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Articles tagged 'secondary markets'

Are (traditional) financial markets broken?

I don’t have much invested in traditional public equity markets, just a handful of relatively small positions in my (self-directed) pension fund. I haven’t done any robust analysis but my intuition tells me that my average holding period for these positions is probably around 2-3 years, with perhaps a bit of trading (lightening up or adding to existing positions) one or twice a year. And watching the markets from the sidelines over the past month or so certainly hasn’t made me regret this modest, passive allocation. When massive, mature companies trade up and down by 10 or 20% in a period of days – with no or little company specific news, confidence in the market’s ability to set prices in an orderly fashion clearly goes out the window. Indeed, the (public) equity markets are dangerously close to losing their ability to provide one of their key benefits: price discovery. And if/when this comes to pass, there will be serious knock-on effects on their other prime (and beneficial) function of capital allocation (and providing access to capital to companies and access to companies to investors.)

The risk is that a tipping point is reached at which the traditional public equity markets cease to be relevant venues for raising capital or investing. As many people have recently remarked (Kill the Quants Before They Kill Us, Beat high-frequency trading machines by not playing their game, etc.) possibly the key driver of this trend is the relentless increase in algorithmically-driven machine trading (high-frenquency or otherwise.) Now don’t get me wrong, I am neither a luddite, nor am I fundamentally opposed to these trading strategies; rather all other things being equal I would probably consider myself a proponent. In moderation, these types of trading strategies add both liquidity and heterogeneity to the market and as such help create a more robust trading ecosystem. But recently, the equilibrium of this system has come unstuck. Anecdotally, it is now assumed that upwards of 60% of trading volumes on the main public stock exchanges are accounted for by algorithmic/machine-directed trading. On some days and in some stocks, I understand that this can be as much as 80+%.

And most of these strategies don’t involve any judgement as to the valuation per se of a company; basically, as the Onion put it so brilliantly many years ago: they are just “trading” a “blue line”.

Blue Line Price History

NEW YORK–Excitement swept the financial world Monday, when a blue line jumped more than 11 percent, passing four black horizontal lines as it rose from 367.22 to 408.85.

So nobody is actually setting the price! (…or more accurately, the “price-setters” in the markets are mostly being overwhelmed by the trend-trading machines.) This does have the side effect of creating real trading and investment opportunities for on the one hand a small number of smart nimble day traders and on the other hand a small number of very long term investors (who have the luxury of having deep pockets and patience) but for the vast majority of investors (professional or private) the market dynamics and extreme short term volatility make participation more and more painful. This is particularly the case in a low-return environment such as today. Clearly execution (entry and exit points) have always been important, even to long term investors, but never have they been make or break like they have been in August: who cares if you have a carefully crafted investment thesis that predicts a 20-40% appreciation over 2-3 years in Company A when depending on the day of the week on which you entered the position, the thesis is rendered somewhat moot by a 20% swing in the share price.

And it’s no wonder that strong, growing private companies are often loathe to have their shares listed: what right-thinking CEO wants to deal with that insanity???

So what’s the solution? I don’t pretend to have an answer, but I do have a couple suggestions that perhaps point in the right direction for smarter people than I to develop into actionable plans:

  • design structural dampeners (through exchange rules and regulations) that limit the volume of algorithmic trading to some maximum proportion (to be A/B tested to find the optimal point – 40? 50? 60? percent?); this could also be a dynamic number, for example increasing or decreasing with intraday volatility to damp same
  • encourage the continued development of private secondary markets (SharesPost, SecondMarket and others) and help to develop them as real alternatives (and complements) to traditional public equity markets.

It’s really important that our global capital markets operate robustly and efficiently. In fact it’s never been more important. I believe that reasonable, robust solutions exist (or can be developed.) But I fear that the inertia and prejudices of entrenched incumbents (exchanges, banks, regulators, governments and investors) will make finding these solutions exceedingly difficult. I hope I’m wrong. Until then, be careful out there (and think about re-allocating some of your capital to the private markets; you’ll sleep better at night!)

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On liquidity.

Where is Goldilocks when you need her?  On the one hand you have high frequency and algorithmic trading dominating the world of listed companies with market shares often exceeding 50% of all volumes traded and with increasing instances of unstable trading and extreme volatility in liquidity as these machines enter and exit the market creating a complex, unstable chaotic system where long term investors who aren’t careful can literally be run over in both directions like Wile E. Coyote on an Arizona desert highway…  On the other hand, in the world of private investments – in particular in the broad category known as venture capital – liquidity remains elusive with (too) many practitioners having a disfunctional and often irrational set of beliefs as to how and when liquidity is acceptable and when it is not, with the end result making naturally illiquid investments even more so.  And yet, wouldn’t it be nice (for investors and companies) to have a long term capital market where liquidity was “just right?”

So what would just right liquidity look like?  Can you have your cake (all the typically enormous strategic advantages that accrue to a private company) and eat it too (the advantages of being listed, afforded by having a periodic mark-to-market and the ability to use your equity as a real currency)?  I think you (mostly) can and am very encouraged to see this sweet spot slowly emerging and gaining traction outside of a handful of what previously would have been considered exceptions to the rule.  In my opinion, the answer (as I have mentioned before) lies in further developing secondary markets in private company equity.

The two most successful companies I have had the privilege of investing in – Markit and Betfair – despite being multi-billion dollar companies and market leaders, are still today private companies and have provided liquidity to investors, management and employee shareholders (in different ways) which has gone a long way to allowing them to remain private and reap the associated benefits.  The flexibility of Facebook’s management to run their company for the long term optimal outcome has I suspect been a direct function of the liquidity that secondary investments (from DST) and a relatively active secondary market in Facebook shares on platforms like Second Market and SharesPost have provided to early investors and employees.  And it’s not just about cashing out – at least half the value of these secondary markets comes from providing a credible mark-to-market and the reasonable expectation that – if needed – an investor could access liquidity.  Perhaps paradoxically, with these two factors in hand, more often than not, investors will actually have a higher propensity to hold on too their investment, not lower.

Another benefit of secondary markets would be to improve the health of the overall venture investment ecosystem which while evolving in fits and starts, most recently with the rise and rise of “super-angels” and “seed funds” still mostly remains in the eyes of this industry outsider, static and prone to herding around the notion that one-size-fits-all in terms of capital structure and financing paradigms is somehow optimal and should not be questioned.  In particular, I fail to understand why the received wisdom of the venture capital community seems firmly stuck on the concept of “nobody exits until everybody exits”.  It’s a dumb concept and worse, quite frankly is at odds with the interests of the various investors and stakeholders in a private company,  including later stage investors (aka mainstream venture capital funds.)  I believe much of the angst surrounding seed stage investing and (traditional) venture capital investing, arises as a result of a dysfunctional transition mechanism. (ie There isn’t really one.)

What I would like to see – and quite frankly have never heard a good counter-argument against – is a more dynamic and flexible financing chain, one that pragmatically combines both primary and secondary elements.  Practically speaking, what would this mean?  At its simplest, it would mean that at any given funding round, the possibility of existing investors exiting part or all of their holding is considered objectively and without undue emotion.  Having participated in many such transitions in companies going from “seed” funding to “series A”, or “series A” to “series B”, etc. the relationship between existing shareholders and the new shareholders is far to often one of conflict – to the extent that this is often seen as just the normal way of things – when there is no reason that this ever need be the case.  Venture capital firms often talk of “needing” to invest a minimum amount of capital and/or “needing” to own a certain minimum stake in the companies they invest in.  While I think the case is sometimes overstated, if you understand the dynamics of their business model, their attitude is easily understandable and basically rational.  And yet, I have never yet seen a venture capital fund offer to buy-out the early stage investors in whole or in part when more often than not this would be an ideal outcome for everyone:

  • the company:  not needing to raise more new capital than strictly necessary
  • the early stage investors: (whether professional angels or seed funds or friends and family) allowing them to reduce risk, recycle capital and retain focus on the market segment (early stage) they know best and which corresponds to their capital base
  • the venture capital funds:  allowing them to simplify the capital structure, deploy more capital and ease negotiations

If this became the norm, I think it would drive a massive downstream benefit which would be to create a more dynamic, focused and intelligent early stage investment paradigm as investors in this ecosystem niche could really focus on funding two types of companies:

  • companies that have a plausible case to become successful but modestly sized businesses worth $10-40 million; and
  • companies that have a plausible case to become “VC fundable” where the goal is to exit in a series A or series B at $10-40 million

This would considerably improve both the availability but also the quality of early-stage capital as the risk / return dynamics would become much less random and the impact and velocity of the best investors in this space would increase considerably, providing more, cheaper and easier access to capital to entrepreneurs while at the same time providing a fantastic “farm-system” of talent and corporate development to later stage VC’s, perhaps even allowing (the best amongst) them to deploy their hundreds of millions or billions of capital efficiently as their ecological niche becomes better defined. I am absolutely convinced that this paradigm would create a much healthier, more vibrant capital market for innovation and disruption, improving returns for everyone in the ecosystem.

What I am not saying is that buying out seed investors would be appropriate in every situation.  Nor that all seed investors would always be happy to sell all or even part of any individual investment.  Nor that later stage investors should always look to buy out early stage investors.  What I am saying is that this discussion should always be a part of the financing tool-kit, this option should always be on the table, and dismissed only when and where it is objectively inappropriate.  Let’s get rid of the dogma and let markets work.  Liquidity:  not too much, not too little, let’s get it right!

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Re-inventing venture capital.

Recently there seems to have been a heightened level of existential discussion on the venture capital industry, its future and appropriate structure and objectives. Perhaps kicked off with Paul Kedrosky‘s report for the Kauffmann Foundation and taken up by people like Fred Wilson, Chris Dixon and others.

A few years ago, when I first started to take a close look at the venture capital industry, its structure and its business model, I must admit the first thing that leapt out at me was that it seemed just as settled in it’s status quo, comfortable in it’s received wisdom as the investment banking industry I had spent over 15 years navigating. Perhaps I shouldn’t have been surprised, however I couldn’t help but find it ironic that an industry ostensibly focused on finding and financing innovative technologies, business models and people, should itself seem so immune from these forces, almost to the point of being anachronistic.

And so I set out about educating myself as to why this was the case. Why was this just “the way things are done”? And unsurprisingly I found a couple good reasons buried in a mountain of inertia and vested interests buttressing the flimsiest of rationales. So answering my friend Max’s request for ideas, here are a few of my ideas on how to improve venture capital.

  1. Greater diversity of economic models: monocultures are naturally fragile – my point is that the GP/LP with 2 and 20 isn’t necessarily wrong or right, but it has weaknesses that would be mitigated by competition arising from a more diverse ecosystem of economic models and approaches.
  2. More emphasis on clear, well-defined sector expertise and specialization (both in terms of firms and people.) Clearly we are talking our own book here, but if don’t believe me, Marc Andreessen makes the point as well.
  3. More permanent equity and secondary markets (and less frequent fund raising.) The most profitable private equity and venture capital firms are the ones that are much better at raising capital than investing it. You get what you pay for. Change the structure and incentives and you’ll change the outcomes. Further, the best course of action for any given company should obviously not depend on their investors’ capital structure and yet under the current industry structure, the dynamics of your partners, venture firm and/or individual fund can and does often drive strategic decision making. It’s called the tail wagging the dog and it’s as sub-optimal as it sounds.
  4. Management fees at cost (not as a % of assets under management) and restricted equity as performance incentives. This one seems like a no-brainer: management fees have a minimum fixed component and generally are correlated with both the number of investments and the complexity of these investments. Typically there is some degree of positive correlation between these factors and assets under management but the implication (which underlies fixed % management fees) that it is mechanical and linear is completely wrong. You would think that investors (‘LPs’) would be 100% behind this innovation, and yet I have been surprised to find that many are at best ambivalent, and some actually hostile. The only reason I’ve been given for this attitude is having ‘certainty’ in terms of costs, although I think this is a total red herring: a cost-driven management fee would entail the venture capital firm getting their budget approved by their Board and given the relative simplicity of the business, would be relatively trivial to determine with a high degree of certainty, even over time.
  5. Standardize investment terms by developing and adopting a document analogous to the ISDA Master agreement structure and pricing supplements (for individual deals.)* Not only would this lower costs and reduce complexity but it would also facilitate a more active and robust secondary market.
  6. More syndication – lead underwriter rewarded for driving process forward; increasing use of ‘managed accounts’ (vs discretionary management.) The idea here is to bring together complementary syndicates of specialist investors, each bringing something slightly different and valuable to the table, as opposed to just a jump ball between a number of more or less identical generalist funds.
  7. Price ancillary services (advisory fees, directorships, etc.) transparently and honestly. This is an area where I think venture capital could learn a lot from their private equity cousins by making more explicit – and charging appropriately for – services they provide to their portfolio companies. Clearly this approach is not perfect nor is it immune from abuse, but by combining with point (4) above and structuring much/most of the payment for services in equity rather than cash, it would actually reduce the scope for abuse and discrimination amongst shareholders and would force both companies and venture capital providers to justify any additional value (beyond investment capital) that venture capital firms or partners provide. Under the current operating model, the venture capital firm’s investors effectively subsidize the portfolio companies’ use of the professional resources of the venture capital firm. And there is a cross-subsidy within the portfolio, with companies that don’t need any services effectively subsidizing those that do.

In fact, if you take a step back and look at these recommendations, they would have the effect of making venture capital look a lot more like a collective, scaled-up version of professional angel investing. And as I was writing (and re-reading) these points, I fear that the short form of a blog post is probably ill-suited to make relevant and nuanced arguments as to the pros and cons of various elements of the venture capital business model. And yet I simply don’t have time to write an essay. I’m not Fred, but perhaps if I’m lucky, that essay will write itself in the comments here and elsewhere. So have at it!

* (via Wikipedia) The ISDA Master Agreement is a bilateral framework agreement. This means it contains general terms and conditions (such as provisions relating to payment netting, tax gross-up, tax representations, basic corporate representations, basic covenants, events of default and termination) but does not, by itself, include details of any specific derivatives transactions the parties may enter into. The ISDA Master Agreement is a pre-printed form which will not be amended itself (save for writing in the names of the parties on the front and signature pages). However, it also has a manually produced Schedule in which the parties are required to select certain options and may modify sections of the Master Agreement if desired. The Master Agreement would be modified to the extent the modification is mentioned in the Schedule. Details of individual derivatives transactions are included in Confirmations entered into by the parties to the ISDA Master Agreement. Each Confirmation relates to a specific Transaction and sets out the agreed commercial terms of that trade. Confirmations are generally quite short as they will normally incorporate one or more of the definition booklets published by ISDA. Each of these definition booklets relates to a specific type of derivatives transaction and, in addition to defining terms, they include mechanical provisions (e.g., Articles 5 and 6 of the 2000 ISDA Definitions set out how to calculate the Fixed and Floating Amounts payable under an interest rate swap) which do not then have to be laboriously reproduced in the Confirmation.

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(Still) more on markets for tickets.

As a result of some of my recent thoughts on how markets for (live event) tickets should work, I was pointed in the direction of a new start-up called yoonew:

yoonew is the world’s first futures exchange for event tickets. We have created a dynamic marketplace that helps online consumers save money and time when buying and selling tickets. Our real-time trading platform gives fans, traders, and resellers a safe and transparent place to trade tickets.
We are passionate about leveling the playing field and creating a fair marketplace where everyone has equal access to tickets. Our team focuses on building new product features that will bring transparency to markets where pricing information is not universally available. We help customers make more informed purchasing decisions so they are confident that their purchase or sale concluded at a fair price.

TechCrunch did a write-up in early January and they got a lot of coverage in the run up to the recent Super Bowl game:

I’m not 100% convinced that they’ve nailed it but it is certainly a very interesting step in the right direction in terms of introducing modern (and useful) markets technology into the historically moribund market for live event tickets. Essentially, they are selling call options on tickets to major sporting events. Moreover they have taken an original and clever approach by – at least initially – focusing on major sporting events (like the Super Bowl) where the terminal value of the underlying is different depending on the buyer. ie If “your” team gets through to the game, the tickets are of more value to you. Of course, with a properly functioning secondary market (irrespective of whether on yoonew’s upcoming secondary exchange or another market – StubHub, etc.) financially this should be irrelevant – the ‘market’ value of the tickets depends only on the clearing price of the event once the participants are known. (ie Super Bowl tickets on balance will be worth more if two teams with big, passionate fan bases are playing as opposed to two teams from smaller markets; NY v New England more valuable than Kansas City vs Detroit for example.) So a ‘rational’ trader would try to buy the cheapest options – not necessarily the option on his team, especially if you could re-sell the option before delivery. (I’m not sure this is allowed, if not it should be.) Nonetheless, the (marketing) focus on ‘real’ end buyers (people that hope to take delivery, rather than just make a financial profit) is a good angle as it plays to the psychology of ‘hedging’ rather than speculating and should add heterogeneity to their risk book.

Notwithstanding the ridiculous US laws proscribing trading on sporting outcomes, there would also potentially be very interesting arbitrage and hedging opportunities (for both yoonew as the market-maker and their customers) with trading sports risk. For example (using the same teams as above) going long New England and NY to make the Super Bowl to hedge the extra cost of delivering tickets to this pairing (vs a less valuable team pairing.) Or going long the team in the host city (which would also probably be more valuable on delivery if they ended up playing.) I’m not sure if they have any plans to offer markets on European (or global) events – it would have been great for the recent Rugby World Cup, imagine if England fans could have bought (what would have been) cheap options on the final in Paris – but if they did they could use Betfair to manage their price risk today.

Longer term, ideally you would hope that sports teams and leagues would embrace this kind of market to help manage their own pricing risk. Instead of just selling tickets (in the primary market), they could sell options on tickets and use secondary markets to dynamically hedge their risk. For a team that didn’t sell out systematically, it would be a good way to monetize potentially empty seats and even for teams that sold out perennially it would allow them to be more aggressive in finding the ‘true’ equilibrium clearing price for a given seat. For investors it would be another potential (uncorrelated) asset class to trade and invest in. I wonder what the implied volatility curve on the NY Giants season would look like? Gamma trading based on the weekly game results anyone? The question is do the owners and managers of these teams understand how this could work to everyone’s benefit or will they stick to the old model of static seat prices and unoptimized revenue management?

I hope yoonew succeeds and helps to develop a more enlightened and efficient market for tickets in live events. One to watch.

All About Alpha has a look at yoonew.

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More on markets for tickets.

Maybe it’s just confirmation bias, but I seem to be noticing a lot more news and commentary on secondary markets for tickets to live events.

The Sports Economist draws attention to an editorial over at ESPN:

TMQ’s Gregg Easterbrook, after a sensationalized introduction, asks an interesting question:

On Monday, sellers on StubHub were asking from $750 up to a rather comical $164,710 for tickets to the Ohio State-LSU game (the latter price is for a prime luxury-box seat). The season finale Giants-Patriots NFL game might be historic; on Monday, sellers on StubHub were offering tickets for $200 up to $26,000, depending on seat location or box quality. Once the NFL playoff pairings are known, scalper Web sites will come to life for those contests, too. The asking price is not always the selling price, of course. But bowl committees and NFL teams must be saying to themselves — if these seats really are worth hundreds or even thousands of dollars on the free market, we should be the ones pocketing that scratch. How long will it be until professional teams cut out the middle person and simply auction off tickets for whatever the market will bear?Any day now, the NFL is expected to announce a deal to affiliate all its teams with one online reseller, probably Ticketmaster or StubHub, formally acknowledging reselling as legitimate and bringing the NFL an expected annual fee in the $20 million range. This might be just the first step in converting sports-ticket selling into StubHub World.

If one thinks of tickets like shares of stock, it is unlikely that franchises will initially place 100% of each season’s seats by an electronic auction mechanism. But what percentage will be “placed,” and what percentage will be auctioned?

I think rich people in particular are willing to pay to sit in the same spot (“their” seats in some sense) near others that they recognize. The latter component may be modest, but it might also account for the some of the interest in prosecuting scalpers in the old days. Legal reselling increasingly puts that component at risk. This is a stretch, but one way of interpreting laws against scalping is that clubs didn’t mind you selling tickets to your friends, just any old high bidder.

Meanwhile, Fortune recently did a profile piece on Live Nation‘s CEO Michael Rapino:

But Rapino isn’t satisfied with dominating the concert business. He is mounting an audacious attack on the record labels and seeking to poach their most important assets – their stars – by turning Live Nation (Charts) into a one-stop operation that handles their every musical need. His offer: We already operate your tours. Why not let us make your albums, sell your merchandise, run your website, and produce your videos and a range of other products you haven’t yet thought of? This is the age of the empowering Internet, after all. Artists are in charge. Who needs a record label?

Depending on whom you believe, Rapino’s strategy will either reinvent the ailing music industry and turn Live Nation into a powerhouse – or cripple his company. Certainly it’s brash talk for a concert promoter whose toddler-aged company has never put out a single record. But artists have been listening closely since Rapino landed a giant catch. In October he struck a first-of-its-kind deal with Madonna, who bolted her longtime label Warner Bros. and signed a ten-year contract estimated at $120 million to let Live Nation handle every part of her business except publishing.

For what it is worth I think they’ll make money on the Madonna deal, even without attributing a value (which is certainly non-zero) to the marketing/business development angle of this innovative and high profile deal.

For more of my thoughts on how I see these markets developing over time, I refer you to a few earlier posts:

Now, I just need to figure out how best to get involved… 😉

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This just in: Google pre-IPO shareholders owed upwards of $35 billion

Mountainview, CA – Having sold almost 20 million shares in 2004 at $85, and then another 14 million shares at $295 in 2005 (not too mention various block sales over the years), and with shares now trading at over $700 this represents almost $19 billion of lost value. In addition, since the IPO there have been roughly $3.4 trillion of transactions in Google shares on the secondary markets. Obviously it is unacceptable that not a penny of this is returned to the founders and employees of Google. While acknowledging the benefits that the secondary share market offers to investors and companies alike, and admitting (belatedly) that ‘it does not make sense to criminalize Nasdaq’, to redress this shocking state of affairs, the founders’ agents have suggested that they would be willing to authorize it against agreeing to a levy on all transactions. Set at 1% for example this would amount to returning approximately $35 billion to the Google entrepreneurs and their backers. “And this is just one company! Think of all the other entrepreneurs and venture capitalists that have heretofore been exploited by the maverick and rapacious stock market operators,” said Jim Smith of the recently formed Re-sale Rights Committee of the Santa Clara County Chamber of Commerce.

OK, so I made the preceding article up. But, it makes sense right? After all it’s only fair. At least that’s the view of the (always-ahead-of-the-curve) entertainment industry as reported this week in Variety (thanks to Dom for the pointer):

“The secondary ticketing market offers benefits to music fans and the live music industry alike. It does not make sense to criminalize it,” said Resale Rights Society chairman-elect Marc Marot, manager of Yusuf Islam and Paul Oakenfold, and former chief executive of Island Records. “But there are real issues of consumer protection here, and it is unacceptable that not a penny of the estimated £200 million ($413 million) in transactions generated by the resale of concert tickets in the U.K. is returned to the investors in the live music industry. Where this trade is fair to consumers, we propose to authorize it by agreeing to a levy on all transactions.

“The online ticketing exchanges have consistently claimed that they wish to work with artists and the live music industry. This society presents them with that opportunity.”

I won’t go into it again in detail (see here and here) but it strikes me that instead of vainly trying to preserve an outdated business model by desperately looking to slap taxes and rents on anything that moves, artists and their agents should be looking to embrace the long proven and manifest advantages of robust, liquid and transparent markets to reduce their risks and refine their pricing. Every syndicate manager knows that having good secondary prices makes their job 100 times easier and – while certainly not the only factor – forms the foundation of the primary market pricing algorithm. And as the traditional securities markets become ever more sophisticated in their use of automation for primary distribution, perhaps the resulting marginalized and surplus syndicate managers should consider plying their skills in the market for live event tickets. The right way to help artists garner the true market value of their talents is to well, let the market work!

And lest anyone in the securities industry feel too smug about how much more enlightened they have always been, remember how Stanley Ross was enemy number one for many in the square mile when he pioneered gray markets 30 odd years ago, and as little as 5 years ago (still today in the US & in Equity markets) electronic bookbuilding platforms were not exactly met with a warm embrace…to use one of Pip Coburn’s favorite quotes on change (Machiavelli):

“… nothing is more difficult than to introduce a new order. Because the innovator has for enemies all those who have done well under the old conditions and lukewarm defenders in those who may do well under the new…”