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Markets for the Digital Generation

Over the weekend, I did a more thorough than usual scan of the hundreds of feeds I now follow on my (somewhat bloated) netvibes page. One of my tabs is dedicated to newsfeeds and blogs on Africa, many of which I discovered as a result of my exhilarating trip to TED Global in Arusha, Tanzania last June. One of the blogs I followed was Benin Mwangi, now at The Cheetah Index, a fantastic resource for anyone interested in the emerging entrepreneurial ecosystem in Africa:

As part of our mission to fill the void left by conventional media in covering African issues, African Path will take an active role in supporting and empowering the continent’s young and progressive decision makers. Today, African Path announces the launch of a dedicated business section under the African Path network which will be branded as the Cheetah Index. Currently the site will run on a Beta version.

The Cheetah Index derives both its name and inspiration from Ghanaian economist Dr. George B.N. Ayittey, author of Africa Unchained. A central topic in this book is the new generation of young African professionals who look at Africa ’s problems from a different and revolutionary perspective. Dr. Ayittey believes that this group of professionals plays a central role in re-vitalizing African economies. This group of progressive, problem solving and action-oriented Africans are called the “Cheetah Generation”.

African Path will build the Cheetah Index into a leading online resource for Africa ’s current generation of decision makers. These will include managers, entrepreneurs, government officials, educationists and other people who influence Africa ’s development. The site will provide breaking business news, profiles on African entrepreneurs and industry news while making it easier for business people from Africa and other continents to connect and network.

Which brings me to what got me excited… In a recent post - “Seeing the Gold in African Agriculture”, Benin points to an amazing essay by G. Pascal Zachary - “The Coming Revolution in Africa” and concludes that there is a great opportunity to help develop appropriate infrastructure to support this agricultural revolution (and that he sees the impetus coming from the private sector):

It sort of reminds me of how cottage industries sprung up around Europe from the 1500’s until the 1800’s. The only thing that I would like to add is that the demands of these farmers will likely slowly begin to spur greater demand for infrastructure. I am predicting that the supply of farm-friendly infrastructure will be fulfilled almost entirely through private sources. This might overtime become a very rewarding business line for the enterprising business person…

Zachary’s essay tells the stories of successful, self-made African farmer/entrepreneurs. Here are three excerpts but I strongly encourage you to read the whole article:

After decades of mistreatment, abuse, and exploitation, African ­farmers—­still overwhelmingly smallholders working family-tilled plots of land—­are awakening from a long slumber. Because farmers are the majority (about 60 percent) of all sub-Saharan Africans, farming holds the key to reducing poverty and helping to spread prosperity. Over the longer term, prosperous African farmers could become the backbone of a social and political transformation. They are the sort of canny and independent tillers of the land Thomas Jefferson envisioned as the foundation for American democracy. In a region where elites often seem more committed to enjoying the trappings of success abroad than creating success at home, farmers have a real stake in improving their ­turf. Life will still be hard for them, but in the years ahead they can be expected to demand better government policies and more effective services. As their incomes and aspirations rise, they could someday even form their own political parties, in much the way that farmers in the American Midwest and Western Europe did in the past. At a minimum, African governments seem likely to increasingly promote trade and development policies that advance rural interests.

(Sakwa left life in the city in his 30s to return and farm his family’s rural land:)

In his second year in Bukhulu, he tilled two acres of land, hiring a tractor to assist in plowing. From an American aid project, he and some neighbors learned to plant crops in straight lines. By the third year Sakwa mastered basic farming, “doing much, much better.” When his old Kampala friends visit him, they ask, “How is this poor village man getting all this money?”

Accumulation is only part of Sakwa’s story. How he spends his profits is significant. One early purchase was a mobile phone, which allows him to keep abreast of local markets and negotiate better prices for his crops. That a farmer who lives without electricity or running water should be able to receive phone calls from anywhere in the world is perhaps the most radical change in African material life in decades. Though wireless service came late to the region, nearly one in five ­sub-­Saharan Africans now owns a cell phone, and the World Bank estimates that the region’s wireless phone market is the “fastest-growing in the world.” One morning, after he plants cottonseeds in a small field, Sakwa receives a call from the headmaster at his daughter’s boarding school (yes, he can afford that too!). The headmaster asks for 500 pounds of beans. Sakwa, who has the beans bagged for sale, wants 15 cents a pound. “Will you accept?” he ­asks.

The headmaster wants to pay less. Sakwa refuses. “I can hold my beans until I get a fair price,” he ­says. A few days later, the headmaster calls back and agrees to the ­price.

(On the failure of ‘official’ agro-policy over the last several decades:)

Disdainful of the market, these agricultural specialists preferred to obsess over arcane questions about soil quality, seed varieties, and some mythical ideal of crop diversity. In classic ­butt-­covering mode, they blamed “market failures” and Africa’s geography for farmer’s low incomes and their vulnerability to famine and food ­shortages.

Then, about five years ago, a few brave specialists suddenly realized that under their very noses some of Africa’s most significant farm sectors were booming—and booming without any help from the legions of agricultural scientists and bureaucrats in Africa. In West Africa, corn production doubled between 1980 and 2000. Harvests of the lowly ­cassava—­a starchy root that provides food insurance for many ­people—­steadily expanded. In East Africa, sales of fresh flowers soared. ­Once-­moribund cash crops, such as cotton, saw a large expansion, first in West Africa and then in Tanzania, Uganda, and Zambia. The list of improbable winners went on and ­on.

Even as a steady diet of stories about “urgent” food crises in Africa dominated public discussion, these successes became impossible to ignore. In 2004, the International Food and Policy Research Institute (IFPRI) published a series of papers titled “Successes in African Agriculture.” The papers both reflected and provoked a revolution in thinking about African farming. They also ended a long conspiracy of silence among aid agencies and professional Africanists. For decades the “food mafia,” led by the World Food Program and the UN’s Food and Agriculture Organization, had refused to acknowledge any good news about African farming out of fear that evidence of bright spots would reduce the flow of charitable donations to the UN’s massive “famine” bureaucracy, designed to feed the ­hungry.

The IFPRI report shattered the convenient consensus among experts, donors, and African governments that farmers south of the Sahara were doomed, perpetual victims who could never feed themselves and hence must permanently proffer the begging bowl. Now, because of IFPRI (itself a junior member of the “mafia”), some African agricultural successes could not be denied. That raised a logical question: If some African farmers can succeed, why can’t even ­more?

Thinking about what made me so excited reading his article, I figure it boils down to a couple of key ideas:

• It illustrates the potential power of the individual when provided with (even the bare minimum of) property rights and access to information (markets) and most importantly, the freedom to succeed. That these basic ingredients are not a given everywhere in the world, and especially in many poor developing countries is a crime against humanity.
• On a more personal note, as a 3rd generation descendant of immigrant Canadian homesteaders*, I feel the opportunities I’ve had in my life leveraged upon the potential for hard working, freedom seeking people to build an enduring economic foundation on the fruits of the land.

I know that the circumstances of Saskatchewan 100 years ago, and sub-Saharan Africa today are extremely different. And I am not so naive as to think that land reform, establishing robust property rights and markets is anything but highly complex and fraught with potential pitfalls. That said, I suspect their is much to be said for simply trying to get governments and others (including NGO’s and foreign governments) ‘out of the way’ and let the farmer/entrepreneurs get on with slowly yes but surely building a better future. I hope Benin is right (that private capital will play a preponderant role,) and I believe that the tools, business models and technologies of the sixth paradigm will play a positive and important role in empowering the rise of the African agricultural entrepreneur over the next 2 or 3 decades.

*The Homestead Act permitted settlers to acquire ¼ mi² of land to homestead and offered an additional quarter upon establishing a homestead. Immigration peaked in 1910 and in spite of the initial difficulties of frontier life, distance from towns, sod homes, and backbreaking labour, a prosperous agrarian society was established. (Source: Wikipedia)

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Although I must say I’m not a fan of Microsoft products (or the company), you have to admire Bill Gates’ optimism and drive to build on his business and financial successes and advance the human condition. For obvious reasons, Bill Gates on a podium in Davos can deliver a far more powerful ‘call to action’ than I can mumbling on here at the Park Paradigm; and so I was very happy to read of him using his star power to deliver a message that I mostly agree with and who’s conclusions I wholeheartedly endorse (see by way of example here or here:)

Bill Gates has challenged companies to engage in “creative capitalism” that delivers profits and helps the poor.

This “capitalism for the 21st Century” had to improve the lives of those who did not benefit from market forces.

The Microsoft founder said capitalism only worked for those who could pay, so firms had to find out “how the power of the marketplace can help the poor.”

Here is the link to the Davos webcast (requires Windows MP or Real Player so I couldn’t read it…not very smart), but found an excerpt posted on YouTube:

The key to my mind is finding a way to help individuals in less fortunate situations, particularly in developing nations, get access to markets and (economic) freedom. My suspicion is that the technological advances (and concurrent cultural change) of the 21st century will hold the key to unlocking this vast human potential. I’m sure it won’t be easy, and I certainly don’t pretend to even have the start of an answer yet, but I am optimistic that at least the path towards the seeds of some of the solutions is slowly starting to emerge from the fog. For those seeking enlightenment in this respect, at the risk of making a premature recommendation (I’m about a third of the way through), I suggest picking up a copy of John Kay’s “The Truth About Markets” and suggest you add his RSS feed to your news reader:

…The stark differences in economic lives around the world are not the result of differences in the availability of resources, or education, or capital, or skills. They are the product of differences in the structure of economic institutions. These latter differences in turn determine the availability of resources, education, capital and skills…

…Economic institutions function only as a part of a social, political and cultural context. This is what I describe as the embedded market.

And it is worth keeping in mind, a couple other observations from Kay:

• Market economies require disinterested government.
• The combination of moral rigour and free enquiry is the basis of disciplined pluralism - the defining characteristic of the successful market economy.

I highlight these because I fear that sometimes - when trying to help the world’s poor and developing countries - successful emissaries of the market economies of the west tend to cautiously avoid giving advice or passing judgement on anything that is seen as a political or cultural issue. I suppose this is a reasonable counter-reaction to some of the more egregious excesses of the imperial past. But well-meaning and understandable as this stance may be, it is most often directly at odds with achieving the economic success sought in the first place. We need to stop being afraid of engaging in criticism of political or cultural artifacts that are clearly impediments to economic growth and improvements in human welfare. At the same time, the technological tools of the 21st century will give individuals and communities in these countries an unprecedented opportunity to dismantle corrosive political and cultural legacies that act as giant impediments to economic growth and freedom. While I remain long term optimistic, one doesn’t have to look far (for example the recent post-election turmoil in Kenya) to see that the path will be a difficult one, strewn with powerful men who have no interest in fostering greater growth, wealth and welfare, but whose only interest lies in controlling such (limited) wealth as already exists.

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A couple days ago I was travelling and so had time to read the FT in some detail, including the extended reporting on the ongoing Northern Rock saga and in particular the government guaranteed refinancing scheme floated by GS/the Chancellor. Basically, the idea is to refinance a big chunk of Northern Rock’s assets via a bond issue secured on these assets, enhanced with an explicit government guarantee. Many commentators have questioned this solution as a (bad-for-the-taxpayer) compromise between nationalization (politically embarrassing to Brown) and an entirely private solution (highly risky, with failure a real possibility and so equally politically embarrassing.) The quick-and-dirty analysis is that in this scenario, the government keeps all the (financial) downside, but gives up the upside if the rescue/restructuring is successful. The fact that the plan seems to include warrants (or some similar provision) for the government tacitly endorses this view (while hardly mitigating the potential outcome.)

Rather than dwell on the overall pros & cons of the proposed plan (which has been amply and eloquently done in many other places,) I just wanted to take a moment to take issue with the likely details of how such a structure would be executed. As it stands, it would seem a bond (or series of bonds) maturing in 3 or 4 years would be issued with a government guarantee. I’m not in the market anymore, but read that such securities would likely be sold at around Libor flat, which sounds reasonable and that the issuer would pay the government for it’s guarantee (ie the government is acting like a monoline insurer in this instance.) When the UK Treasury issues bonds directly - ie Gilts - at these maturies, they would be priced at around Libor -70 bps.) S0 for the Treasury to be equally well off, the issuer would need to pay an insurance premium of 70 bps on the amount guaranteed to the Treasury, or in this case c. £600mn. Of course this does not take into consideration whether or not the assets (Northern Rock mortgages, etc.) being financed are ‘good’ risks nor what it would cost to finance them without the government guarantee. Even if you accept the premise that the market is temporarily irrational and that the whole point of this government sponsored refinancing is to bridge this market dislocation, the ‘historical’ market cost of refinancing these assets would be signficantly above Libor flat. This difference should also be factored in to the insurance premium paid to the Treasury.

I hope I am wrong and that the winning package chosen by the Treasury includes a premium that is commensurate with the risks and the extra costs of using the Government’s balance sheet in this way, but my fear is that politics trumps economics and that UK taxpayers will end up taking on a substantial liability without being fairly compensated. Exactly the kind of thing that happens when you start confusing other people’s money (entrusted to you to manage) as being your own.

I hope I am wrong and the bid the Treasury ultimately accepts includes a commercially adequate insurance premium

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On yesterday’s announcements from Apple. Many hundreds and thousands of professional and amateur commentators I’m sure have already insightfully and accurately dissected Steve’s keynote and written complete and intelligent reviews of Apple’s new products. So I’m not going to bore you by trying to compete. Just two observations - admittedly first impressions, one which is somewhat tangential but still germane to some of the ideas I’ve been throwing around with respect to the entertainment industry (although I’ve been mainly focused on music and live events.)

1. The new Apple TV might just be as transformative for the movie business, as the iPod was for the music business. Very impressed. The rental model also - while not ideal - is probably a good compromise (at least in the short term): a good transition model to clear the way for future business models that are completely digitally native. I would have liked to have seen slightly longer time windows, in particular for the once started viewing - say 48 or 72 hours (instead of 24) but not a bad start. And being able to buy DVD’s with digital copies is also a good idea. (What would be fantastic would be a DVD exchange facility whereby you could exchange your old DVDs for new (HD if available) DVDs that include a digital copy, for say half-price. I think the studios would make lots of money as people would then be motivated to renew their entire DVD libraries at once, and as an added benefit, the old DVDs (collected in bulk) could be disposed of in an environmentally friendly way.
2. Apple needs just one more piece of hardware - one more appliance - in order to kit out a 21st century digital home: something that combines the Apple TV, with a touchscreen (and iPod Touch GUI) and an amplifier. For anyone that has their home wired with speakers in each room, this appliance would allow you to access your iTunes music and play it through the speakers in each room.

Apple (AAPL) was down heavily yesterday with the rest of the market, but if my first gut feeling about Apple TV is right, it goes from being a very expensive stock to something worth considering once more (especially if this market sell-off knocks it even lower.) Thoughts appreciated. (Disclosure: I own a small number of Apple shares in my pension plan.)

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As reported by Andrew Orlowski in The Register (thanks to Chris for the pointer), it seems that the Commons Culture, Media and Sport Committee’s Second Report on Ticket Touting (published last week) while tepidly accepting that a secondary market in tickets is a good thing (or at least not unambiguously the spawn of demons) - has at the same time recommended a secondary market tax in favor of primary market incumbents:

British MPs who oversee the Department for Culture, Media and Sport are a sensible bunch, with a keen eye for special pleading. But they’ve erred badly today. In a report on online ticket touting, the MPs have today given a strong recommendation for a levy on the resale of tickets for live events. (Report here.)

Resellers - and therefore punters - will be forced to pay this levy, and a levy collection agency would need to be established to distribute the tax. There’s no recommendation that the levy is returned to performers, as the MMF (Music Managers’ Forum) has proposed. As it stands, the levy will merely oil the machinery of the primary market: the promoters and their agents. This is a quite amazing stunt to pull off - and should serve as a wake-up call to everyone…

…there’s a very healthy after-market for tickets, sold through auction sites such as eBay and bulletin boards such as Gumtree and Craigslist. This is exactly what the internet is supposed to be good at: eliminating wrinkles caused by consumers having a lack of information. And it works very well.

Yet the major promoters have very nearly succeeded in banning this market outright. Instead they’ve won themselves a “right” not enjoyed by book authors, songwriters or composers - or even the RIAA! (Authors, publishers and record companies don’t get a cent from the second-hand sales of books and records.) …

The Committee said it wants the secondary market to continue, and declared itself reluctant to intervene. But it did so anyway, giving credence to a long laundry list of grievances raised by the mega-promoters, including Harvey Goldsmith. Goldsmith wants to extend his huge market power in the primary market by banning the secondary market, and does so by conflating issues such as fraud with touting. Of course, there’s already legislation in place to deal with fraud. But the ticketopolists want to fight fraud the cheap way: getting us to pay a tax, rather than using better technology or employing a few more people to check against abuse. And in this case, they’ve won an improbable victory.

I’ve only had the chance so far to read the summary or the report (but have printed out the whole c. 200 page pdf to read later) but I can’t for the life of me figure out how they managed to reach their final recommendations, which seem to contradict their own findings (!):

While the superficially obvious solution—of increasing ticket prices to whatever level the market will bear—might keep all the potential profit within the industry and effectively eliminate the secondary market, it would run counter to the industries’ pricing policies which aim to make tickets affordable by their grass roots and genuine fans upon whose continuing interest and attendance the long term wellbeing of the industries depends. [Give me a break!!! There are so many holes in this argument I don’t know where to start…] We did not receive any evidence from the grass roots or fan bases complaining that they were unable to obtain or afford tickets for their chosen events…

…We also believe that the existing situation whereby large profits can be made on the secondary market with no benefit to the organisers or owners of the primary rights is unfair and must be addressed. [Why????? Change the primary market price if you think it is wrong!!!!] …

…We welcome the initiative of the Music Managers Forum to seek agreement for a voluntary scheme under which sellers of tickets in the secondary market would pay a proportion of the profit to the original organisers to be distributed in the same way as the original amount paid. In return, the organisers would recognise the legitimacy of the secondary seller and not seek to invalidate the ticket being sold. [So the secondary market participants pay the primary underwriters for their inability to correctly price and risk manage their inventory…wow. Wow! All I can say is I wish we had that kind of mechanism when I was underwriting bonds for a living!] Such a scheme would recognise the right of those in the entertainment and sports industries to a share in the profit made by others out of the events for which they are responsible in the same way that creators of artist works now benefit from sales of their works through resale royalties. We believe that a scheme of this kind offers the best chance of meeting the concerns of event organisers while still allowing the secondary market to operate unfettered and we strongly encourage all those involved to consider it seriously.

May I suggest an alternative model? A simple one. Liberalize and regulate the secondary market. Full stop. Fraud and manipulative and abusive trading is proscribed with both criminal and civil penalties depending on the situation (analogous to securities markets.) And the market decides. I guarantee you the world will not come to an end. Events will continue to be underwritten. Artists and performers will end up being fairly paid (sometimes a lot more, sometimes a bit less but closer to “fair market value” in all cases), consumers will be happier, and underwriters and distributors will make a decent living and innovation will thrive.

The crowning irony is that folks like Mr. Goldsmith would probably continue to be very successful - and the Sharpe Ratio of their business vastly improved - in such a new world. After all they still have their relationships which in an efficient electronic market paradigm generally become even more valuable insofar as they cannot be industrialized and yet can be monetized against a much more efficient infrastructure. But fear and habit are powerful ghosts…and change is well, scary. Like the recorded music industry before them, rather than clinging for dear life to the status quo, major promoters should be leveraging their position of market knowledge and leadership to participate and profit from change: partnering with and investing in innovative new participants and business models. And not leave it until it is too late.

I just wish I had know about the report. I would have liked to submit my Tickets & Markets Part 1 and Part 2 as evidence…

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The emergence of the euphemistically labeled ’sovereign wealth funds’ as (the) major players in global capital markets was one of the stories of 2007, brought home in the latter part of the year by some massive investments in major global banks (such as Citigroup and UBS) who were looking to quickly shore up their capital bases following their widely reported asset write-downs. A story which is continuing into 2008 with both Citigroup and Merrill Lynch (and almost certainly others) in the process of finalizing additional capital injections (mainly) from these investors:

(from The Economist) The risk of a big bank going under has receded as $27 billion (and counting) of capital has flowed into the sector from sovereign wealth funds. Recipients include Merrill Lynch, Citigroup, Morgan Stanley and Switzerland’s UBS (or, as wags now call it, Union Bank of Singapore). These injections may have upset existing shareholders, who have seen their stakes diluted, but they have ensured that although big lenders have wobbled, none has toppled.

(from Times Online, link above) [Merrill Lynch] is however in talks to raise up to $4 billion of fresh capital, with the KIA understood to be one of the big investors in the latest consortium. The Middle East sovereign wealth fund is reportedly also prepared to invest up to $3 billion of the $15 billion of new investment Citigroup wants to raise under Vikram Pandit, its newly installed chief executive.

Chinese state-backed investment funds or banks are expected to stump up collectively another $9 billion for Citigroup, which ousted Chuck Prince as its chief executive late last year after having to take multibillion-dollar writedowns on its balance sheet. The remainder is expected to come from public market investors.

Last month Merrill agreed deals to raise up to $5.2 billion from Temasek, the Singapore government-owned fund, and $1.2 billion from Davis Selected Advisors, the US asset manager. In November the Abu Dhabi Investment Authority, the investment arm of Abu Dhabi, injected $7.5 billion into Citigroup, in return for a 4.9 per cent stake. Last month China Investment Corproration, agreed to inject $5 billion into Morgan Stanley in return for a 9.9 per cent stake.

So just for argument’s sake, let’s say these investors are going to invest c. $50 billion (give or take a few…billion) of capital into these financial institutions. It obviously begs the question: why? A cursory analysis I believe throws up a few possibilities:

• Because they expect to earn a good risk-adjusted return on these investments over the medium term.
• Because they can: ie this is a rare opportunity to deploy substantial amount of capital without moving the market against you.
• Because there are additional ’strategic’ and /or ‘political’ benefits (over and above the expected financial returns.)
• Because they are major customers of these firms and they want to build even closer relationships and share in the upside of their own custom.

I figure that it is probably some combination of some or all of these factors. Let’s take them one at a time.

Because they expect to earn a good risk-adjusted return on these investments over the medium term.
This should - and probably is - the main reason. Classic distressed play: solid underlying business and franchise with one-off (solvable) problems creating a buying opportunity for investors with ‘patient capital’ - a medium to long term horizon (something that these funds ostensibly have.) I wouldn’t pretend to have done any sort of modeling (rigorous or otherwise) to have an opinion on the specific investments being made (and prices being paid) but wonder at a high level whether modern global (investment) banks are good long term investments (at any price.) I will come back to this point in a subsequent post. (Of course if these investors are looking to trade out of these positions over 12-36 months, my scepticism is much less relevant.)

Because they can: ie this is a rare opportunity to deploy substantial amount of capital without moving the market against you.
This may sound naive but is actually pretty important. Managing tens or hundreds of billions of funds may sound easy and fun (the world is your oyster) but as any good fund manager (hedge, sovereign or otherwise) knows, in many markets and instruments, size can be a curse on two counts: firstly, finding investments that are big enough to ‘move the needle’ - ie make a difference to the overall returns of the fund; and secondly, having identified such an opportunity, actually being able to execute without overwhelming the market and/or incurring such high transaction costs that the returns effectively disappear. In this sense, beggars can’t be chosers works both ways: you take what’s on offer (at least whatever seems at least somewhat reasonable.)

Because there are additional ’strategic’ and /or ‘political’ benefits (over and above the expected financial returns.)
Perhaps. I’m not really qualified to say, although I suspect that if the above two conditions are met, this is probably the icing on the cake (as opposed to the driving consideration.) As the sovereign wealth funds quickly grew in size, number and ambition (in particular straying out of bond markets into public and private equity) over the past few years, much of the political and business establishment in the developed world was growing increasingly anxious about what they saw as the potential of their economies and national corporate champions being unduly influenced by foreign governments. (Without I might add seeing the irony…) These funds as a result face(d) a real risk of being shut out of many potential (large) investment markets. Taking into account the challenges they already faced with respect to their size (see above) this would be disastrous. Bailing out key major financial institutions should in principle be a great way of keeping the door open and building political goodwill.

Because they are major customers of these firms and they want to build even closer relationships and share in the upside of their own custom.
The Victor Kiam gambit: “I liked it so much, I bought the company!” Maybe. Although the basis risk is huge and the potential for conflicts of interest enormous.

So if you had $50bn burning a hole in your pocket, would you do the same trade(s)? While based on my framework above, I can see what might be driving these investors, I’m not sure I’d do the same. Even if the goal is only to take a short term (1-3 year) “trading” view on valuations, there are probably better (ie more liquid, less risky) ways to express such a view even for the size. Some background on my view in Part 2.

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For those of you who aren’t prediction market enthusiasts, there is a vibrant community that has developed - much of it manifested online - over the past few years. Like many such emergent communities, there is much passion amongst the members for there chosen area of focus. Generally this is a good thing but is not immune to excess from time to time as some of this passion occasionally splills over into what might fairly be described as zealotry. I guess I would consider myself to be a member of this community, probably somewhere towards the middle or the back of the room: trying to follow the main plots, absorbing quite a bit of information and occasionally asking a question or making an observation. So in this micro-context, on the spectrum from zealot to reactionary sceptic, I’d probably be halfway between the middle and sceptic; however if you choose the general population as your sample, I’d be close to the zealot camp. Everything is relative.

But - much as I entertain a similar passion for the potential power of markets in “predictions” as many of the leaders of this movement, I have to chuckle when I run across some of the more - shall we say “emotional” discussions within this community. Again while this is a common characteristic of most new ‘movements’, and in no way unique to passionate prediction market proponents, it is still funny to see this community’s People’s Judean Front and the Judean People’s Front equivalents bash it out on the airwaves so to speak.

And of course there is a small fringe that is keen to control the terms of engagement - the quintessential ‘rule-writers’, often obsessing about semantics and making sure that everybody innovates but only in the ‘right’ way. Another irony - from my point of view - is that many (perhaps most?) of the most active, eloquent and committed members are American (or more relevantly based in America), where of course the wise people in Washington, DC make it as hard as possible to run said prediction markets without risking 2-5 years… Actually, when you stop to think about it this is actually less surprising than at first glance: repression is a great catalyst to passion. (Thank goodness!)

Anyhow, last week’s Clinton victory in the New Hampshire primary has thrown this community into a tizzy…sort of like kicking an anthill…many many column inches have been written defending, deriding and analyzing the fact that the ‘(prediction) market(s)’ got it WRONG! ie Didn’t accurately predict the outcome - indeed they were no better than the POLLS! Oh the shame…

Well - and I suspect many others have already made the same observation so I make no claims to any original insight - this line of reasoning misses the point entirely in my opinion. The ‘failure’ of New Hampshire was the result of primarily two factors:

1. It wasn’t a failure. No market is always right. More importantly markets reflect the information available to and the interests of their participants. Basically markets are very efficient mechanisms (I would claim the most efficient) for processing information. No more, no less.
2. In this particular instance, the probability of the market producing an erroneous forecast was high due to the lack of liquidity. This is a problem of all political markets in the US. Show me a market on the New Hampshire primaries with tens of thousands of participants and millions of dollars traded and I will show you a market that creates more valuable information. BUT it would still on occasion be ’surprised.’

Basically I guess what I’m trying to say is the expectations seem to be set all wrong by many inside the community. I think “prediction markets” - creating markets in information and outcomes is a wonderfully important and valuable thing to do. Equally however I think that anyone that represents such markets as being able to predict the future is a charlatan. What they can do is collect and synthesize powerfully and efficiently all the dispersed available information - using money as the relevance filter. This is very valuable in its own right and is defensible. Promoting prediction markets to true sceptics (ie mainstream American politicians) on the basis that they are a Delphic Oracle is surely a path to certain tears and ultimately is almost guaranteed to fail.

Markets don’t compute unknown unknowns. That doesn’t mean they are useless, just that they have to be understood in context.

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It seems William Hill is having some trouble adapting to the digital century (from The Guardian):

A failed website relaunch has wiped £22m off William Hill’s profits for 2007.

The bookmaker admitted today that it has scrapped a major upgrade of its internet betting operations. The platform, dubbed NextGen, had been scheduled to launch by last month and allow the firm to significantly improve its online gambling offerings.

But following an internal review, William Hill – which has been without a chief executive for more than three months – has decided to ditch NextGen. It now plans to use a “third-party technology solution” that will not be ready until the end of 2008.

I wonder if the kids over at Betfair could lend a hand?

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Regular readers will have probably noticed that I’ve been somewhat preoccupied by the music business over the last few months. Ostensibly this is because it is a high profile industry that has been much in the news as its 20th century business model is torn asunder by the digital revolution. While this is certainly a factor, this situation is not entirely unique to the music business and so I had to ask myself why I’ve been so drawn to read, think and comment on this particular industry. I think it comes down to two additional factors.

First it’s cool. I could pretend that I’m above that - blase - but let’s face it…it’s rock and roll. I could pretend otherwise of course but it wouldn’t be true.

Secondly (and more in keeping with the usual tenor of this blog) - and I’ll admit to bias - there are significant parallels with financial markets (with the key exception that while financial services have managed to sneak into the Devonian while the music industry seems by and large to be desperately clinging to it’s pre-Cambrian ways.) More specifically, it is a business whose core value springs from human genius and creativity and whose product (in a digital age) is essentially an interesting barbell of abundance and scarcity. Once one understands this, it becomes pretty obvious how a combination of existing computing, communications and markets technologies could be put together to create an entirely new paradigm for the music industry. A paradigm that would increase wealth for artists and performers, improve the service offered to their customers and provide a good return on financial/managerial capital needed to oil the machine. Furthermore, much of this could be generalized to much if not all of the entertainment industry. And - perhaps the topic of a future post - maybe even to any industry predicated on individual talent and creativity. (Investment banking? Money management?)

There is just one giant problem: it doesn’t look anything like the existing paradigm. The giant music companies of today would either have to disappear or completely transform themselves. Voluntarily. At least for it to happen quickly. While this is not entirely impossible, it certainly isn’t going to happen with the current crop of incumbent managers. They are about as likely to give up their sinecure as stick a needle in their eye. Ain’t going to happen. Hell this doesn’t happen in most ‘normal’ industries. It is damn sure not going to happen in a business where the executive perks include hanging out with the Rolling Stones and getting your picture taken with your arm around Shakira’s waist. I imagine - much like an investment bank - given the potential rewards, it takes a certain significant cunning and ruthlessness to get to the top of one of these companies and so the grip on power is not surprisingly equally tenacious. How else could you explain this proud public boasting about one’s own ignorance (apparently not just reserved for guests of Jerry Springer…):

Morris was as myopic as anyone. Today, when he complains about how digital music created a completely new way of doing business, he actually sounds angry. “This business had been the same for 25 years,” he says. “The hardest thing was to get something that somebody wanted to buy — to make a product that anybody liked.”

And that’s what Morris, and everyone else, continued to focus on. “The record labels had an opportunity to create a digital ecosystem and infrastructure to sell music online, but they kept looking at the small picture instead of the big one,” Cohen says. “They wouldn’t let go of CDs.” It was a serious blunder, considering that MP3s clearly had the potential to break the major labels’ lock on distribution channels. Instead of figuring out a way to exploit the new medium, they alternated between ignoring it and launching lawsuits against the free file-sharing networks that cropped up to fill the void.

Morris insists there wasn’t a thing he or anyone else could have done differently. “There’s no one in the record company that’s a technologist,” Morris explains. “That’s a misconception writers make all the time, that the record industry missed this. They didn’t. They just didn’t know what to do. It’s like if you were suddenly asked to operate on your dog to remove his kidney. What would you do?”

Personally, I would hire a vet. But to Morris, even that wasn’t an option. “We didn’t know who to hire,” he says, becoming more agitated. “I wouldn’t be able to recognize a good technology person — anyone with a good bullshit story would have gotten past me.” Morris’ almost willful cluelessness is telling. “He wasn’t prepared for a business that was going to be so totally disrupted by technology,” says a longtime industry insider who has worked with Morris. “He just doesn’t have that kind of mind.”

Doug Morris is the CEO of Universal Music and the quote above is from an excellent recent profile in Wired. If you are like me it will make you laugh and cry simultaneously as you begin to understand how completely unsuited Mr. Morris is to running a business - let alone a music business - in the 21st century. On the other hand, you have to give him credit for not trying to pretend otherwise. Kicking and screaming. That’s the only way he’s going to change… Ok so assume I’m right, why don’t the shareholders just get rid of him? And given that Universal is a division of a company (Vivendi), rather than a public listed company, this should be easy right? (No agency problem, no powerless Board vs. imperial CEO…) Well, curious to know the answer to that question, I decided to have a quick look at Vivendi and their management structure.

While I must admit they have a pretty friendly and modern looking corporate website, identifying and reading about their senior management did not exactly fill me with confidence that they could add anything to the discussion let alone stand up to someone like Mr. Morris who I imagine is a charismatic, wily and tough (American) operator. Basically, even if they did have the moxy to give him the boot, they would be unlikely to be any more successful in filling the strategic vacuum. Don’t get me wrong - I suspect the Vivendi executives are all very intelligent, diligent men, and of course not knowing anything about them beyond what is on their website, I could be wide of the mark. Disclaimers aside however, it strikes me that for instance, Regis Turrini - SVP Strategy and Development is unlikely to be a thought leader in terms of tuning Vivendi’s business model to embrace the opportunities of the digital age:

Mr. Turrini, 48, is an attorney admitted to the Paris bar. He is a graduate of the faculties of literature and law and the Paris Institute of Political Sciences, and an alumnus of the Ecole Nationale d’Administration (postgraduate public policy college).
He began his career as a judge in the French administration courts. He then joined law firms Cleary Gottlieb Steen & Hamilton (1989-1992), followed by Jeantet & Associés (1992-1995), as a corporate lawyer. In 1995, Mr. Turrini joined the investment bank Arjil & Associés (Lagardère group) as executive director. He was then appointed managing director and, from 2000, managing partner.

And I’m afraid the supervisory board is unlikely to be of much help either - with only one member born after 1950, they may well have a wealth of experience but somehow I doubt their ability to confidently challenge Mr. Morris on his strategy. I doubt any of them have Facebook accounts…I wonder if any of them use iTunes…

To be fair, if you read the Wired article, Universal is not entirely standing still, also see for instance there possible involvement in a Pepsi/Amazon music giveaway promotion. But there is a big difference between reacting - fighting every step of the way - and pro-actively reinventing your business model. Given the events of the past few months and the acceleration of change as artists wake up to the empowering possibilities of the emerging paradigm (after having been fed and often swallowing a load of crap by their erstwhile partners for the last few years…) the record companies really have no choice now but to try to adapt. (MTV has a great summary of some of the watershed events of 2007.) But this is happening under duress and while the left hand tries to innovate, the right hand is still waging a rearguard action to stymie anything that might threaten the ‘way things were’. Much has been written about pioneering new approaches like Madonna signing with Livenation and Radiohead managing themselves the release of their latest album. The emperor has been stripped of his clothes. Thom Yorke (of Radiohead) puts it clearly in an interview with David Byrne (of Talking Heads fame:)

Byrne: What about bands that are just getting started?

Yorke: Well, first and foremost, you don’t sign a huge record contract that strips you of all your digital rights, so that when you do sell something on iTunes you get absolutely zero. That would be the first priority. If you’re an emerging artist, it must be frightening at the moment. Then again, I don’t see a downside at all to big record companies not having access to new artists, because they have no idea what to do with them now anyway.

…(on their ‘free’ digital pre-release:)
Yorke: In terms of digital income, we’ve made more money out of this record than out of all the other Radiohead albums put together, forever — in terms of anything on the Net. And that’s nuts. It’s partly due to the fact that EMI wasn’t giving us any money for digital sales. All the contracts signed in a certain era have none of that stuff.

And like a rolling stone, this movement is gathering momentum, it seems almost daily. Just this week Robbie Williams has decided to go ‘on strike’ from EMI; although his stance seems more opportunistic given that - as a big star already - nobody forced him to sign his contract with them… (Perhaps he was poorly advised?) Even the Economist - my favorite periodical - has joined the fray. (At least this has a chance of capturing the attention of the ‘establishment’, I hope someone sends a copy to the Vivendi Board members just in case they missed it.)

It’s worth taking a closer look at EMI. I’ve never had the pleasure to meet Guy Hands, but by any estimation he is clearly a very clever man and has a good understanding of valuing mature businesses that have strong asset bases and/or generate (or have the potential to generate) strong free cash flow. I think he made a mistake with EMI. It’s easy to be an armchair manager - and hindsight is easy - but (and you’ll just have to trust me here) I thought as much when the deal was first done. And this is putting aside the fact that - almost certainly for the first time in his career - after having lost a few deals due to his disciplined approach to pricing, he finally succumbed to the private equity fever and his capital burning a hole in his pocket and over-payed. This - and the subsequent tightening of credit markets - has certainly made things worse. (On the other hand these facts can act to muddy the waters, masking the real - more fundamental - error in this investment.) The interesting mistake is more fundamental and specific to EMI and the music industry and no it has nothing to do with the fact that he “knows nothing about this special industry” - as so many insiders are claiming.

Indeed, having someone from outside is probably just what the doctor ordered. And his instincts were in my opinion spot on in a couple key respects. First (and the ’simplest’, most basic private equity play), that the business was mismanaged - or more accurately not managed. Like many talent-based industries, succesful ‘producers’ often end up at the top; however more often than not, top ‘producers’ make poor managers. Separate production (creative) from management and run a tighter ship operationally and financially. So far so good. Secondly, that music publishing libraries have significant value, value that can be better unlocked through a more deliberate strategy and more efficient capital structure (supported by the historically strong cash flow generating ability of these assets.) So where did he go wrong? On two counts I reckon. Firstly he should have just bought the library. I suspect that this is probably all he wanted and to be fair it probably wasn’t an option given the frothy tone of the market during the deal. He probably figured there was enough wiggle room to sort out the rest and end up with the catalogue at a reasonable price. Secondly and more importantly, he underestimated the speed and scope of the gathering tide of secular change that was coming crashing over the music industry, making the economics of the deal (even at a lower price) tenuous at best.

If he is as good a trader as his track record suggests, Mr. Hands should re-mark his book lower and proceed apace with re-inventing EMI as a force in this new landscape. The fact that he is an outsider should help. Although I wonder if it wouldn’t be easier to start with a completely blank slate - cleaning up the existing mess probably doesn’t leave a lot of spare capacity to build something innovative and new. Or perhaps he waits a few quarters and buys in the innovation - waiting to see which of the myriad new ventures (like Sellaband or DeepRockDrive) currently bubbling up gains real traction. Of course this might be expensive but the only thing that is sure is that the old way of doing business is on the way to the graveyard.

Besides reading the Park Paradigm, I suggest he have a look at David Byrne’s thoughts in Wired on how things might evolve, here are a few exerpts but I encourage you to read the whole article:

What is called the music business today, however, is not the business of producing music. At some point it became the business of selling CDs in plastic cases, and that business will soon be over. But that’s not bad news for music, and it’s certainly not bad news for musicians. Indeed, with all the ways to reach an audience, there have never been more opportunities for artists.

…What do record companies do?
Or, more precisely, what did they do?

* Fund recording sessions
* Manufacture product
* Distribute product
* Market product
* Loan and advance money for expenses (tours, videos, hair and makeup)
* Advise and guide artists on their careers and recordings
* Handle the accounting

This was the system that evolved over the past century to market the product, which is to say the container — vinyl, tape, or disc — that carried the music. (Calling the product music is like selling a shopping cart and calling it groceries.) But many things have changed in the past decade that reduce the value of these services to artists.

…For existing and emerging artists — who read about the music business going down the drain — this is actually a great time, full of options and possibilities. The future of music as a career is wide open.

It comes down to intelligently managing a combination of abundant assets (digital music) and scarce assets (live performances) and optimizing the business model to provide value to both the producers (artists) and the consumers (fans.) An interesting and exciting challenge, but one that the current powers that be in the music industry seem unable and unwilling to grasp.

Sounds like a great place to invest…

And just to show that there are no hard feelings, here’s one for Mr. Morris and his friends: