(followed from previous post)
Greed is good
I would like to bring forward a notion that I seldom see mentioned in research, but which in my view explains a large part of the dynamics at play here. One feature I particularly find relevant in Prof. Christensen’s research is that he dives down to the individual’s level. The Innovator’s Dilemma brilliantly demonstrates how managers make decisions that will not damage their careers, which are in line with the company’s processes, resources and profit formula, but end up destructive when disruptive competitors emerge.
By the same token, I believe one needs to embrace the prevailing mentality in our business circles in order to better understand some of the dynamics. In particular with regards to money. I’ve seen where the promise of riches leads first hand, in investment banking, financial trading and private equity in New York City, London and Paris. It’s always been in the sacrifice of long-term goals, to the benefit of short-term gains.
The following paragraph in the HBR article attracted my attention:
[Copy of the paragraph starting with: Emancipating management].
I have no doubt that many, if not most, executives act with the best interest of the company at heart. Or would like to do so. I would however add that on top of the career worries mentioned, the other reason that makes executives take short-term decisions is their personal gain.
A whole generation has been led to believe that it was now possible to make a lot of money, quickly. We are routinely fed with stories of investment bankers, traders, hedge fund or private equity managers, start-up founders, etc. who make fortunes in just a few years. If you are a banker and your bonus is paid when you make deals, regardless of what happens further down the line, will you go after the easy ones, or take more risk for a potentially higher payout later? If you are a private equity fund manager (VC or else) and you have the choice of making quick wins that could land you millions, or invest in MCI and nurture those companies over very long periods, with a high risk of failure, which one will you choose?
The problem with MCIs is that they operate, by definition, on unchartered territories. Given the choice between the high probability of a smaller payout now, or the lower possibility of a higher payout in a longer time, most finance executives will choose the first one. That is because the backdrop we operate in favors money over value. Entrepreneurs who sell their companies for large sums of money are our modern economic heroes. Regardless of how it happened, if it was pure luck and opportunity, whether they produced jobs, or truly made our world a better place. Money is the yardstick by which we measure success, therefore the shorter, easier route will be favored over the longer one.
I am sure there is a large body of literature on the subject, probably more so since the 2008 crisis and the realization that bonus systems had to change. This needs to be further studied, but field experience has taught me that the compensation mechanisms are not suited for the long-term value that MCI represent, even in private equity.
Public companies are not immune either, despite vesting stock option schemes. Among the large companies, Jeff Bezos at Amazon probably stands as the odd man out, favoring long-term growth over short-term profits.
Nomenclature: performance-improving innovations
There seems to be a struggle with naming that category. In the 2012 NYTimes articles, it is named “empowering” innovation. The issue with “performance-improving” is that it seems a bit close to “efficiency”, since you can improve the internal performance, as well as the product itself.
I’m no good at finding names but why not name it just “performance innovation”, “substitution innovation”, “next-generation innovation” (especially when you think about the iPhone), or something else. I do agree though, that finding a new name is better than using “sustaining innovation”, which is attached to the disruption theory and does not concern the outcome on job creation.
I found the 2014 HBR article, which I had not read before, very illuminating indeed. This is what I like most about Prof. Christensen’s theories: once you understand them, it feels like you were walking in the darkness and someone gave you light. Then you can use them to predict future outcomes. I also read the 2012 NYTimes article and watched a couple of interviews and conferences on YouTube. Here is my humble view on the matter, as a 15+-year finance professional active in private equity and venture capital.
FOREWORD: The future of mankind
Firstly, the Capitalist’s Dilemma inserts itself perfectly in the existing debate on the future of humanity. One such stream is robots vs. humans at work. Some think that robots replacing humans is good, because it will free up our time, which we will then occupy with more leisure, not work. These optimists believe that we will also get richer, as robots don’t need to be paid, thereby allowing us to get the extra cash generated by their work. I personally doubt that, but this is not the issue here. My point is that Prof. Christensen’s concepts can help us better articulate the debate: robots are essentially efficiency innovations, they do tend to destroy jobs and free up capital. What we do with it is another question altogether, but at least we now have a solid grounding in theory, common words and concepts to talk about the matter.
Other thinkers point to the fact that in every earlier industrial revolution, existing jobs were destroyed before new ones were created. Schumpeter gets quoted a lot by this group. A couple of examples are often used, e.g. the fact that blacksmiths and horse managers disappeared when cars became mainstream, but a whole economy appeared around the making, marketing, and repair of cars. The concept of market-creating innovations perfectly illustrates this phenomenon. I would be curious to know how Schumpeter’s theory interacts with Prof. Christensen’s.
B2B vs B2C
I noticed that many of the examples used in the article concern consumer-facing products or services: Geico, the Ford T or Toyota Prius, calculators, iPod/iTunes, etc. (and in the NYTimes articles: the transistor radio, Schwab, personal computers). Is this because it is easier for readers to relate to them? Or are there real differences between B2B and B2C innovations?
To be fair, some of the innovations put forward are B2B in nature, such as the Toyota just-in-time process, the Bessemer Converter, Toshiba’s 1.8-inch hard drive, and cloud computing.
Intuitively, one would think that businesses being obsessed by efficiency, companies selling products and services to other companies might just target that efficiency. Enterprise software could be one such illustration of efficiency innovation.
Performance-improving innovations save jobs too
Prof. Christensen makes a very fine observation on efficiency innovations: they allow companies to stay competitive and salvage some level of employment.
I wonder whether a similar argument can be made about performance-improving innovations. The iPhone is a great such example in my view. After the first iPhone, which was a market creating innovation (and a disruption to computers, as the point was later made), almost all subsequent iterations could be described as sustaining innovations — or performance-improving innovations, from the job creation viewpoint. Yet if Apple had not made the model evolve, it probably would have had to cut numerous employees researching the technology, designing the products, and supervising the work needed to make, launch, and sell every new model. I haven’t checked Apple’s recruitment and retention policy and numbers, but I believe the case could be made that PCI either create jobs (new hires to replace retiring workforce) or save jobs.
Market-creating innovations and platforms
I find the axiom mentioned in the HBR article spot on, i.e. there most probably is an opportunity for MCI in products or services used by the skilled and the rich. Private chauffeur services are such an innovation. When it launched in France, Uber was not a competing service to regular cabs, but to the high-end cab services such as Club Affaires G7. You had to be a show business star, a political figure or the employee of exclusive companies (elite law firms, investment banks or strategic consultancies) to be able to receive such a treatment and level of service. Uber brought these to the next layer of the population.
That being said, I wonder where platforms fit, in Prof. Christensen’s model. Uber and Airbnb have not created a cheaper product or service, they facilitated their emergence. Platforms act as intermediaries, in certain cases helping others leveraging underused assets (house or car spaces), or facilitating freelancing by providing traffic and clients. It could probably be said that they both free up capital and create jobs, indirectly.
VC and IRR
This is an area I hope I can contribute to, having worked for many years on investment projects of different natures (VC, growth capital, LBO) in several countries and with various institutions.
MCI or Efficiency Innovations
I would agree to both presented arguments that some VC firms go after market-creating innovations, but that many others settle for efficiency innovations
>> One hypothesis worth researching, in my view, is whether the size of available funds is a discriminating factor at all.
Market-creating innovations, while they probably offer the largest potential payout, are probably those that require the highest amounts of capital, almost by definition: those products target large numbers of non-consumers, and therefore need to be available everywhere, in large quantities. This involves a disproportionate level of inputs ahead of profit generation, therefore requiring venture capital. VC firms routinely raising billion+-dollar funds, such as Andreessen Horowitz, Sequoia Capital or Accel Partners probably have more capacity to go after MCI than do smaller VC funds.
>> One interesting piece of research would be to rank MCI that appeared, say, over the last 5-10 years and see how they were funded, and by whom.
The 30% IRR Target
I totally subscribe to the viewpoint that in an era when capital is cheap, target returns should be lower. Most VC funds, and most investment committees, still target a 25%-30% IRR on ventures, when both interest and inflation rates are close to zero. Besides, the cost of starting and operating a business has decreased too, especially in tech. All things being equal, this tends to make ventures less risky, at least in the earlier stage. Yet, even VC investors trained in the last decade insist on targeting the same returns as their predecessors. I tried to trace the origin of the famous 30% IRR target, and could go back to at least 1984. A report from the US Joint Economic Committee on venture capital and innovation, which surveyed close to 50% of leading VC firms in that period, indeed points out the following:
“The analysis shows that the expected rate of return from investments increases for riskier, early-stage financing and declines for the less-risky, later stage financings, although it remains above the 30 percent annual rate for all classes of venture capital investments.”
(Joint Economic Committee, Congress of the United States (1984). Venture capital and innovation. Joint Committee Print 98-288, December 28, 1984. US Government Printing Office (Washington), Printed 1985)
I checked both 10-Year US Treasury rates (assuming VC funds were invested and divested over a 10-year period) and inflation rates for the periods 1974-1984 and 2007-2017. The table below shows averages for both indicators and periods.
[Table cannot reproduced.
It shows average US Treasury 10-year rates of 9.81% over Jan.1974 to Jan.1984 vs. 2.82% over Jan.2007 to Jan.2017. And average US inflation rates of 8.43% and 1.66% respectively]
I am no economist, but it stands to reason that aiming at the same returns across two vastly different economic environments doesn’t make much sense. Yet, it doesn’t seem the 30% IRR target is disappearing anytime soon. We live in an era than has seen a handful of start-ups reach over $100 billion market valuations in a very short time. In which being privately valued at $1 billion has become so common that not only does it have a name, but the tag itself is already a thing of the past. The decacorn is the new unicorn.
There lies the paradox. Although it is still statistically near impossible to make large returns on venture capital investments, LPs, GPs, business angels, start-up founders themselves, and even the general population live in the belief that it has become much easier to make large swathes of money with young innovative companies.
Top decile analysis
Let me make a remark here, on the paradoxical fact that as an asset class, venture capital has not returned much in recent years. I would urge you to consider decile analysis. There is a cloud of secrecy on returns, but as you know, it seems that a handful of firms make all the positive returns in the asset class. Just as any other industry, venture capital is impacted by new entrants who know less about the trade, and therefore dilute the industry’s overall performance. Another impact of cheap capital has indeed been that many VC firms were created in recent years, whose members often lack both expertise and experience. It is widely accepted in the industry that top decile VC firms produce stellar returns, which is why it is so difficult to invest in them, as there are many candidate LPs.
It doesn’t really change the argument presented in the HBR article, but I feel that it would make it stronger to mention that fact.