Archive for the ‘Finance, Investments & Governance’ Category

The crowd makes the decision

Watch out Howard Stern: your role as judge on America’s Got Talent could be in jeopardy, thanks to Crowdsourcing — a proven, web-powered way to raise money and troubleshoot problems. And, this may be just the beginning. Research published in the K@W newsletter (a Wharton Business School publication) shows organizations can now gain significant value by leveraging the crowd to make important decisions on which projects to focus on or which creative execution to choose.

Crowdsourcing is the online process of obtaining needed services, ideas, or funding by soliciting contributions from a large group of people outside of an organization or its supplier network. Raising money, in particular, is very popular. One of its leading platforms, Kickstarter has raised more than $1-billion in pledges for 135,000 projects from 5.7 million donors, a Wikipedia posting notes. Offering an alternative to bank or venture financing is one thing, but can the wisdom of the crowd compete with experts to decide which projects to pursue or talent to back?

New research Professors Ethan Mollick (Wharton) and Ramana Nanda (Harvard) looked at this question by analyzing how theatre projects get funded, and later performed in market. Studying these types of decisions is a good test of crowdsourcing’s potential because they require both a subjective (i.e. artistic taste) and objective assessment (i.e. determine the long-run success of the project). Importantly, the U.S. arts world is a good test bed for evaluating crowdsourcing decisions. Since 2012, more money has gone to the arts through crowdfunding than the government-run National Endowment of the Arts.

The researchers compared the funding decisions by theatre experts and the crowd on six projects. The experts were experienced judges who worked for the NEA. The crowd was participants in a Kickstarter campaign. The findings were thought-provoking. The decisions of the experts and crowd were very similar with a 57% to 62% concurrence on the choices. Yet, decision alignment does not automatically translate into good decisions.

To measure the quality of the choices, the researchers also analyzed the economic impact of the successful theater projects. They found that many of them evolved from a one-night only event into recurring performances that, in some cases, provided dozens of employment opportunities not to mention long-term revenues.

Implications for companies Crowdsourcing decision-making is an appealing tack for many companies. Many decisions, especially ones with subjective criteria, can benefit from multiple lenses that remove the bias of internal experts (e.g., the ‘not invented here’ syndrome), or produce additional opinions when expertise is lacking. Tapping the crowd can be faster and less expensive than finding subject matter experts or using consultants. Finally, relying on the crowd could avoid the internal politicking that comes with high-stakes choices that lack objective data.

A variety of decisions can be made by the crowd. For example, marketers can use it to help them choose the brand messages or advertising creative that best resonates with their target audience. Furthermore, venture capitalists can leverage a community of technologists or consumers to help them decide which startups to fund. Importantly, tapping the crowd does not negate the importance of internal experts, who can still be used to make sure the crowd’s choice passes the ‘common sense test’ and that decisions incorporate all the data.

Tapping an external community, however, will not be ideal in every situation. Many leaders will be unwilling to outsource major decisions given their egos or risk aversion. Furthermore, using the crowd for smaller decisions like picking advertising creative could be impractical and demotivating to staff. Finally, leveraging the crowd may lead to poor results if not properly executed.

Starting out While this research is encouraging, its conclusions should be validated for different situations and industries. One way to do this is to compare the internal decision with the crowd’s choice. To do this, it is best to begin with a pilot. The pilot would have a clear objective with well-defined and articulated choices. To maximize the crowd’s value, the target decision should integrate both subjective and objective evaluations. Managers should also carefully pick the community they want to leverage, within the right online platform. Special attention should be paid to maintaining confidentiality and intellectual property requirements before reaching out publicly. When the pilot is finished, managers should compare the results of each decision and the impact of each process.

For now, Howard Stern can rest easy. Crowdsourcing decisions will never replace thorough analysis, time-tested judgment and gut feel. However, these qualities come with a price, which is often high in terms of cost, time and hassle. If crowdsourcing can be validated for other use cases, then tapping wisdom of the crowd will become an important decision support tool.

For more information on our services and work, please visit the Quanta Consulting Inc., web site.


4 dangers to be way of in 2014

The holiday season is a time for celebrating — and prognostications for the coming year. I’m typically an optimist, but not this time.  Though many factors point to a rosier 2014, every company faces some significant direct and indirect risks, many of which lurk below the surface. Fortunately, these dangers can be alleviated with good analytics and planning.

Recent positive economic news (e.g. the strength of equity markets, low interest rates and the abatement of EU and U.S. debt crises) have given corporate managers some cause for optimism. It would be understandable, but hazardous, for managers to let their guard down.  Many risks continue to menace organizations, four of which are:

Stagnating prices

Raising prices is a quick path to higher profits. To wit, a 1% increase in prices with a 30% margin can improve the bottom line by 20%.  Just try making it happen. Since the financial meltdown of 2008, it has been difficult to raise prices while maintaining market share. In Canada’s retail sector, for example, the arrival of Target and Marshalls plus recent grocery price wars, is expected to depress industry profitability for some time.  Many other sectors like services, manufacturing and communications are finding it difficult to sustain margins due to buyer pressure, global competition and steadily increasing costs.

Mitigating the risk

From a pricing perspective, firms need to more aggressively sell their products in markets that are less price sensitive or that are rapidly growing markets, both locally and in the developing world. Furthermore, those companies with differentiated value should look to take pricing up by better aligning price points to the unique benefits delivered.

Cost pressures

Global consultancy EY estimates that a 1% reduction in costs can produce the equivalent of a 10% increase in sales.  Achieving this is another story. In many firms, most of the easy supply chain and headcount rationalization savings have already been tapped. Moreover, the era of low raw material and wage inflation may be coming to an end, tracing to two key drivers —  the recent uptick in consumer demand and the possibility that China’s growth engine will reignite, driving up raw material costs. Adding fuel to the fire is continued exchange and interest rates volatility, which can play havoc with costs.

Mitigating the risk

Product and operational innovation is the key to driving margin improvement.  On the cost side, it is possible for organizations to further reduce cost without cutting key capabilities. For example, managers can reduce development costs and better target needs by co-creating products with their customers and leveraging rapid experimentation practices. Innovative operational strategies can drive higher efficiencies through the implementation of initiatives that reduce complexity, as well as crowdsourcing and gamificationpractices.

Supply chain disruptions

As has been shown many times, unforeseen events like natural disasters or political crises can seriously disrupt a firm’s operations, dramatically impacting product supply and revenue. Risks are magnified when a company’s supply chains are regionally concentrated and highly integrated.  For example, Japan’s Fukoshima nuclear disaster led to global shortages of spare parts  and shuttered assembly plants for Honda and Nissan. A recent report by Swiss Re, a reinsurance company, highlights the ongoing risk of major natural disasters such as flooding, earthquakes and storms.  The report identifies above-average risk for many global economic hubs including: Tokyo, Hong Kong-Guangzhou, New York, Los Angeles and Amsterdam-Rotterdam.

Mitigating the risk

Maintaining a low-cost supply chain must be balanced with the need for added production flexibility and agility.  Managers can minimize this operational risk by having: multiple supply-chain partners for critical and expensive inputs; close and symbiotic relationships with each vendor; and the internal capability (e.g., engineering, procurement) to quickly shift production if necessary.

Cyber attacks

Computer attacks and viruses represent a clear and present threat to every enterpriseand industry.  This year, the Securities Industry and Financial Markets Association released a report that showed  more than half of the world’s securities exchanges had experienced cyber attacks during the past 12 months. Janet Napolitano, the outgoing U.S. homeland security chief, recently said, “Our country will, at some point, face a major cyber event that will have a serious effect on our lives, our economy, and the everyday functioning of our society.” Importantly, these cyber attacks can appear out of the blue.  According to software provider Symantec, 40% of all the computers that were impacted by the Stuxnet virus, which allegedly targeted Iran’s nuclear infrastructure, were located outside of Iran.

Mitigating the risk

Reducing the impact of cyber attacks requires an acknowledgement of the threat, an understanding of internal vulnerabilities and the business continuity plans to deal with potential disruptions. Furthermore, IT managers should work together with their industry peers to explore industry early warning systems and safeguards.

For more information on our services or work, please visit the Quanta Consulting Inc. web site.

Strategic planning with game theory

If they haven’t done so already, many companies will soon head into their 2014 strategy and capital planning season. Whether driven top-down or bottom up, a planning process can be difficult and contentious due to conflicting strategic goals, a lack of data, as well as insufficient resources and time.  Furthermore, managers naturally manoeuver to get their projects funded and existing budgets protected.  Inevitably, there will be winners and losers.  This zero-sum environment can easily lead to strife, and quite often, poor investment decisions.   Fortunately, there is a better way to make these vital decisions.

Planning challenges

Strategic planning in large enterprises is rife with obvious and hidden problems.  Organizational dynamics create inherent punishments and incentives that can lead to spending distortions like ‘empire building’ (asking for more resources than are currently required) or ‘under counting’ (purposely underestimating the true cost or resources needed to get a project started).

There are also issues at the people level.  In 20+ years of executive facilitation, I have regularly seen leaders exhibit stubbornness,  uncooperative behaviour and parochialism. These negative behaviours can make it very difficult to reach a supportive consensus, let alone make the right decisions.  Even if agreement is reached, individuals may consciously or unconsciously undermine the implementation of the plan because they never really bought into the choices in the first place.

Enter game theory

A little while ago, we were engaged by the CEO of a products company to help provide analytical and planning support for his firm’s annual strategy development exercise.  He felt their traditional process was not effectively allocating scare capital to the highest revenue/lowest risk initiatives and getting sufficient buy-in during and coming out of the process.  Moreover, the CEO wanted to avoid win-lose outcomes that inevitably trigger management in-fighting and reduce execution speed.

Early in the engagement, we saw many similarities between the company’s challenges and game theory principles.  Game theory is the use of mathematical modelling of conflict and cooperation between decision-makers. At its core, issues with strategic planning resemble one game, the prisoner’s dilemma.  A prisoner’s dilemma is a situation in which multiple players have options whose outcome depends on the simultaneous choice made by the other; this scenario is often expressed in terms of two prisoners separately deciding whether to confess to a crime based on possible punishments.  In an organizational context, various managers or business groups compete for the same finite pie (read: capital, resources) through different initiatives that have various payoffs and risks. This competitive situation breeds mistrust and a misunderstanding of future cash flows/challenges, often resulting in poor strategic choices and inefficiencies, rather than cooperation and rational decision-making — which maximizes the outcomes for all.

Making it work

To break this behavioural and analytical logjam, we took leaders from across the organization through our Game Theory tool kit.  This process is designed to facilitate better strategic and financial decisions by bringing organizational and business issues into the open; fostering math-driven, rational decision-making and securing alignment around final decisions.  We define alignment as a condition where each leader or division is maximizing his or her own corporate and personal interests while having no unilateral incentive to deviate (or sabotage) the plan, since his or her strategy is the best they can do given what others are doing.

Through a series of workshops, we led management through the following (simplified) approach:

  • Establish the goals of the exercise, choose the internal players and align around the current internal and market state
  • Clarify the strategic options, with estimated payoffs and risks
  • Select the appropriate game(s) to run
  • Model a number of strategic and investment options i.e. have the leaders/ teams play the game with the consultant acting as a neutral facilitator.
  • Align around the “best” decisions

Overlaying game theory methods into the planning process worked well for this client.  Our systematic, logic-based analysis helped the leaders come to rational funding decisions that met long-term corporate and managerial needs.  Using game theory minimized the impact of negative individual and cultural factors, especially in ‘give and take’  situations where management bias and hubris can skew decisions. Finally, the use of computer modelling was essential to performing a thorough analysis of multiple strategic options, easily keeping track of hundreds of different internal and external variables.

Yes, but…

Utilizing game theory is not a slam-dunk.  When poorly understood or executed, game theory can be distracting  and lead to flawed analytical results. Furthermore, these tools require a resource that is comfortable with advanced math, facilitation and modelling.  However, these issues are not deal-breakers.  Our game theory experience with multiple clients proves that there is no better way to tackle complicated strategic decisions, increase “issue” visibility and secure executive alignment.

For more information on our services and work, please visit the Quanta Consulting Inc. web site.

Game theory for the real world

Many companies are turning to game theory to help make strategic decisions.  GT is the use of advanced mathematical models to analyze different game scenarios (read: strategic decisions) available to different parties (e.g., competitors, suppliers, regulators) in order to predict potential outcomes.  GT is not new.  Economists, political scientists and the military have used its principles since the 1950s. In the 1980s, businesses began using GT to help them make pricing, product, M&A, and labour negotiation decisions. While the math can appear arcane and divorced from corporate reality, we know that the GT principles – when stripped down to their essence – are powerful decision support tools.  This value was clearly illuminated in one of our 2012 strategy projects.

The client, situation

The CEO of a medium-size company engaged us to help navigate some crucial choices.  The firm needed to decide whether to undertake a game-changing acquisition of a similar-sized, private company with complementary assets. The target company had put itself in play due to ineffectual (though not fatal) financial performance.  Our clients viewed themselves as either buyers or bystanders.  They wanted to understand possible competitive moves, the implications of these moves as well as what and how to bid. There was also a chance a foreign buyer or a firm from outside the industry would enter into the fray and make a bid.   To assist management, we deployed our GT model.

Enter Game Theory

M&A transactions involving multiple participants and bidding strategies are ideal applications for GT since these decisions blend both strategic and financial inputs and considerations.  Potential M&A deals typically employ sequential games that would be played out over a given period of time.   In this case, the number of potential players and the actions they could take would generate thousands of possible outcomes for management to consider. To cope with this complexity, we used a sophisticated, but easy to understand, software algorithm that models what decisions a company should take — considering the likely behaviour of others –- to attain its goals.

Our first step was to assemble all the critical information relevant to the deal.  GT methodology focuses on collecting a variety of inputs including: possible players, aims of each player and conceivable actions of these players.  Our goal was to get into the heads of each player to understand their strategic objectives, economic incentives and likely behavior. We collected this information through an extensive competitive intelligence process including ‘what if’ scenario development and client role playing. At the end of the information-gathering phase, we input all the information into the algorithm and began the mathematical modeling.  The number crunching yielded potential outcomes by player for each one of their and the other player’s possible moves.

Business outcomes

The results of the analysis were illuminating for management, both from a transaction, stakeholder-alignment and competitive-intelligence perspective.  Not only did the model suggest the optimal course of action and its payoffs but it also highlighted opportunities for the firm to cooperate with foreign competitors (some with very different business aims) and partner with third parties through win-win strategic alliances.  Furthermore, it gave management insights around how the negotiating process would play out as well as potential bids from unforeseen actors.  Overall, use of GT ensured executive buy-in and documentation of the current state while improving alignment around the new M&A strategy.

Although some executives are reluctant to admit they use the tool, many organizations such as Microsoft, BAE Systems and Chevron have publicly acknowledged its value in helping make complicated, high-risk decisions.  Despite its many benefits, GT does have its share of detractors who complain about its complexity and disconnect from familiar decision-making practices.

These negatives are over-stated.  Complex math or software packages aren’t necessary to perform comprehensive modeling when Microsoft Excel will do.  Secondly, though GT does assume player rationality, it need not be a default assumption in the model.   Our methodology factors in the innate irrationality of many people’s actions, especially in situations like negotiations where management bias and hubris can skew decisions.  Finally, executive expectations need to be calibrated early on. GT is not a strategy panacea but merely another tool that should be used with other decision-making approaches like strategic planning and discounted cash flow analysis.  It should never replace good judgment and financial analysis.

For more information on our services and work, please visit the Quanta Consulting Inc. web site.

Strategic cost reduction

In times of declining profitability or strategic inertia, many managers will hastily launch cost reduction programs. Unfortunately, many of these one-off efforts will fail to hit their financial targets while producing collateral damage to the firm’s morale and capabilities.  Companies who approach cost reduction strategically with an eye towards ensuring long term growth and competitiveness will improve the odds of achieving their objectives while minimizing long terms risks.

Cost savings initiatives are not pre-ordained to deliver sub-optimal results.  Failure shares many causes, ranging from timid managers and sloppy implementations to employee resistance and a poor understanding of the firm’s cost structure.  What they all have in common is a tactical, short term approach.  My firm has devised a better way to deliver real and long term cost reduction. Our Strategic Cost Reduction approach considers cost savings activities not as a one-time event but within the context of driving strategic priorities, capabilities and organizational alignment.  We have battle-tested this methodology in over a dozen enterprise-wide, cost reduction initiatives.  Below is a simplified overview of our 3-step approach:

1.         Align on priorities

Common sense dictates that you aim cost savings efforts against non-core, low priority corporate activities. However, in a complicated organization or in the absence of a comprehensive strategic plan these priorities will not always be apparent.  Asking 2 fundamental questions will help shed light on your true cost picture.  i) What are the major short to medium term product priorities and capabilities that guide your capital and resourcing decisions?  To be focused and ensure proper execution, managers should have a list of 4-6 product and capability priorities needed for profitable growth.  And, ii) do the majority of your costs and resources line up against these priorities and capabilities?   

Asking these questions can illuminate a harsh reality. In many companies – particularly large, matrixed and decentralized ones – there is a poor connection between key business building priorities and spending.  This leads to inefficiencies and waste as well as under-investment in vital parts of the enterprise. When capital and management attention are finite, leaders must effectively and efficiently allocate capital to their key priorities. 

2.         Focus your cuts

Once a spend-priority misalignment is identified, the key challenge becomes where, what and how to cut – and where to reinvest for growth.  We have witnessed hasty executives radically cut costs at the same time carelessly damaging key competencies and hurting morale.  On the other hand, we have seen hesitant managers aim only for easy, superficial cost savings, ignoring the considerable amount of fat lurking just below the surface.

This is where SCR comes into play:  managers need to cut spending in areas that do not support growth-focused product initiatives and differentiating capabilities.  At the same time they should reinvest some of the savings in high potential, business-building programs. To find the waste and inefficiency, managers should take the costs that were not directly tied to identified priorities in step 1 (e.g., cross business/functional costs and expenses associated with non-priority activities) and then reallocate them against the same priorities and core capabilities to get a true read on costs. This can be accomplished by classifying spending into one of 3 strategic buckets. Of course, each firm will bucket their costs differently depending on their competitive position and strategic choices

1) Differentiating products and capabilities that drive support their unique value proposition and growth. Priorities like product innovation, analytics and brand development could make up 50% of a firm’s total cost structure.  These will often require more, not less, capital and resources than is currently deployed;   

2) Table stakes operations and competencies. Examples of these market ‘cost of entry’ activities include logistics, customer service and manufacturing.  They can often yield savings of 3-10% by area through operational enhancements such as Lean or strategic procurement.

3)  ‘Keep the lights on’ spending that is used to maintain operations. These cost centers (e.g., HR, facilities management, professional services) frequently have the ability to deliver up to 25% reduction in savings through far-reaching cost reduction strategies like outsourcing or performance cutbacks. 

This analysis can yield telling results.  We have seen organizations allocate 50% of their available capital to ‘keep the lights on’ activities yet spend only spending 20% of their capital against strategic and growth-focused initiatives.  On the other hand, we have seen careless firms expend 55% of their capital on multiple growth priorities (still under spending on each of them!) yet spend only 15% on competitive matching functions that support client retention and basic marketing.

To cut strategically, managers should focus cost reduction efforts against Bucket 3 areas that do not directly support growth, ensure customer retention or build market-beating capabilities. If more pruning is needed, the emphasis would move to non customer-facing Bucket 2 activities.  Leaders should be cautious not to mortgage the future by crudely cutting (optimizing is fine) Bucket 1 expenditures.  

3.         Consider business enablers

In many cases, firms with complex organizational structures, processes and policies will be challenged to cut costs, even with SCR and proven cost savings methodologies.  In these environments, leaders should consider more sophisticated cost reduction strategies such as complexity reduction, supply chain re-engineering or in-sourcing expensive outsourced functions.  Not only can these methods produce compelling cost savings, but they also can help accelerate program execution and further develop core capabilities.

For more information on our goods and service, please visit the Quanta Consulting Inc. web site.

What went wrong with the Facebook IPO?

What was supposed to be one of the most heralded IPOs ever is turning out to be a disaster for Facebook and the banks that backed it. So far, the IPO has been a dud with the stock trading at $US 28.19 as of May 30, down 26% versus the $38 issue price.

What went wrong is indicative of the challenges valuing and executing IPOs in the technology space. Four main problems stand out:

Bad valuation
Facebook and its lead investment bank Morgan Stanley committed a major faux pas aggressively valuing the company at $104 billion.  Originally, Facebook set its share price conservatively at between $28-35 a share.  Strangely, right before the IPO, the company upped the price to $38 per share or what the brokers considered “priced for perfection.”  After the negative disclosures and insider selling, it became evident that the shares were not perfectly priced and fell to more realistic levels.

According to Ken Marlin, Managing Partner of Marlin & Associates, a leading technology-focused investment bank, “Pricing high-growth tech stocks is an art – mixed with some science. [The underwriters] got the “price” right, but got the ‘value’ wrong.  For perspective, Facebook’s valuation was close to 100 times last year’s profits, significantly higher than tech giants Apple and Google that make far more money.

Realistically, no one really knows how to value millions of users, let alone Facebook’s 901 million users. Although user data – status updates, photos, likes and videos – has value, marketers have yet to figure out how to monetize it beyond simple display ads.  The fact is “Facebook has not yet been able to find an ad model to generate revenues commensurate with its valuation,” says Saikat Chaudhuri, a management professor at Wharton.

Bad Timing
Just prior to the IPO, Morgan Stanley and other analysts lowered Facebook’s earnings expectations.  Facebook had repeatedly warned in its IPO filing about the challenges it was facing in mobile advertising: As consumers increasingly use mobile applications to access sites like Facebook, the firm will need to figure out how to shift its ad sales to mobile platforms, a place the company admitted it does “not currently directly generate any meaningful revenue.”   It also cited growing competition from Google and social networking upstarts such as Pinterest, noting that its users could simply jump to another site if unsatisfied. This news likely contributed to the shares tumbling.

Of course, timing is everything and hindsight is always 20/20.  However, if Facebook had executed its IPO last year behind tailwinds of rapid growth and significant buzz and only a distant mobile hiccup, they may have been able to support a higher valuation – at least until this quarter.

Bad execution
Poor execution of the IPO played a part in the share decline. As an example, Facebook increased the number of shares by 25% just prior to the IPO, an unwise strategy when the shares are actually over-valued.  Those investors who received more shares than they wanted effectively became forced sellers when the quick profits failed to materialize a couple of days after the IPO.

Secondly, the timing of key activities makes you wonder what signals the company was sending out. In the banks handling the IPO, analysts – legally obliged to act independently – cut their forecasts for the firm after the IPO filing update.  At the same time their investment banking colleagues and Facebook leaders were pushing for a sale at the very top end of their price range.

Bad karma
Confidence in the IPO fled after it became public that many of Facebook’s early backers were increasing the size of their selloffs. For example, Peter Thiel, one of Silicon Valley’s smartest investors and a Facebook board member announced he would be selling 16.8 million shares, up from 7.7 million shares. Though he likely knew nothing more than what was in the public filing, this decision could not have helped the sentiments around the IPO.

Thiel was not alone.  Some 57% of the shares sold came from Facebook insiders. Typically the percentage of insider sales is under 10%. In other recent tech IPOs including Groupon, Zynga and Yelp the percentage was less than 1%.

More worryingly, investors could have been spooked by the actions of a major advertiser.  Just prior to the IPO, General Motors decided to pull $10 million in advertising from the site, saying that the ads had proven to be ineffective.  GM’s assessment is consistent with our firm’s social networking research which has found that Facebook users are less tolerant of being marketed to as compared to more business-focused sites like LinkedIn.

Going forward…
Can Facebook bounce back and justify its lofty $104 billion valuation? Maybe.  It all comes down to whether it can quickly develop a mobile-enabled, profitable and defensible business model that does not alienate users. Moreover, there remains plenty of ways (e.g., as a payments platform, via media content sales, or through subscriber revenues) to profitably grow revenue.

In the short term, however, the company may have to continue splashing its site with advertising to generate more revenue. This raises the specter of Facebook becoming another MySpace, a failing social network site littered with ads.  If this happens, users may then defect to another, less cluttered social network, triggering further share prices declines.

For more information on our services and work, please visit the Quanta Consulting Inc. web site.

Reduce risk via operational hedging

Exchange rates play an important role in determining corporate profitability and competitiveness. The current strength of the Canadian dollar poses unique risks and opportunities for Canadian companies with global supply chains and those who sell in many geographic markets.

Specifically, firms must manage having their revenues denominated in Canadian dollars and their costs denominated in other currencies. Exchange rate fluctuations, specifically a steep fall in the loonie, will introduce significant variability in costs and revenues potentially wreaking havoc on profitability, competitiveness and shareholder value.

While there are solid benefits to a strong dollar (e.g. stronger purchasing power), there are also compelling financial and strategic risks around a rapid and sustained fall in the loonie. Managers would be wise to pursue a more holistic and longer-term approach to risk management, with particular attention paid to operational strategies.

The loonie is at a record high versus key foreign currencies. Canada’s dollar traded stronger than parity with its U.S counterpart on average this year for the first time in three decades. The currency averaged 98.92¢ per U.S. dollar in 2011 – the highest annual value since 1976 when it traded at US.63¢. The loonie’s relative value against the greenback is vital to almost every company as the U.S. is by far Canada’s largest trading partner.

Furthermore, the loonie is overvalued against other key currencies. For example, Canada’s dollar had its strongest annual close against the euro since the shared currency began trading in 1999. Is a strong loonie sustainable in the long term? Not likely. According to the IMF, the loonie is will be 20% overvalued versus the greenback on a purchasing power-parity basis. The larger the overvaluation and the longer it is sustained, the greater the business risk.

A rapidly falling loonie will have serious implications for Canadian firms with outsourced production including higher input (raw material, labour and transportation) costs, a potential loss of domestic market share versus domestic producers and eroding profit margins. There are many macro-economic and political reasons why the loonie could drop quickly and precipitously.

Ongoing uncertainty around the European debt crisis as well as a slowdown in Chinese growth may dampen the global economy and demand for the commodity-driven loonie.  Canadian fiscal performance may hit the skids plus there remains the potential for falling interest rate spreads versus the U.S. Finally, continued political instability in the Middle East and Asia threatens to create instability in the currency markets. Canada is a relatively small currency market and is not a safe haven for international investors in times of turmoil. When fear grips markets, flight-to-safety flows hurt the loonie.

The impact of a long-term fall in the dollar’s value and the associated exchange-rate risk is not only limited to short-term financial exposure. In an integrated global economy, companies face strong interdependencies across their risk categories – strategic risks, operational risks, financial risks and external risks – which can quickly degrade their competitive position, limit decision-making flexibility and shrink operating margins.

Traditional financial hedging tools, designed to smooth out short-term cash flows, are often insufficient or too expensive to address large and sustained exchange rate shifts. To effectively manage these longer-term risks, companies should employ “operational hedging.”

Operational hedging is a holistic risk-management approach that allows for greater flexibility in how supply chains, product distribution patterns and market-facing activities are designed and changed. Managers would use operational hedging strategies in conjunction with financial hedging to pre-empt or mitigate the effects of a large, exchange rate-triggered change in their cost structure, customer demand and competitiveness. Typical operational hedging strategies could involve revamping a firm’s supply chains, go-to-market program and purchasing strategies based on their unique business model and market environment.

Firms should approach operational hedging in a systematic fashion by: determining the vulnerable areas in the business (i.e. the cost and revenue drivers that are most impacted by large exchange-rate swings); considering various scenarios for currency-related risk impact (e.g. using multiple exchange rates over different periods); perform a sensitivity analysis on these drivers to determine the total business impact; and adopting operational hedging as a foundational risk-management strategy. In terms of operational hedging, strategic choices could involve evaluating the location of production facilities, sources of raw materials, pricing strategies, logistics networks, and how sales and marketing channels by geography are organized.

When deployed proactively and carefully, operational hedging can be a powerful tool to minimize the impact of major currency shifts on costs and revenues, while enabling firms to potentially leapfrog less-agile competitors. Managers need to be mindful that a proper operational hedging strategy may require significant time and investment to implement, whereas a steep decline in the dollar’s value could erode operating margins and competitive positions rapidly.

For more information on our services and work, please visit the Quanta Consulting Inc. web site.

Rebooting financial institutions

The challenges facing the financial services industry are legion, ranging from a global economic slowdown and increasing regulation, to low interest rates and the possible defaults of Greece, Italy and Portugal. For financial institutions to prosper in this ‘new normal,’ they will need to refocus most of their efforts to the right side of their balance sheet.  This is the part of the business that contains customer liabilities (i.e. deposits), debt and capital – what is used to fund assets and loans found on the left side of the balance sheet.  

Before the 2008 financial crisis, most banks de-prioritized the right side in favour of aggressive left side strategies that drove ever-higher revenues and earnings (and expectations).  This impetus combined with a loss of valuation transparency in many of the complex assets left the banks dangerously exposed from a risk perspective and unbalanced from a liabilities and capital standpoint.  The 2008 crisis showed how vulnerable even the largest and most august firms were. While many banks have reduced their reliance on unstable sources of funding and increased the stability and duration of their borrowing, many have not made any appreciable progress. 

Given market precariousness, a repeat of 2008 is still possible.  Leaders will need to improve  their right side performance, with the right mix of strategies and client liabilities, to reignite their growth engines and ensure financial stability.  Three ways managers can achieve this is to get much closer to their target customers, optimize their product portfolios, and improve risk management practices.

  1. Get closer to the target customer

With flat consumer and corporate demand, financial institutions must deploy strategies that improve customer satisfaction.  Achieving this will enable them to: maximize retention (strong loyalty correlates with high profitability) of their most valuable customers and increase cross-selling of higher margin products. Customer-centric strategies benefit both the left side (higher revenues, lower costs) and the right side (better quality deposits) of the balance sheet. American Express has successfully followed this strategy through the launch of a small-business focused brand, the Open card.  By delivering a broad offering – from credit services to business networking – to a dynamic segment, American Express has been able to access new liquidity pools and refashion its funding profile, potentially reducing their reliance on capital markets. 

  1. Optimize the product portfolio

Banks should emphasize strategies that rebalance the portfolio, towards clients and products that are rich in liabilities (such as vanilla checking accounts) and require minimal capital reserves, and away from low margin businesses that need high levels of capital.  A pioneer of this strategy, according to strategy+business magazine, is the credit card provider, Capital One.  In the late 1990s, Capital One realized that they can no longer properly fund their business model through wholesale markets or brokered deposits. The company avoided failure in the mid 2000s by aggressively revamping their funding pools and buying two stable and profitable retail banks. Later, Capital One continued on with this strategy by purchasing the online bank ING Direct.  These strategic moves have helped the firm outperform its rivals since 2008.

  1. Improve risk and capital management

The credit crisis brought to light misalignments in many banks between their risk policies, practices and credit structures.  Powerful software tools and risk management approaches (economic capital for one) have been available to better translate multiple risk positions into equity capital requirements.  However, many firms have neglected to use them. This must change.  At the same time, leadership teams need to also consider the people part of the equation.  For example, most companies would benefit from a culture change around risk (i.e. risk is not something that is bypassed through regulatory loopholes) and by underscoring the importance of risk management training and compliance practices.

Given competitive yet risky financial markets, there is some urgency for banks to use right side strategies to rebalance their balance sheets.  What they need is strong leadership, strategic finesse and executional excellence.

For more information on our services and work, please visit the Quanta Consulting Inc. web site.

Avoiding M&A pitfalls

Improving growth and business confidence usually triggers a flurry of M&A activity. Bold CEOs will use M&A to outflank competition, build strategic capabilities and drive profitability. Sounds like a winning formula If only these deals are a proven way to improve financial performance.  Numerous studies have shown that in 60-80% of cases, acquisitions and mergers have not led to long term increases in shareholder value.  While many of these failures can be attributed to business reasons, a great number can be blamed on the failings of human psychology and corporate culture.  Issues such as organizational bias, management self deception and weak planning can all contribute to poor M&A performance. 

Below is a list of the most common deal foible we have seen, with further insights provided by strategy+business magazine.

Dealmaker bias

Deals are often difficult to walk away from because they take on a life of their own.   Since they have invested so much of their time, effort and career equity, dealmakers will typically feel intense psychological pressure to shepherd the deal through to completion.  This pressure can lead to managers favouring information that supports the deal while ignoring information that should give them pause. In other cases, transaction urgency is institutionalized and magnified by a reward system that emphasizes deal completion over ROI. Finally, significant momentum or ‘deal fever’ can often take over an M&A process leading to management blinders around transaction risk or the cost of the deal.   

Self deception

Many organizations regularly and inadvertently deceive themselves into thinking they follow M&A best practices when in fact they don’t.  For example, managers often delude themselves around the extent of their market knowledge, only to bump against deal-breaking information deep into the process.  While companies may have a disciplined M&A approach (designed to reduce risk and streamline their efforts), they will regularly ignore the process out of laziness or arrogance. Finally, leaders will frequently over-estimate their firm’s capabilities and under-estimate competitive threats, resulting in a significant increase in deal risk and resources required.

The numbers trap

Naturally, many companies focus on the purchase price as the primary way to make the business case work.  However, an over-emphasis on the price ignores many other vital factors that can significantly impact long term value and cost.  These include:  the cultural fit between the firms; the ease of post-acquisition integration and the availability of talent in the target firm.

The myth of confidentiality

It is rare that prospective deals stay under the radar for very long, particularly when low to mid-level managers become privy to the process. A confidentiality breach can have major consequences including: a rapid and unexpected rise in the target firm’s stock price (suddenly making the deal less attractive); inciting a competitive response or; provoking turnover in the target firm.

Ignoring the day after

Given the size of many deals, one may be surprised to learn that many companies under-plan around what should happen after the deal is consummated.  This occurs for two reasons.  In the rush to do the deal, managers put off what they think could be easily done after closing.  Secondly, the people running the deal usually lack the expertise to plan and implement the messy work of post-transaction integration. This lack of attention will quickly derail the initiative and push out the time to value. 

There is no bulletproof way to making every M&A deal work.  However, CEOs can improve their odds of success by avoiding these pitfalls. 

For more information on our services and work, please visit the Quanta Consulting Inc. web site.

Planning for the next Black Swan

Companies have been through a lot over the past 10 years – 9/11, SARS, and the 2008 financial crisis to name but a few catastrophic events.   If you thought we were done with major global disruptions, think again.  Looming on the horizon are potentially new Black Swan events like a Eurozone collapse, a possible war in the Middle East  or a major Chinese currency devaluation.  All of these threats dramatically amplify business and financial risk for companies, their markets and their employees.     

Coined by Nassim Taleb in his 2007 bestselling book, a Black Swan is a major occurrence that is unexpected and generates a tremendous impact. In spite of its outlier status, human nature invents explanations for a Black Swan after the fact, making them explainable and predictable.   These low-frequency, high magnitude events can be triggered by any one or a combination of factors within the realm of  politics, technology, healthcare, economics, the environment or government policy.  Although they are very difficult to predict, Black Swans have occurred on a regular basis, somewhere on this planet, over the past 75 years. Many commentators believe that catastrophic events are becoming more prevalent due to issues such as climate change, poor regulatory oversight and increased political strife in weak states. 

Not only is the frequency of Black Swans increasing, but so is their magnitude. Dynamic such as faster communications, pervasive global supply chains, and ubiquitous social networking create conditions that increase interdependence, accelerate the pace of change and restrict management control. Disruption can come to a firm directly through its assets, customers and employees or indirectly through its partners, suppliers and regulators. As examples, the great Japanese earthquake of 2011 led to parts shortages in North American plants.  The 2008 collapse of Lehman Brothers triggered a global liquidity crisis. It’s no longer a question of whether a Black Swan will impact your firm, but when and how.  

Typically, large companies rely on enterprise risk management systems, or worse, management judgement, to predict potential interruptions to their operations.  However, standard ERM approaches are problematic when it comes to forecasting Black Swans.  For practical and budgetary reasons, these systems focus on the risks organizations typically encounter – around people, finances and business continuity – while ignoring the myriad of low-frequency risks beyond a company’s control.  Furthermore, these systems can not account for management bias which creates risk blind spots.

Boards and senior leaders have a clear responsibility to protect shareholders and other stakeholder from the effects of credible Black Swans.  What can be done to assess and mitigate the major business risk from these catastrophic events? Booz & Co., a consultancy, recommends that company’s undertake a Disruptor Analysis Stress Test.  Complementing the firm’s existing ERM approach, this test would be periodically administered by a senior team of risk managers and line of business leaders.  

The analysis includes a 4-step process:

  1. Understand the current state

To find vulnerable nodes in the business, it is vital to map the full operational profile – relationships, costs, revenues, capital deployed etc – of the firm including its suppliers, channel partners, stakeholders and customers.  This analysis should  go beyond direct relationships to key interdependencies like ‘suppliers of suppliers’ as well as market dynamics such as competition and industry structure

  1. Develop the disruptor list

Given the unexpectedness of Black Swans, managers needs to cast a wide net to identify potential disruptions to the operating model. To be comprehensive, this list should encompass every potential interruption across multiple geographies based on what could occur within a 1 year horizon.

  1. Asking “what if” questions

During this phase, the team would explore what would happen to the enterprise if one or a more of these events transpired.  This type of scenario development helps discover new hazards and drives further clarity around previously identified risks.  Moreover,  these activities can help uncover informational blind spots and bias while building internal knowledge. 

  1. Create contingency plans

Contingency plans are then developed based on the most likely to occur “what if” scenarios.  These plans would include financial, operational and human resource strategies for coping with the scariest Black Swans.  Though this planning is handled internally, many companies may choose to gain an independent, third-party validation of their thinking.

It is virtually impossible to produce quality contingency plans for every possible Black Swan.  Yet, impossibility does not mean senior managers should not try to minimize organizational impact by raising internal awareness, gaining cross functional alignment and making preparations.  Indeed, success favours the prepared mind.

For more information on our services and work, please visit the Quanta Consulting Inc. web site.