Two trading firms, one of them an established Wall Street player and the other a Midwest upstart, are each about to premiere a sophisticated new financial tool: a box-office futures exchange that would allow Hollywood studios and others to hedge against the box-office performance of movies, similar to the way farmers swap corn or wheat futures to protect themselves from crop failures.
The Cantor Exchange, formed by New York firm Cantor Fitzgerald and set to launch in April, last week demonstrated its system to 90 Hollywood executives in a packed Century City hotel conference room….
…On Wednesday, Indiana company Veriana Networks, which says its management includes “veterans of the Chicago exchange community,” unveiled the Trend Exchange, its own rival futures exchange for box-office receipts.
These are exactly the kind of novel risk management marketplaces that will continue to emerge over the next 5 to 10 years as technology enables robust, easy and cost-effective trading and settlement mechanisms and data (which is the raw material of any exchange or risk management toolkit) continues to grow in size, richness and availability across every sector of the economy. Indeed the greatest impediment to the development of such markets is cultural: there is still an irrational, sometime hysterical, aversion to any risk management tool that is non-traditional and can be characterized as gambling. Of course gambling, trading and hedging are indistinguishable in practice and can only be differentiated in context, and really only represent differences in intent. As such, it is very difficult to proscribe one while allowing the other(s). There are however reasonably good, tried and tested regulatory frameworks that have been developed over decades to manage unhealthy practices (insider trading, market abuse, etc.) in traded markets for outcomes and commodities. Using these, regulators should be happy to quickly approve as many new marketplaces or exchanges as creative entrepreneurs and traders invent and let a thousand flowers bloom. I don’t think it is for the regulators to second-guess who might be interested in trading such markets and why, as long as the market rules and framework are robust, transparent and participants are swiftly held accountable for any abusive behavior.
But that certainly isn’t the way the establishment sees things and even those that are developing new markets often see their market as an exceptional addition to the risk management landscape rather than a specific example of a more general case. (Although to be fair this may be simply a tactic to curry favor with the forces defending the status quo in order not to appear to be too heretical and so smooth approval for their specific new initiative.)
“The day that a widow or orphan bets against ‘Finding Nemo 3′ — that’s not a good day,” said Rob Swagger, Veriana’s chief executive.
Why? Why shouldn’t anyone be able to put their knowledge and insights to work to make a return. Why is it ok for a ‘widow or orphan’ to bet on GE’s future performance (by buying or selling their shares) but not to bet on the potential return of a film? It simply doesn’t make sense. Or the view that certain risks or outcomes are worthy of being traded and managed but not others?
Government authorities have generally approved only those futures exchanges that allow for the redistribution of a preexisting risk. Sports betting is not approved because, unlike a farmer selling a futures contract to offset losses from crop failure, neither party involved in the wager has an economic interest in the underlying event.
This statement is of course patently ridiculous. Many, many agricultural risk contracts are traded amongst principals who are neither producers nor end consumers, and to say that there is no ‘real world’ economic risks that could be managed via sports trading is just silly given that sports is an enormous, global business with hundreds of billions of dollars of capital at risk. And if that weren’t enough, it is happening anyways, with admittedly high risks of fraud and abuse. Wouldn’t it make more sense (in the context of protecting vulnerable market participants) to encourage regulated, robust, well monitored marketplaces rather than cling to the current Potemkin-esque prohibition? (Disclosure: I am a shareholder in Betfair.)
In any event, I can only endorse Cantor’s vision of creating a new, more vibrant and useful market for managing risk and structuring finance in the entertainment industry:
Now Cantor hopes for its exchange to be the first of many complex financing products for the entertainment industry. In one of the more ambitious plans, Jaycobs wants to team with filmmakers to create something like an initial public offering of stock in a specific film, staking out a potential new way to finance production.
And I hope they (and Trend Exchange,) working along side the CFTC are able to quickly illustrate that well-built and well-regulated marketplaces can mitigate the potential dangers while at the same time providing a powerful and useful set of tools for managing risk and generating returns. Perhaps this will help pry open the door to seeing more and more outcome markets develop of the course of the next several years.
Today Markit Group announced that General Atlantic has invested $250 million, valuing the 7 year old company at a whopping $3.3 billion. Founded by Lance Uggla, Kevin Gould and Rony Grushka in 2003 to address the growing need for quality data in the burgeoning credit derivatives market, what followed was several years of unbelievably good execution and disciplined acquisitions which has positioned the company as a critical component at the heart of the trillion dollar OTC derivative markets. The products they provide aren’t considered sexy (something that is often given all too much importance in this status conscious industry) – but their data, valuations, indices, trade processing and other products and services are the plumbing that is key to the continuing operation of many financial markets. They are a great example of creating value by building a great platform and understanding how to monetize data. I had the good fortune to be a non-executive director from 2003 to 2006 and I can say without hesitation that this team is one of the best I’ve ever seen and fully deserve the success they have achieved. (Congratulation guys. Awesome, truly awesome.)
And I am certain there is more to come. Their primary constraint has and will likely continue to be the physical/logistical limitations of growing as fast as they have but each year they only improve and in terms of acquisitions the company they most remind me of (in terms of disciplined and deliberate execution) is Cisco. Besides, General Atlantic doesn’t invest in companies where they don’t think they can make 20-30% annual returns or more.
And yet many (most) people in the ’start-up’/'tech’ scene whether in the UK or the US have never (or only vaguely) heard of Markit. (For example, I counted only about 50 or so tweets referencing the announcement today, less than for any TechCrunch launching start-up…) Why is that? Obviously I can’t say for sure but (in no particular order) would guess the explanation perhaps lies in the following:
not venture capital funded; funding initially came from it’s cornerstone customers, the investment banks, and then later from some very smart hedge funds
focused on the wholesale financial services industry (and not on consumer or media or other mass markets)
key products and services (and associated economics) unknown to those outside finance and even worse generally considered ‘boring’
management team laser focused on execution, not PR (although to be fair they had this luxury not needing to sell to the mass market)
and so folks like TechCrunch and VentureBeat don’t know or write about them (aka “if a startup isn’t listed in CrunchBase does it really exist?” syndrome)
Indeed for me, Markit is a poster child for the cognitive, cultural and expertise chasm that exists between ‘Wall Street’ and ‘the Valley’ (or the ‘City’ and the ‘Roundabout’ to use the less good UK-centric metaphor.) They might as well be on different planets. Indeed bridging this divide is at the core of what we set out to do at Nauiokas Park and was the driver that led Paul Kedrosky and Tim O’Reilly to launch the Money:Tech conference in 2008 (which sadly didn’t survive the financial crisis and quite frankly was met by a deafening indifference by the vast majority of the Wall Street side of the equation.)
And yet, the opportunities available to those who can successful bridge this gap are enormous. Well, anyway that’s what we think. And the crisis in venture capital ostensibly caused by too much capital? I’m going to disagree with Paul and Fred and suggest it’s not too much money overall; rather it’s too much money concentrated with too few investors, focused on too few sectors, who end up all chasing the same deals. So to the LPs out there my message would be: don’t shrink the pool, enlarge the opportunity space. Oh, and try to make sure you’ve got exposure to the next Markit Group.
Five years ago I wrote a thought piece called ‘Through the Looking Glass’ to provoke non-linear thinking and foster debate on the possible future direction of the financial services industry and market structures. (I later turned it into a short video called AmazonBay.) It was a retrospective told from the point of view of an observer in 2015. It was never meant to be taken literally – in particular with respect to (most of) the specific corporate mergers – rather I used these as a concise and dramatic way of highlighting the possible or even probable consequence of the deep secular currents that I felt would inevitably work to reshape the landscape.
(December 2015:) …The global securities and investment banking groups that dominated the market in the last century are now extinct. In their place we have an intelligent galaxy of new specialist advisory, investment management, algorithmic software and consulting firms networked with a universe of powerful transaction facilitation exchanges. Banks now exist only as giant regulated pools of capital.
Following the sweeping banking reforms proposed last week by President Obama, and the fact that we are now halfway to this hypothetical future, I thought it might be worth doing a quick mark-to-market of how my ideas have lined up with reality.
Oracle
stock exchange consolidation and emergence of new exchange venues (A-) pretty close both in outcomes and timing – the major stock exchanges have been merging a-go-go while at the same time new trading venues have proliferated, and exchange (or quasi-exchange) trading of new asset classes continues to develop strongly.
sports/outcome trading in US legitimized (B-) my narrative had this happening in February 2010, not there yet but Congressman Frank’s bill might open the doors later this year and the trend seems to be on the right track and will probably be signed into law by Obama (!); as an aside was way early on a Betfair IPO…
giant bank mergers followed by break-up of vertically integrated universal banks, with Goldman Sachs leading the way (A) we have seen the big get mostly even bigger (RBS/ABN, BoA/ML, Barclays/Lehman…and while JPMorgan didn’t buy MS, they did get Bear Stearns and WaMu); GS hasn’t yet broken itself into three as predicted but I’m still confident it will lead the way when/if industry structure changes, and more generally the trend of regulatory thinking across the globe is definitely a trailing wind for the kind of change I envisioned. The 2010-2012 timeframe for the re-organization of global banks is probably a bit early but plausibility has certainly gone up (from near zero) significantly since I wrote this.
more (and more) algorithmic / automated intermediation of markets (A-) this was obliquely referenced in my article but was really at the heart of the idea that this fictional ‘AmazonBay’ platform would end up dominating this aspect of markets; clearly the market is heading this way – in fact it may seem obvious now but most people did not fully understand this even as little as five years ago.
Amazon anything (B+) The jury is probably still out on this one, but in my view it is looking increasingly likely that Amazon.com will become a giant of the next economic paradigm; whether or not they use their vast intellectual and technological resources to participate more directly in the financial services arena is not yet clear, but I can tell you the only ‘big company’ job I would not hesitate for two minutes to accept if it were offered would be CEO or CSO of Amazon Financial Services (AFS) Jeff are you listening?
(Note: Remember I used real company names mainly to add vividness to the ideas underlying the narrative. The key concept I wanted to convey with this GS break-up vignette was that the vertically integrated model would decompose under the light of new technology and regulations into a (technology-centric) Sales & Trading component, a more focused, relationship driven Advisory component (cf. the emerging proliferation of pure advisory ’boutiques’) and independent, conflict-free Asset Management businesses (cf. the secular growth of hedge funds and Barclays sale of BGI, etc.))
(February 2009:) …Reacting to new competition, Goldman Sachs becomes the first major investment bank to break itself up. Securities and distribution are sold to Ebay Financial Markets, while the remaining activities are split into two new companies: GS Advisory Services and GS Capital management…
Charlatan
eBay anything (D) Despite the fact that the actual companies cited are more symbolic than literal, the choice of eBay to represent the cutting edge of online, data-driven, algorithmic marketplaces was simply awful. To the extent that it risks distracting the viewer from the key, underlying messages. It is now entirely implausible and so instead of bridging the cognitive gap, the inclusion of eBay simply extends it. Thank goodness this is somewhat mitigated by my inclusion of Amazon.com (see above) as the other new markets avatar but they come late to the narrative…
sports trading developing as an asset class (C+) this clearly hasn’t happened, although there are one or two small funds and firms offering managed accounts; and a vibrant ecosystem of professional traders and the associated software has emerged around the Betfair and other exchange platforms. In my defense, I picked sports as just a provocative and emotionally attractive example of the idea that – enabled by technology – a vast array of new tradable markets in goods but also outcomes, would emerge. Work in progress.
credit crunch and asset bubbles (D) although the overall purpose of the piece was to provoke thinking on the sustainability of existing business models in financial services in the face of radically shifting underlying technological, economic and demographic trends, I failed to include a thread touching on the possibility of catastrophic systemic discontinuities arising as a result of the prevailing market structure and business models. It’s a significant ommission, especially as at the time of writing this I was in the process of exiting my former responsibilities as a senior executive in the credit business due in part to my increasing discomfort with the sustainability and prudence of the risk pricing in that market.
All in all, I would give myself a mid-term grade of B+/A- with room both to improve and to slip back. Mostly on the right track, especially with respect to big themes but perhaps a bit optimistic in terms of some of the timelines. What do you think? Better? Worse? To be fair, the correct measuring stick is not so much whether or not I was right or wrong, even in terms of ‘macro’ predictions but whether or not this article and video helped catalyze serious discussion, debate and thought about the potential for disruptive and non-linear change in the financial services industry. Alas I have no idea how one could even attempt to measure that, but any thoughts or anecdotes you might have with respect to this would of course be appreciated.
I’ve been avoiding putting together a list of predictions for 2010 (more on that later) but just couldn’t resist suggesting that 2010 could well be a breakout year for weather risk management. All of the conditions necessary have finally started to come together and with the worst of the 2008/2009 hysteria behind us (without passing judgement on the future direction of markets), companies (and hopefully individuals) will start to wake up and respond to the risks and opportunities inherent in weather variability. I wouldn’t be surprised if weather risk was one of the top three risks faced by the vast majority of (non-financial) corporations, perhaps even the most important risk in some cases, and of the same order of magnitude as liquidity, foreign exchange, commodity and interest rate risk – all risk categories for which massive global markets in risk pricing and transfer exist. Weather in this regard remains significantly underdeveloped:
(via Ben Smith, First Enercast Financial) For example the Department of Commerce estimates that more than $1 trillion of U.S. economic activity is exposed to weather. Even if a small fraction of new risk is hedged through derivative contracts, 2010 will be a very good year for these markets.
The massive costs incurred in much of the northern hemisphere over the last few weeks due to heavy snowfalls and cold temperatures are just one more example of how important a factor in economic outcomes weather risk can be. For example, just take the exceptional – and uninsured – costs incurred by local authorities and airport operators across the UK for snow removal, sanding, salting, loss of revenues, etc. Previously, a manager of a company (or government entity) who suffered an exceptional weather-related loss could shrug their shoulders and plausibly say “it was out of my hands.” In a way that would be impossible if for example their organization suffered a massive loss because their buildings or equipment perished in a fire and they were not insured. In that scenario, shareholders or taxpayers would be incandescent with rage at the incompetent risk management of the managers. Not managing weather risks is no different in substance (now that appropriate weather insurance and derivatives are increasingly widely available), only remaining so in perception as awareness lags.
Of course I am biased, having invested in Weatherbill, which is at the vanguard of transforming weather risk markets:
(via J. Scott Mathews, WeatherEX LLC) The weather market was built upside down, which is quite a feat, even for financial engineers. What we mean is that it started on the wholesale level without any retail underpinnings. It started out like a castle in the air…The changes coming in 2010 for the weather derivative market will be keyed “from the bottom up.” Solutions companies such as Guaranteed Weather and Weatherbill who bring management choices to “ground level” risk holders are helping to complete a strong base to keep that castle from crashing on us.
The difference between weather derivatives (Weatherbill.com) (or any other new risk management tool) and say books (Amazon.com) is that risk management tools need to be ’sold’ – there is a learning curve, however shallow; and while most people instinctively understand and can conceptualize their weather risks, their survival instincts – honed by decades of doing business with rapacious financial services firms – and fear of ‘getting their eyes ripped out’ means that they are understandably cautious when considering using weather risk management instruments for the first time.
This is where Weatherbill’s business model I think is particularly well adapted to the opportunity: on the one hand, they have a very modern (open) approach to pricing: anyone can go to their website and play around in their pricing ’sandbox’. Try doing that ten years ago when you wanted to price up a complex FX or interest rate option. Basically it was build your own model or keep sending pricing request to your favorite sales person (who would then have to go beg the trader for a price, and in addition to the regular parameters, the client’s identity, the salesperson and the trader’s mood would also be imputed into the price. That is of course if he felt like making one.) On the other hand, (and this is something that has evolved over the past couple years) Weatherbill has aggressively sought out distribution partners – insurance brokers, industry platforms (eg travel sites), etc. – as trusted providers to their respective customer bases, they are ideally positioned to help their customers manage their weather risks by leveraging Weatherbill’s platform. I first wrote about this a few months ago, and since then they have signed up a number of new and significant partners.
I love skiing and my family take a season pass at Les Trois Vallees. Obviously weather risk is central to running or enjoying a ski resort. While there are many different types of risk you could look at in the context of a ski resort, in the interests of simplicity (ease of understanding/customer acceptance) and maximum pain relief, there are two risks that I would have loved to have had an embedded hedge for in our season ticket (and I suspect the same would go for someone buying a week-long pass for their holiday, in fact they would probably be even more sensitive/appreciative.)
Not enough snow to ski risk: ie not that the snow is great or this or that…the basic risk that the pistes are closed. For most modern ski resorts this is actually a function of temperature and not precipitation, as they use snow-making machine to lay down a base. Temperature risk is much easier to measure and price (than snowfall) and has much lower geographic variability ie you don’t need a weather station on every piste on the mountain.
Rain risk: ie the only time it is absolutely unpleasant to ski is when it is raining. Also, rain typically doesn’t help the existing snowpack, making skiing after rain often unpleasant as well.
Using Weatherbill to hedge their risk, Les Trois Vallees could offer a ski-pass that reimbursed me for every rainy day and for every day say less than 80% of their runs were open due to lack of snow. In an age of increasing climate uncertainty (or perception thereof) I am 100% certain this would help them market (and sell more) season tickets. And for week-long tickets, it would be a great marketing tool for advance sales (with significantly positive cashflow benefits), and great for improving the user experience. Imagine a vacationer whose week in the Alps is ruined by 5 days of torrential rain…getting their money back on the lift tickets (irrespective of whether or not they braved the elements) would go a very long way to having them consider giving it another try next year.
Of course this is but one example, I’m sure all of you can think of hundreds more. In fact it might be harder to think of services or businesses that are completely immune to the weather. So really, what are you waiting for? Start hedging!
This week NEA announced the close of their latest fund at $2.5 billion. That seems like a lot of money for one venture fund, although perhaps if the intention is to focus on (highly capital intensive) clean tech and/or biotech they will be able to deploy this amount effectively. Of course NEA, founded in 1978, has a long and successful track record, with I imagine many long-standing relationships with LPs and excellent ‘brand recognition’ within the universe of potential LPs, and so it is hardly surprising that they are able to raise such large funds. After all – especially with respect to institutional investors – the analog to the ‘nobody-ever-got-fired-for-buying-IBM” paradigm operates in their favor.
A couple years ago, when I first started thinking about what would become Nauiokas Park, a good friend told me that private equity was all about raising capital, not investing it. Of course I understood what he
…private equity is about raising money, not investing it.
was saying, but thought he was using hyperbole to make the point that raising capital was more important than just a means to an end (investing.)
Now I understand that however cynical it may sound, he wasn’t trying to be clever: the way the institutional marketplace for private equity (including venture capital) is structured is all about raising capital and only incidently about investing that capital.
For better or worse, the year-end is typically a time to step back and take stock, to reflect on the year that was and the year to come. And indeed I have been thinking about what we could have done better or differently last year and what we need to focus on in this new year. And the short answer is we need to spend less time thinking about the economic and industrial landscape, developing our investment framework, sourcing potential investments and nurturing our existing investments, and more time soliciting potential investors: pitching our skills, our approach and the opportunity we believe exists to people and institutions that will determine whether or not we can turn our vision into reality. And like any start-up, we are going to have to be hard-headed about how we approach this as the proverbial runway is running out. As they say, there is a fine line between tenacity and obstinacy. I want to try to stay on the right side of that line.
Of course, once the lightbulb goes on it becomes obvious that raising money would be the most important talent of any prospective private investment firm: your LP’s, shareholders, investors are your customers (and not your portfolio companies.) They are they ones that ‘pay the rent’. They consume your service which is to invest their capital. Ah but the better the service, the more customers you have and the more successful you will be, right?
Well not exactly. In investment management generally it is very hard to determine a priori the quality of service one is likely to receive, which is why so often prospective investors – be they retail or institutional – fall back on historical performance to make their judgements. This reliance on historical data is clearly imperfect. However, when considering (many types of) hedge fund or mutual fund, given the typical investment horizon and liquidity profile, a consumer of these services can at least adjust relatively dynamically if they make a mistake. The effect of this is to reduce the psychological barrier to ‘taking a risk’ on any particular investment manager in these asset classes. But given the long time horizons and relative illiquidity in private equity, investors cannot exit a decision easily and so are (even more) inclined to stick with well-established firms and are less open to considering newcomers.
Basically “track record” is the box that needs to be ticked. And is much more important than having a coherent, well-researched and plausible investment thesis. After all, if you have the money, the deals come to you. But a track record in private equity is hard to come by quickly. (And it needs to be the ‘right’ kind: the first time I was told (by a prospective investor) that having been a founding investor in two multi-billion dollar companies didn’t ‘count’ because I wasn’t “a professional investor” when I made the investments was frustrating and somewhat irritating I have to admit.)
A company active in a two-sided market provides it’s services to two distinct constituencies. Often times, they provide those services for free to one side of the market, in order to increase the value of the services they provide to the other side of the market. For example, Visa provides consumers a free payments service (and actually often pays consumers to use their service via loyalty programs, cash back, etc.); in so doing they can charge merchants to use their services which have value to the merchants because of the number of consumers who use their platform. In effect, Visa sells ‘access to consumers’ to merchants. In a different context but the same vein, Google sells access to consumers to advertisers.
Successful private equity and venture capital firms “sell” access to dealflow to their investors and limited partners. It is a two-sided market. And so it is natural that network effects apply and rational for investors to be pre-disposed to the biggest, most established players. It is reasonable to think that NEA (and KPCB, Index, etc.) or Blackstone (and KKR, Carlyle, etc.) will see a high proportion of the best deals. So far, so true. But unlike electronic payments or algorithmic online advertising, investing (in private companies) does not scale and so unlike these markets, the law of diminishing returns kicks in much, much earlier. The industry (well, much of it) admits as much: I suspect if you offered the GPs of NEA a $10 billion fund, they would probably demur. Indeed I suspect if you offered USV a $500mn fund, they would probably turn it down. The key point is that for any given private investment strategy (sector, stage, etc.) there is clearly a maximum optimal fund size. For a company like Visa or Google, this is not the case – more customers, more merchants, more searches, more advertisers – it’s all good.
Jeff Bussgang recently estimated that the (US?) population of active VC partners was approximately 1000. I don’t know how many mutual and hedge fund managers there are but I suspect it is at least an order of magnitude higher than this. This seems intuitively wrong: investing in a private company is more work and there are more of them. You have a thousand investors looking at a universe of tens of thousands (or more) of investable private companies and tens of thousands of investors looking at investing in a universe of thousands of public companies…
Paul Kedrosky (and others) have written extensively and intelligently on how the venture capital industry needs to shrink. How too much money, chasing too few opportunities has destroyed returns. The logic is compelling. However I would posit that the problem is not too much money per se, but too much money with too few and homogeneous investors.
Let’s look at these two constraints sequentially (although they are co-dependent to a large extent.) If you double the number of GPs but provide ten times more investment capital, on average the valuations of the investments they make will go up five times (thus significantly compromising their future returns.) Ah but this logic assumes a closed system – ie that both the number and types of investments are held constant, and so increasing the ‘money supply’ drives inflation (and lower real returns.)
Well in a world where the number of GPs is constrained, and most of them come from similar geographic, educational and professional backgrounds, this assumption is likely to be more right than wrong. Indeed it is embedded in the initial conditions above – ten times more capital allocated to the asset class does not result in ten times the number of GPs. And yet the number of investments any GP can effectively manage is by definition bounded (at a reasonably small number.)(Which is of course why firms like Apax eventually exited venture capital and ‘graduated’ to private equity.) Perhaps an even more important gating factor however is the number of potential investments a GP can seriously analyze and consider each year (dozens? a hundred or two?)
And we uncover the Achilles Heel of the (otherwise extremely successful) ‘Silicon Valley’ model: the relative homogeneity of the environment leads inevitably to a collective narrowing of the universe of potential investments that is considered and amongst these, an additional narrowing in the way they are evaluated and considered. ie Everyone sees the same deals and runs the same slide rule over them. And so more capital simply means valuation inflation and ultimately, lower returns.
But what if we were able to disrupt this state of affairs? Having spent the past two years intensively researching the markets we are interested in, I simply don’t accept that the ‘problem with venture capital’ is a bounded set of investment opportunities. I’m sure there is some limit to the number of good entrepreneurs, viable business models and attractive market opportunities but we are nowhere close to reaching it. In fact, it is so far away we can’t even see it yet.
No, the problem is a failure of market design. (The irony being of course if this market design failure were in any other industry, venture capitalists would be aggressively investing in companies and business models designed to correct and take advantage of this failure.) The problem simply stated is too small a number of too many similar venture capital and private equity investors. The solution is more, and more diversity. The question is how?
I’m sure you won’t be surprised to hear that I have a few ideas on the subject, and for my first (and only) New Year’s resolution, I will endeavor to articulate these in a multi-part series I will call ‘Saving Private Equity’. Some earlier thoughts on the subject can be found here.
The more cynical amongst you might accuse me of simply ‘talking my book.’ Perhaps. Probably. A more flattering way to look at it is that I am living my convictions. And the lesson I’ve learned is that we need to focus almost exclusively on fund raising for now even if that means disappointing some of our portfolio companies or missing out on a great investment opportunity in the short term. It’s not fun or particularly interesting but like almost any other startup, without capital the rest is just theory. Time to stop thinking and start pitching!
So my question is when does Amazon.com split its retail operations from its AWS platform business. I’d love to see these priced separately. Actually, truth be told, I suggest Amazon.com is actually three businesses:
Earlier this year I suggested that AWS in particular could well be the totemic representative technology that inaugurates the sixth techno-economic paradigm:
Just as Intel’s 4004 microprocessor was the catalyst for a wave of creative destruction in the 70s and 80s, will AWS prove the same for the 00s and 10s? Probably. We’re seeing it already. And it’s going to disrupt the hell out of the mastodons of industry across most sectors of the economy. Why? Because their cultures and leaders are entirely ill-equipped to face such a fundamental paradigm shift. They know how to play by the old rules. The strategic competitive advantages they built up over decades risk suddenly – poof! – to become obsolete.
The central concept in this new option is that of the Spot Price, which we determine based on current supply and demand and will fluctuate periodically. If the maximum price a customer has bid exceeds the current Spot Price then their instances will be run, priced at the current Spot Price. If the Spot Price rises above the customer’s bid, their instances will be terminated and restarted (if the customer wants it restarted at all) when the Spot Price falls below the customer’s bid. This gives customers exact control over the maximum cost they are incurring for their workloads, and often will provide them with substantial savings. It is important to note that customers will pay only the existing Spot Price; the maximum price just specifies how much a customer is willing to pay for capacity as the Spot Price changes.
Spot Instances are ideal for Amazon EC2 customers who have workloads that are flexible as to when its tasks are run. These can be incidental tasks, such as the analysis of a particular dataset, or tasks where the amount of work to be done is almost never finished, such as media conversion from a Hollywood’s studio’s movie vault, or web crawling for a search indexing company. For most of these tasks their completion is not time critical and as such they are ideal targets for additional cost savings.
Before I go any further, let’s just say it’s pretty exciting to see vision become reality even if in this case I’m only a distant spectator. Markets in anything. Digital markets. Themes that go back to the founding mission statement of the Park Paradigm:
(December 2005) The technology of the digital age is driving an unprecedented explosion in the ability to create markets in anything. Trade anything. Not just physical goods. Not just financial instruments. But ideas. Events. Outcomes.
The emergence of these kinds of markets will – over time – impact how we view and interact with the world in all aspects of our personal and professional lives. They will fundamentally alter the current world economic and social paradigm.
Chris Swan calls them virtual resource markets and correctly points out that, at least for now, the market is “closed” – ie users cannot trade their capacity amongst themselves, however I suspect that it is just a matter of time before such a market is organized. But what would be even more useful (and exciting) than a closed market on Amazon EC2 resources, would be an open marketplace for on-demand spot computing resources. ie A marketplace which is agnostic as to where the compute resource comes from, so long as it is a robust and more or less uniform resource.* However for this to be useful for the end consumers of this computing commodity, the ability to switch automatically and seamlessly from one cloud computing source to another based on price and/or availability would be crucial. Indeed this would be the key value driver for anyone hoping to operate a compute resource exchange. Sure the price discovery and transaction mechanisms would be necessary but these are relatively trivial to build and hard (in isolation) to monetize. The real value creator for any exchange (just ask the CME) lies in clearing and settlements. (For the non-financial amongst my readers this is the back-end of the trade, fulfillment essentially.)**
Note, however, that this feature is not market-based pricing. Amazon determines the spot price and can raise that price enough to gain back capacity at will, at no real cost to itself. There is no competition. There is no commoditization. There is just consumption of what is not being used.
The truth is, real commoditization of infrastructure services–or any other cloud service, for that matter–isn’t in the best interest of Amazon or any other service provider.
Regardless, commoditization can’t happen without open standards that allow easy portability and interoperability of data and code, as well as security, control, service-level assurance and compliance systems. Those standards are coming, but it is impossible to predict when they will arrive. I only hope Amazon embraces them when they do.
I’m not sure I agree with his view however that commoditization isn’t in the best interest of Amazon. The underlying asset is ultimately relatively undifferentiated (a compute cycle is a compute cycle is a compute cycle) which is in fact the definition of a commodity. If you are a provider of a commodity – unless you can maintain a monopoly or a cartel – it is in your interest to create as big and vibrant a marketplace as possible. Supply creating demand. And particularly if you fancy yourself the most efficient, large scale producer of said commodity (as I’m sure Amazon does), all the more reason to want a big, liquid market of consumers. It is the exchange and clearer that want to create lock-in, not the producers. To be fair, for the moment AWS is both and indeed this is the point James is making I think, but I would be surprised if they had the intention (hubris?) to think this is anything but a transitionary arrangement.
Of course, as a traded market in this critical 21st century resource develops over the next decade and beyond, the business opportunities abound. Better yet, many of them are well known and can quickly be adapted (from other asset markets) to apply to the compute resource market. It’s not a business yet, but it only took a few hours before the first ticker tapes(here also) began to appear for EC2 pricing:
An entire ecosystem will surely emerge – exchanges, prime brokers, risk management derivatives, algorithmic trading… I’m sure there will also be some interesting second-order opportunities. Linking spot computing prices with spot electricity prices. Selling green compute cycles (ie powered by renewable energy sources only.) Allowing anyone to sell compute cycles into the grid (think SETI@home meets micro-generation). The mind races.
Welcome to the sixth paradigm.
* like a bond futures contract, one could imagine allowing any compute resource fitting a certain minimum specification into the “basket” of deliverable resources; typically in this scenario there would be a “cheapest-to-deliver” resource in the basket which presumably would get allocated first.
** I can’t help but wondering if the amazing technology developed by our portfolio company CohesiveFT couldn’t be adapted or re-purposed to form the core fulfillment engine of a compute resource exchange. The fact that they are Chicago based and their CEO/Founder is ex-O’Connor makes me wonder even more!
A couple of months ago, I had the privilege to have been invited to speak at eComm 09 in Amsterdam. I have posted on this previously but recently the video of my talk was posted and perhaps will make it easier to understand my accompanying presentation. If you can spare 20 minutes (there is an additional 10 minutes of q&a at the end) and are interested in understanding how Nauiokas Park defines our opportunity space, please have a look as it is probably the most succinct expression of the worldview we bring to investing and analyzing potential investment opportunities.
And here is the presentation again, in case you would like to follow along as you listen to the video:
Well-built developer platforms are the future of every industry. (-ReadWriteWeb)
Note: Their is a small glitch around 7:40 where the video skips over a few seconds; funnily enough (for the conspiracy theorists out there) this is exactly where I say that had ZSIN’s existed, the extent of the disasters that occurred in the mortgage securitization markets would have been at least an order of magnitude smaller…)
A phrase popularized by the late Charlton Heston in his crusading role as the poster boy for the NRA. But I’m surprised it hasn’t yet been officially adopted by more old economy industry groups as a rallying cry to marshall support to save and protect their dying business models. To the bitter end.
An Ontario court has shut the door on attempts to create new web sites to repackage real estate listings using data from the Multiple Listings Service system.
In a ruling released Monday, Mr. Justice David Brown of the Ontario Superior Court said Toronto real estate broker Fraser Beach did not have the right to provide broad public access to MLS data through a web site he helped create while working for BCE Inc. division Bell New Ventures in 2007.
The decision comes after the Toronto Real Estate Board (TREB) shut down several attempts in recent years to create new web sites allowing members of the public to sort MLS data – including an operation started by Mr. Beach.
That the Canadian Real Estate Association would want to protect its MLS data is entirely reasonable, indeed it is a very valuable dataset. However one would hope that they would take this as a wake-up call and start thinking very hard about developing a new business model around this data. One that reflects the modern realities of a fully connected, digitized economy. Perhaps they are. To be honest I have no idea. So acknowledging that this is pure unadulterated speculation, I suspect they aren’t. I suspect like the newspaper, music, bookselling, banking, etc. sectors before them, the main focal point of their efforts is to keep the bloody genie in the bottle. At least for long enough for the old hands to ride off into the sunset and let the next generation deal with it.
It’s a shame really, because on paper – as for most incumbents – not only do they have the most (everything) to lose when the paradigm shifts, but they are also by far the best positioned to maintain a leadership position so long as they adapt (in time.) Inertia, installed base and brand recognition take care of that. Basically they’ve got a strong hand. But time and time again it seems that these kinds of companies and institutions can’t help themselves but to overplay it. Taking another card while holding two Jacks kind of thing. Admittedly it would be hard work for someone to build up a competitive offering to the MLS from scratch, but I suspect not impossible. I don’t know what the public information access laws are like in Canada but if they are similar to those in the UK for instance, a smart entrepreneur might mimic the route taken by Zoopla and bootstrap prices starting from public sales records. And even if they do manage to maintain a data monopoly, they and their member agents will be faced with an increasingly angry client base who won’t readily accept being held hostage by secretive data trolls.
If I were a Canadian real-estate broker, I would be leading the charge to flip the MLS and traditional broker roles on their heads. Having read this excellent post on the future of my profession, I would understand that my customers are (mostly) not looking to do away with me but to get real value from my services and insights and conversely will become annoyed and resentful if they get the feeling they’re just paying a toll to a glorified data monkey.
The way a broker creates value in a world of abundance (vs a world of scarcity) is fundamentally different. Someone forgot to tell the record companies. Let’s not make the same mistake again. Save a real estate broker: free the data.
I thought I’d play a little markets jeopardy with the headline to this post. The question of course is: “what would happen if Google stopped mucking around and just came out and said it?” Said they were going to take their massive dataset, brilliant algorithms and (hire) all the smartest people in all the lands and offer a free service to “do anything anyone anywhere might conceivably want to do.” That should be enough to cast a pall over even the most profitable or promising companies. Sell everything (else) and buy Google, right?
Many of you are of course thinking no, not right: the premise is far-fetched (not to say ridiculous) and even if you accept it in the spirit of the thought experiment it so obviously is, the conclusion – that they take out every other competitor at the kneecaps – is not a given by any stretch of the imagination. And yet, when Google announced that they were going to launch a free property listing plug-in to enhance their UK maps product, the market reacted pretty much as if Google were indeed Merlin the Magician and just by waving it’s googly wand it could take over any market at will just by unleashing its fierce intellect and sizzling technology on the hapless incumbents. In this particular instance, Rightmove’s (the leading UK property portal) shares collapsed on the news trading down 10% on the day and c. 15% in all since the story broke. Now to be fair, having traded as low as 156p at the start of the year, RMV shares have had a pretty solid 2009, hitting a high of just over 600p and trading around 550p before the Google ‘news’ hit the market. And since investing (and especially trading) is not about picking the prettiest asset but picking the asset you think most others will find prettiest, I don’t blame any fund manager for selling first and asking questions later. And I have much sympathy for those that think that Rightmove’s market leadership is vulnerable in the medium term; only I don’t harbor much fear that this threat will come from Mountainview. The competitor that Rightmove’s shareholders should be keeping a close eye on isn’t Google, but Zoopla of course. (Reminder: we are investors in Zoopla.) Ah, but Zoopla has a silly name, it can’t be a real threat. Google however…
And it’s not just UK property where I think the mainstream markets and pundits breathlessly get it wrong about Google. In area after area they have proven not to be a very successful or threatening competitor and in other areas their entry has often been a boon for specialist competitors in the segment due to the legitimizing power Google brings to the table. They are able to (implicitly) validate new business models in ways a smaller, more specialist start-up could never dream of, and yet this market validation very often plays right into the hands of folks who, well, know what the hell they are doing.
Don’t believe me? Let’s take just a couple areas where – if you believe the logic in the argument used to justify Rightmove’s downtrade – Google should be causing wholesale panic and disruption:
Financial Information: maybe I’m wrong but I don’t exactly see Thomson Reuters or Bloomberg shaking in their boots, and yet here is a sector that is tailor made for Google’s engineering, distribution and technology assets, and one where they have had years to refine the value proposition; and yet Google Finance remains essentially a working prototype of a back-of-the-napkin sketch of what a Google financial information portal could become. Umair challenged CEO Schmidt to take up this challenge a couple months ago but I’m not convinced it would be as easy as it looks.
News aggregators: Google News is all we need right? (Perhaps supplemented with Google Reader…) There’s no reason for sites like Digg or Daylife or the Huffington Post to exist. I mean what are these guys thinking: some of them even started after Google News went into public beta. Crazy. Except they actually work, they have customers willing to use them despite Google News existing. But really, how long can this last?
Advertising: I must be joking now. After all advertising is the one market Google owns; the market that gave them their billions that allowed them to hire all the smart (non-evil) people and enter and take any other market at will. Right? Well if you think so, have a look at this recent post from Paul Kedrosky. It’s why vertical search and specialist sites exist. It’s why you (usually) go to Amazon.com if you know you are searching for a book, and not necessarily via Google.
And I could go on. But the point of this post is not to say that Google are useless, yesterday’s game, past their prime. In fact my best Google-fanboy guess would be that they are far from the point of diminishing returns and structural foolishness. My point is rather that they are not – or at least not universally – the ‘destroyers of all economic worlds’; that as they grow to become a company of thousands of employees in dozens of locations they will inevitably have to deal with some of the structural pathologies that this involves, including rising mediocracy and products looking more like camels than horses. Oh yeah and evil too. Yes they are a fierce competitor and certainly there is some risk that they could destroy your business model and take your business with it. But this is far from certain. They are human. They make mistakes. They execute poorly. They don’t always (or even often) win. And best of all, once you’ve proven that you can beat them, they just might buy your company.
Update:
I forgot to send you to a great essay by John Borthwick, thinking about the challenges Google faces going forward and highlighting the structural shortcomings of trying to regulate behavior in the fast moving world of technology, inspired by Ken Auletta’s book Googled: The End of the World As We Know It.
And of course Jeff Jarvis wrote a book about the opening premise of this post (which perhaps Santa will bring me) called What Would Google Do?
Using the tried and tested TED 20min format, it was a great opportunity for me to collect my thoughts into (what I hope was) a coherent overview of how I think technological and economic forces will shape the optimally adapted ‘industrial stack’ for the sixth paradigm. It’s a great summary of the prism through which we look at potential investment opportunities and I hope will help us articulate this more powerfully to entrepreneurs and prospective investors.
I’d love to hear any feedback (good, bad and ugly) from any of the eComm delegates who saw my presentation and hope to continue the conversation with you and others here. You can also follow me on twitter @nauiokaspark.
Thanks to Paul and Lee for inviting me and especially to those of you who took the time to respond to my call for input – it was tremendously valuable in helping me to shape and refine my thinking and in building the presentation; just a few years ago, assembling this kind of distributed brainpower would have been impossible, and I hope I never lose my ‘childlike sense of wonder’ at the boundless possibilities that technology enables.)
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