Transferring risk to shareholders: Quarterly greed with no skin in the game

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Michael Lewis has a great expose on Wall St (both culture and incentives) this month, titled The End of Wall St’s Boom.

While the whole piece highlights the train wreck that is current Wall St culture, there’s great insight at the end as to why this happened so badly now.  And, as with all things, it comes down to what you do when you play with other people’s money.

When as a public firm, that means raking in profits when risk is taken, while not personally accountable for any (the public shareholders become a backstop, where partners’ own wealth was once at stake), then the long-term equity values begin to recede in importance to the quarterly/ annual bonuses.

What this highlights is the lie of Wall St finance, that bankers created vast amounts of wealth and needed to be paid to do it well.  Instead, it highlights that in banks, it makes sense to take the winnings out and distribute them to the shareholders in good times.  As a partnership, that used to happen.  As public entities, the shareholders were fleeced and left holding the bag.  I sense we’ll need to see public entities with less-well paid bankers and private entities whose shareholders will again create and share in the gains (and losses).

What we’ve also seen is that diversification is a farce in a world where derivatives tie all publically available assets together…the strategies to control risk should return to underwriting of individual investments.  As with all things, assumptions break he most complicated models, so its common sense, vision, and leadership–not spreadsheets–that will show us the way forward and make the world a place better than today.  As Thanksgiving nears, let us give thanks that we can gather our loved ones around and as the night gets darkest, it always gives rise to a brighter tomorrow.

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Congrats to Obama…now the work begins

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Congrats to Barack Obama for his victory in the election!  As a symbol of what this country represents…how an unknown young man can rise to lead this great nation, he provides an incredible role model and inspiration.

I hope he is Kennedy-esque.  This country has been weighed down in frivolousness for too long…I’m glad he is expressing the seriousness of the task ahead and the moonshots we’ll need to get behind to get the country back on the right track.

After 8 years on the path to imperialism, we now gain the opportunity to lead in a different way.  I hope Mr. Obama fulfills the promise and hope he has ignited in so many.

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Happy to announce release of HealthProvidr.com, Massage Therapy edition

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As many of you know, I’ve been busy at work creating Health Shoppr, a company focused on bringing transparency, choice, and personalization to health care.

As step one of that journey, I’m pleased to announce the public release of HealthProvidr.com, starting with a community and career resource for massage therapists.  Our goal is to help massage therapists succeed in their chosen profession by providing more choices and options relevant to each practice.  Our next step will be the creation of public web profiles for each massage therapist, helping them to promote their practice using the power of the internet.

Please stay tuned, as we release the consumer version of our technology, HealthShoppr.com.  There, we will start by helping consumers compare their options in massage therapy, and find the therapist that best fits their needs, by comparing practices in the same way they’re currently able to compare plane flights, hotels, books, and collectibles on sites.

We’ll be starting beta testing soon in California.  Please let me know if you’d be interested in testing our technology (and the massage it entails).

We look forward to sharing with you our vision for healthcare: a system based on choice, service, personalization, transparency, and wellness.  We look forward to blazing that road and hope you will join us.

Goals of a solution to the current financial situation

This is a reblog of a comment to the Roger Ehrenberg’s recent article explaining some of the root causes of the financial market crisis

Terrific piece, Roger.

What should the goals of any solution to the economic downturn and credit crunch include? I’ve attached a few of the things I think are important:

1) Transparency: No closed doors and real discussion of the objectives, risks, and alternatives

2) Re-establishment of risk: Allowing risk premiums to be re-established and restoring the risk/ reward trade-offs of investing

3) Reduction in leverage: Juicing rewards with leverage is a game that benefits traders, not customers (they can lever up themselves prior to allocating assets to a portfolio). Through regulation, disclosure, and/or raising the cost of capital–make sure this leverage-induced brinksmanship goes away

4) Put all transactions on the books. A lot of effort goes into accounting gimmicry. Make all corporate assets disclosed on the balance sheet. Disclose liquidity (regulating all agents would be bad…PE and VC both legitimately invest in illiquid assets).

5) Buy assets at market value. If market value can’t be determined, use different assets that can be valued. If market value makes firms insolvent, make sure they die quickly. Finding a bottom will get us back on the path to growth.

Originally posted as a comment by Vijay Goel, M.D. on Information Arbitrage using Disqus.

Smaller community banks benefitting from Wall St ills

As you may expect, the flight from big national banks is reinvigorating local banks through increases in deposits and tapping into local bank balance sheets (not weighed down by the mortgage game played by WaMu and the big boys).

Might our answer be in letting the big trees fall and letting the seedlings finally get some sunlight?

Good article showing the abilities of the smaller guys : http://www.washingtonpost.com/wp-dyn/content/ar…

Demonstrate that while the Interstate system of our financial markets may be in disarray the local roads and state roads are still providing the services needed to keep the system afloat.

Originally posted as a comment by Phanio on A VC using Disqus.

Does welfare and cleanup offer the highest return on ~$1T in capital?

From the Treasury Department’s proposal:

Overall, financial institutions serve a vitally important function in the U.S. economy by allowing capital to seek out its most productive uses in an efficient matter.

As we are rushed into the expenditure of $1T of capital with no clear understanding of the returns on that capital, nor accountability for the money spent, I am forced to reflect on whether we think this is the best way to spend that money.

As an entrepreneur who’s put my own assets on the line to create a business, and had most financial institutions tell me that my venture was too risky for them to contemplate or didn’t guarantee a high enough return, I now reflect the questions back that I’ve received:

• What are the sustainable advantages of doing this transaction that ensure a multiple on my investment?
• What preferential terms will I get over the common stock to make sure my risk is reduced relative to the existing owners and executives?
• How do I know that management’s own assets are on the line?  Are their personal net worths tied in with my success?
• What is the Total Addressable Market?  What pain are we solving for them?  How are they paying us to remove that pain?

If wealthy accredited investors and their institutions need this clearing of mortgage debt to occur, how are they going to pay to make this happen?  If they don’t care, and are putting their money on the side until the carnage clears, isn’t it just better to accelerate the carnage and let market reach bottom so opportunities now promise returns again?

As potential “rescue” investors, if there is nothing of value salvageable out of this mess, even with a down round of existing equity, then we should focus on building alternate institutions to allow us to move forward rather than throwing good money after bad.

$1T is a lot of capital.  I’d rather put it to work to build next generation institutions and technology than support an industry already being displaced by the winds of creative destruction…and the faster we make this change the more likely we are to lead moving forward rather than be stuck with legacy infrastucture that resists the path forward.

Wall St. Welfare: Bailouts serve as taxpayer blood in the water for Wall St sharks

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The best traders are similar to cornerbacks in the NFL…they operate on an island and have poor memories.  Instead, they play each play to gain the greatest possible advantage, no matter what the last play held.

As the financial sector crumbles and institutions tumble, the American taxpayer has been set up to take the bag, supposedly for the national good.  And what impact does that have on those who’ve created this falling house of cards?  These sharks see blood in the water and are each seeking to extract a new chunk of taxpayer flesh.

The NYTimes has an excellent article on the entitlement mentality of Wall st

Even as policy makers worked on details of a $700 billion bailout of the financial industry, Wall Street began looking for ways to profit from it.

Financial firms were lobbying to have all manner of troubled investments covered, not just those related to mortgages.

At the same time, investment firms were jockeying to oversee all the assets that Treasury plans to take off the books of financial institutions, a role that could earn them hundreds of millions of dollars a year in fees.

Nobody wants to be left out of Treasury’s proposal to buy up bad assets of financial institutions.

“The definition of Financial Institution should be as broad as possible,” the Financial Services Roundtable, which represents big financial services companies, wrote in an e-mail message to members on Sunday.

The group said a wide variety of institutions as varied as mortgage lenders and insurance companies should be able to take advantage of the bailout, and that these companies should be able to sell off any investments linked to mortgages.

The scope of the bailout grew over the weekend. As recently as Saturday morning, the Bush administration’s proposal called for Treasury to buy residential or commercial mortgages and related securities. By that evening, the proposal was broadened to give Treasury discretion to buy “any other financial instrument.”

The lobbying became particularly intense because Congress plans to approve a package within just two weeks, without the traditional hearings and committee process.

Clearly there’s profit in the air and financial firms are looking to extract as much value as possible.  Which is why, we the taxpayers, should not let that happen as they try to extort us in the cleanup of their own mess.

There are several principles that we should stick to, including avoiding free riders and receiving transparent valuations even if we inject some liquidity into the markets.

From Roger Ehrenberg’s Information Arbitrage:

investors are expecting a bailout of institutions deemed “too big to fail,” with benefits flowing directly to those firms’ equity holders instead of the U.S. taxpayer who is providing the funds. This is clearly at odds with free market principles, as the common stockholders become “free riders.” Does this need to be in order to stave off financial catastrophe? I’d say not. And whoever says this is the case has something to gain, like being bailed out from poor investment decisions. Those at Treasury, the Fed and Congress: JUST SAY NO.

Buying assets at anything other than fair market value is against every principle we should be enforcing. Transparency. Accuracy. Full disclosure. This is a non-starter. Who cares where the assets are carried on a firm’s books? If Morgan Stanley has them at $.30, Merrill at $.32 and Goldman at $.50, this is not the point and should play no part in the analysis. There should be a reverse auction to determine price, with the Treasury buying the cheapest and moving up the line. Depending on where firms are carrying these assets, it might require a write-down that would threaten its solvency. If not, great. The firm has liquified the assets and the U.S. taxpayer gets the upside over time (monetizing the liquidity option, in my parlance). However, if there is a capital gap I’d suggest that the Treasury gets issued convertible preferred stock on attractive terms, supporting the firm in its operations while substantially diluting common equity holders. In this case jobs are saved, the institution continues to operate as a smaller, leaner, hopefully more prudent firm while the U.S. taxpayer, once again, owns the liquidity option.

Remember, at the heart of the problem is that there was too much cheap capital in the market.  While we don’t want all capital tied up, investors will adjust to a level of risk in the marketplace and seek places to grow their money.  Our problem is that too much capital was too readily available and people lost an appreciation of risk.  Bringing cheap capital back and rewarding stockholders by giving them a mulligan on the risks they chose is the wrong answer.  Ultimately, all money managers would lose their jobs if markets remained locked indefinitely.  They’ll make sure that doesn’t happen.

In the end, it will be painful as market trading and valuations return to levels that appropriately reflect the fundamentals.  The system built on outsized valuations and unreasonable leverage multiples needs to die…and I’ll be aghast at any taxpayer money wasted in the attempt to save the mansions of those who want to continue to feed off the carcass of a failed system of bubble finance.

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Fall of traditional investments beneficial to new ventures?

Roger Ehrenberg of Information Arbitrage has an interesting take on the implications of the financial services chaos on capital for startups.

Given that investors still have money and they’ll be looking for returns, the flow of funds into Treasuries and other low-yield investments will reverse.  Stocks and bonds in public markets will likely face challenges in terms of upside relative to risk and cost of capital.  That leaves alternative investments where alpha truly exists…and early stage companies who may benefit from the challenges faced by existing players appears to be one such source of outsized yields.

Savvy, long-term investors will use this opportunity to deploy capital in alpha-generating strategies with longer time horizons, while using their large pool of short-term liquidity to meet current obligations. As some of the gains from the long-dated portion of the portfolio are harvested, they will be redeployed into new alpha-generating strategies or used to augment the liquid portfolio.

And as I noted in Investment Banking 2.0, small is beautiful. Boutique investment banks focused on providing merger advice, general corporate strategy, private placements and alternative investments. Venture capital firms that still do real venture capital, focusing on seed stage, A and B round investments. Focused hedge funds that are excellent at specific disciplines, and haven’t diversified away the lions’ share of managers’ returns.

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Merrill and Lehman fall: Evolution beginning on Wall St.

Wow.  Big day in the financial marketplace.  The day of reckoning comes for Lehman and Merrill decides to cash in whats left and exit stage right.

At the end of the day, the game of mortgage hot potato is coming to an end, bluffs are being called, and winners and losers are now being tallied.  Bad risk assessment is bad risk assessment and somebody needs to hold the bag.

It all comes down to cash, and we’re seeing the same lessons played out in LTCM and Enron– run out of cash, no matter what BS you put on the balance sheets, and you’re dead.  Simple lesson small business folks live by every day.  In the big corporate game however, you get to play with other people’s money and with year over year rewards, you care less about sustainable investing and more about playing chicken while being the last one standing.  Overreach and you just lost a lot of someone else’s money.  Underreach, and you have a pretty poor bonus compared to your friends and you may lose your job.  Given the incentives, why play it safe?

The culling of the losers creates new opportunities in the financial sector.  B of A will be busy digesting Merrill and the integration of those two cultures will create some interesting head-scratching moves in the near future (they won’t lose as many people as you may otherwise expect– where would they go?)  The firesale on poorly performing mortgage assets will a windfall for the vultures/distressed fund folks that have been starving for some time.  Hopefully, this will provide a floor for the housing market, which has been propped up on poor fundamentals for a while now…buyers asking prices well above what sellers are willing to pay.  New opportunies to skim the cream of what’s out there will arise…and I’d imagine some emerging risk-assessment firms will get their day in the sun (the FICO score as the risk assessors panacea is hopefully exiting for a few years at least).  Quants will pull back, as they realize that their assumptions need to be fixed before they hit the gas pedal again.

What’s really been confusing to me is the willingness of “smart” money to let investment firms lever up their bets and profit off the leverage.  Any investor can borrow money and increase their risk on their own…yet its the lack of liquidity that comes with the leverage that’s bringing down the firms, not the actual losses on the invested products (if you can cover the margin calls, you can weather the storm…none of these assets have come to term).

Will we see no-leverage funds compete head to head on real returns?  Will capital reserves and risk profile become real metrics people examine when purchasing funds going forward?  I think these safeguards, understanding of a risk portfolio, and potential shift to a value-creation from a sales culture, are going to be the most interesting elements of the next generation of securities and products as we move past this risk-insensitive debacle.

Thoughts?

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Strategy for startups: 5 tips for building a performance culture

Potential turning into momentum

This is article 1 of the Strategy for Startups series

One of the hardest transitions for startups is going from 1-2 guys killing themselves to make an idea happen, to then having a team of folks, salaries, and the beginning of a hierarchy where people get positions and titles.

The problem with startups is that founders start out with big titles– and as the organization grows, people seem to get added underneath, but its harder to add people on top. And the roles of people with those big titles really changes as a larger organization emerges from the scrappy startup.

Its not just about hiring A people…its hiring A people that have the right tools for the job they need to perform. As this is a dynamic process, one of the keys to success is understanding the jobs that need to be done and will need to get done in the next few months and putting people into roles where they can stretch to fill the task. Here are 5 tips to make that happen.

1. Clear mission focus: Everyone on the team should know what problems the company solves, and for which customers. Each person in the organization should know how their job contributes to that goal and be evaluated against metrics they control that move that goal forward.

2. Development goals: For each role, determine what skills needs and experiences are required to get the job done, both today and 12-18 months out.  Give people a snapshot of skills required, current status, and things to work on.  Then make sure you give them opportunities where they can prove themselves.  Reward those who grow into their role with a new “stretch” opportunity. Don’t allow those who can’t stretch into the new role block those underneath them.  Here’s where a lot of hires go bad…you hire an “athlete” with a nice personality.  Evaluate this person for their toolkit and the potential to stretch into the role you need filled.

3.  Accountability: Make metrics transparent and show who’s hitting targets, who’s missing them, and who’s building solid capabilities.  Celebrate the wins and get to the bottom of the losses.  Spend time to fix the holes where performance is poor.  Give both financial rewards and recognition to those who exceed targets.  Those who miss targets shouldn’t receive rewards…regardless of the reasons behind it (and there are always reasons beyond their control–if you accept them, then that excuse becomes ok and no one will take the targets seriously).

4.   Create opportunities: Encourage those who’ve met the tasks of their current role to take on new responsibilities.  Carve our development opportunities or let them drive their own.  In all cases, reward those who see opportunities and create impact that drives the mission forward.

5. Encourage curiosity: Leaps in performance come from the questioning of the status quo.  Celebrate well-executed failures (if you don’t fail often enough, you’re not trying very hard) and build upon the new learnings.  Make problem-solving non-hierarchical.  Encourage debate and the challenging of assumptions.  If you’re hiring better people than yourselves, you’ll find them constantly surprising you with new insights that can accelerate your business on the path to success.

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