Failure is an option…

As regular Readers of our blog will know, the Awbury Team is inherently paranoid (in the Andy Grove “Only the Paranoid Survive” sense). We are also regular readers of the transcripts from the Farnam Street blog’s excellent podcast series, which we can recommend as a window into the thinking of a diverse range of first-class minds.

So we read with particular interest a section in Shane Parrish’s recent conversation with Jim Collins (“Built to Last”, “Good to Great” to name a few of his published works) which dealt with how supposedly great businesses or institutions fail, often quite surprisingly in the eyes of the outside world.

In examining what causes such decline, Collins posited 5 stages, the first 3 of which are often hidden from outsiders, explaining why failures can often be unanticipated or unexpected.

Of course, one can reasonably ask how long in practical terms the potential lifespan is of any business model, but the point that Collins makes is that what become catastrophic or ultimately terminal failures usually have internal causes; and that failure should not be seen as inevitable for those who are aware of the risks.

The first stage harks back to the structures of classical Greek tragedy- when a character becomes so successful or powerful that this leads to arrogance, hubris in tragic terms. In the case of a company, its management comes to believe that it is somehow better than anyone else.

Interestingly, in stage two, Collins points out that, while one might think that this arrogance can lead to complacency, the real danger is overreach. Not satisfied with its level of achievement and market position, a company’s management aggressively seeks yet more dominance and growth, or believes it can translate its “success” into other areas. In essence, stage two behaviour amounts to a lack of discipline- say in the form of an ill-conceived but superficially attractive “transformative” acquisition. Clearly, there is a fine line here. There could be further apparent success, or stage two can imperceptibly shade into stage three, when hitherto unseen strains or imperceptible risks begin to surface, but management dismisses or chooses to ignore them- because they are so “successful” that the fault must lie elsewhere.

Now hubris (having passed through “ate” or folly) leads to the potential for nemesis (inescapable doom). Now the problems become visible externally, and there is some sort of significant failure or mis-step, which cannot be hidden or suppressed. Even now, there is still the chance of redemption and recovery if management is able to discern and understand the causes, and responds in a reasoned and disciplined way. However, in many cases, it does the opposite. The team panics and acts incoherently without thinking through consequences, or somehow hopes for rescue from an external source.

If that happens, with resources and capital exhausted, and leadership absent or remaining in denial, the business slides into oblivion or irrelevance, leaving the way open for the cycle to start again elsewhere.

At Awbury, while we certainly aim to be the “best in class” at what we do, we have no intention of succumbing to hubris, as we continue methodically and patiently to build and extend our franchise. To behave otherwise would be folly!

The Awbury Team

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Hi Ho, Hi Ho, it’s off to (We)Work We Go…

While the endgame for WeWork, following the debacle of its recent failed and withdrawn IPO, is still unfolding, and a lot of ex post facto schadenfreude has been exhibited, it is worth pointing to certain aspects of what has happened that demonstrate that reality eventually intrudes upon suspension of disbelief.

We have written before of how the need for a business to be profitable prior to a public listing seems to have become a rather quaint notion. The WeWork saga demonstrates that in spades.

However, there is more to it than that.

Consider the widely used financial metric of “EBITDA”, often as a proxy for cash available for debt service and capex. As anyone who has read a syndicated bank loan document knows, the definition of and adjustments to “EBITDA” show that its natural meaning can be tortured within an inch of its life. In addition, “Adjusted EBITDA” is a favourite of companies in corporate presentations to demonstrate that their prospects are somewhat better than the numbers produced by statutory accounting may suggest. Yet, WeWork, with its now much-mocked concept of “Community-Adjusted EBITDA”, took the distortion of reality to a new level. Nevertheless, that appears not to have prevented sundry investment and commercial banks, who should have known better, from reportedly promising the earth in terms of what WeWork should be valued at upon a public listing. USD 47BN was “conservative”. As an aside, according to the Financial Times, the SEC has recently issued fresh “guidance” to company CFOs on the topic of EBITDA, while the IASB is considering standardizing the definition of what operating profit is, presumably in an attempt to prevent what is a useful concept becoming discredited.

Secondly, robust governance matters. The S-1 which WeWork issued ahead of its proposed IPO disclosed a catalogue of circumstances in which there were clear conflicts of interest between the company and its CEO/Co-Founder, but which WeWork’s Board had seemingly chosen to overlook, or even approved. Of course, in any organization, particularly one growing so fast and with a dominant and controlling founder, there is always the potential for the agency issue and misaligned incentives to lead to outcomes that, when scrutinized, do not pass a reasonable test of propriety. In the case of WeWork, these seem to have become inextricably entangled with personal interests. Sadly, as the case of Theranos amply demonstrated, Boards often struggle to act as a check on a dominant CEO. WeWork is hardly alone on that score.

Thirdly, if a key investor pours in so much money that it removes any real incentive for the founders and managers of a start-up to exercise discipline in terms of how they allocate capital and spend cash, it makes a mockery of the paradigm that a start-up should be “lean and hungry”; not because, at the other extreme, operating on “starvation rations” is somehow a virtue, but because a surfeit of capital, and no real controls on how it is spent, create inflated expectations in terms of the value supposedly being created, leading to “magical thinking”.

Fourthly, WeWork was treated and ostensibly valued as if it had somehow created a technology platform, when its core business model was, in fact, that of an entity that leased-long and sub-let short. The mis-match between (un)predictable cash inflows and demonstrable lease obligations was breathtaking, even if an increasing proportion of its available space was leased to large corporations, less likely to be vulnerable to economic cycles.

And, finally, if there is no clear trajectory to real “cash” profitability or generating any return on capital invested, how is it possible to create a valuation model that has any credibility? If a valuation is based upon the expected Net Present Value of future cashflows and/or dividends, and no-one can explain how that number will ever become a positive one, valuing “potential” crosses over into the realm of fantasy.

Of course, it is easy to mock. Clearly the spaces which WeWork created were attractive and showed the potential for improving the concept of an office or workspace. What was, and remains troubling is the fact that somehow its business model was treated as if it was revolutionary, when it was nothing of the sort; and that a wide range of parties became invested in maintaining that fiction, because the alternative probably became too awful to contemplate.

At Awbury, we take the view that, while clearly there are and will be paradigm-shifting businesses created by those who have a vision of the new, because that is evidenced by long experience, the constraints which surround such entities remain the same- a path to profitability and positive cashflow, good governance, management accountability and robust accounting, to name a few. One can create a transformative business, but breaking free from reality is a lot harder.

The Awbury Team

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Banana Split Thinking…

Surveys of (re)insurance industry participants are a common method of assessing those issues which are of most concern at any point in time. One can compare them with the World Economic Forum’s (WEF) annual “Global Risk Report”.

One of the more long-established such series is the annual CSFI/PwC “Banana Skins”, in which (in the case of the recently published 2019 Reinsurance Survey) the views of some 320 executives who were polled on what they saw as the major risks facing the industry. Strangely enough, WTW then published its own much less frequent “Extreme Risks Report”, produced by its in-house “Thinking Ahead Institute”. Having one’s own “institute”, or access to one, is a growth industry…

A comparison of the respective “Top 5s” shows:

Banana Skins

Extreme Risks

1. Technology          

Global Temperature Change

2. Cyber Risk  

Global Trade Collapse

3. Climate Change    

Cyber Warfare

4. Change Management  

Resource Scarcity

5. Regulation 

Currency Crisis

The “fear remit” of the Banana Skins is clearly more inward looking and industry-focused than that of Extreme Risks, with the former being based on a survey and the latter on a more formal internal research methodology.

Of course, as with the WEF’s own offering, anyone reading them is likely to conclude that they are statements of the obvious, hardly containing any new information; representing, as they do, the current perceptions of a group, or number of supposedly expert individuals. They are not “forecasts”, nor are they “impact-weighted”, and they both suffer from the problem of familiarity threatening to breed contempt: none of the risks ranked at any level in either publication is, as we mentioned” exactly new, so “risk fatigue” is a concern.

The real question to be posed is: “Will any of this make a difference to the actions of any management team within the (re)insurance industry?” Frankly, we very much doubt it, because any executive who was not aware of and familiar with any of the risks articulated would not be performing at an acceptable level and should probably be cashiered.

It is, therefore, debatable whether such publications serve much purpose beyond telegraphing what the conventional thinking is. In providing a common taxonomy of perceived risks they also raise the issue of “framing” in the sense that, if the conventional thinkers and industry members are focused on what is published, perhaps that limits their exploration of risks not articulated? After all, the rankings are meant to convey a level of concern, so diverting attention from what is not there. Of course, many companies do have “Emerging Risks” as a remit for their ERM or Risk Management functions, although we wonder how much traction their findings get if they are (paradoxically) seen as “outside the mainstream”.

At Awbury, we do, naturally, make sure we are aware of what others are thinking, because we do not function in a vacuum, and the existence of such publications is useful in terms of understanding why others may behave in a certain way. However, we prefer to go our own way when it comes to risk identification, assessment, and ranking; and we worry about succumbing to risk orthodoxy, not out of any sense of superiority, but because it is the risks that you do not see and so do not address or prepare for that have a tendency to cause ruin.

A Publication of the Awbury Institute…

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