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Articles tagged 'finance'

Markets in everything, Part 471: Hooray for Hollywood

The LA Times published an interesting article yesterday discussing the arrival of two new exchanges focused on helping hedge box office risk:

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.

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Kublax (RIP)

Today Kublax announced that it was closing down:

The race the create the for the UK has claimed its first victim. Kublax, a Seedcamp 2007 winner which launched in August 2008, has now gone into administration, saying it was unable to secure a further funding round.

I’m pretty disappointed to tell the truth. Not so much because we held a small stake (via our investment in seedcamp) although this is unfortunate, but mainly because I think their business proposition is valid and although they certainly made mistakes along the way, these mistakes were probably avoidable and actually more to do with raising capital and managing a start-up than anything specific to Kublax. Of course to be fair, in any new venture all aspects of execution are at least as important as the idea and/or market opportunity and a two-legged stool won’t stand. Debating which leg is missing or broken and why is ultimately a somewhat irrelevant exercise. The reality is they didn’t make it happen. Nonetheless I feel badly for Tom and Sri, who I know put a lot of passion and effort into building Kublax and stayed focused and pragmatic to the end.

The general (ie non Kublax-specific) lesson that I would put at the heart of a case-study on Kublax is that capital is important. Now that might sound blindingly obvious – and of course it is – but stay with me. The lesson I see is that not all (‘tech’) start-ups can succeed bootstrapping a few hundred thousand pounds into a sustainable business model. As a relative outsider, I have and remained perplexed by the ‘one-size-fits-all’ capital model that seems pervasive in European venture capital, which often in reality turns into a feast or famine of capital for individual start-ups. Kublax was built on a shoestring and quite frankly it showed. The chicken never laid the egg and so the end became an inevitability. But I wonder if it could have been different.

You might be wondering why we didn’t invest in Kublax.* It really came down to one thing: we did not have the capital resources required to allow Kublax to hit ‘escape velocity’. I have looked very closely at Kublax over the last 18 months, and indeed we wanted to invest. However as a result of our analysis, we believed that the best risk/reward scenario would have required them to raise at least £2 million pounds and possibly as much as £5 million. Upfront. Not being in a position to provide this quantum of finance at the time, it would have been foolhardy to commit capital only to be ultimately at the mercy of other people’s investment committees. Further – and accuse me of hubris if you like – we felt strongly that our specific skills, knowledge and networks would be able to materially help the company successfully address some of it’s key strategic and operational challenges. However it would not have been economically rational for us to deploy these resources against only a modest investment. So we were confined to waiting on the touch line for others to drive the process. In the event, none did.

Lack of capital was not the only problem at Kublax, but I think the other key issues that the company faced could all have been addressed given sufficient capital. I will highlight four examples:

  • capital structure (specifically who owned how much and why)
  • management depth and experience (in particular in financial services)
  • product and user experience (never evolved beyond alpha quality); and
  • marketing and brand awareness

All of these issues could possibly have been solved with an appropriate infusion of capital from a serious and domain-knowledgeable investor. A cynic might point out that these four factors are pretty much the only four factors that matter so saying you would invest subject to being able to improve these is tantamount to saying you would invest if the company was ‘good.’ Well yes. Sort of. I think in the case of Kublax, the investment decision would have boiled down to a ‘build vs buy’ logic. Starting from scratch is hard and for all its faults, Kublax had done a lot of the basic plumbing (hard, unrewarding but necessary) and didn’t get a chance to start laying the tiles (hard but rewarding.) I find it hard to believe that asset is of no value.

In any event, given Kublax’s seedcamp pedigree, I imagine that most or all of the establishment London venture capital firms had the opportunity to look at Kublax. I think it would be very interesting and helpful to the broader UK/European start-up ecosystem to understand the key factors that informed their decisions to pass. Ask your favorite London VC to comment below.

So would we have invested if we had been in a position to underwrite a £2-5 million investment? Quite possibly. And indeed we would have made a determination on each of the four points above to really understand if these issues could be addressed, and the execution risk reduced accordingly. Alternatively we might have decided (and still might in the future) to incubate something similar ourselves.

In any event I wish Tom, Sri and the rest of the team at Kublax all the best for the future and hope they take away as many positives as possible from what must be a very disappointing outcome.

* I am referring here to what I call “Kublax Mark II” – in the early stages of the company’s life there were some clear management issues and dynamics that overshadowed the business and market opportunity. However seen from the outside, the company and it’s shareholders eventually addressed these issues and seemed to have a fresh start with some new investors coming on board and importantly a new CEO (Tom Symonds) early last year. It’s at this point we became interested (having explicitly passed a year earlier due to our lack of confidence in how the company was being managed.) Unfortunately one of the lessons is that it seems in the world of capital raising you often really do only get one chance to make a first impression…

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“I’ve had nothing yet,” Alice replied in an offended tone, “so I can’t take more.”

“You mean you can’t take less,” said the Hatter; “it’s very easy to take more than nothing.”

Mad Hatter

I’m sure it wasn’t his intent, nevertheless I had to smile when I read Umair‘s latest post on “Re-inventing Wall Street from the Bottom Up”, as it is a wonderful endorsement for what we are trying to build here at Nauiokas Park. He writes:

Instead, Wall Street needs to be reinvented from the bottom-up: by a new generation of radical innovators, to create thick value, for an authentically shared prosperity.

Building a disruptively better global financial system is the central challenge —and the largest, richest opportunity — for today’s economic revolutionaries. It’s time for Finance 2.0.

Investors, entrepreneurs, and radical innovators of all stripes: it’s time to It’s time to go big, or go home. You’re happy that social gaming is worth billions. That’s nice. But it’s also chump change. Because the gains that can flow from better capital markets are worth trillions.

Finance — not video games, advertising, cleantech, or social nets — is where 10x+ returns lie for today’s venture investors, and life-changing fortunes lie for entrepreneurs.

Hallelujah. Anyone who knows us knows that this is right out of our pitch book. And yet. It’s not easy. And I’ve been wondering why that might be. How much of it is a ‘turkeys not voting for Christmas’ problem? Or is it a question of ‘Lord, make me chaste. But not yet…’? I don’t know, hard to tell. Anyhow I’m sure we’ll get there in the end, but there is so many exciting opportunities and so much potential sometimes I struggle to understand why we aren’t reduced to beating back hungry investors with a stick. 😉 I guess the real answer is that we need to spend more time seeking capital and less time investing it. But I tell you that just doesn’t seem right. It should be the other way round, no?

A wise man (not being sarcastic – he really is wise) once told me of a very large private equity firm where he used to work at one time. He said they had a lot of smart and ambitious people. And a few well, Forrest Gumps. The latter took care of investing, while the former focused on the much more important job of raising more and bigger funds. I thought he was joking. I’m now pretty sure he wasn’t. (Note to self: area no. 697 of financial services ripe for disruption: allocation of capital to private equity managers…)

There has been much recent angst in the venture capital world about funds that are too big, and indeed the same debate flares up from time to time in the hedge fund world where many strategies (although not all) have analogous scaling problems (over-crowded trades, positions too big for the market, opportunities too small to ‘move the needle’ of a big fund.) But investors time and time again prefer to take the safe route and ‘buy IBM’. The classic fail-conventionally-versus-succeed-alone trade. Don’t get me wrong, there are some amazing big funds – where as an investor you get to eat your cake and have it too: ie great returns and the ‘safety’ of a tried and trusted organization – but there are also many many mediocre funds who have grown out of their edge and had their business objectives perverted into raising and keeping ever larger amounts of AUM, rather than having the objective of generating the best possible risk adjusted returns. I guess the fund-of-fund structure was one answer to solving the dilemma of how do you scale allocation of funds into many small and/or new managers, unfortunately more often than not, many of these funds find it easier and safer (reputationally not financially) to slide back into allocating to the same old, same old. (And a few bad apples discredited the whole concept by just putting all their money into a ponzi scheme and taking fees for their trouble!) I’ve thought about this a bit, and I must admit I have yet to come up with a clever mechanism that would solve the problem of efficiently (and safely) getting investment capital out into the ‘long tail’. But I’m sure it exists. Especially with the tools and access to information available today.

We also need to fix the supply-side by taking away the naked incentive for asset managers to blindly pursue AUM growth as a priority. This is easy. It was the first thing I said I’d do differently – three years ago – if i ever managed outside capital. It seemed so bloody obvious: management fees pay the cost of running the business, carry or performance fees are the juice. So set management fees at the level of the operating budget. Simple. You would think investors would love this as it reflects the true cost of managing the investments and aligns interests. Sure, it is a bit more complicated than just multiplying the capital by a fixed percentage, but only a bit: the cost structure of an asset manager is not exactly complex – people, an office, some travel, IT (more or less depending on the strategy) and some professional fees (legal, accounting, etc.) Further if there are economies of scale to be had in the strategy in question, these would be naturally passed on to the investors as the costs as a percentage of assets would naturally decline as assets grow, but the managers would be indifferent to this and so aim for an amount of assets that allowed them to create the best returns net of management fees. Indeed this is exactly what Paul Kedrosky suggested the other day. (Once again perhaps we were too early!) We thought potential investors would love this. The reality (so far) is that most have been at best indifferent and in a few cases outright skeptical – “That sounds too clever, why don’t you just stick to 2% like everyone else…” (I’m not making that up!) ie Don’t rock the boat. And that’s a problem, because we’re all about rocking the boat! And I can’t see how we can be otherwise and remain credible when our value proposition is to identify and invest in disruptive business models… (Sigh.)

Anyhow, Umair don’t lose faith, we’re working on it!

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On financial networks.

I was cleaning up my office a bit this afternoon and came across my copy of Andy Haldane‘s brilliant paper “Rethinking the Financial Network (April 2009). People (including me) like to complain about the lack of leadership and insight at the commanding heights of the financial system, but based on this paper alone, I’m not sure the UK could ask for a better Head of Financial Stability at the Bank of England. (He was appointed to that position in late 2008, once the horse had not only left the stable but the country…)

If you are interested in the workings and health of the financial system, you simply must read this paper if you haven’t already. I won’t attempt to summarize it here, it is worth reading in its entirety but will excerpt his conclusion:

Through history, there are many examples of human flight on an enormous scale to
avoid the effects of pestilence and plague. From yellow fever and cholera in the 19th
century to polio and influenza in the 20th. In these cases, human flight fed contagion
and contagion fed human catastrophe. The 21st century offered a different model.
During the SARS epidemic, human flight was prohibited and contagion contained.

In the present financial crisis the flight is of capital, not humans. Yet the scale and
contagious consequences may be no less damaging. This financial epidemic may
endure in the memories long after SARS has been forgotten. But in halting the spread
of future financial epidemics, it is important that the lessons from SARS and from
other non-financial networks are not forgotten.

I’m fairly certain he is not a reader so I can take no credit, but it is very rewarding to see someone in his position with such a firm grasp on the concepts I’ve been trying to articulate (much less completely and articulately) for some time now. (see The science of Financial Regulation (June 2009) and Averting (financial) ecological disasters (August 2008)) I hope his voice is listened to and his insight and intellect used to help us build a better, more resilient financial system for the future.

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Intelligent Financial Engineering

One of the main failings of much (most?) mainstream reporting and commentary on financial markets and financial services is that all too often it reduces the issue to a black or white caricature of the reality. Absolutist headlines are more compelling I guess… And at the risk of sounding elitist, I suspect that too many journalists writing on the subject of financial derivatives and financial engineering more generally, are not sufficiently comfortable with the subject to form more nuanced analyses. It must also be said that ‘Wall Street’ has been content to perpetuate the aura of mystery that surrounds derivatives; this attitude was a natural consequence of their traditional business model which was predicated on information arbitrage – aka ‘knowing more than your customers.’

I have to admit, I can understand why – given the egregious behavior of so many ‘financial engineers’ over the past 5 years or so, and the very real and unfortunate consequences now being borne indifferently by guilty and innocent alike – the public might rally around the pitchfork journalists and the witches’ coven they claim to expose. And my frustration is aggravated as this reminds me that through their reckless actions, a bunch of greedy, cynical, cowardly so-called professionals have put in peril the very real and tangible benefits modern financial technology can bring to the global economy and human society; something I passionately believe in. Think of the jerks you knew when you were a kid: the ones that didn’t know when to stop, the ones that pushed until the adults were forced to intervene, the ones that ‘ruined it for everyone else’. (I suspect it’s not just a metaphor: it wouldn’t surprise me if many of the worst offenders were these kids growing up…)

And so, given this context, I hope you’ll understand why I was especially heartened when I read about JPMorgan’s simple but innovative use of carbon derivatives to drive sales of more efficient cooking stoves in east Africa:

JPMorgan (JPM, Fortune 500) is quietly pushing the boundaries of the carbon market – a sprawling international experiment to reduce the greenhouse gases that cause global warming – by subsidizing the distribution of efficient cooking stoves in poor countries. Because the new, improved stoves save fuel and produce less carbon dioxide than traditional stoves, they generate so-called carbon credits that can be sold to companies or individuals who want to offset their own emissions.

The business is complicated, controversial and potentially very profitable.

How profitable? If all goes according to plan, JPMorgan will expand its support for cook stoves from Uganda into Kenya, Ghana, Cambodia and beyond. Each stove is estimated to reduce carbon dioxide emissions by two to three tons a year; each ton generates a credit worth $10 or $15 a year, and potentially more, for the bank.

“If you can distribute 10 million stoves, you are talking about a substantial tonnage of carbon,” says Odin Knudsen, who oversees JPMorgan’s carbon finance business. Do the math – you could be looking at a business with modest costs and between $200 million and $450 million a year in revenues.

But even here we run into the biases I highlighted above – “…complicated, controversial…” How? Why? Completely unsubstantiated. But I suspect most readers will read this and involuntarily nod their heads in agreement, conditioned to accept these assertions as given. Complicated? The author misses the irony, given that within the article the trade is succinctly and accurately described. I suspect most readers understood. Controversial? How so? To whom? The author fails to back this up with any real evidence or even a compelling example of what could go wrong. (Even though there are a few fairly obvious ways such an initiative could ‘go off the rails’, that would be worth reporting.) I assume it is just a knee-jerk assumption that any big bank making money from poor people is doing something evil.

Putting that meta-analysis aside…what a great initiative. While only scratching the surface, this kind of transaction is typical of what I believe we will see more and more of as we move to the sixth paradigm. The really exciting part is how this illustrates what is possible when you start to marry global financial markets to local, micro-economic outcomes. Take it one step further and you can start to provide credit secured on individual carbon allowances, to finance efficient capital investments. Or imagine not just selling a stove, but a fix-price fuel contract in tandem. And where the stoves are used for heating, embedding weather derivatives in the contract as well.

I hope they have much success with this initiative. I look forward to hearing more about it in the next few years (and maybe getting involved in some way…) I just hope the individuals at JPMorgan driving this project weren’t those immature jerks in high school! 😉

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Is this the future of financial markets? (a link to the short documentary film alluded to in my previous post.)