:: The Park Paradigm ::

Markets for the Digital Generation

Over the last few years I’ve become increasingly interested in trying to understand why large companies - companies full of smart, ambitious people and commanding significant resources (financial, intellectual and human) - seem universally to find it so difficult, verging on impossible to take certain kinds of what I would consider ’smart’ risks, while simultaneously having seemingly unlimited appetite for what I would consider ‘dumb’ risk.

Clearly, I should expand on this notion of ’smart’ vs. ‘dumb’ risks, lest you too quickly accuse me of hindsight bias and ex-post triumphalism. So in my humble opinion…

Smart risks, are risks where the impact of failure is limited and known upfront. Typically this would include the potential

1. financial loss (outright and/or opportunity cost as relevant),
2. reputational damage (in the sense that a failed outcome could result in any stakeholders being legitimately offended or repulsed; not in the sense that we might look a bit silly for having done something that failed) and,
3. wasted time (not the financial cost - that would be ‘included’ in financial loss above, but literally the time it takes to discover / acknowledge failure - something that fails quickly being better relative to something that will take longer (to know if it has failed); this is based on the assumption that even the best endowed company does not have unlimited human and intellectual resources and so can only pursue a finite number of opportunities or ideas)

Smart risks, are risks where the impact of success is unlimited and potentially paradigm changing, and is in any event an order of magnitude bigger than the corresponding failure.

Dumb risks, are risks where the impact of failure is unlimited and unappreciated:

1. financial loss (outright and ususually opportunity cost),
2. reputational damage (in the sense that a failed outcome could result in any stakeholders being legitimately offended or repulsed; not in the sense that we might look a bit silly for having done something that failed) and,
3. wasted time (not the financial cost - that would be ‘included’ in financial loss above, but literally the time it takes to discover / acknowledge failure - something that fails quickly being better relative to something that will take longer (to know if it has failed); this is based on the assumption that even the best endowed company does not have unlimited human and intellectual resources and so can only pursue a finite number of opportunities or ideas)

Dumb risks, are risks where the impact of success is limited and at best linear, and is in any event an order of magnitude smaller than the corresponding failure.

Ok fair enough, but surely I’m not suggesting that companies when faced with the choice between these two kinds of opportunities systematically pick the latter? Well yes I am Virginia. Let’s frame the distinction between ’smart’ and ‘dumb’ risks a different way, and perhaps you’ll see why…

Opportunity A has a 90% chance of succeeding. It is an opportunity similar to many the company has pursued historically. The company knows these kind of opportunities well. If it succeeds, our business will be 12% better for sure. There is an 8% chance that it doesn’t work well and our business will be the same to 5% worse. There is a 2% chance that out-of-nowhere a meteor strikes and makes it a spectacular failure making our business 80-100% worse. The probability weighted outcome is approximately +9% and 98% of the time the outcome will be acceptable.

Opportunity B has a 70% chance of failing. It is an opportunity that is very different to anything the company has considered before. The company feels this opportunity is in uncharted territory. If it fails, our business will be 1% less well off that it would have otherwise been. There is a 28% chance that it doesn’t work as well as hoped but it does ok and as a bonus an uncharted territory is now mapped; the business is 7% better off. There is a 2% chance that this opportunity strikes gold - is paradigm shifting - and the company is 3x better off than before. The probability weighted outcome is approximately +7% but 98% of the time the outcome will be perceived as a failure.

If you ask me ‘Opportunity B’ is the smart risk. Why? Because ‘Opportunity A’ has as a possible outcome blowing up your company. Bad. And by the way, who is to say that 2% is the true probability. Taleb articulated this line of thinking much more robustly and eloquently in The Black Swan:

…some business bets in which one wins big but infrequently, yet loses small but frequently, are worth making if others are suckers for them and if you have the personal and intellectual stamina. But you need such stamina. You also need to deal with people in your entourage heaping all manner of insult on you, much of it blatant. People often accept that a financial strategy with a small chance of success is not necessarily a bad one as long as the success is large enough to justify it. For a spate of psychological reasons, however, people have difficulty carrying out such a strategy, simply because it requires a combination of belief, a capacity for delayed gratification, and the willingness to be spat upon by clients without blinking.

People like to take linear (as opposed to non-linear) risks. They see safety in risks that are likely to succeed the vast majority of the time (even when failure, although rare, would be catastrophic.) They don’t want to risk ridicule by taking risks that are different and seem likely to fail (even when failure is very inexpensive, and success would bring enormous success.) Finally, people create institutions and models and processes that reinforce and validate how they already would like to behave.

The answer (to the headline question) is complex and somewhat varied, but one element is probably universal and arises out of the behavioral psychology of large, centrally-managed groups; John Kay frames this particular element well in his column this week:

For a time, I ran a company that sold models to large corporations. Although we urged clients to use these models in their decision-making, we did not actually do so ourselves. When I posed the question why, I realised that our analysis served the same function for our clients as Darwin’s list of pros and cons. People did not use our models to help make decisions, but to justify decisions they had previously taken. The results might be used internally to seek approval for an investment or an acquisition, or externally to persuade investors or regulators to give support. The board, or the main shareholders, would insist on the appearance of the formal process we were hired to provide.

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Clouds and silver linings and all that… Yes, it would seem that the US might finally get a more intelligent, less balkanized regulatory environment for financial services. Before the announcement yesterday, Forbes reported that Treasury Secretary Paulson would be unveiling a comprehensive ‘overhaul of US financial regulation’:

Paulson’s plan would give the Fed regulatory authority over all financial institutions that operate with government guarantees such as deposit insurance for banks and would cover the insurance industry. A new regulatory agency would oversee consumer protection issues while the Office of Thrift Supervision, which supervises thrift institutions, would be folded into the Office of the Comptroller of the Currency, which regulates banks.

The plan is also understood to include merging the Securities and Exchange Commission with the Commodity Futures Trading Commission, and to provide for tightened regulation of mortgage origination.

The proposals are likely to generate intense scrutiny in Congress and within the financial services industry. Past efforts to change how regulation is handled have met with strong resistance, especially those affecting the insurance industry which has fought off past efforts to switch its regulation from state to federal level.

In the event, this was pretty close (via Reuters):

The proposals, in the form of a 218-page “blueprint” that was started before markets unraveled in August, offer no quick fix for the credit contraction that threatens to tip the U.S. economy into recession. The plan was already meeting some resistance from Capitol Hill and competing corners of the government bureaucracy as a potentially protracted debate took shape.

Under the proposals, the current patchwork of as many as seven federal regulators would be consolidated under three agencies: the U.S. Federal Reserve, a newly created financial regulator, and a third agency for consumer protection and business practices.

As a starting point (and without having read the underlying report), it would seem like this is a fairly sensible direction. Of course and unsurprisingly, the reactionaries in the room are already crying foul; in trading that’s called “talking your book.” Indeed if your competitive advantage and or your livelihood is predicated on maintaining and/or navigating a thicket of over-complex and over-lapping regulatory regimes, it is hardly surprising that you aren’t exactly going to enthusiastically embrace simplicity and transparency. I mean without the kafka-esque and byzantine system of state insurance regulation, you might get far too many upstarts innovating and competing…that wouldn’t do at all…and it is logical to assume that no one but the CFTC could properly regulate futures markets right?

While removing unnecessary complexity from the regulatory environment is a good thing in and of itself - a necessary but not sufficient - response to contemporary financial market stresses, it doesn’t really get to the heart of what drives most (if not all) systemic crises in financial markets. In my opinion, the combination of substantial leverage with significant hubris lies at the root of the excesses that are now being unwound. Of course I am not alone in articulating this opinion, and there are many who would in fact look to specifically target regulation with the goal of limiting both of these elements. I would strongly caution however the law of unintended consequences is likely to apply in spades and so would be loathe to try to manage either of these via legislation or prescriptive regulation.

That said, for any institution that is either ‘too big and/or complex and/or interconnected’ to fail (and thus subject to a de facto government or central bank bail-out) it would seem reasonable to expect them to have their leverage signed off by a regulator. The key is to make a distinction between allowing someone to blow themselves up (no problem, no need for outside interference) and allowing someone to start a chain reaction (due to their size/complexity and/or connectedness) - and this irrespective of what kind of institution they are (bank, securities firm, hedge fund, insurer, etc.)

Hubris is harder to manage or regulate. Mandating what bonuses are to be paid would be a fools game, solve nothing and almost certainly give rise to toxic unintended consequences (not to mention the ‘wasted’ creativity dedicated to navigating around whatever rules were invented.) If a private company wants to line it’s employees pockets in a highly asymmetrical fashion that is a matter for its shareholders to take-up with management… Instead, I would suggest that the only way to mitigate hubris in the financial markets is to allow creative destruction has to operate over time. Clearly the compensation paradigm of the investment banking industry is inappropriate to the nature of the business and risks that they run. The least worst form of organization and compensation structure for the industry is I believe the partnership. (It is not surprising that Goldman Sachs is consistently the most successful bulge bracket investment bank given that it was the last to end its formal partnership and still to this day maintains by far and away the culture and compensation policy closest to that of a traditional partnership.) It is also unsurprising that on average, the investment banks have fared far worse than hedge funds over the last year. So if this is true, why did partnerships largely disappear (or become marginalized) over the past 20-30 years? Firstly, the rise of OTC derivative markets and other facets of ‘modern’ finance required ever larger balance sheets and capital resources to the extent that these became out of reach for even the largest and most successful partnerships. Secondly, the sustained bull market (and quick intervention of the Fed in times of duress) papered over many of the intrinsic advantages of partnerships - ie banks (and bankers) could have their cake and eat it too.

I would speculate however that the next decade or so might see a return to prominence for small and medium sized banking and investment partnerships. Indeed to some extent this is already happening. Don’t get me wrong, I’m not suggesting that the giants are going to disappear, just that they will inevitably refocus on the elements of the business where large financial resources are a true sine qua non and/or competitive advantage and retreat from the elements of the business where these are just a license to take inappropriate risk. For example, instead of a monolithic Citigroup as we know it today, you might have a galaxy of small to medium size firms orbiting the core Citigroup balance sheet and banking functions (payments, deposit taking, etc.)

For a number of years I’ve been saying that fundamental change in the investment banking industry was inevitable; it was only the timing that was uncertain. As long as record profits kept rolling in (however fragile or unsustainable they may have been in the long term) nothing was likely to change. Unfortunate but understandable. But turbulence and losses typically catalyze change; this just might be the beginning of the new paradigm I’ve been waiting for.

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Reuters reports:

Canadian university faces off with digital generation

A Canadian university has instilled a culture of fear by threatening to expel a student for cheating because he set up an online study group on Facebook, critics said this week.

Toronto’s Ryerson University threatened to expel first-year computer engineering student Chris Avenir last week, arguing that his study group on the Facebook networking site might encourage cheating.

Ryerson decided to lift the expulsion threat on Tuesday, but Avenir will get zero credits for the course work discussed on the Facebook forum last autumn, and the university has put a disciplinary notice on his record.

Begs disbelief. Even better (worse), it was the Information Technology Management department (!):

But James Norrie, director of the School of Information Technology Management at Ryerson, said on Thursday the issue was one of accountability, whether online or offline.

I guess Ryerson must be focused on corporate recruiters who are looking for 1950s-style “organisation men”, bent on conformity and sympathetic to control-freakery. Let’s just say that I would be disinclined to recruit future Ryerson grads if this is representative of what they are being taught. Of course, I might make an exception for Mr. Avenir and the other members of his Facebook study group. I would however suggest to him, especially as he is a freshman, to get the hell out of there and transfer to a school that is in the 21st century!

(Finally I can’t resist commenting on the delicious irony of the student’s surname; how could Ryerson do this to Mr. Future?!?)

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I’m on record with my opinion that gigantic financial services firms were beyond the ability of any individual - however talented - to manage effectively. At least (or especially) using the centralized ‘Sloanian’ management paradigm. Citigroup is of course the poster boy for this conjecture.

So it was natural that the following story: Citigroup Chief Signals Major Asset Sales caught my eye:

Citigroup Inc. Chief Executive Vikram Pandit has begun separating the wheat from the chaff in the New York financial giant’s global empire - and there looks to be a big pile of chaff.

Pandit met with stock analysts Thursday and confirmed the bank plans to shed assets to reorganize its business. Analysts from Credit Suisse who attended the meeting said the giant bank is preparing to shed hundreds of billions of dollars worth of assets to support a turnaround that could take a number of years.

So perhaps the new boss - given his somewhat unorthodox rise to the CEO suite - is going to be able to do the right thing. To unwind the complexity. To break up the firm into optimized units? Too early to say, although some didn’t seem to think this was on the table:

While large sections of Citigroup are apparently being set on the examination table, “We did not walk away with the impression that management intended to exit any major business lines in whole,” Katze said. “Smith Barney will not be for sale anytime soon, if management has its say.”

And of course with the pending arrival of the sixth paradigm, this would seem self-evident:

Katze also expects Citigroup to diagnose the need for a “massive amount of streamlining” and an upgrade of technology and systems infrastructure across the bank.

The $100bn question however is: Can an elephant learn to dance to a completely different tune?

Stay tuned.

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Above and beyond the traditional reasons to invest in exciting and disruptive start-up companies, the ability to build the organization from the ground up - starting with a blank sheet in the context of corporate culture and organizational structure is another reason I prefer investing in small private companies (rather than large public companies.)

Many large companies succeed (more or less) despite their internal organization and cultural paradigm. It is a problem to be overcome. (Although few management teams of such companies would admit to this I fear.) Most new, small companies can build a 21st century workplace and culture. It is an additional (bonus) source of competitive advantage.

If you have 20 minutes, have a listen to my friend and ex-colleague JP’s presentation at LeWeb3 (December 07) if you want a good explanation of how the enterprise is likely to evolve (thanks to Mike for the pointer):

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I don’t know what to say. It seems this morning a big brouhaha has erupted over a “private offshore trust” (…oooohhh maximum scariness and implied skullduggery…) that holds £50bn of Northern Rock’s “best” mortgages…

Nationalizing Northern Rock - however much they mucked up so far in the timing and execution of that - is the only sensible thing the Brown/Darling duo have done on the economic front since taking office. So not being very sympathetically inclined to them at this time, one would hope that the opposition would take a page out of Barrack Obama’s book and be pragmatic and honest when holding the goverment to account over the (important) details of execution. Instead we get a shrill, even hysterical response from the Tories and a good dose of the same from the press.

Granite - the main securitization vehicle (and main wholesale funding mechanism) for Northern Rock - is not exactly a secret. And there is nothing mysterious or - as far as I know - untoward about it. Anyone vaguely knowledgeble about the bank would be completely aware of it. This is not some dodgy Enron-esque SPV… And the fact that it is ring-fenced from the rest of the bank is (a) totally normal and (b) no big deal. Let me qualify (b) - yes, the rest of Northern Rock’s balance sheet is probably weaker for it - but duh, that’s one of the reasons they needed to be rescued in the first place…and given that the credit markets have seized up, on balance it is not obvious that it would help anyone (taxpayers) to bring it back on balance sheet forcibly (anyone want to buy £50bn extra gilts?). (Not to mention the bullet through the heart that would be for the credibility of the UK financial system and rule of law…) The price paid for the bank should reflect the contractual relationship between Granite and Northern Rock.

A final word, this last bit is where I’m a bit mystified as to the arguments of SRM and RAB as to the remaining equity value of the bank. They seem to think that it is worth quite a bit. Rather than go to court and fight it out, why doesn’t the Government offer them a right of first refusal on what ever deal ends up getting proposed. So for example, if the government decides to offer 10p / share, let any other (qualified, with proof of committed finance) buyer have the option of buying it at that price instead. …including the debt without any government guarantee. Not a level playing field? Sure it is. You just need a big strong balance sheet and access to credit markets in that sort of size. It is not the Government’s fault that SRM/RAB probably don’t fit that bill. If we’ve got to where we are, I suspect it is because nobody that does (have the capacity to marshall tens of billions of pounds of finance) thinks it is a particularly good way to spend it and so the government has to step in to mop up the pieces. As a UK taxpayer, I will be looking very carefully at the price the Government pays for the equity, especially if it is much above nil. And then I would hope that they work hard to re-finance it and flip it as quickly as optimizes their IRR, like any good private equity firm worth it’s salt. In this vein, rather than Ron Sandler or perhaps alongside him, I wouldn’t mind seeing Wilbur Ross or someone like him minding the shop.

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Few (non-tech) companies have even one director with a strong understanding of technology; in terms of executive directors, while the CEO and CFO are almost always represented, the board level CIO is a rare bird indeed. In this week’s Digital Business supplement, Ade McCormack asserts - correctly imo - that “Technology management is a board issue”:

There are many reasons why IT management fails to stem from the boardroom. These include: *Many business leaders have had a largely tech-free career. Their lack of experience in using technology as a tool beyond word processing makes them feel vulnerable. Making technology management non-strategic helps to keep their weakness off the agenda. * Many technologists do not want “users” interfering in technology decisions, often because their ill-informed input would be detrimental to value maximisation. Keeping users at arm’s length was standard practice because clunky technology tools and approaches did not lend themselves to mid-project change requests. Despite big improvements in the tools, user-inclusiveness is still some way off. *Some technology vendors have too much influence at board level. Their account director has more clout in technology decision-making than the CIO. This is a parlous state of affairs. Under these conditions technology management will be driven by the cash flow requirements of the vendor rather than the imperatives of the business.

Good governance, cost management, innovation management and ultimately shareholder value all require strong board level technology management.

Good IT management does not mean becoming a technologist, although future board members are likely to have spent part of their career in the IT function. It does mean ensuring there is a management process to reduce technology risks - many of which stem from abdicating decision-making to the IT function.

It also requires good technology leadership to ensure that creators and supporters of new technology feel sufficiently valued to stick around.

I first wrote about this (again spurred on by one of Mr. McCormack’s articles) almost two years ago. Unfortunately some of my optimism then was probably misplaced (or at least mis-timed) - I’m not sure we’ve made much progress on this front since then; David Yu’s rise to become the CEO of Betfair (in January 2006) still seems sadly to be very much the exception…

When I am investing, this is one of the first things I look for - does the management understand the strategic importance of technology to their business and if so how does this translate into how they run the business. Not surprisingly, my personal portfolio has a strong bias towards private companies who in my experience are often much further along in terms of embracing technology as a core pillar of their strategic discussion. All to often, many executive and non-executive directors of large public companies see technology as the bit that makes sure their Blackberry is working (or for the true traditionalist - that makes sure their secretary’s computer and printer works so that important emails get printed in a timely manner…)

I hope there are more signs of progress on this front over the next two years. Ultimately, I think it is inevitable but it might well take a generational switch in the boardroom before we see significant changes in approach or attitude. In the mean time, this offers a great window of opportunity for companies and leaders who are willing to embrace this line of thinking now.

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I have to admit I am not exactly shocked that the Park Paradigm isn’t required reading in Redmond. In fact I’m not even sure it renders in IE. (Do you get fired - or worse - if caught using Firefox at Microsoft?) But obviously Steve B. and his non-exec boss Bill G. have either not read my back-of-the-envelope suggestion on what to do with the company, or have chosen to ignore it. Perhaps they had a look, called up a couple of their favorite bankers, and were put off by the fact they hung up when asked to price up a $100bn term acquisition facility… (Fair enough, December 2007 was always going to be a tough month to cobble this kind of deal together. )

So instead of making the company leaner, more focused, less complex, easier to manage and more appropriately capitalized, they decided to go a different way. More bloat, less focus, more complex, harder to manage and inefficiently capitalized. Hey why not? It’s a plan.

Since writing my suggestion in October, Microsoft has announced the acquisitions of Multimap, Fast Search and now Yahoo. The first two of these three fit the typical Redmond acquisition m.o. :

…Microsoft’s problem isn’t that they have bought bad companies with bad technologies at bad prices. Mostly just the opposite. There are a lot of very smart people at Microsoft, starting at the top. They have bought many really interesting companies with really neat technologies and incredibly smart people. And then they kill them. They don’t mean to. But it is unavoidable. The corporate antibodies in a giant like Microsoft inevitably end up overwhelming the acquisitions (which especially given that by the nature of the industry, most are very young and very fast growing, innovation-driven companies that have not had time to evolve any defenses against mature mega-corporation antibodies. Don’t feel bad Bill, it’s not a Microsoft thing, it’s a Fortune 100 thing. The nature of your business (technology) just exposes you more is all.

The Yahoo acquisition is a bit different, both in scale (ie needle moving, not just a couple weeks free cash flow) and in the sense that it is a mature, struggling big(gish) company (as opposed to a fast growing entrepreneurial start-up); in many respects similar to Microsoft (with the small difference of not having a Windows/Office cash cow equivalent puking money week in week out.)

So is the Yahoo deal fundamentally dumb? Not necessarily. Indeed it isn’t by any means a complete surprise given previous approaches and widespread speculation and commentary on the idea. (I admit to having traded small amounts of Yahoo from the long side over the past 9 months or so basically looking to bet on this deal. I am somewhat pissed off that I was not in the trade when it actually happened.) The logic in this merger is less typical Silicon Valley and more Rust Belt in the sense that it is two mature ex-growth companies with leading market positions looking to rationalize - combine cost centres, share customers, extract “synergies” of course - and to generally give management something to keep busy with for a few quarters so they don’t have time to worry about strategy. Clearly Microsoft and Yahoo have many complimentary, overlapping and duplicative products and technologies so the scope to do some worthwhile and value producing old fashioned consolidation and restructuring is definitely there. For instance, I suspect it would make a lot of sense to use Fast technology for all of their search products going forward.

So fine buy Yahoo. My previous advice stands. In fact it becomes even more pressing - more complexity to unwind, more assets to regroup intelligently and spin off before they are completely absorbed in the giant corporate goo. That said, the numbers won’t look as good (except to the lucky Yahoo shareholders who have been bailed out.) But hey that’s what happens when you pay $45bn for $700mn of earnings and crummy operating cash flow. Which is of course what happens when you have money burning a hole in your proverbial corporate pocket because of a ridiculously under-leveraged capital structure…

One of the reasons I think the Microsoft situation is so interesting is that it is a particularly good metaphor for the “paradox of growth” facing many (most? all?) giant mega-corporations, including - and perhaps more relevant to many of this blog’s readership - the world’s financial services giants (banks, insurance companies, securities firms, exchanges, etc….) Citigroup may be the current poster child for this but this should be cold comfort for many of their peers and competitors. The single-minded pursuit of growth eventually always runs up against the law of large numbers. I figure it boils down to two fundamental limiting factors - diminishing returns on scale and exponentially increasing management complexity.

The optimal size (past which these limiting factors start reducing value faster than growth adds value) will of course be different by industry and activity and even by firm, but will exist all the same. Once this point is reached, it behooves management - and I would say especially the non-executives who are by definition supposed to be able to see the forest for the trees - to react and adjust accordingly. This could be by divestitures, de-mergers, recapitalisations, etc. Unfortunately for many reasons, the management of public large-cap companies typically are geared only to “go forward” and this type of behavior is too often an anathema. Indeed some of the great successes of private equity have imo been due to their ability to manage without concern for growing any line except the return-on-capital-employed line, and so to dispassionately dismantle overly complex and wrong-sized companies.

So should I buy Microsoft shares? If there was a chance that Bill & Co. would implement some variation or other on my suggestion, I would say yes. If they continue with business as usual? No way. Probably a reasonable short. Maybe the right position is short the underlying share and long OTM calls? Is this the right position to have in [fill in favorite large financial institution here] as well?

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It seems that the Board of Citigroup is finding it tough to identify a suitable replacement for Mr. Prince…(from the FT):

Josef Ackermann, chief executive of Deutsche Bank, has turned down an approach from Citigroup about taking charge of the US bank, underlining the lack of high-profile external candidates for the job.

I would suggest that this is because they are running up against three problems:

1. They are fishing in too small a pool: the number of people who have previously or are currently running large financial services companies (or even just big divisions within them) is very very small…but I imagine that the Board is probably thinking (who can blame them in these litigious times) that now is not the time for inspired and/or lateral thinking.
2. Impossible to align incentives: the only reason anyone would accept this poisoned chalice of a job would be in return for very significant - and guaranteed - cash; but of course that is unacceptable (rightly so) to the Board because it would be giving away a very expensive free option and send all the wrong signals to investors, employees, regulators etc. And remember, given (1) we are talking very significant cash (probably in EUR or CHF to boot, even models don’t want to be paid in USD these days…)
3. But the number 1 reason is that…(drum roll please)… it is an impossible job. Citigroup (and they are not alone here, it’s just more obvious sans CEO) is too big. And more importantly too complex for any one individual to manage efficiently in its current form. Like many mega-financial services firms, it is a jumble of heterogeneous businesses, risks and activities some of which gain greatly from economies of scale, but others that equally have significant dis-economies of scale. And the combination of all these businesses injects massive complexity. Let’s just say that I would guess Mr. Coase would find Citigroup “unoptimal”. They have too many variables and not enough equations. For anyone to claim that they could “do it” would just be hubris.

So what, should the Board just give up? Let it rumble along without a leader? Crazy as it sounds, I’m not sure they would be any worse off: it would probably save them a billion dollars of comp over the next 3-4 years and would avoid the risk of moral hazard thrown up by problem (2) and I’m not so sure the business would suffer unduly. It might get a bit testy at the top of the management pyramid but the people in the trenches probably wouldn’t see much difference in their day-to-day business. Of course the longer the Board takes to find someone, the more this case (might) be proved! But lest you dismay, even I am not so outrageous as to suggest the shareholders accept this as the least bad long term solution. No, if I were ADIA, Prince Waleed et al, I would be pressing Mr. Rubin to dedicating 2008 to the great unwinding/clean-up and switching my recruiting efforts to finding the 3-6 people who could lead (many of whom would ostensibly be Citi insiders) the future sons and daughter companies of Citigroup. Many of these proto-companies would not only be world leaders in their markets (like Citigroup), but would potentially be world beaters (unlike Citigroup); and there is no reason to think that in some instances they wouldn’t keep strong commercial ties with their siblings.

Just to be clear I’m not saying that building Citigroup was a mistake, just that it is unfinished business: a lot of interesting reactants have been brought together in solution, but now the end products need to be precipitated out. (Apologies to the non-chemists if this seems a strange metaphor.) Otherwise you’re just stuck with a beaker full of gray gloop, and the risk that it might explode to boot!

Finally some of you might be thinking “you’re just saying this because you aren’t up to the job and therefore can’t imagine that anyone else could be…hubris indeed!” Actually if its hubris you want, I would suggest that I could probably do as good a job as many (all?) of the candidates being considered - not the least because I would come without the same baggage and expectations, but am happy equally to admit that the complexity of the job (as currently specified) would be beyond my abilities. But let me finish by turning it around. Would you accept the job if it was offered to you? Seriously. Be honest. And if so, under what conditions? How much would you need to be paid?

The dilemma the Citigroup Board faces is that anyone who unflinchingly answers uncategorically yes (the usual “right answer” for a search) is disqualified as either a lunatic or a delusionary or both. Mr. Rubin I’m afraid I can’t help you with your search but I would be happy to serve at the pleasure of the Board if you want to brainstorm on reaction coordinates and such.

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It’s not like they exactly need my validation. But if you want to glimpse into the future of what would generically be called “investment banking” a good place to start would be at Citadel:

Since its founding in 1990, Citadel has grown into one of the world’s most sophisticated alternative investment institutions. Our team of professionals allocates investment capital across a highly diversified set of proprietary investment strategies in nearly every major asset class. Through a combination of world-class talent and the use of advanced technology to suppoer them, we relentlessly seek to initiate and capitalize on change in the global financial markets with the goal of remaining at the forefront of the industry.

I must confess to a very limited knowledge of the firm, based almost entirely on what I have read in the press and taking note of the deals they have done and how they have approached the business of investing. (So please accept that my opinions on Citadel are based on conjecture and are accordingly quite possibly off the mark.) What has always resonated with me is their emphasis on building a robust, scalable infrastructure based on viewing technology strategically as a core component of their approach to investing and financial markets more generally. (For those unfamiliar with Citadel, here is a Bloomberg Magazine article that gives a good overview.) Citadel Solutions formed earlier this year to leverage their leading edge infrastructure is a case in point:

The Citadel Solutions team is at the forefront of shaping processes within the capital markets, taking leadership positions in industry working groups and continuously driving improved workflow. This passion for process is a cornerstone of our culture and represents the close partnership between our people, our technology and our clients. As a result, our technology is continuously updated to support best practices and we believe in perpetually strengthening our team with the best talent available to deliver the highest levels of service.

This combination of People, Process and Technology has been central to our success and is now available through our administrative service offering. By partnering with us, our clients can focus on their core business of investing, while leveraging the unique and advantaged position of Citadel Solutions to support their middle and back office service requirements across nearly every asset class, market and geography.

With this in mind, let’s say I wasn’t surprised when I heard that Citadel was injecting a large amount of capital into E*Trade. I won’t pretend to know whether or not (or even how) the numbers stack up - I don’t have the resources at my disposal to undertake that kind of analysis but I suspect it will be a great deal for Citadel and one of those deals where frankly I wish I had the financial and human resources to have done.

Most of the commentary on the deal has been focused on the purchase of E*Trade’s distressed sub-prime assets at what would seem to be an attractive price. Indeed this would seem to be a major part of the financial risk Citadel is taking and is interesting in the context of establishing clearing prices on these types of securities and (hopefully) encourage the return of liquidity to these markets around a new pricing equilibrium. I have no idea as to whether or not Citadel will make money on this (I suspect they will) but I see this as the less interesting part of the trade, at least from a strategic point of view. Assuming that you ring-fence that part of the trade - which after all is ‘just’ buying a portfolio of assets and so is ‘just’ a question of price (as to whether it was a good or bad trade) - it would seem to me that you are left with Citadel taking a large (and cheap) position in E*Trade’s core operating business: a (relatively) modern, electronic agency retail securities trading and distribution business. This type of business is potentially very valuable (one only has to look at the valuations of their erstwhile peers - TD Ameritrade, Schwab - or the recent purchase by Goldman Sachs of 10% of CMC Markets in the UK valuing it at c. $2.5 to $3bn), and notwithstanding the fact that the E*Trade franchise is somewhat tarnished by their recent troubles, could prove to be a very cheap option if they can now isolate their core operating business from the mess because of the Citadel deal.

Furthermore - and this is pure speculation on my part - I imagine there are additional benefits to Citadel from having such a strong position in this kind of distribution and trading platform: it is a great place for Citadel to originate and distribute risk. Indeed it is my understanding that E*Trade historically was a big customer of Citadel’s options market-making business; the potential to grow this kind of relationship would be beneficial to both firms.

I must admit to being slightly confused as to why E*Trade ever thought it was a good idea to get into the business of taking principle risk. I mean they were outside the historical (and sub-optimal) banking/securities firm paradigm, and yet like a moth to a flame used their success to migrate their business model into the conformist Wall Street main stream. Marrying agency intermediation, distribution and origination businesses with principal risk taking in the same capital structure just doesn’t make sense: the incentives are all wrong and the risk/return/capital equations for each type of business are entirely different. With toxic results - it’s not just theory. Principal risk taking is intensive in financial and infrastructural capital needs, and light in human capital. The agency businesses are intensive in human and (in some cases) infrastructural capital needs, and light in financial capital. However the human and organizational dynamics of corporations do not allow these distinctions to be applied, or at best only at the margins. So what? Well let’s just say the best job in a modern universal bank is running the loan portfolio; in good times you have no losses and so good returns and usually the agency side of the business does well too. This is important because your compensation is anchored in the firm. If your star salesperson is paid $5 million for generating $50 million of revenues, well ‘your’ revenues of $200mn should get you paid at least as much right? Only the salesperson used a few hundred thousand or maybe millions of capital (needed from a regulatory point of view) while you used a few tens (or even hundreds) of millions. The capital made the money. Not you. Of course that’s obvious, no way that the compensation policy doesn’t take this into account you say. Trust me, it’s not completely ignored of course, but the arb works. And then in bad times everyone is screwed but since it’s not a partnership, the portfolio guy isn’t giving anything back even if he’s down $400mn. The worst the agency guy can do is a goose-egg, so at least compensation is (broadly, ignoring fixed operating costs) symmetrical.

But even ignoring the distortions engendered by the internal compensation arbitrage, as an investor you are buying a bucket of gray paint which is unnecessarily hard to price - you’d be much better off buying the individual colors and mixing them yourself. The portfolio effect within the firm is good for management - they reap the benefits of diversification, while for investors they only see a dulling of returns and a dilution of accountability. The optimal capital structure for an agency business is very different than that of a principal investment business.

I’m not sure this is all very eloquently articulated. It’s probably an essay not a blog post…but perhaps it will help clarify slightly if I tell you where I think this inevitably will lead us to (but it could take 20 years): a world where you have regulated pools of capital (banks), unregulated pools of capitals (hedge funds), originators/distributors (customer-facing) and exchanges. Each with an optimized capital structure aligned to the nature of their underlying financial and/or operational risk. Now it’s not to say there won’t be any loose coupling of all of these, but for example - and coming full circle I hope - Citadel owning 20% of (a pure agency) E*Trade might be the kind of thing we see more of not less in 2020.

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