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Markets for the Digital Generation

It would seem obvious to anyone who has ever boarded an airplane that weather is a primary factor in determining whether or not any given flight will take-off and/or land on schedule. The impact of adverse weather conditions is even more acute for commercial flights using increasingly congested major airport hubs, with the complexity of managing thousands of co-dependent paths within the network. This weather-driven uncertainty has a real and measurable financial impact on carriers and air travelers including (but not limited to): extra fuel, maintenance and staff costs, customer compensation (or at the very least poor customer satisfaction); and for their customers lost time and productivity (not just on delayed flights as customers are forced to ‘build-in’ the uncertainty implicit in the flight schedules to their planning.)

In the past, there was no practical way to price and manage this risk; the transaction costs and computational intensity of trading and managing such a granular and complex set of weather risks would have certainly outweighed the potential benefits. Today however thanks to accelerating technological advances in computing and communications, and taking inspiration from the creative application of technology to pricing, managing and distributing risk derivatives pioneered by innovative young companies like Weatherbill, this is clearly no longer the case. I would go so far as to posit that any CEO and/or Board of a commercial air transport business is at risk of breaching their fiduciary duty if they are not seriously contemplating how they can manage and mitigate weather risk in their operations. At the very least, it should be quantified and reported - much in the way fuel-price risk now is - and any hedging (or deliberate decision not to hedge) strategy articulated and explained to shareholders and any relevant regulatory bodies.

To help get this Boardroom debate started, Weatherbill has helpfully just published a white paper framing the problem and at a high level quantifying the risk of weather-induced delays for US commercial airlines (from the report summary:)

Between June 2003 and April 2007, over 25% of all flights in the United States were disrupted
(either cancelled or delayed). More than 55% of those disruptions (almost three million) were
due to weather- the leading cause of flight disruptions in the U.S. In an effort to educate airlines,
airports, and consumers about their weather risk, WeatherBill has identified the most sensitive
airports and airlines to adverse weather to facilitate reliable estimates of future flight disruptions.
Fifty-four major airports and sixteen larger airlines were studied. There are three main results:

1. WeatherBill can statistically quantify the relationship between weather delays and
observed temperature and precipitation at major U.S. airports and airlines
2. The study shows that disruptions are more common with precipitation than temperature
3. Temperature-linked delays are seasonal

We have included a list of the top five airlines and airports with the highest & lowest
percentages of weather disruptions at the end of this summary. Those lists are already widely
available. What follows immediately are lists of airlines, airports, and their delay sensitivity to
precipitation and temperature, in minutes. WeatherBill hopes this new data will help the flight
industry and travelers better understand their weather delay risk.

I would suspect that most (all?) of the airlines would have there own detailed data on this, so it is unlikely (I would hope!) that anything in this report will come as a big surprise but I would be curious to know how (if?) they apply this data in managing their business (setting schedules, pricing, etc.) Having quantified the risk, you might think the next logical step would be to initiate a risk management program to monitor and potentially manage (through trading granular weather derivative contracts) this risk dynamically. While I think this is a sine qua non for anyone managing an airline, I believe there is a much more exciting opportunity (than simply mitigating downside risk) that arises from the ability to measure and manage economic sensitivity to weather: the opportunity to build such an advanced knowledge of operational risks into the customer proposition. So what exactly am I talking about? Well, at the simplest level to illustrate, an airline could sell ‘weather-protected’ tickets: tickets offering for example a full or partial (or variable) refund for weather related delays or cancellations. Not only would this improve the customer experience, but would be very helpful in offering a differentiated price based on time-sensitivity of the traveler: a business person going on a day-trip for a critical client meeting vs a university student traveling home for the vacation probably have a different sensitivity to the ‘cost’ of a delay or cancellation. Or maybe not. The point is, let the customer pay accordingly. It wouldn’t be perfect - there is basis risk involved - and I suspect that from a marketing/adoption point of view there would be an optimal level of complexity (accuracy) vs simplicity in structuring these sorts of deals; and obviously it wouldn’t necessarily ‘change’ the outcome (weather is weather) but those customers who most valued their time would be compensated accordingly.

This dynamic (weather-) risk adjusted approach to pricing and management would also be relevant to airports and private charter or air taxi operators. Airports - especially those run ‘for profit’ - could build weather sensitivity into their landing and operational fees. For private aviation, while generally less subject to the negative weather-related knock-on effects endemic to the large commercial ‘hub’ airports, the relative importance of weather on flight disruptions is almost certainly higher than for commercial airlines (being less exposed to the other primary causes of flight disruptions (as defined by the US DoT): carrier delays, security delays, and late arrival of an earlier leg.) Also given the use of smaller aircraft, the sensitivity to adverse weather may also be greater in some cases (than for large commercial aircraft.) This approach would also be relevant for air cargo operators and given their concentrated hub operations and expertise in highly sophisticated logistical optimization, one could argue that implementation would be easier for companies like FedEx and UPS. (One problem however might be finding enough risk capacity on the ‘other side’ for Memphis…)

The Weatherbill study points out that (due to a lack of data and complexity beyond the scope of their paper) they did not consider ‘wind’ risk in their study, although they suggest that this is likely to some extent to be embedded in the temperature risk in some regimes (ie disruptions correlated with high summer temperatures may well reflect higher convective winds and/or thunderstorms related to these high temperatures.) However, there is no (technical) reason why over time sufficient (and sufficiently granular) relevant data on windspeed couldn’t be captured and used in pricing models up to and including in real-time. This would require data-capture not just at ground stations (airports) but in the air (aircraft) but the technology exists and the cost of transmission, storage and computation have (or will soon) declined sufficiently to make using what would be an incredibly vast and dynamic data set tractable (in a way that it would not have been even 5 years ago.)

You may recall I touched on this subject (dynamic outcome-driven air transport pricing) previously; and while weather risk management would be a good start in terms of bringing airlines into the 21st century, in my opinion a much deeper and more fundamental reappraisal of their business model is called for. Fundamentally, airline seats (or on any carrier for that matter) are substantially fungible - ie a ticket gives the right for one person to travel from point A to point B. Ok, Ok … before you get the pitchforks out - yes there is a difference in value between a seat on a Gulfstream V and the middle seat in row 34 on DiscountAirways… but the differences are relatively easy to understand and so I believe would be (mostly) efficiently priced in an open market. But ok, for the sake of simplicity, let’s set aside private or charter operations for the moment, and concentrate on scheduled commercial airlines. What you have today is a fragmented and reasonably opaque primary market* and no real efficient secondary market. (*Although the advent of the internet generally, and a number of innovative start-ups specifically has vastly improved the situation from that of a decade ago…) Why is this? Practically speaking it is because the airlines don’t want to allow transferability - they are unable or unwilling to embrace the fact that what they are selling is a commodity. That they are selling the transport of packets on a network. It’s an ego thing. They think they would lose out. Putting aside the fact that most of these companies have lost billions of dollars over decades (so I’m not sure what they think they have to lose), I am convinced that by encouraging a robust and complete secondary market in airline seats, not only would consumers win (through more transparent and rational (supply/demand) driven pricing) but the airlines - at least the well-managed ones - would be huge winners. First they would be able to save money by eliminating (or redeploying more productively) the boffins they currently pay to build ridiculously complex and customer un-friendly pricing schemes in the vain hope of optimising a priori load factors and revenues, and instead be able to focus on managing their assets, optimizing their routes and schedules and making their customers happy (insofar as they could see a return on this investment from a structurally higher secondary price for their seats.)

Stop for a moment and think how fundamentally this would change the paradigm of running an airline - load factor would disappear as a relevant metric because by definition, every seat on every flight would be theoretically ’sold’ - ie would have a market price (which in some cases may admittedly be zero…) - it would make explicit the fact that an airline is actually long a portfolio of options and could - using the feedback loop implicit in a robust secondary market - seek to manage this portfolio in such a way as to maximize the premium income. Part of this strategy would involve deciding when and how many seats to sell in the ‘primary’ market, and may in some cases involve also buying - yes buying - back seats in the secondary market as demand dynamics change. I sense that many of you are still uncomfortable with the heterogeneity of the market - ie the lack of fungibility - and the impact that would have on the liquidity of a secondary market. Perhaps this analogy will help: think of the (corporate) bond market - by definition it is much more complex and heterogeneous than the ‘equivalent’ market in common equity. Not only are there differences in the credit quality between companies (think different service levels, seat coverings, entertainment systems, airport lounges…) but even for the same company their are securities with different characteristics (maturities, seniority, coupons, etc.) (think flight times, class of service, changeability, etc.) - none of which inhibits the market from operating. Furthermore, the price signals this market sends with respect to these variables are important inputs for optimizing the management and balance sheet structure of these same companies. By allowing the CFO to see the relative cost and cost volatility of having a BBB vs a AA financial structure, she is much better able to make a decision as to which is best for her shareholders. In the same way, an airline executive would be able to better understand if his investments in customer service or in-flight entertainment provided positive returns to the shareholder (based on an average per-seat premium reflected in the market.)

I imagine that a further argument against such a market would be ’security’ (ie ‘identity’): the airlines (and various government agencies) need to know who is travelling in any given seat. Well again - thanks to technology - this is a red herring argument. There is no reason to believe that in a world of ubiquitous mobile phones, electronic payments and fulfillment that this ‘problem’ is not entirely tractable. Indeed, to take the securities markets as an example - due to various ‘know-your-customer’ and anti-money laundering statues - the days of anonymously trading bearer certificates are long gone; and yet the number of participants and transactions in financial markets has never been higher. So yes, any secondary market would need to robustly and accurately identify the ultimate ticket holder but this would not be a problem. (Additionally, in the first stage I would imagine it would probably make sense to start with a market that ended T-1 - ie not allow trading in the last 24hrs before a flight - which would significantly remove or mitigate a number of potential operational risk factors arising from such a market. Once these risks were better understood and engineered around, one could imagine eventually allowing trading up to the moment the flight closes for boarding.)

You may recall that in my earlier post, I mentioned Farecast as one of a variety of companies innovating intelligently in this space. This is a company that was on my “IRWIWHHTOTI” (I-really-wish-I-would-have-had-the-opportunity-to-invest) list (for reasons I hope would be clear to my regular readers…) Unfortunately, they have just sold themselves to Microsoft. Why do I say unfortunately? (1) There is now no chance to invest in or buy the company. (2) Microsoft has a long and not-so-illustrious reputation for buying really interesting and innovative companies (good) and then having their own big-corporate antibodies attack and often kill said innovation and energy (not so good.) (See here for more thoughts on Microsoft.) I hope this doesn’t happen to Farecast (in the same way I hope CBS won’t kill last.fm) but let just say I’m cautiously pessimistic. I am entirely sympathetic to the founders - liquidity is important (you can’t pay mortgages with ‘potential’ upside) and understand how the structural constraints of the mainstream VC business model drives the logic of this kind of exit. But the combination of these factors leads from time to time to what I would consider excellent opportunities to deploy smart, unconstrained capital. Since this is something I personally have limited amounts of (alas) I will be working to convince others of the merits of this view, with the goal of being able to act on a small number such opportunities when they arise in future…

Many of the issues that would be faced in creating such a market are very similar to those faced by secondary markets in live event tickets. Whilst, I wouldn’t want to distract the founders and executives of the companies pioneering in this space (against much hysterical and illogical reactionary resistance from some of the incumbent market participants,) I wonder if they might be available in a year or two’s time to sit down with me and my partners and construct a plan to turn this vision into a reality. Or I wouldn’t be surprised if someone were already working on it. If so I’d love to know more.

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Risk is the possibility of an event occurring that will have an impact on the achievement of objectives. Risk is measured in terms of impact and likelihood. (Source: Wikipedia)

So much of our life is about judging and taking risks and yet we are mostly ill equipped by our educations and culture to do so effectively. Kahneman and Tversky of course were pioneers in articulating and explaining many of the basic human errors and biases and anyone who is not familiar with their work and yet interested in the subject I would strongly recommend further reading. (For a specific take on behavioral psychology with respect to financial markets, I would recommend reading the books and/or research of James Montier, an ex-colleague of mine.)

You may have noticed that I haven’t posted anything in the last few weeks. At the end of February and at the start of March, I was very very busy with work; more recently - in the last week - I have been ski racing. Unlike last year, I haven’t had nearly as much preparation but nonetheless felt confident given the training I had done that I could build on last year’s good results, especially in the speed events. And in the Downhill, I felt I could finish in the top 3. This was my key objective for the week.

The week started with a Super-G race (slightly slower than Downhill, with a few more turns) and I finished 11th, 2 seconds behind the winner. I am less comfortable with Super-G and made a couple of smallish mistakes that probably cost me a Top 5 finish, so this was a solid result on which to build. Next came the Downhill - on the same hill as the Super-G - and in the training run, I finished 8th, just under 2 seconds back. I felt extremely confident as I had not given 100% and was certain that I could improve by between 2 to 3 seconds. The winning training run time was 1:15:30. I figured that it would probably take 1:14:00 to win the race, and under 1:15:00 to be in the top 3. We headed up for the race run. The weather changed, with clouds coming in reducing the visibility. I became more confident of my predictions, and my ability to ski these times. My start number was 26, so the top ranked competitors had all finished before my turn came: 1st - 1:14:00, 2nd 1:15:47, 3rd 1:15:64… my confidence soared. The race was there to be won, and a spot on the podium was easily within reach. I went for it.

I have probably skied this Downhill course (or parts of it) almost 100 times in training and races over the last decade. I know it very well. I have never skied the first 35 seconds faster in my life. When you are racing Downhill, one of the best ways to gauge your speed is how far you fly when you go over a bump. Over the first two bumps, I went further than ever before. Over the third (and last) bump it was the same. To the extent that my usual line over the bump was now wrong: I landed too low. I needed to correct this and quickly put in my edge. But by going too low and so far, I landed in a compression (a small dip in the terrain, that has the tendency to throw you on the back of your skis.) And the light was flat. So I didn’t see it (the dip.)

As I landed in the compression and set my edge, I was thrown onto the back of my skis, caught an edge and spun out. From 90kph to zero in a dozen meters or so. I just remember two things. First, “damn - there goes the race”, and (probably a couple tenths of a second later) “don’t crash, pull it out.”

Four small elements: land too low, set edge too quickly, hit compression, flat light. Remove any one of these and I’m 90% sure nothing happens and I’m in the finish line with my best ever result 40 seconds later. As it was, I made the split second decision to not quit, start pushing with my poles and finish the race. It doesn’t take a genius to figure out that stopping in a Downhill is disastrous. I skied the rest of the course indifferently and finished 7 seconds down. This only rubbed salt in the wound - only 7 seconds down meant that I was almost certainly on track for a time below 1:16…

I was gutted.

I took a risk. It didn’t pay off. I kept asking myself over and over, “what if…?” I replayed the fateful moment a hundred times or more in my head. I didn’t sleep well that night. I couldn’t stop thinking about how I had wasted a golden opportunity.

As the week progressed, I skied ‘ok’ but never really had what I thought was a really good run. My results were more or less in line with my results from last year. I was disappointed. But as the week came to a close, my son helped me see things in a different light. He asked me how I thought I had done and if I was happy with how the week had gone. Obvious questions, but answering them made me change my perspective. Overall, I was clearly disappointed not to have done better, not to have improved on last year’s results; and in particular not to have nailed my run on the Downhill. But on the other hand, I had not skied particularly well and yet was on a par with my results last year when I thought I had skied well. My base level had clearly improved.

And I was forced to ask myself: “What if I hadn’t skied so aggressively in the Downhill? Not made the mistake and finished 5th? or 10th? Would I have been just as disappointed? How would I have felt knowing that had I attacked the course, I might have won?

I realized that I had made the right decision. The only thing to do was to attack. To take risks. To seize the opportunity. The upside of winning for me was much higher that the downside of not finishing in the top 10. Even though I lost. Especially because I lost.

Taking risk means losing sometimes. The market’s estimation of the probability of a given loss is implicit in option, betting or insurance pricing. But a probability is just that - any individual outcome is either 0 or 1. Even if the probability of 0 is 5%, on one event the outcome can obviously be 0. Which doesn’t mean the probability was wrong (or right) ex-post. Or that probabilities are of no use in risk management.

It means that one needs to understand the relative consequences of a bad and good outcome in absolute terms ahead of applying some more or less robust estimation of the probability of each. I think this is where a lot of traders and financial organizations go wrong. They look at a bad outcome - say losing $1bn - and estimate the probability of this occurring - say 5% - and come up with a probability adjusted loss of $50mn. They look at a good outcome - say making $100mn - and estimate the probability of this occurring - say 95% - and come up with a probability adjusted gain for the trade of $45mn. And then they ask, can we afford to lose $50mn on this trade? (Of course I am over-simplifying, but not to the extent that it alters the point…)

Of course from time to time, the bad outcome will happen (despite having only a probability of 5%) and the trade will lose $1bn. There is no such thing as a realized probability-adjusted loss or gain…

When deciding whether or not to take a particular risk, first you need to understand how the worst case outcome will affect you. Next you need to understand if the upside potential is worth the downside risk. Finally, when you lose - which is inevitable - even with 99% sure things, you need to have no regrets. Put it behind you and move on. ‘Back-trading’ yesterday’s risks is the surest way to ensure failure.

And so it isn’t hard to jump to the conclusion that the best measure of a trader, is her attitude and actions in the face of losses. The true measure of one’s character is taken in the face of adversity. It is not an original idea but worth remembering from time to time. Especially in times like these.

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What’s not to like? My mind was set racing after reading about Max Donelan’s “energy harvester” in the Economist recently:

The “energy harvester” that Max Donelan of Simon Fraser University and his colleagues describe in this week’s Science looks like an orthopaedic knee-brace. It tucks behind its wearer’s knee and has extensions that strap around the front of his calf and his thigh. When the wearer walks, the knee’s motion drives a set of gears which turn a small generator.

On the face of it, that sounds like a recipe for making walking difficult. Surprisingly, it is not. Although the leg muscles perform “positive” work when they accelerate the leg forward to begin a step, when the leg straightens at the end of the step they perform “negative” work as they slow the leg down. If the generator in the harvester were connected during the accelerating phase the process would, indeed, be expected to increase the load on the muscles. But if it were connected only during the decelerating phase it would impose no load. It might even make things easier.

(The BBC website has a video here.)

The potential for this kind of power generation seems vast, especially in the developing world. Not only could it prove to be a robust and portable personal power source , because it doesn’t rely on a centralized infrastructure it is at once an empowering technology (excuse the pun) and without negative environmental consequences. Not only could individuals in places like rural Africa and India have free (beyond the inital investment in the equipment) access to power for things like lighting, mobile phones, and even networked computers or even femtocells, they would not be emitting any greenhouse gases, and insofar as they could replace dirty fuel burning lamps with LED lighting, pollution would even be reduced.

One of the biggest changes has been the use of light-emitting diodes (LEDs). This has transformed wind-up lighting products, says Rory Stear, chairman of Freeplay Energy, which specialises in such “self-powered” devices. The company’s Indigo lantern, for instance, can provide up to two hours of light from just one minute of winding. LEDs also last for a long time: those in the Indigo are rated for 100,000 hours, whereas a filament bulb might burn out after 16 hours.

Such products can make a huge difference to power-starved people. Freeplay’s charitable foundation reckons that the use of kerosene, candles and firewood for lighting absorbs 10-15% of monthly household incomes in sub-Saharan Africa. It is planning to test a range of wind-up LED lanterns in Kenya and South Africa this year. These, it hopes, will allow people to do things like studying at night, increasing their security and coping better with medical emergencies. Freeplay Energy is also developing self-powered medical equipment, including a fetal-heart monitor.

Imagine this married to the emerging global carbon markets, and you can imagine a day not so far in the future when a farmer in Tanzania can pay for efficient LED lighting, a mobile phone and usage fees (which he uses to stay in touch with market conditions for his produce, including hedging commodity and weather risk and as a payments platform) all by selling his carbon emissions allowance to the market. Of course, we are a bit away from having a workable “retail” CER market, but if you ask me this is exactly the sort of thing the World Bank should be working on in cooperation with entrepreneurs in developing markets.

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After seeing this video tonight for the first time, I’m willing to go out on a limb and predict that Barack Obama will be the 44th President of the United States:

Armed with this new certainty, of course the first thing I wanted to do was to back him in the ‘Next President’ market on Betfair where he was trading at 2.80 (which by the way makes him currently the favorite in this market.) However as I am currently traveling in the US, Betfair doesn’t allow me to access my account. This of course is due to the ridiculous and hypocritical US anti-gambling statues. Very annoying. So now I have to wait until I’m back in Europe and hope the price doesn’t move against me. I’m pissed off with Betfair, even though I know it’s not their fault… Can we change this? Mr. Obama I hope your answer will be:

Yes, we can.

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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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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:

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Almost as if on cue, imagine my surprise (and delight) to find this month’s Prospect magazine (quickly becoming a must read for me, as a wonderful complement to my weekly Economist fix) feature an essay by David Goldblatt “Taking Sport Seriously” on its cover:

Sport has never been more important, but its meaning and appeal are still not taken seriously, at least in Britain. It is time for sport to enjoy the same cultural weight as the performing arts, and to be judged by the normal standards of public life.

The focus of the essay is on the lack of political and cultural respect accorded to sport in our - with particular focus on British - society and how this is incongruous with the role it actually plays in our culture, our economy and our society. The author spends some time explaining the historical context and does a good job of framing how this bias against sports (being accorded the legitimacy it is due) came to be; in politics, culture and - yes, finance - sport is trivialized and not seen as worthy of “serious” attention - after all, they are “just games”…

Yet serious organised play cannot be purely spontaneous. If we wish to watch the spectacular, to participate in its grand narratives, we need rules and rule-making institutions; we need facilities, stadiums and professional athletes. Spectaculars require backers; the circus must be paid for. Sport needs, attracts, and must deal with money and power, and the backers will always be looking to buy or take their share of glory. How are we to police the line between the realms of power and play, economic space and social space? The production and consumption of modern sport clearly is political, albeit with a small “p.”

The author goes on to propose his view of a more appropriate positioning of sport in our society:

What would a healthier sporting culture look like? It would start from two ideas. First, sport should be treated with the same seriousness that is accorded to the performing arts. Second, it should be judged by the same standards of transparency, sustainability and democracy that we expect elsewhere in public life.

While finding much to agree with in his framing of the current state of affairs and the broad lines of his call to acknowledge and even embrace the reality of the key role it plays in our culture and our economies, my opinions diverge quite strongly with respect to his take on the role of markets in buttressing or even leading this realignment. His logic breaks down when he states that private capital and market forces are inimical to the emotional and ethereal value that lies at the heart of sports cultural value:

In sport, as in so many other areas, we seem to have accepted the triumph of private capital and global markets as irreversible. The private ownership of British football clubs, often by foreign billionaires, may appear to be a fait accompli, but it remains a flawed model. After all, what is a club? Stadiums, players, coaches and directors can and do change, and yet Arsenal is still Arsenal. What gives Arsenal continuity is the accumulated social capital amassed by generations who have attached significance to the narratives generated by the team’s performances. This network of memories, meanings, identities and rituals constitute a precious form of value which cannot be owned by anyone and should not have its fortunes exclusively linked to the vagaries of private capital—just ask people in Brooklyn how they feel about the Dodgers’ flight to Los Angeles in 1958.

He goes onto demand that we “balance private capital’s opportunity to make profits from [sports] with its duties of care.” I don’t disagree but find nothing contradictory in the preservation of “this precious form of value” with ownership by private capital and market mechanisms generally. That is not to say that good regulation and governance is not needed - indeed regular readers will know that I consider that a sine qua non of robust and efficient markets - but it confuses the lack of these with private ownership. They are not linked. I would go further and say that market forces are the best guarantors of good stewardship in the medium term precisely because there is a direct (non-diffuse) interest in preserving the “magic” that drives so much of the value. Indeed, the greatest risk of amateurish, parochial and near-sighted governance is more often found in sports and countries where the sport is considered a “public good” and so risks being compromised by the corrupting and often opaque forces of undemocratic and politicize power that typically favors a privileged and incumbent elite.

(For example, if the IRB were “privatized”, the next rugby world cup would almost certainly have gone to Japan (and not New Zealand.) Furthermore, Argentina (and other emerging rugby nations) would have long ago been given the opportunity to regularly compete with rugby’s elite. Both these would be to the benefit of the game; creating more (and spreading more widely) the “precious value” that sport brings, and would make commercial sense. However the political appointees that run the IRB - and are not subject to the discipline of private capital, but answer to the powers of the incumbent (self-perpetuating) elite - are free to ignore this even at the risk of damaging the long-term value of the game.)

Market mechanisms - allowed to work - will indeed promote the cultivation of the grass roots and ensure a necessary level of competitive parity because it is in their self-interest (economically.) One only has to look at the professional leagues in the US to see that private capital understands this impeccably. The failure in the UK (and elsewhere) - and I am sympathetic to his view that there is a failure - comes from the muddying of the waters by according sport a “special” quasi-public status: it’s a variation of the tragedy of the commons - the capitalists only abdicate their responsibilities because they can. ie Someone else (the government, the community, etc.) pays for it. So (mainly correct) diagnosis, but wrong treatment.

In any event, I applaud Prospect for doing its part in engaging the debate and the author for framing the issues so eloquently and challenging our society to reassess our preconceptions on this subject.

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In a leader this week on banking in Africa, the Economist asks the questi