Pretty much anyone who has been involved in financial markets for any length of time and has some success knows that these markets are not efficient. And thank goodness. Well sort of. Thank goodness from the point of view of an investor, because this creates the ability to generate excess returns. But most investors don’t, most because quite frankly – although rarely admitting it – they’re not even trying.
There are many reasons why markets are not efficient, most with roots in the fact that markets are by definition complex adaptive systems which have constantly changing dynamics and local equilibria. But one of the key drivers contributing to the dynamics of this system is the psychological biases that have been effectively embedded in the DNA of the modern “industrial” asset allocation paradigm. The natural and instinctive herding mechanism that is built into the way humans think.
For most people, there is no way to switch this off; the best one can hope to do is have high self-awareness and try to compensate for this bias. Interestingly, some people are physiologically missing these mental pathways. As an example, think of people afflicted by Asperger’s Syndrome. I’m not a doctor but some of the most (consistently) successful traders who I have had the privilege to meet or work with over the past couple decades certainly seem to have personality and behaviour traits that line up with (at least mild) versions of the Wikipedia definition of this conditions. I’m pretty sure this is not coincidence.
But generally, most people (and thus the institutions they represent) make (investment) decisions locked inside a Keynesian Beauty Contest – trying to guess what everyone else thinks is pretty, not searching for intrinsic prettiness. And this is often a reasonable strategy, ie they are not behaving irrationally. Although it will never produce consistently strong returns – certainly not on an absolute basis, it will for long periods avoid consistently poor relative returns and even if absolute returns are poor (or even catastrophic) there is significant and very real safety in having fallen (jumped?) off the cliff in a herd. People like covering their ass. Wrong together rather than successful alone. Loss aversion. It’s a rational survival strategy.
And this behavioural framework applies through the whole asset allocation food chain – LPs to Funds to Companies – which means a couple things:
the big tend to get bigger (buy IBM)
there is an extremely high energy barrier to new entrants (at every level of the food chain)
an actor’s ability to raise capital is the most important factor in their ability to raise capital (recursive)
and for asset managers their core business becomes gathering (not investing) capital (tail wags dog)
Which creates a big opportunity/risk pair (or set of fractal pairs):
(for individual actors) an opportunity: for those that can break away from this cognitive and behaviour framework to make outsized excess returns if their convictions are fundamentally sound
(for society) a risk: that intrinsically value creating investments (funds, companies) are starved of capital, while many mediocre “me-too” investments are overcapitalised
In my opinion there is no precise, fundamentally “right” optimal balance in this pair, or certainly not one that is consistent in all environments but I suspect that our current state is quite far from a potentially optimal range. It’s great for a (very small) number of actors that may have the skills and good fortune to take advantage. But collectively poor for our societies and economies. Systemically brittle. From this societal point of view, I think it is important to at least try to redress this balance. I don’t have a magic solution for doing so, but as suggested above, self-awareness can be quite effective in helping to mitigate (at least a good portion) of our systemic biases. It won’t eliminate the Keynesian Beauty Contest paradigm, but it will at least dampen it.
Lest you think I’m exaggerating the extent of this herding behaviour baked into the world’s capital allocation system, let me share some of my first-hand experience of this. For almost a decade I was a syndicate manager. For those of you not familiar with investment banking jargon, my job was to manage the process of raising capital (in an industrialised, repeatable process.) While my focus was fixed income (bonds) (meaning that each year I was involved in managing hundreds of deals – ie my data set give me a decent sample size), the capital raising process – whether you are raising a seed capital round from angels, doing an IPO or selling a bond issue – is fundamentally the same. And if I were to draw a graph of the first questions investors asked during the marketing of a new issue of securities, it would have looked something like this:
(Yes, sadly Virginia this is how too many of the traditional managers of your savings frame their decisions…)
But, for the smartest investors (defined by those who consistently delivered better returns, who – during my tenure as a syndicate manager – were mostly a small number of hedge funds) this graph was inversed. It’s not that they didn’t care at all how big the book was or who else was investing, but that these were structurally second-order, tactical questions for them. First they made up their mind whether or not they thought the investment was compelling and only then did they factor in the deal dynamics in their bidding tactics.
I was reminded of this and inspired to write this post (in the hope of contributing to increasing the systemic self-awareness alluded to above) by a couple posts that I stumbled across in my bedtime reading last night that highlighted the biases (failings?) of investors in the venture capital food chain (LPs and VCs.)
If you can make as good a case as Microsoft could have, will you convince investors? Not always. A lot of VCs would have rejected Microsoft. Certainly some rejected Google. And getting rejected will put you in a slightly awkward position, because as you’ll see when you start fundraising, the most common question you’ll get from investors will be “who else is investing?” What do you say if you’ve been fundraising for a while and no one has committed yet?
While Eghosa Omoigui of EchoVC talks about the risk/opportunity pair that arises from the “Trough of Conviction” that LPs and VCs are prone to get stuck in:
Conventional wisdom has always been incredibly seductive. Particularly as it requires little to no intellectual effort. I am slowly forming a hypothesis that pattern matching in VC is showing similar characteristics, oddly enough.
Today’s VCs are falling prey to the minefield of so-called axioms masquerading as truisms. So sticking to the â€˜x for yâ€™ or â€˜a for bâ€™ pitches is simple, believable and thus fundable. I have no issues with this framework. It helps entrepreneurs to tell a story and VCs love to fund storytellers. But it implodes when faced by disruptive innovation, which I have seen recurrently present itself as an undiscovered versus unmet need.
â€¦So all this boils down to the apparent calcification of pattern recognition (formulaic VC?), and the departure from the two-sided risk-taking marketplace (entrepreneur AND venture capitalist) that was always a key part of early stage venture. A fulltime dependency on pattern-matching when unaccompanied by thesis formation means that you will miss the big winners. As the venerable Tom Perkins declared, ‘If there’s no risk, you’ve already missed the boat.’
And he goes on to quote Elon Musk:
â€œI think itâ€™s important to reason from first principles rather than by analogyâ€¦The normal way we conduct our lives is we reason by analogyâ€¦
We are doing this because itâ€™s like something else that was done..or it is like what other people are doingâ€¦slight iterations on a themeâ€¦
â€œFirst principlesâ€ is a physics way of looking at the worldâ€¦what that really means is that you boil things down to the most fundamental truthsâ€¦and then reason up from thereâ€¦that takes a lot more mental energyâ€¦
Someone could â€“and people do â€” say battery packs are really expensive and thatâ€™s just the way they will always be because thatâ€™s the way they have been in the pastâ€¦â€
Now perhaps by endorsing this view I myself am suffering from confirmation bias, after all, the DNA of Anthemis Group is entirely thesis-driven (both in the businesses we support with capital and in how we’ve organised Anthemis and our approach.) Although it is too early for me to definitively say our thesis is proven. That said (self-awareness!), this framework is the same one that informed my biggest previous (investment) successes – Betfair, Markit, Weatherbill, Zoopla – that have vastly outweighed the ones that didn’t work out. (Interestingly, one example of a poor investment I’ve made was in a company called GnuTrade. And although GnuTrade didn’t succeed, a company formed at almost the same time with the same vision called eToro has succeeded spectacularly. Thesis confirmed, backed the wrong horse.)
So my “call to action” is that anyone reading this who has responsibility for making investment and capital allocation decisions fights harder against their biases to simply follow the path of least resistance – the crowd – and to develop and embrace real conviction, arising from a robust cognitive framework, and to act on this. Even if only at the margins. Let’s move the needle. We owe it to our children to try.
 I was somewhat surprised that I couldn’t find any research that had been published on this topic that might prove/disprove this correlationâ€¦  Some venture-backed companies can also fall into this trap…  I believe that opportunity and risk are like fundamental particles that only exist in the universe in pairs, two different sides of the same coin so to speak.  Anthemis is proud to be a small investor
â€œWhich path do you intend to take, Nell?’ said the Constable, sounding very interested. ‘Conformity or rebellion?’
Neither one. Both ways are simple-minded – they are only for people who cannot cope with contradiction and ambiguity.â€
â€• Neal Stephenson, The Diamond Age
At Anthemis Group we believe that the key to (business) success in the Information Age lies in building strong, vibrant, inter-connected networks of smart people and businesses. The digital tools of the 21st century allow us to do this with a depth, breadth and speed hardly imaginable only a decade ago. And yet however powerful, these tools do not replace the value of face-to-face connections.
Every community needs to ask itself, “Who are the people that are going to drive this community forward in the next 10 years?” and figure out how to support them. – Charlie O’Donnell
With this in mind, last week we hosted our 2nd (annual) Anthemis #HackingFinance retreat (#AHFR13) gathering 60+ amazing individuals – startup founders and executives, investors, designers, senior financial services executives, thought leaders and the Anthemis team – in the magical alpine setting of Meribel.* We asked them to take a step back from their busy professional lives and connect. With each other. With the environment. With the future. And for at least a few fleeting hours, think about how this community, this ecosystem might contribute to the re-invention of financial services. Think about how together we can build better business models, create better products and services, shape better regulation. Think about how we can clear a path that takes us from the manifest obsolescence of industrial age finance to a new paradigm for the provision of financial services that is natively aligned to the technological, economic and cultural realities of the 21st century.
Hackers believe that something can always be better, and that nothing is ever complete. They just have to go fix it – often in the face of people who say it’s impossible or are content with the status quo. – Mark Zuckerberg
Anthemis is still a very young company. The resources and effort – time, money, people – required to organise and host this retreat were material to us. Like a startup company, it’s hard to build a traditional financial model to gauge the value or to try to quantitatively measure the RoI. And yet it is abundantly clear to us that the value created by such an event is very real – not just for Anthemis or our portfolio businesses, but for the wider ecosystem. Value that arises directly from the energy, passion and engagement that each and every participant brought with them. For that I am incredibly grateful. We’ve tried to build Anthemis as a substrate: fertile soil from which wonderful businesses can grow, seeded by talented people who share a common passion and sense the manifest opportunity that exists to create a better financial future.
In the language of flowers, anthemis (chamomile) means patience in adversity. It was known as the herb of humility because, as a lawn plant, the more it was trodden on, the faster it grewâ€¦In Biodynamics, the chamomile preparation promotes a good breakdown of the proteins in the compost to humic plant nutrients, and prevents the protein breaking down to ammonia which would be lost to the atmosphere. It helps soil to retain nitrogen and calcium, keeping them in the living realm and preventing loss to the atmosphere. Chamomile preparation strengthens the plantâ€™s regenerative life activity and reunites this with the physical. This ability has led chamomile to be referred to as the â€œplantâ€™s physicianâ€ in folklore. It has been said that if you have a failing plant, simply plant chamomile next to it and it will revive. (from Chamomile â€“ The Plantâ€™s Physician)
It hasn’t always been easy for us, building a business is hard. Raising capital is hard – especially when you deviate from the status quo in any way. But we knew that going in. I don’t think there are too many things in life that are truly worth doing that aren’t hard. And being surrounded by incredible people who trust and support you** – the entrepreneurs we’ve backed despite our modest resources, the early investors who have backed our vision, the people who have helped us in a thousand different ways just because they thought what we were trying to build was worth building – makes all the tough moments just that, moments. And makes it clear that “the juice is worth the squeeze.”
Over the coming weeks, we will do our best to distill the learnings that emerged from the many conversations that echoed across the alpine meadows and peaks. And where relevant we’ll help encourage and assist with implementing many of the ideas and potential collaborations that arose. And stay tuned to our YouTube channel for a taste of what transpired (and in the meantime you can get a glimpse of last year’s event below.) Although it’s a year away, we’ve already started dreaming about next year’s event, maybe we’ll see you there!
You never change things by fighting the existing reality. To change something, build a new model that makes the existing model obsolete.” – Buckminster Fuller
* It’s no coincidence to us that some of the most productive and creative gatherings are hosted in the mountains: Allen & Co.’s Sun Valley conference, the Aspen Ideas Festival (and numerous others), Dialog, Davos (before it jumped the sharkâ€¦) etc. – one can not help but to gain a new perspective and think big thoughts when faced with such a majestic landscape. Also the effort required to get to these locations helps to reinforce the disconnect from one’s day-to-day concerns and routine.
** I cannot thank enough all the #hackers – so many of whom traveled from the furthest reaches of the globe to join us. In particular I’d like to thank Kirsten Dunlop and Suncorp who not only travelled all the way from Sydney to join us but who kindly sponsored our opening dinner. I’d also like to thank the entire Anthemis team for their positive energy and willingness to do whatever was asked of them to make our retreat a success, but in particular would like to thank Simrat and Pascale and my dear wife Sandrine without whom the retreat simply would not have been a success.
Anyone who is at all interested in innovation and disruption in banking and financial services will have noticed that the world is seeing a Cambrian explosion of startups targeting this industry. It’s an exciting time for us at Anthemis Group, as we have been working to position ourselves for this wave of change for many years. “Skating to where the puck will be” as they say…
The explosive growth of new entrants in financial services – both of individual companies and the universe of such companies – is of course exciting for us, but does pose some challenges, most of which arise from resource constraints, notably time/bandwidth and capital. We are working hard to address and overcome these challenges as we grow our unique “meta-company” model, however it continues to puzzle me how much new capital continues to be ploughed into “industrial age” business models, particularly in banking. Two (unrelated) articles that surfaced in my news stream this weekend inspired me to ask the question out loud.
While I think that Metro Bank has a (much) better approach to traditional branch banking than most incumbents, and I can believe that it is plausible that the Rainbow branches could be better managed as a “clean”, independent entity, I fail to see how either of these strategies will lead to long-term, sustainable success and strong investment returns for their backers. Neither is natively adapted to transition to the business models that will emerge as Information Age leaders. Their economics are fundamentally flawed; being more efficient/better managed will give them an advantage over the incumbents, perhaps sufficient for some short term (2-5 year) wins. But in the longer term, they are just as exposed to disruptive new models as today’s incumbents (perhaps moreso given their lack of TBTF inertia.) (On the other hand, if they are able to take advantage of their challenger status, access to capital and more nimble management to partner with or acquire some of the new Banking 3.0 leaders, perhaps they can emerge as winners in the longer term…)
The economics of truly new entrants like Fidor Bank, Simple, Moven and dozens of others are not just marginally better, but in some cases an order of magnitude (or more) better. Clearly as new entrants they face many (often different) risks in gaining adoption and scaling. And while the success of any individual company amongst these “digitally native” new entrants is not assured, I would suggest that the big winners of 21st century banking will almost certainly be found amongst these types of businesses (and not from the ranks of traditional, branch-centric models.) As such I find it ironic that much more investment capital (seemingly an order of magnitude or more) is chasing these old models.
Having worked in capital markets and the investment world for a couple decades now, I actually do understand the dynamic at work – people (especially those working for large institutions) typically feel more comfortable investing in “more of the same”: better, faster, smarter versions, sure but… Of course it is easier to make linear projections of the past into the future. Investing in new models requires people to acknowledge discontinuities and exponentials, which is admittedly hard. The thing is, if you are in the middle of an epochal change in economic and societal frameworks (which I believe to be the case), this is the only rational choice.
For anyone thinking of investing in the future of banking, I’d invite them to compare the metrics (customers, assets, volumes, unit economics, etc.) of these digital newcomers with companies like Metro or Rainbow per dollar or pound of invested capital. Now think of what any of these companies could do with Â£100mn, let alone a Â£1bn… The puck may be in the corner for now, but I’d rather be in front of the net.
Many years ago, enterprise software was written to run on mainframe computers. This was the best (only?) solution at that time that had the requisite memory and processing power to run these applications and so – despite their cost, inflexibility and operational complexity – mainframes represented the optimal computing model for enterprise applications. Until a new computing model emerged. Based on powerful, plentiful and inexpensive blade servers and a number of new, standard software components, this “technology stack” became the new optimal computing model for running more and more of the enterprise. LAMP was the new 700/7000.
Not only was this new model less expensive, more robust and more resilient, it was much more adaptable. Further, the open standards encouraged a tremendous amount of innovation and experimentation which in turn fostered the development of a vast array of specialist but compatible variations. This enabled bespoke solutions for different applications and environments to be easily developed without the need to build a new platform each time. And as each component in the stack had a very specific role or purpose, its design could be optimised without compromise.
The traditional banking business model mirrors the mainframe: a vertically integrated, all-in-one solution with all the resources and tools needed to deliver banking products and services in one big (black) box. In the context of the 20th century competitive and technological landscape this worked fine. It was the optimal solution. But like the mainframe of the computing world, the all-in-one “big iron” approach to banking is no longer the optimal business model with which to efficiently and profitably serve the banking customers of today. A new approach, predicated on assembling specialist providers of the component elements required to deliver end products and services will prove to be the new optimal business model for banking. Welcome to the (banking) stack.
Take for example the process of making a loan. This actually breaks down into a “process stack” that at a high level looks something like this:
Each layer of this stack requires different skills and resources. The value drivers for each activity are different. Each requires a different mix of technology, design and talent and the application of fundamentally different business models and capital resources. As such, trying to house them all in the same organisation means that some or indeed each of these activities are operated in a sub-optimal fashion. Indeed, the stronger the culture, the better managed the bank is (in the context of traditional, hierarchical models), the more acute is this problem.
That said, so long as margins remained high and competition muted, with competitors operating more or less efficient and skillfully executed versions of the same business model, sticking with the “mainframe” model was just about tenable. However this is no longer the case. New entrants – unburdened by legacy technologies and mindsets – are emerging across the stack with business models that are natively adapted not only to leverage the technologies of today but that also address the changing expectations of customers in terms of pricing, design and user experience. In many parts of the stack, incumbent institutions will find it hard to compete as the best of these new entrants gain traction.
The best managed of today’s leading institutions will adapt to this changing landscape. How? By letting go of their traditional business models, opening up their value chain and making an honest assessment of where in the stack they have a sustainable competitive advantage and where indeed they do not. This is not a trivial change for most traditional banks and aside from the adjustments in technology and business model it will entail, perhaps the most challenging aspect in this transition will be to change the culture and mindset of these institutions for whom open architectures and collaboration is often anathema.
But for those institutions that are able to make these changes, the rewards will be significant. By focusing their resources and talents on the areas of the stack where they have a true competitive advantage, exiting other areas where they are structurally uncompetitive and collaborating with (and investing in) companies with disruptive new and powerful value propositions in these areas, they will successfully navigate the transition to becoming an information age bank.
Taking the example above, already it is becoming clear that the traditional models for originating, underwriting and processing loans are no longer competitive. New models from companies like FundingOptions, Zopa, OnDeck Capital, Kabbage and many others are proving to be much more effective and economical. Traditional banks should be lining up to partner with companies like these and in particular become lenders and provide core transaction banking services, areas where they do have a real competitive advantage. They should also be leveraging their strong distribution channels to drive customers to these platforms in exchange for lead generation fees. Of course for the managers and employees responsible for these functions within traditional banks, the transition will be painful, ultimately their jobs will disappear. However, in any case, this outcome is inevitable as their value proposition and competitive position becomes ever more compromised.
By embracing change and working within the grain of this new paradigm, incumbent banks can do much to ensure their future success and survival and will find it much easier to rebuild trust – with customers, regulators and their communities – mitigating the short term pain and setting themselves on a path to sustainable profitability. The alternative is to keep doing the same thing and slowly but surely rust away. The best banking executives of tomorrow will need to be as familiar with APIs and SDKs as they are with APRs and RAROC.
And one can only wonder why this same ambition, this same energy, this same sense of purpose seems all too often to be completely absent today. Why our leaders – in politics as in business – seem far too often to set the bar so remarkably low, rationalizing this lack of ambition as pragmatism. Just being “realistic”. Yes, there is a place in this world for pragmatism, for realism. But this does not excuse the apathy – or worse cynicism – of our society’s most fortunate and powerful in the face of great opportunity and risk (for these two are just different faces of the same coin.)
Preserve my job. My power. My capital. Nothing truly worthwhile in any domain of human achievement has ever been accomplished by people or societies that were ruled by this mindset. And yet it is pervasive.
As our global society and economy transitions from the industrial to the information age, the size and scope of the challenges we face are even bigger than those involved in putting a man on the moon. Every facet of our institutions (government, business, education, culture) will need to be re-configured over the next few decades if we are to survive and ultimately thrive in this new world. We need ambitious, passionate, energetic people to stand up and embrace this opportunity for re-invention. Leaders. Doers.
At Anthemis, I am tremendously fortunate to be able to work with dozens of such people who bring their talents and energy to bear each and every day working towards our big, important goal of re-inventing finance. Â They do this not because it is easy, but because it is hard. Not because success is assured, but because it is important for them to succeed. Sure, it’s easier to be cynical. To say it can’t be done.
We choose to go to the moon. We choose to go to the moon in this decade and do the other things, not because they are easy, but because they are hard, because that goal will serve to organize and measure the best of our energies and skills, because that challenge is one that we are willing to accept, one we are unwilling to postpone, and one which we intend to win, and the others, too. Â – John F. Kennedy
We do have choices. The future is ours to invent. Join us.
Last week I was away with my family for a few days. In a location where there was no working internet connection and a very sketchy 3G signal. As a start-up founder with a never-ending to do list, this was quite disconcerting (especially as it was unexpected.) So aside from freaking out for a couple days, I had no choice but to catch up on both sleep (I hadn’t quite realized how big my sleep deficit had become!) and reading. Which ended up reminding me that disconnecting from time to time can pay dividends.
The Undercover Economist is a terrific account of how economics drives behaviors and his view on how a change in our underlying economic drivers is fundamentally undermining our existing (traditional) organizational and institutional frameworks particularly resonated with me:
…economists believe there’s an important difference between being in favor of markets and being in favor of business, especially particular businesses. A politician who is in favor of markets believes in the importance of competition and wants to prevent businesses from getting too much scarcity power. A politician who’s too influenced by corporate lobbyists will do exactly the reverse.
At the end of the book, he includes the introduction to a later book Adapt: Why Success Always Starts with Failure. He tells the story of a young Russian engineer Peter Palchinsky who challenged the top-down, hierarchical thinking of first Tsarist and then communist Russia over a hundred years ago:
What Palchinsky realized was that most real-world problems are more complex than we think…His method for dealing with this could be summarized as three “Palchinsky Principles”:
first, seek out new ideas and try new things;
second, when trying something new, do it on a scale where failure is survivable;
third, seek out feedback and learn from your mistakes as you go along
…Most organizations and most forms of politics have the same difficulty in carrying out the simple process of variation and selection…if we are to accept variation, we must also accept that some of these new approaches will not work well. That is not a tempting proposition for a politician or chief executive to try to sell…
…There is a limit to how much honest feedback most leaders really want to hear; and because we know this, most of us sugar-coat our opinions whenever we speak to a powerful person. In a deep hierarchy, that process is repeated many times, until the truth is utterly concealed inside a thick layer of sweet-talk…Traditional organizations are badly equipped to benefit from a decentralized process of trial and error…(yet) the more complex and elusive our problems are, the more effective trial and error becomes, relative to the alternatives. Yet it is an approach that runs counter to our instincts, and to the way in which traditional organizations work.
Building on these principles, he suggests the recipe for successfully adapting is comprise of three essential steps:
Try new things, in the expectation some will fail;
Make failure survivable, because it will be common;
Make sure you know when you’ve failed.
What you want to do as a company is maximize the number of experiments you can do per unit of time. -Jeff Bezos
Much as I enjoyed Tim’s book, I was blown away by The Connected Company. Simply stated, I suspect it will go down as one of the most important management books of the early 21st century. It is a remarkable treatise on the new optimal organizational framework for businesses of the Information Age. I’ll admit to some bias as I don’t think I could have written a more articulate or complete account of the philosophy and theory underlying our approach to building Anthemis.
We are reaching a complexity tipping point, beyond which organizations will not be able to succeed without a change in structure.
…And if the world is constantly changing, the only sustainable competitive advantage is to be the one most responsive to change. That means that the speed at which you can learn is the only thing that can give you a long-term sustainable advantage. The problem is that while today’s companies are very good at processing information and producing outputs, they don’t know how to learn.
Indeed the fractal (Dave uses the term “podular”) nature of how we are building Anthemis is a direct attempt to create a more adaptable – and ultimately more resilient – company fit for the challenges of the 21st century. By explicitly embracing a networked rather than hierarchical structure we have built in the ability to experiment and fail while at the same time giving us many more chances to succeed. Dave also highlights that this new type of organization is in essence a complex adaptive system and some of you might recall from previous posts and presentations that the work of Herbert Simon on this subject has had a profound impact on our thinking.
To design connected companies we must think of the company as a complex set of connections and potential connections, a distributed organism with brains, eyes and ears everywhere, whether they are employees, partners, customers or suppliers. Most importantly, a connected company must be able to respond dynamically to change, to learn and adapt in an uncertain, ambiguous and constantly evolving environment.
A connected company is a learning company.
We see Anthemis as a network, an ecosystem where our main responsibilities are (1) to articulate and evangelize a robust vision – re-inventing finance for the Information Age – and (2) to create a fertile environment where passionate, talented individuals, teams and companies pursuing various components of this vision are provided with the tools – capital, talent, connections – that materially improve their chances of succeeding. Anthemis as a city (as opposed to a traditional company) is another interesting metaphor for our approach that Dave also explores:
Taken together, agile teams, service contracts, composability and loose coupling allow the creation of complex service clusters and networks that operate in a peer-to-peer, citylike way. In fact, these kinds of “service cities” can sometimes be so complex that the only way to manage them is not to manage them. Instead, the company focuses on creating an environment within which they can thrive.
The key to creating a successful organization in an era of unrelenting (and often accelerating) change is to build for agility. However the traditional organizational structures that were so successful in the Industrial Age are fundamentally unable to respond to this challenge:
Many business systems are tightly coupled, like trains on a track, in order to maximize control and efficiency. But what the business environment requires today is not efficiency but flexibility. So we have these tightly coupled systems and the rails are not pointing in the right direction. And changing the rails, although we feel it is necessary, is complex and expensive to do. So we sit in these business meetings, setting goals and making our strategic plans, arguing about which way the rails should be pointing, when what we really need is to get off the train altogether and embrace a completely different system and approach.
Dave highlights Amazon.com as one of today’s leading companies that has already adopted many of the tenets of the connected company. He describes their approach as breaking big problems down into small ones; distributing authority, design, creativity and decision-making to the smallest possible units and setting them free to innovate. At Anthemis, we take this one step further as most of the teams focused on each of these “smaller” problems are actually companies in their own right with their initial connection into the Anthemis ecosystem being forged via a financial investment. Aside from our legal structure however, the important distinction between ourselves and a venture capital fund is our clear long-term vision of creating a new leader in financial services: the vision is the glue.
The way we think about it is, on those big things, we want to be stubborn on the vision and flexible about the details. -Jeff Bezos
Essentially our job (at the Anthemis Group node) in this context boils down to designing and building the structure and system that supports the people and businesses in our network and then operating that system. Further we have a key role in creating and supporting a broad and diverse portfolio of experiments in order to maximize our chances of discovering and building the best and most sustainable financial services businesses in a context of rapid technological change and an evolving competitive landscape.
And perhaps in a future updated edition of his book, Dave will be able to point to us as a great example of a successful “connected company”!
Power in networks comes from awareness and influence, not control. -Dave Gray
Update: In this video, Gary Hamel talks about many similar themes, highlighting that our existing management and organizational paradigms are 100 years old and increasingly anachronistic in a world of accelerating change.
The micro-cracks are turning into fissures, soon to be gaping crevasses as (finally) the obsolescence of our industrial age banking system plays itself out in spectacular front page headlines. Meanwhile it would seem that our society and our leaders are (mostly) frozen in some kind of macabre trance – eating popcorn and mesmerized by the inevitable Crash.
If you look at the LIBOR scandal in the context of the technology of the fast emerging information economy, it is absolutely mind-boggling that such an anachronistic process even exists in the world of 2012. In a world where every financial flow is digitized and only really exists as an entry in a database. In a world where truly enormous real-time data sets (ones that make the underlying data required for a true LIBOR look puny) are routinely captured and analyzed in the time it takes to read this sentence. In a world where millions (soon billions) of people have enough processing power in their pocket to compute complex algorithms. In a world where a high school hacker can store terabytes of data in the cloud. Â In this world, we continue to produce one of the most important inputs into global financial markets using the equivalent of a notebook and a biroâ€¦ WTF???
The rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time.
For each (of 10) currencies, a panel of 7-18 contributing banks is asked to submit their opinion (yes, you read right) each morning on what each rate (by maturity) should be. The published rated is then the “trimmed arithmetic mean”; basically they throw out the highest and lowest submissions and average the rest. No account is taken of the size or creditworthiness or funding position of each bank and the sample size after the “trimming” for each calculation is between 4-10 banks. However, the BBA assures us that this calculation method means that:
…it is out of the control of any individual panel contributor to influence the calculation and affect the bbalibor quote.
You don’t need to be a banker or a quantitative or statistical genius, or an expert in sociology, or even particularly clever to figure out that this is a pretty sub-optimal way to calculate any sort of index, let alone one that has an impact on the pricing and outcomes of trillions of dollars worth of contractsâ€¦
In the 1980s when LIBOR was invented – and (lest the angry mob now try to throw the baby out) it should be said an important and good invention – this methodology just might have been acceptable then, as the “best practical solution available given the market and technological context.” Banks used to have to physically run their bids in Gilt auctions to the Bank of England (thus why historicallyÂ banks were located in the City, tough to compete on that basis from the West End or Canary Wharf, at least without employees a few Kenyan middle distance Olympiansâ€¦) But you know what? Â And this is shocking I know…Â They don’t do it that way anymore!!!
So if LIBOR is important (and it is), how should we be calculating this in the 21st century? Here’s a few ideas:
include all banks participating in the market – and not necessarily just those in London – how about G(lobal)IBOR??
collect and maintain (in quasi-real time) important meta-data for each contributing bank (balance sheet size and currency breakdown of same by both deposits and loans, credit rating, historical interbank lending positions, volatility/consistency of submissions, derivative exposure to LIBOR rates, etc.)
collect rates and volumes for all realized interbank trades and live (executable) bids and offers (from say 9-11am GMT each day)
build robust, complex (but completely transparent and auditable) algorithms for computing a sensible LIBOR fixing arising from this data; consider open-sourcing this using the Linux model (you might even get core LIBOR and then forks that consenting counterparties might choose to use for their transactions, which is ok as long as the calculation inputs and algorithms are totally transparent and subject to audit upon request1)
This is not only possible, but in fact relatively trivial today. Indeed companies like the Climate Corporation*, Zoopla*, Metamarkets*, Palantir, Splunk (and dozens and dozens more, including newcomers like Indix* and Premise Data Corp) regularly digest, analyze and publish analogous datasets that are at least (almost certainly far more) as big and complex as the newLIBOR I’m suggesting.
Indeed, the management of this process could easily be outsourced to one – or better many – big data companies, with a central regulatory authority playing the role of guardian of standards (the heavy lifting of which could actually be outsourced to other smart data processing auditorsâ€¦) In theory this “standards guardian” could continue to be the BBA(the “voice of banking and financial services”) but the political and practical reality is that it should almost certainly be replaced in this role, perhaps by the Bank of England, but given the global importance of this benchmark, I think it is also worth thinking creatively about what institution could best play this role. Perhaps the BIS? Or ISO? Or a new agency along the lines of ICANN or the ITU -Â call it the International Financial Benchmarks Standards Insitute (IFBSI)? The role of this entity would be to set the standards for data collection, storage and computation and vet and safekeep the calculation models and the minimum standards (including power to subsequently audit at any time) required to be a calculation agent (kitemark.) Under this model, you could have multiple organizations – both private and public – publishing the calculation and in principle if done correctly they should all get the same answer (same data in + same model = same benchmark rate.) Pretty basic “many eyes” principal to improve robustness, quickly identify corrupt data or models.
As my friend (and co-founder of Metamarkets and now Premise Data Corporation) David Soloff points out:
If nothing else, this weekâ€™s revelations show why it is right for British political figures, such as Alistair Darling, to call for a radical overhaul of the Libor system. They also show why British policy makers, and others, should not stop there. For the tale of Libor is not some rarity; on the contrary, there are plenty of other parts of the debt and derivatives world that remain opaque and clubby, and continue to breach those basic Smith principles â€“ even as bank chief executives present themselves as champions of free markets. It is perhaps one of the great ironies and hypocrisies of our age; and a source of popular disgust that chief executives would now ignore at their peril.
Rather than join the wailing crowd of doomsayers, I remain optimistic. The solution to this – and other similar issues in global finance – either exist or are emerging at a tremendous pace. I know this because this is what we do here at Anthemis. But I’m clear-headed enough to know that we only have a tiny voice. Clearly it would seem that our long predicted Financial Reformation is starting to climb up the J-curve. I just hope that if Mr. Cameron does launch some sort of parliamentary commission that voices that understand both finance and technology are heard and listened to. Excellent, robust, technology-enabled solutions are entirely within our means, I’m just not confident that the existing players have the willingness to bring these new ideas to the table.
* Disclosure: I have an equity interest, either directly or indirectly in these companies.
1There may exist some good reasons for keeping some of the underlying data anonymous, but I think it would be perfectly possible to find a good solution whereby the data was made available to all for calculation purposes but the actual contributor names and associated price, volume and metadata were kept anonymous and only known to the central systemic guardian. Of course you’d have to do more than just replace the bank name by some static code, it would need to be dynamically changing, different keys for different calculation agents etc. but all very doable I’m sure. You’d be amazed what smart kids can do with computers these days.
Though your towers were tall
and your powers were grand
you could not understand
how you fell from great heights
and you burrowed with speed
a kingdom you did lead
from heaven to hell
– A Fistful of Swoon, Vandaveer
Excuse me if I seem a bit sarcastic but I can’t help but smile. Slowly but surely the masters of the universe seem to finally be waking up to the inevitability of the eventual obsolescence of the archetypal business model of 20th century banking. I’ve been talking about this for a decade and the fact that it only took, let’s seeâ€¦a gigantic global financial crisis and several years of messy aftershocks for these great and good to even start thinking about switching horses? Well, you just have to laugh because the alternative is simply too depressing.
I happened to be traveling a fair bit this past week, which for me means I actually have a few minutes of downtime to read the Financial Times (thanks to British Airways and the rules forcing everyone to turn off all electronic devices upon take-off and landingâ€¦) and stumbled upon three articles that caught my attention. First up on Tuesday was Hugo Banzinger – Deutsche Bank’s Chief Risk Officer – highlighting the fact that “Banks must regain investors’ trust” on the op-ed pages. Really??You think?
Banks have also remained remarkably silent on how they plan to adjust their business models. Lenders will have to demonstrate that their future business models are beneficial to society, that they can be run safely and that they are able to restore profitability to make them attractive investments again.
Many investors shy from investing in bank equity. Business models and future profitability are too uncertain. Restoring bank profitability is of utmost importance, requiring drastic actions. The standardisation of products and automation of process has to replace the tailor-made approach of many trading desks. IT investment costing billions will be necessary. The number of people on trading floors will have to drop to levels seen at exchanges. Salaries will have to normalise to levels comparable to other services industries. Capital intensive inventory for securitisation will have to return to its originators. Market making will have to be networked and back offices will have to adopt lean production methods as seen in modern manufacturing.
These changes will eventually lead to a process revolution of the kind we experienced in retail banking in the early 1990s.
The industrial revolution in investment banking is all about creating a new paradigm for the execution of capital markets business. It is about reinventing the organisational mindset, replacing the traditional front, mid- dle and back office with a highly flexible and efficient product factory attached to a profes- sional cadre of relationship managers and solution providers who work with customers and clients to tailor products and solutions to be produced and executed by the factory. It is about viewing the services we provide as two distinct value propositions, one resting on the creativity and knowledge base of the bank and its bankers, and the other resting on the efficiency and accuracy of production and execution.
Much is promised by banks in terms of â€˜putting the customer firstâ€™ and â€˜delivering solutions not productsâ€™ however the reality is that, even if this is the good faith intent, the current structure of the banks is still aligned to the delivery of financial products as a holistic package with all the ancillary bits (settlement, research, payments, etc.) thrown in to a greater or lesser extent. An essentially analogue model for an emerging digital world. The â€˜digitalâ€™ model breaks down all aspects of the business into dis- crete component parts and allows for each to be optimised (either in-house or out- sourced) and then packaged and delivered to the client according to their needs.
Through this industrialization of the process, the skills and functions of the bankers must equally realign, with expert designers, engineers and manufacturers on the production side, and state of the art customer service representatives on the other.
I guess I just must have been saying’ it wrongâ€¦
Next, a bit later in the week, the infamous Sallie Krawcheck – yes the former Citigroup CFO & Head of Strategy, former CEO Citigroup Wealth Management, former President of the Bank of America Global Wealth & Investment Management division – was also given a slot by the Financial Times editors to explain to us that “JPMorgan shows fighting complexity is futile”. Gee, is this complexity stuff a recent development??
But despite coming a bit late to the game, she nails it:
It is complexity that in good part defines Wall Street and forms some of financeâ€™s highest barriers to entryâ€¦In the main, the response from regulators to the perceived causes of the downturn has been to fight complexity with complexity.
Iâ€™m not suggesting that no economies of scale make sense in banking or financial services more generally, only that they are subsumed by complexity within these â€˜integratedâ€™ financial behemoths. I even have some sympathy for the seductive logic underlying integrated business models, however in my view the theoretical benefits of an integrated model â€“ while possibly intellectually robust on paper â€“ are impossible to exploit in reality. It ignores what I describe as corporate entropy: ie in any corporate process there exists an inherent tendency towards the dissipation of useful energy.
Indeed â€“ sticking with the chemical analogy and without writing a book about it â€“ it would be fair to say that giant bank mergers are at best an (intrinsically unstable) intermediate product in the reaction coordinate and to make any sense need to be followed by a subsequent division into multiple new end products (which individually release the benefits of economies of scale and synergy without the instability engendered by excessive complexity.) So Citigroup (or UBS or HSBC or RBS/ABN Amro, etcâ€¦) should naturally â€œdecayâ€ to form multiple specialist firms that are more focused and efficient than the multiple firms that had been combined first to form these giants.
Of course more regulations hurt the large financial institutions, but they hurt new entrants more. And competition is a whole lot scarier than regulation to incumbents. If you want to get a sense of this, you could do worse than reading Aaron Greenspanâ€™s take on US payment regulations http://www.moneyscience.com/pg/bookmarks/Admin/read/77403/held-hostage-how-the-banking-sector-has-distorted-financial-regulation-and-destroyed-technological-progress-pdf. And similar examples exist across the spectrum of financial services and across the globe.
The irony is that most financial regulations are born through the desire to protect the little guy from losses, and to some extent they achieve this on one (direct) level but following the law of unintended consequences, the result to often is to create an environment where far larger risks (and losses) are incurred at a systemic level. And who pays for that? Well as we all know now, increasingly itâ€™s all of us (including of course, the little guy.) Via government subsidies, interventions, increasing costs to maintain ever larger and more complex regulatory regimes, all of which need to be paid for with higher taxes and more importantly slower economic growth. Here the bankers are right, all these new regulations make our current system less able to produce growth which of course hits the 99% hardest. But then the bankers stop before asking for a level regulatory playing field that would pour fuel on the smouldering fire of new, innovative, disruptive entrants. Please Lord deregulate me, but not just yet.
But of course if you are reading this, you already know we’re working hard and investing big to help change this. And despite my slight snarkiness above, I am actually excited to see views I’ve held dearly for many years starting to be adopted by (some of) the leaders and personalities of the financial services establishment. (Indeed, Sallie if you’re reading this, I’d love to have the opportunity to tell you about Anthemis and compare notes on the future of finance. And good to see you on twitter. Welcome to the (financial) reformation!)
The third article was about Senator Sherrod Brown trying to revive new legislation is the US which would mandate a break-up of the megabanks. He states:
â€œI am confident that we will see the government over time requiring some divesting of assets because if [big banks] keep getting an advantage in the marketplace, and they keep growing and having a higher percentage of assets, itâ€™s basically a government-endowed advantage. Thank you, US taxpayers.â€
I wonder if we might eventually see something along the lines of the break-up of AT&T, a process that was initiated in 1974 but took ten years and lots of litigation before taking effect in 1984. However ultimately, the problem with banking is not just about size. In this respect, I have some sympathy for the banking lobby: creating 5 or 10 mini-JPMorgans or BoAs is not really the solution (although it could be an intermediate step.) Sheila Bair has also been making the case for smaller, less complex banks:
Yet instead of waiting for the government or shareholders to act, the leadership of these megabanks should take the lead in downsizing. The best way for Dimon to provide a better return to his investors is to recognize that his bank is worth more in smaller, easier-to-manage pieces. Let’s face it, making a competitive return on equity is going to become even harder for megabanks as their capital requirements go up, their trading and derivatives activities are reined in, and their cost of borrowing rises as bond investors recognize that too-big-too-fail is over. If, by downsizing, Dimon can achieve valuations comparable to the regional banks’, he will potentially release tens of billions of value to his shareholders.
More importantly, I think we will inextricably move towards a fundamental reconfiguration of the industry: away from vertically-integrated monoliths and towards an ecosystem or “stack” of firms focused on different components of the industry. The stack metaphor I think is particularly apt, not only because it is a useful conceit to describe the financial system but also because finance is essentially an information technology business and much useful inspiration can be taken from observing the evolution of the ICT industry as it moved from the mainframe to the internet to the cloud era. And it’s not entirely coincidental that I first presented these ideas at a telecommunications conference in 2009.
In such a world, it would not be inconsistent to have several megabanks with enormous balance sheets, but these would likely be very simple constructs – highly regulated and limited utilities, providing a basic deposit taking and liquidity providing function to the system. As I suggested in my AmazonBay video in 2005, the ultimate destiny of (the core) of the global megabanks might to simply become “giant regulated pools of capital.” Such banks would have relatively few employees, extremely robust but relatively limited infrastructure, and would make consistent but modest returns on their capital. They would sit towards the bottom of the financial stack, the financial equivalent of the massive (but usually faceless) data centers that run the internetâ€¦
As you might suspect, we have a number of ideas of how this reconfiguration might play out, and this thesis deeply informs our investment process and some aspects of it are already reflected in our portfolio, other aspects not yet but soon we hope. I was thinking of writing an article that would map out how we see banking services being organized in say 2022 but rather than give too many of our secrets away here and now, I think I’ll keep some of these in reserve for the moment. Especially since the industry seems finally to be starting to pay attention and I don’t want to lose our 10 year head-start on designing the future of finance as it makes my job so much easier! As William Gibson said, “the future is already here, it’s just unevenly distributed”.
optimally support our core mission to build the leading “digitally native” diversified financial services group of the 21st century
fundamentally and structurally align our key stakeholders: investors, management, employees and our portfolio companies and their founders
create transparent economics that are clearly driven by long term wealth creation through capital growth
be as simple as possible while remaining operationally and tax efficient
We wanted a structure that would avoid:
misaligned economics – in particular any structure which would incent management to raise capital without regard to cost; we want to be in the business of investing and growing capital not collecting it
misaligned horizons- in particular having our investment decisions driven by tactical (time-driven) rather than fundamental considerations; the tail should not wag the dog
undue complexity – in particular where it might lead to reduced transparency or fundamentally drive management or investment decisions; as simple as possible but no simpler
And so we very deliberately – against the grain of many (smart) people’s advice1 – decided to set Anthemis up as a company, or more specifically as a group of companies with a simple holding company at the top of the group structure. In order to give you some insight into why we made this choice, I’ve tried to distill what we believe to be the key advantages of this structure in the context of our business model, vision and goals:
We have one clear, measurable and transparent objective: grow the value of Anthemis shares over the medium to long term. All of our management decisions – which can essentially be distilled into allocations of human and financial capital and assessing the opportunity costs of both – are guided by our best judgement as to how these choices will affect the long term value of our shares. We get this right and everyone is happy. We win (or lose) together with our people, our shareholders and ultimately our portfolio companies and their founders.2
All investors are invested in the group’s parent company: Anthemis Group SA, a Luxembourg Societe Anonyme. We have only three classes of shares: preferred (with a simple 1x liquidation preference), common (essentially arising from the exercise of employee performance options) and founder shares (which are economically identical to common shares but carry certain limited governance rights and more onerous vesting and transfer provisions.) Investors and employees don’t need an advanced degree in financial modeling in order to understand the value or performance of their holdings. Beneath the parent company we have a small number of both operating and holding entities all of which are 100% owned by the Group, the corporate form and domicile of these entities has been chosen to ensure a tax efficient and compliant structure that is also cost effective to run. It is exceedingly simple to understand which we believe has its own value.
We have an enormous opportunity in front of us, one which requires our full attention and all our energies. Opacity is a tax on efficiency and productivity. It drains your mental energy. It increases entropy. Transparency sets you free. If nothing else it means that you never have to remember what you said to whom when. More importantly it builds trust which is the currency that fuels networks and ecosystems. Of course it is much easier to be transparent when your structure is simple and aligned across stakeholders. Paraphrasing Warren Buffett, “our guideline is to tell our stakeholders the business facts that we would want to know if our positions were reversedâ€¦and we believe candor benefits us as managers: the CEO who misleads others in public may eventually mislead himself in private.”
Building great businesses takes time. Typically at least 7-10 years in our opinion, sometimes longer. And having invested in and built a great business, why would you want to sell it? Or more precisely it would seem crazy to have to sell it. And yet that is exactly the constraints faced by traditional GP/LP venture funds. Sure a GP can ask for an extension, but that doesn’t change the fundamental truth that irrespective of circumstances, they have an obligation to exit their investments. Aside from the misalignment of fund terms with optimal venture capital investment horizons (which, to be fair, could to a largely be remedied if fund lives were 15 or 20 years rather than 10), the other disadvantage of being structurally forced into shorter, time-limited investment processes is that one inevitably risks being seduced by the siren call of high IRRs to the detriment of building real, tangible long term wealth which ultimately arises from actual cash on cash returns.
An evergreen – ie equity – capital structure is the simplest, most elegant solution. We also believe in robust and conservative balance sheet management: to use the trader’s vernacular, we believe in running a matched book. Equity financed with equity. If we do our job successfully, the last thing investors should want is to be given their capital back before they want or need it. If we are successful, there will be any number of ways to create liquidity event(s) as and when required by our investors. If on the other hand we are unsuccessful, quite frankly the structure won’t make a damn bit of difference to our investors’ outcomes. In fact they may well be better off holding corporate equity rather than distressed fund units, but almost certainly they would be no worse off.
There are more than simply structural differences between Anthemis and a venture capital or private equity fund; the most important of these is our ambition to build a coherent yet diversified group of companies that is perennial. This means that our investments (and eventual disposals) are framed in the context of optimizing our business portfolio and overall return on invested capital and are considered through a lens of corporate development rather than simply as individual financial investments. The fact that our current investments (we currently have 20 companies in our portfolio) have been entirely concentrated on “venture” stage companies reflects quite simply our thesis that the global financial services sector is at the early stages of what we believe will be a secular transformation of the industry as “industrial age” business models are disrupted and ultimately replaced by “information age” or as we like to call them “digitally native” business models.
Over the next 10-20 years, our plan is to initiate, grow and consolidate our positions in the companies that emerge as leaders in this new economy. At the same time we plan to continue to make investments in disruptive startups emerging on the “innovation frontier” in order to maintain a vibrant pipeline of emergent technologies and business models in order to retain our immunization to the innovator’s dilemma. We believe that the optimal organizational paradigm of the information age will be predicated on networks, not hierarchies and have crafted our approach to building the leading financial services group of the 21st century to be inherently aligned with this hypothesis. Our vision is to build Anthemis into a strong but loosely-coupled network of complementary businesses focused on financial services and marketplaces; not to build a monolithic, hierarchical conglomerate. We never want to become too big to fail, our clear aim is to become too resilient to fail.
Although our investment thesis is fundamentally different, from a structural or even philosophical point of view our approach is very much inspired by Berkshire Hathaway. (Spookily, upon founding Anthemis, Uday and I happened to be very close to the same ages respectively as Warren Buffet and Charlie Munger when they “founded” Berkshire Hathaway in 1965. Here’s hoping history repeats!) As an aside, Henry Kravis once called Berkshire Hathaway “the perfect private equity model”, though why KKR didn’t or hasn’t adopted a similar structure is interesting. (One wonders if it isn’t as a result of the relative risk/reward (fee-driven) profile for the GP in a traditional private equity structure vs. the (equity-driven profile) of a founder/manager in corporate holding structureâ€¦) Other examples of thematically or industry focused groups from whom we draw inspiration are companies like LVMH or Richemont (luxury and branded goods) or Naspers and DST (media and internet) but ultimately we have the sense that what we are seeking to build is somewhat unique, something new. An evolution in corporate organizational structure which is adapted to the emerging social and economic landscape of the global information economy.
(excerpt from LVMH Group Mission:) The Group’s organizational structure is decentralized, which fosters efficiency, productivity, and creativity. This type of organization is highly motivating and dynamic. It encourages individual initiative and offers real responsibilities – sometimes early on in one’s career. It requires highly entrepreneurial executive teams in each company.
For both Anthemis investors and for the companies in which we invest, our focus and approach provides an interesting and complementary alternative to traditional venture capital funds. Although it would be naive to pretend there is no competitive overlap, our conviction (confirmed by our experience to date) is that we are in fact a positive new entrant in the venture ecosystem that complements rather than competes against more traditional venture investors. Not “either/or” but “and”. For the startups in which we invest, we know that building an investor syndicate of diverse and complementary talents which includes the networks and company building skills that the best VC partnerships bring to the table is the best way to ensure their chances of success. Our portfolio companies are much stronger for being able to combine our (sector-focused) talents and resources with those of leading VC firms such as Atlas Venture, Bessemer Venture Partners, IA Ventures and others too numerous to mention. And it is equally clear to us that Anthemis is strengthened by the continuous learning and exchanging of ideas that comes with having the privilege of working alongside so many smart and seasoned partners and associates of these VC firms.
For our investors, we offer a unique and efficient way to gain intelligent exposure to the future of financial services. And while clearly there are some similarities in our risk/return profile with that of a traditional venture fund (given that a very significant proportion of our balance sheet is invested in early and venture stage companies), we are nonetheless not strictly speaking substitutable (in the way say traditional “bluechip” generalist VCs might be.) And as we grow – just as for the startups in which we invest – our risk profile will naturally evolve. Indeed one could think of Anthemis as a financial services “meta-startup”. That said, when considering Anthemis I suspect that many of our existing and potential future investors would characterize Anthemis as a direct venture-stage investment, with any allocation coming from within their venture capital (or private equity) bucket. As such, I thought it would be interesting to examine how Anthemis might stack up in the eyes of an investor in the context of the five recommendations of the Kauffman report.
(1) Abolish VC mandates
Not sure if this is directly relevant to Anthemis. However we would agree that anything that encourages a return to substance over form in the context of LP asset allocation is a good thing. A private equity investment process that focuses more on the “what” rather than the “how” strikes us as being more sensible given the heterogeneity and illiquidity of these types of assets.
(2) Reject the Assumption of a J-curve
Traditional venture capital theory (useful it seems when justifying reporting opaqueness!) states that investments in startups (and thus portfolios of startups in a particular vintage fund) go through a cycle by which their valuations initially decline before later increasing in the goodness of time as the big winners in the portfolio emerge (and are fed more capital) and the losers fall away (with relatively limited capital having been invested.) Kauffman however found that this theory while it sounds good, isn’t borne out by reality; rather most funds experience an “n-curve” whereby valuations increase substantially in the first 2-3 years (driven by follow-on venture financings at higher and higher – but generally unrealizable and almost always unrealized – valuations), only then to deteriorate over the remaining life of the fund. (ie Big winners often don’t emergeâ€¦) Unsurprisingly, they also found that these increases in (paper) value topped out at almost exactly the same time that GPs sought to raise their next fund, producing a flattering backdrop upon which their LPs could tick the track record/historical returns box. The reader can draw their own conclusions, but Kauffman concludes that “too many fund managers focus on the front end of a fund’s performance period because that performance drives a successful fundraising outcome in subsequent funds.”
Investors in Anthemis don’t have to worry as to whether there is a J-curve, an n-curve or an “any-other-letter”-curveâ€¦as they are owners of preferred equity in Anthemis. We don’t raise subsequent funds. The Anthemis founders and management are significant shareholders whose performance compensation is largely equity-driven. Any time Anthemis raises new equity capital (our analog to raising a new fund), both our focus and the new investor’s focus is on future expected returns on this capital. Full stop. If we go to raise new capital and investors think the share price on offer is too high (or at least too high to offer them the risk-adjusted returns they expect), they won’t invest. If the Anthemis Board thinks the share price offered is unattractively low (insofar as the cost of capital exceeds the company’s expectations as to it’s projected risk-adjusted returns and/or those available from new investments), it won’t issue.
Every smart entrepreneur and venture capitalist understands the intrinsic tension between capital and dilution which acts as a powerful aligner of interests. We simply embrace this dynamic, aligning our returns to those of our investors and removing path dependency and our ability to arbitrage the structure at the expense of our investors.
(3) Eliminate the Black Box of VC Firm Economics
I must admit that before reading the Kauffman report, I didn’t realize how little information VCs provide to their LPs. It’s pretty ironic given that most VCs spend more time negotiating (and are more dogmatic about) the nuances of control and information rights in the companies in which they invest than pretty much anything else, including valuation. The report highlights that “LPs seem to lack the conviction to require the information from GPs in the same way the GPs themselves require it” and apparently don’t use the leverage that they potentially have to force the issue, according to one GP quoted in the report “LPs never walk away.” Sure. Um, that sounds like a robust and healthy investment process. Yikes. But the boxes are ticked and the forms all filled in nicelyâ€¦and so everyone’s happy.
Another perceived top-tier GP agreed with our view about the importance of transparent partnership economics and he admitted “no good answer” as to why LPs couldn’t receive the same information about his fund, except that the information is “never shared.”
Ok so you can get away with it, fine, but why? Why not be transparent? It sounds like a bunch of derivatives bankers that won’t share the model because they’re afraid the client will find out just how big their margin is and “won’t understand” all the costs (systems, people, capital – immediate and contingent) that this gross margin needs to support. (Irony alert: of course these same bankers usually hold up this gross margin to their managers as profit, blithely ignoring these same items in the pursuit of a “fair bonus”â€¦) Imagine Joe Entrepreneur saying to Jim VC: “Just write the check and trust me. It’s complicated, I don’t want to cause you any unnecessary anxiety or have you misunderstand the numbers. That would be distracting. I’ll let you know when I need more. Thanks.” Come to think of it Jack Dorsey could probably get folks signed up on those termsâ€¦
So Anthemis is not a black box. We treat our investors like any startup would treat their VC investors. We have certain information and governance rights written into our articles and in general we respect and are open with our investors, doing our best to keep them informed and making ourselves available when they have ideas or questions they would like to discuss. We have audited financial accounts, a clear remuneration policy (overseen and approved by the Board including at least one Investor director) and quite frankly a pretty transparent and straightforward approach to investor relations. We can’t imagine having a conflictual, non-trusting relationship with our investors. What we are trying to build is hard enough as it is, we need our investors to be on board: not just financially, but intellectually and emotionally.
And so I hope Warren doesn’t mind if we adopt Berkshire Hathaway’s first Owner’s Manual principle as our own:
Although our form is corporate, our attitude is partnership. Udayan, Nadeem and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we are also, for the moment and for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.
(4) Pay for Performance
Our first hand understanding of how this principle was being misapplied in much of mainstream finance and asset management was yet another proof point for our thesis that financial services business models were ripe for disruption. It is the shield the industry wraps itself in: “we may be paid well, but we are a meritocracy and our pay is justified by our performance.” This may have been true once – and in some firms in some activities it probably remains true today – but these are too often the exceptions not the rule. It’s a whole other essay as to how and why this is and how it came to be so, but I’ll spare you the details and jump straight to the punch line: too many compensation models are structurally biased to favor human over financial capital and worse, compound this bias with path-dependent outcomes that reinforce the skew, sometimes dramatically so.
The standard 2 and 20 fund compensation paradigm is one of these. There is nothing fundamentally wrong with the principal behind it – you get a management fee to cover your overheads and a performance kicker if you generate returns (even better if there is a hurdle rate which should be based on the risk-free return plus possibly some margin for the extra risk or illiquidity depending on the strategy.) And frankly, this model can and does work, especially when the managers have a substantial stake in the fund (both in absolute terms and in terms of a % of their net worth) and when the fund has performance high-water marks and/or hurdle rates. Good examples of this model working are often found in the hedge fund world, where principals often own much or even most of the fund and their holdings represent a very substantial proportion of their total net worth.
In cases where these conditions aren’t met it often doesn’t work out so well. The fixed percentage management fee acts as an opiate, driving managers over time to focus their energies on asset gathering (not management.) The temptation to increase AUM to the largest (credible) size is strong as doing so essentially gives the managers a free upside performance option as the management fee alone becomes enough to pay themselves handsomely. Heads I win, tails you lose.3 This pathology is bad in any asset management context, but is particularly toxic with respect to venture capital given that it is an strategy that involves investing in a limited number of essentially illiquid securities.
If you are a macro hedge fund investing in FX and interest rates, the fact that you are managing $100mn or $100bn possibly doesn’t matter (especially if a big chunk of the capital is your own.) If you are investing in venture – or for that matter small cap public equities – a strategy that is highly successful with $100mn of capital can be a struggle to execute when you have $1bn or more to play withâ€¦) Unsurprisingly you often see some of the best VCs (who have easy access to capital) drift towards growth/private equity strategies where they can intelligently deploy larger sums. Done well this can be a good strategy (for all) but still we wonder why LPs aren’t more flexible and proactive in negotiating more tailored fee structures, either on a per fund and/or per firm basis.
In this context, our relatively simple, transparent “corporate” approach to compensation is an interesting alternative – it aligns management (who are also significant investors) with outside investors under all circumstances. First, not only is there no incentive for management to raise capital (grow assets) for the sake of it, there is actually a strong disincentive to do so: more capital means dilution. It has a cost. Raising capital is only interesting at a price that allows Anthemis to improve the risk adjusted returns of its existing and potential future portfolio of businesses. If the cost of raising equity is too high (ie the price of our shares is too low), it is financially more attractive for Anthemis (and our existing shareholders) not to raise more funds and to simply manage our existing portfolio of assets. To be clear – especially given the nature of our assets – I’m not suggesting that it is possible to create a spreadsheet that will spit out a definitive share price at which we should issue or not – there are too many subjective and uncertain inputs and pricing the opportunity cost of capital (which is essentially what I’m talking about) is as much art as science, especially at this stage of our development.
But what is clear – and structurally friendly to shareholders – is that there is symmetric risk and reward for management when raising capital. Just as there is for the founders of companies that VCs invest in everyday. You don’t see Jane Entrepreneur raising $100mn on a $1mn pre-money because she could then afford (to pay herself) a big salary; rather she is going to look first at what is the minimum amount (including a margin of safety) of capital needed to achieve her key value-creating milestones (while paying herself a reasonable salary.) If the price offered is unattractive, she’ll probably err on the side of raising less capital; if the price offered is generous, she’ll probably err on the side of raising a bit more. Simple. Valuation matters. Dilution matters. And most importantly, what is good for Jane in this context is (almost) always good for her existing investors. Alignment.
So how do the management and employees at Anthemis get paid? Basically there are three components, all of which are easy to understand and ultimately transparent to our investors:
Baseline: We pay our people competitive salaries and annual bonuses based on their experience and market value; this gives us some flexibility and resilience with respect to managing operating cash-flow while allowing us to attract excellent people who don’t have to be independently wealthy to finance their employment with us. Note that a very significant part of our overhead costs including salaries and bonuses are actually financed by our successful advisory businesses which are profitable on a stand-alone basis. These businesses then give a decent return on capital to the group while more importantly enabling significant operating leverage vis-a-vis our investing activities. Under a traditional GP/LP structure, given the size of our balance sheet, we would currently only be able to align a small fraction of our professional resources to support our principal investment activities. (And we would not be able to leverage the extremely valuable strategic and informational advantage arising.)
Performance bonuses (cash): With respect to our advisory businesses, insofar as our operating revenues permit, we accrue a performance bonus pool. The size of this pool depends on achieving a certain net operating margin target as set and is agreed by the board.
Long term incentive plan (equity): Each time we raise new equity capital, we create an option pool equivalent to 20% of the amount raised; these are options on common shares and have an exercise price equal to the price paid by investors in that round and are subject to standard vesting provisions. The options are then allocated to staff over the expected deployment period of the capital raised, based on a number of criteria (skewed towards their respective contributions to the development and performance of our portfolio participations) – again all agreed by the board. Some are also held back in reserve for new hires and exceptional performance rewards. In our opinion, this option structure offers a competitive performance incentive to Anthemis management and employees with a payout profile that does a much better job (than traditional GP carry structures) of aligning the interests of management and investors. Unless we increase their value and create liquidity in our shares, we don’t get paid.
(5) Measure VC Fund Performance Using a Public Market Equivalent (PME)
Earlier I mentioned that we were inspired by Berkshire Hathaway; one of the elements of their approach that we most admire is their very simple but obviously relevant approach to creating value4:
Our long-term economic goal is to maximize Berkshireâ€™s average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress.
Intrinsic value is formed by three components: the value of investments, the value and growth of operating earnings and a third, more subjective element Buffett calls the â€œwhat-will-they-do-with-the-moneyâ€ factor. In other words the efficiency with which management deploys cash (from retained earnings and new capital raised) in the future. This last factor unfortunately for those who love algorithms is extremely important to the determination of intrinsic value and yet unmeasurable, it’s a judgement call. As an imperfect proxy to intrinsic value, Berkshire Hathaway tracks the per share book value and it’s performance vs both the S&P500 and the S&P Property & Casualty Insurance indices, believing that over the long term this measure at least gives a reasonable indication (although understates) the change in intrinsic value of the business.
Obviously we are not Berkshire Hathaway and so it would not (yet) be meaningful for us to simply take an identical approach to reporting, but we are adopting the same intrinsic value-based approach to evaluating and analyzing our performance and valuation. And once we have enough data to be meaningful, we will certainly look to track and publish (at least to our investors) a similar proxy metric that will allow our investors to compare our performance to the relevant benchmark(s).
The Kauffman Foundation in their report suggests that the Russell 2000 is an appropriate benchmark against which to measure generic US venture capital returns. Given that we invest globally and predominately in financial services and related businesses, I suspect we will need to look at other potential benchmarks and/or perhaps a mix of 3 or 4 different indices. In the past two years since creating Anthemis, the S&P500 is up c. 11% and the MSCI World Financials index is down c. 10%, I’m happy to report that so far we’re doing better than bothâ€¦ As an aside, if there are any index geeks out there reading this who have suggestions as to which index or indices would be the most appropriate benchmark for Anthemis, I’d be happy to hear your thoughts.
For most of my career I worked in capital markets and investment banking and mostly found it to be an incredibly stimulating environment and felt privileged to work every day alongside so many smart and ambitious people. I was particularly fortunate to have worked in fixed income at Paribas for most of the 90’s where I serendipitously found myself at the heart of the birth of the Euro bond markets, with the opportunity to participate directly in building new markets, products and businesses. And once the Euro came in to being, I naturally looked for the next big thing to build, the next big innovation, only to realize (slowly, over the course of several years) that the Euro project truly was exceptional in every sense of the word and that – like most big successful industries – there was actually very little interest in change or disruptive innovation. That “if it ain’t broke, don’t fix it” was the overriding philosophy. (Actually it turns out to be worse, “even if it is broke, don’t fix it”â€¦)
It is difficult to get a man to understand something, when his salary depends upon his not understanding it. – Upton Sinclair
And so I left. And when I immersed myself in the world of startups and venture capital, I was very excited to be leaving this mentality behind – after all venture was all about the new new thing, right? And although I found this to be true of the founders and companies financed by venture capital, and just as in investment banking was thrilled to find myself amongst another group of incredibly smart, ambitious and (new!) passionate people, I was surprised to find this didn’t extend to how VC partners thought about their own business and business models. In this respect, they were collectively just like the bankers I had left behind. (And given the context, this was even more cognitively unsettlingâ€¦)
Uday and I (and our newest partner Nadeem) set up Anthemis because we were convinced that a very big opportunity exists to do things differently in finance. And while it wasn’t at the core of our mission, if you think about it venture capital itself is part of the financial services pantheon and without having set out deliberately to do so, perhaps we will play a small role in catalyzing disruptive change here as well if our model proves to be successful. Meta-disruption anyone?
Thinking about it, I suspect our model could work for other industries and sectors – especially for those where there are strong network effects and where companies and businesses form an interdependent ecosystem and/or value chain. For example an Anthemis for retailing? health? energy? As an investor, I would certainly be interested in building a portfolio of these. Think of it as the the equivalent of sector-focused ETFs but for disruptive, emerging growth companies. Until/unless they were listed, it would be hard to short these companies so it would be impossible to run a balanced long/short strategy in both directions. But a more adventurous or aggressive investor could at least express an even more aggressive view on industry disruption by shorting an index of the incumbents in each sector (against a long position in the innovation holdcos.)5
What is clear is that change is coming to the world of private capital markets, whether it is sector-focused holding companies like Anthemis, platforms like AngelList, CapLinked or even Kickstarter and others, private company exchanges like Second Market and SharesPost, new approaches to the VC model like A16Z,Â Y Combinator, 500 Startups and many other ideas I’m sure that will emerge. Given our nature, I guess it’s not too surprising to find ourselves disrupting on this dimension too! Interesting times indeed. Stay hungry. Stay foolish.
1The consensus advice was not to “rock the boat” by doing anything that might be perceived by potential investors as innovative or different. It’s not that we didn’t believe the advice – indeed we were certain that in the case of the vast majority of traditional private equity LPs, this was going to be true. (And has been confirmed by the Kauffman report who note that “GPs indicated that they and their partners had discussed offering alternative structures and received very negative reactions.”) So are we stupid? Well I hope not. Our decision to ignore the advice to pursue a traditional venture capital LP/GP structure was based essentially on four points, in order of importance:
conviction: a fund structure fundamentally did not correspond to our vision, objectives and business model and would have forced us to make material comprises in all three which we were unwilling to do
ethics: having worked in investment banking and capital markets for many years, we had a clear and deep understanding of the traditional incentive models in the asset allocation and management value chain and we believed that in many cases these were fundamentally broken, causing (mostly avoidable) misalignments of interests with often toxic outcomes; we did not want to be a party to this – we wanted Anthemis to have a fully transparent and aligned structure
strategic: we wanted our shareholders to deeply understand and endorse our vision, to become truly our partners for the long term and be able to weather the good and the bad and intelligently hold us to account because they get what we are building and believe in the opportunity; it may sound crazy (for someone who wants to raise capital) but by making it harder for investors with a “box-ticking” or “herd-following” mentality to invest, we felt this would help us ensure that those that did were both smart and aligned with us as founders
pragmatism (or cynicism!): we believed that even with a plain-vanilla, consensus structure, we would struggle to tick all the boxes of a traditional LP who would rather invest in the 4th fund of a serially underperforming VC fund or even the first fund of a GP with years of junior experience at an established VC, than in a team of seasoned operating professionals with a clear vision, who’s track record of success wouldn’t however fit neatly into their approval grid; we weren’t IBM and we figured they probably weren’t going to risk getting fired by investing in us
2There are two main ways in which our performance can have a positive effect on our (minority-held) portfolio companies:
if our performance is good and our share price is strong, this gives Anthemis (greater) access to (relatively) cheaper capital which will allow us greater scope to support the growth ambitions of our portfolio companies as opportunities arise; their success drives our success which in turn helps us be an even better, stronger strategic shareholder to them
if our shares perform strongly, this creates an interesting currency that we can offer to the founders and executives of our portfolio companies, allowing them a mutually attractive third alternative to hold or sell if and when the day comes when they would like or need to reduce their holding in their company; we hope and expect that this will create a unique and powerful incentive that allows us to retain talented people within our ecosystem over the long term, which we consider to be the single most important driver of sustainable long term success
3To be fair, as Kauffman points out in their report, LPs are enablers of this and if a manager can charge 2% (or more) of AUM and their customers (the LPs) are willing to pay this, there is nothing intrinsically wrong with this if it is justified by performance. I would however suggest a modification that would both allow great managers to charge whatever the market will bear and better align outcomes. For all management fees above the operating costs of the firm, the GPs could “re-invest” this surplus in the fund. Note this throws up some complications in a fund structure (in an equity structure such as ours, this would simply mean paying out surplus “management fees” as restricted equity) but I don’t think it would be impossible to come up with a decent solution. Even if not perfect, it would clearly drive a better GP/LP alignment. Indeed this is effectively what (most) of the best hedge fund managers do, essentially re-investing their surplus income back into their fund(s). Clearly this is easier with a hedge fund that will often have daily or at least monthly NAVs but again I don’t think it would be impossible to come up with a reasonable methodology to enable something similar for venture GPs.
“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover â€“ and this would apply even to Charlie and me â€“ will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What our annual reports do supply, though, are the facts that we ourselves use to calculate this valueâ€¦
â€¦Inadequate though they are in telling the story, we give you Berkshireâ€™s book-value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshireâ€™s intrinsic value. In other words, the percentage change in book value in any given year is likely to be reasonably close to that yearâ€™s change in intrinsic value. You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a college education. Think of the educationâ€™s cost as its â€œbook value.â€ If this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college rather than a job. For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education. Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didnâ€™t get his moneyâ€™s worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.”
5Indeed, I kind of regret not having done so with Anthemis by shorting one or two of the broad public financial sector indices at the same time as going long Anthemis. Although having been very long financials in 2006 (structurally as a result of my 16 years in banking), I can’t complain too much having sold down as quickly as possible my direct holdings and implicitly – by leaving my job – my ongoing embedded exposureâ€¦ As an example, Weatherbill (now Climate Corporation) where I led the angel round in 2006 is now worth upwards of 9x where I invested, whereas Allianz (where I worked via DrKW) is down c. 40%! If you use Commerzbank as a proxy for Dresdner (RIP) it’s down by c. 95%!! And yet investors still consider public stocks like these less risky than venture stage companiesâ€¦go figure.
Last Thursday I had the great privilege of having been invited by the remarkable Laurent Haug to present a snapshot of our vision of the new emerging universe of “digitally native finance” at the wonderful Lift12 conference in Geneva. Twenty minutes is not a long time (and thank goodness Laurent indulged me with a couple minutes more) to convey both the context and the substance of what we believe to be a fundamental shift in the paradigm of the financial services industry, but I hope I was able to give at least a good high-level overview. Most importantly, I hope I was able to convey the excitement we feel at the vastness of the opportunity and the win/win/win (for the customers/companies/economies) available to those who embrace the opportunity for technology-enabled disruption in financial services by introducing them – however superficially I’ll admit – to just a handful of companies who are at the vanguard of this wave of change.
For those that are interested, my presentation and video (updated!) is below:
For those that are interested, here are links to all the companies mentioned in the presentation, those in which Anthemis is invested are marked with an asterisk. Clearly this is just the tip of the iceberg and there are many, many more companies and entrepreneurs and venture stage companies now focusing on creating the future of financial services – a veritable Cambrian explosion of innovation: (note: this selection is somewhat random and driven by a desire to show an interesting / representative cross-section rather than trying to pick out the most important or most successful companies in the space)
As I said in my presentation at Lift12, it is an incredibly exciting time in this space, and it is tremendously satisfying to see all the work we’ve done to position Anthemis at the heart of this opportunity space starting to bear fruit. Working with the amazing entrepreneurs and companies in our portfolio is a privilege and we are constantly impressed by their vision, focus and energy which is infectious. And beyond our existing portfolio, we have an incredibly strong and varied pipeline of new companies we hope to bring into our ecosystem over the next year or so.
You never change things by fighting the existing reality. To change something, build a new model that makes the existing model obsolete. – Buckminster Fuller