene I

Enid visits the Roberts’ cottage, and talks to Annie Roberts, who has a heart condition. When David Roberts comes in, Enid tells him there must be a compromise, and that he should have more pity on his wife; he does not change his position, and he is unmoved by his wife’s concern for the families of the strikers.

Act II, Scene II

In an open space near the factory, a platform has been improvised and Harness, in a speech to the strikers, says they have been ill-advised and they should cut their demands, instead of starving; they should support the Union, who will support them. There are short speeches from two men, who have contrasting opinions. Roberts goes to the platform and, in a long speech, says that the fight is against Capital, “a white-faced, stony-hearted monster”. “Ye have got it on its knees; are ye to give up at the last minute to save your miserable bodies pain?”

When news is brought that his wife has died, Roberts leaves and the meeting peters out.

Act III

In the home of the manager, Enid talks with Edgar Anthony; he is the chairman’s son and one of the directors. She is less sympathetic now towards the men, and, concerned about their father, says Edgar should support him. However Edgar’s sympathies are with the men. They receive the news that Mrs Roberts has died.

The directors’ meeting, already bad-tempered, is affected by the news. Edgar says he would rather resign than go on starving women; the other directors react badly to an opinion put so frankly. John Anthony makes a long speech: insisting they should not give in to the men, he says “There is only one way of treating ‘men’ — with the iron hand. This half-and-half business… has brought all this upon us…. Yield one demand, and they will make it six….”

He puts to the board the motion that the dispute should be placed in the hands of Harness. All the directors are in favour; Anthony alone is not in favour, and he resigns. The Men’s Committee, including Roberts, and Harness come in to receive the result. Roberts repeats his resistance, but on being told the outcome, realizes that he and Anthony have both been thrown over. The agreement is what had been proposed before the strike began.

Missing from the synopsis are some of the more subtle themes in Galsworthy’s text, including the recognition by Harness of the reality facing the company (that it will not survive if the strike continues and the men’s jobs are on the line) irrespective of Roberts’ concern for a wider struggle against “Capital”, John Anthony’s arguments about the primacy of the bottom line and his duty not to compromise, and the concern of the majority of the directors of the company for public opinion (and their personal reputations).