Friday, April 27, 2012

Consider the Balance Sheet

I am reflecting today on the relationships among the following three things:
  1. innovative new technologies for bringing Investment into Enterprise
  2. real competition for the Exchange-based solutions
  3. purpose-built for monetizing sustainability
Today innovations in information and communication technologies - computers, the Internet, email, the World Wide Web and wireless communication, generally -  are giving us unprecedented possibilities for Enterprise and Investment to engage directly, where before they could only come together indirectly, through intermediaries.

This innovation inverts the current industry-standard relationship between Assets and Cash Flow, as established and maintained by the Exchange.

Consider the Balance Sheet.  It has a right side and a left side.  On the right, are Liabilities.  These are mostly debts for money borrowed at interest that must be repaid according to an agreed schedule, under threat that the Enterprise will be dissolved, and its assets sold off, if the borrowings are not repaid when due. On the left, are Assets.  These are the things the Enterprise owns and uses in the conduct of its business.  When Liabilities are deducted from Assets, what you have left is Equity.

What is missing from all this is cash flow, and yet cash flow is what drives all real value.

Unless the assets of an Enterprise are commodities that trade for a price in a liquid market, the value of those assets will depend on their ability to contribute to the generation of cash flow by the Enterprise (or by others who might use those assets, in competition with the Enterprise).

Lenders know this.  They look at Assets mostly as collateral, a secondary source of repayment.  What they lend against, primarily, is credit; the ability of their borrower to generate a sustainable stream of cash flow over a period of time sufficient to support the borrowing (after building in an adequate margin of error to absorb the bumps and bruises that are a regular part of everyday living, commercially and otherwise).  Done properly, lending is really just about cash flow management.

Equity is different.  Equity is about new value creation.  If you agree with me that real value creation comes from the use of assets to generate cash flow (through the commercial exchange of a price for artifacts constructed by the Enterprise that are unique in being both singular and special), you will agree also that all true equity investing is essentially speculating on future cash flows, which is where real value is actually created.  Equity lives in the margin for error that Debt builds in for its comfort and security.

This is where the Exchange-based solution for indirectly connecting Enterprise and Investment adds to the complexity of an already complex dynamic.  The Exchange turns Equity into an Asset, and then turns that Asset into a commodity that is traded for a price in a highly liquid, commodity type market that is operated by the Exchange.  This increases exponentially the speculative characteristics of the investment: there is now speculation about future cash flows, but also speculation about how other market participants will perceive and price those future flows.

We pay a high price for the liquidity provided by the Exchanges: hyperbole, volatility, instability.  Most of all, Enterprise and Investment get transformed into Ownership and Management.  Instead of sharing interests aligned along common concerns for cash flow and core values, both Enterprise and Investment are forced to adopt the values of the Exchange, and what the Exchange values is volume.  That is how the Exchanges make their money: on the volume of shares (or other securities/commodities) being traded over their Exchange.  The best way to drive up trading volume is to drive up price.  So, what the Exchanges demand of both Enterprise and Investment is constantly accelerating growth in share price.  Or, more generally, Growth.

Real growth is good for everybody, but the Exchanges don't really care whether the growth is real or imaginary, and that's where the problem with the Exchange-based solution really comes in.

If the Exchanges can be made to operate within the limits of real growth, the liquidity they provide, and the price we pay for that liquidity, is a pretty good deal.  It's only when the feeding frenzy starts, and caution gets thrown to the wind, that problems develop.  We get booms that always, eventually, go bust.  Sometimes, the busts are manageable.  Other times, they can be devastating.

Many argue that the exuberances of the Exchanges can be effectively constrained through moral persuasion and governmental regulation.  I contend that we will get better results from competition.

In the days before computers, and today's complex of information and communication technologies ("ICT"), generally, competition for the Exchange-based solution was hard to find.  Bringing Investment into Enterprise requires lots of discussion, to exchange information and align assessments of both cash flows and core values.  Doing that at scale, from remote locations, was for all practical purposes, just not possible.  Today's complex of computer-driven ICT completely changes that dynamic.  Further, we now have many purpose-driven financial institutions, such as Pension Funds, Endowments and Insurance Companies, that aggregate large amounts of our personal wealth. So we now have vast pools of surplus wealth available for investment that are professionally managed by Enterprises that are motivated by their own cash flow and core value considerations to prefer Investment that performs programmatically, over the longer term; that is, they have sustainability as a core value.  Finally, there are proven, reliable techniques developed mostly around Real Estate, but increasingly being ported over to more technology-driven Energy and Infrastructure Project Finance Investments, that need only to be strengthened by the new-venture underwriting expertise of the Venture/ Private Equity experience to evolve new techniques for bringing Investment into Enterprise, directly, across a broad range of asset classes.

These new technologies for bringing Enterprise and Investment together, directly, from remote locations, to agree a sharing of interests in cash flow and core values that are emerging at the intersection of Real Estate, Project Finance and Venture/Private Equity will have the advantage over the Exchanges whenever sustainability is a core value.

The Exchanges are not designed to value sustainability.  They are purpose-built to value growth.  Growth is part of sustainability, but sustainability is bigger than growth.  Sometimes, it will be enough to concentrate on monetizing growth, and the Exchange will continue to be a good choice.  Other times, sustainability will be the more important concern, and these new technologies will be the better choice.

The only thing that remains, is to work out the details of what these new technologies will look like.


Wednesday, April 25, 2012

Can we put the genie back in the bottle?

These days, I am hard at work listening to the conversations as they unfold within the large, growing and vibrant community of people concerned about Sustainability, looking for the right place where I can enter the dialogue, and make a positive contribution to this important issue.

I agree with many others that Sustainability is a critical issue, perhaps the most critical issue, for our times.  I also agree with the view that this is one of the very few truly unique experiences in human history, one that has never really been encountered before, at least not within the history of our Western traditions.

Dating back to the days of the early Greeks, and even before that, to the ancient Persians, Sumerians and Babylonians (modern day Iran and Iraq, curiously enough), there has alway been a frontier: more or less open and unoccupied space beyond our borders into which we can expand when we need to, acting as a safety valve for the excesses of our industriousness, offering the promise of more land, more resources, more of whatever it is we feel we need.

To be sure, there have always been borders, but up until now, those borders have always been limits more or less of our own making, built and maintained for our own comfort and security.  And they have always been more or less porous. People have always found ways to move through, over and around the bounds, to explore what lies beyond, and lay down those pathways that become the highways for larger-scale geopolitical expansion when the pressures inside get too great.

For the first time in history, in our time, that is no longer the case.  We have reached the limits of the Earth, and found that it closes back in upon itself.  We have ventured beyond the Earth, out into the vast expanse of Space, and found that there is nothing really out there for us.  Many still argue that Technology can conquer Space; that we still don't know what good things we may find, if we just keep looking.  That may be true, but right now, that feels more like science fiction than science fact.  At this moment, it seems that there is nothing that the Engineers can build, or that anyone is willing to finance, that can make expansion into Space a practical reality for the rest of us.

No, for the first time in the whole history of human history, I believe, with others, that we have reached a limit beyond which we cannot pass, a limit whose ontology is not a human cognitive construct, but something beyond our power to make or change.  I am reminded of a story from the Bible, where God tells Man: "be fruitful, and multiply, and fill the Earth, and subdue it".

Now, its seems, we have filled the Earth, and made it our own.  And with ownership comes responsibility.  We have to care for what we own, as if it is our own.  Otherwise, we will lose it.

To me, this is not 'end of days' stuff.  It is instead the momentous beginning of the first truly new era in human history since the invention of large scale agriculture which is the foundation of everything else we know as our prosperity today.   It is what John Fullerton of The Capital Institute,, has called The Great Emergence: an epic shift from a paradigm for prosperity built on geopolitical expansion fed by growth in resources under our dominion, to a prosperity of open-ended growth in knowledge, and the continual evolution of work and wealth, as we learn to live, and live well, within the limits of what has been given to us. (Those limits, by the way, are still vast beyond our knowing, just not so vast in a geopolitical sense).

This, to me, is what Sustainability in all its many guises, is really all about: a paradigm shift of truly epic proportions, one of the few true shifts in human history, on par with the Invention of Language, the Invention of Tools and the Invention of Agriculture which have combined to bring us to the point we are at today: living fully within the physical limits of the biosphere which is our home.

As I listen to the growing conversation about Sustainability (putting to one side those on the lunatic fringe, who really just have some personal axe to grind), it seems there are two distinct threads in the discussion.  There are those who are concerned with the physical challenges of living within the physical limits of the biosphere: climate change, population density, environmental degradation, food, health, energy, etc.  Then there are those concerned with the financial challenges arising out of the growing volatility and consequent instability of an increasingly interconnected global capital markets system.

My mission is to draw the proper connection between the two.

I start on the financial side, because investment, in our world, is de facto the way most resource allocation decisions get made.  Since Sustainability is largely an issue of resource management, it is also, unavoidably, largely an issue of investment.

As I listen to the conversation on the investment side of the Sustainability dialogue, it seems to be driven largely by people who just want to slow down the speed of trading that takes place over the increasingly global network of financial Exchanges.

Personally, I don't see how we are ever going to get that particular genie back into its bottle.

Nor do I believe that just slowing down the Exchanges (which will require, ultimately, regulation enforced by Law; people who find a way that they can make money - lots and lots of money - will not stop doing that just because someone else wags a finger at them, and calls them miscreant) is the fix that we need.  Instead of regulating the Exchanges, the paradigm shift to Sustainability really requires an equally fundamental shift in how we invest in Sustainability: we need to invent brand new solutions for sustainably financing the business of sustainability (and the governments that regulate - and in some cases own and operate - those businesses).

Competition, not regulation, is the right path forward.  And competition requires innovation.

Consider that the Exchange-traded financing solution that dominates the world of investment today - and that is showing itself increasingly to be structurally unable to detect and respond to the values of Sustainability (much the way a thermometer, for instance, is structurally unable to detect and respond to the passing of time; for that we need something that is not a thermometer, for that we need a chronometer) - is itself an invention of the 19th Century.  At that time, Sustainability was not the issue it is becoming for us today.  Growth was the issue, and expansion along America's Western Frontier, fed by the motorized machinery of mass production.  Exchange-traded finance evolved as a solution purpose-built for monetizing Growth through Economies of Scale.

It may be possible to cobble onto this Engine of Growth some sensitivity to Sustainability, as well, but that will always be, at best, a compromise.  It may slow things down, but it won't put things on a proper path.

If we want to get serious about Sustainability, we must also get serious about the need to invent, adopt and implement innovative new investment choices, choices that are built for one specific purpose: to monetize Sustainability as the new engine of our prosperity.

The demand for that kind of radical re-invention, in my view, will not come from the investment side of the debate.  It has to come from outside the world of finance.  It has to come from those who want real solutions on the physical side.

These people may think they really don't care about investment, but really, they do -- and have to.


PS - It may be important to note that I do not see Growth as antithetical to Sustainability.  Growth is still important, but Sustainability is bigger than Growth.  With growth, there is always displacement.  But where Growth is blind to that displacement, and largely ignores it, Sustainabililty sees it, embraces it, and deals with it.  That is why Sustainability is Growth, but also more than Growth.  It's evolutionary.

Friday, April 20, 2012

Sustainably Financing the Business of Sustainability

I am following a blog called Feld Thoughts, posted by a Venture Capitalist named Brad Feld.

Brad's thoughts today hit on two themes: the need for themes when investing in business, and the need for great businesses to have not just customers, but what he calls "raving fans".

For Enterprise, themes are important because if you choose well, you get customers who are raving fans (Brad's words).  If you choose poorly, you get something less.

So, here's is the theme for my business: sustainably financing the business of sustainability.

What is sustainability?

It is living with limits.  A limit may be a goal, something towards which we strive.  It may be a boundary, within which we are safe and secure.  It may be a constraint, beyond which we cannot go without impairing the integrity of our activities.  It may be an irritant that stimulates inquiry that leads to insight that drives the evolution of knowledge, work and wealth that is the real story of human history, and the real driver of our prosperity.

Limits are everywhere, physically and economically.  It is important that we know, more or less, where they are and what they are.  If we mistake a boundary for a constraint, we get not safety, but stagnation. If we mistake a constraint for a goal, we get irrational exuberance, and a turbulent prosperity of booms that always go bust.

Sustainability is what lies between the two extremes of stagnation and exuberance.  It is vital, energetic, exciting, resilient, adaptive, evolving value creation that is at once both stable and dynamic.

Every business is in the business of sustainability, unless it is hyping exuberance, or stifling innovation.

Sustainability is emerging as an important theme in finance and investing, especially among our largest Institutional Investors: pensions, endowments, insurance companies and commercial banks.  Some of this is being catalyzed by concerns about the environment, and the limits of industrial expansion imposed by the limits of our biosphere.  Some is being catalyzed by concerns about the economy, and the rapidly accelerating cycle of boom-and-bust that many see as increasingly anything but sustainable.  Some is being catalyzed by corporate misconduct, and the stunning collapse of so many companies that turn out to be more hype than substance.

In this way, limits to sustainability in the connections between Enterprise and Investment can be seen as an irritant that is stimulating inquiry that will lead to insights into new and better ways to align the interests of Enterprise and Investment in a shared commitment to both real value creation, and sustainability.

Anticipating this drive towards sustainability as a value that is shared between Enterprise and Investment is the evolution of Project Finance as a new solution for bringing together Enterprise and Investment around revenue sharing as a strategy for investment return realization.  This technique supports: alignment of interests between Enterprise and Investment along multiple points of value, financial and additional; the transparency of business operated according to a pre-agreed plan; and decisions that balance short-term performance against longer term sustainability.

Right now, Project Finance is practiced primarily as an alternative form of public finance.  Projects tend to be quasi-governmental in both purpose and scale, and some form of governmental credit is usually required to stabilize investor return expectations.

However, this technique is so effective at delivery sustainability, that it is easy to see how it can only become more mainstream, as sustainability continues to grow as an important theme with both Institutional Investors, and the individuals whose wealth these Institutions are charged with investing.

I don't know if the professionals at large financial institutions will ever become what Brad Feld describes as "raving fans" of using proven project finance techniques to sustainably finance the business of sustainability, but who knows?

Thursday, April 19, 2012

Project Finance as Business Finance

I received today an email solicitation from Euromoney Books promoting a series of publications on Project Finance.

Topics covered include: modeling a base case and sensitivities; structures for allocating risk; and sector-specific considerations.

The last topic is the one of greatest interest, for this reason.  Project Finance as it is currently practiced is largely viewed as an alternative to governmental funding for infrastructure projects: transportation, energy, water and wastewater, telecommunications and the like.

The Capital Markets, not these private partnerships, are generally viewed as the financing solution of choice for general business activities.  Partnership are reserved for quasi-governmental finance.

Is that a technology choice, or an accident of history?

Project Finance is actually a more recent innovation in capital formation than the Capital Markets.  It is only really possible in this, our own Computer Age, where forward commitments, rather than past performance, can be used as the basis for establishing investment needs and return expectations using the powerful computerized spreadsheets that we take for granted today, but only came to be in our own life times; and where computerized information can be shared among multiple participants from remote locations in real time, using desktop/laptop computers, email, the Internet, the World Wide Web and cell phones.  All powerful inventions and innovations that have only become fully available for routine use for connecting Enterprise and Investment in our times.

The Capital Markets, by contrast, are a vestige of the 19th Century.  They are place-based solutions for making indirect connections between Enterprise and Investment in the days before technology made real-time, direct communication possible.

Project Finance is leading innovations in finance in the 21st Century, powered by technologies for computerized data collection, information construction and remote communication.

Right now, mostly, governments are using these innovative solutions.  It is only a matter of time, however, before they make their way into general business.  Not as Project Finance, but as Base Case Cash Flow Partnerships.

Tuesday, April 17, 2012

Proofs. Or hyberbole?

For Enterprise, the path to the money lies through the laying down of proofs that will attract Investment.  There are different grades of proof, beginning with the Emotional or Intuitive belief that drives Enterprise to create new value in the first place, and moving through logical analysis of emotional expectations, scientific validation of logical conclusions, engineering designs to implement the science and the logic, commercial commitments to a project, and ending with a history of financial performance, in the field, over time.

Each level of proof takes time and costs money to develop, which is the great conundrum for both Enterprise and Investment.  Enterprise needs Investment to prove its value creation thesis. Investment needs Enterprise to prove its worth.  It's a classic problem of trust and confidence that is the job of professional financiers to resolve.

Wall Street offers an interesting solution.  It promotes the buying and selling of shares in public companies that are already successful.  This gives Investment the opportunity to participate in Enterprise that doesn't really need the money. Historical proof of value, which takes time to build and skill to analyze, gets replaced by future projections of past results.  And these projections are never of sustained profitability.  They are always of growth (or decline) in share price.

Emotion takes over from reasoned analysis, and Enterprise is driven to play to that emotion.

In a system that is supposed to be built on Proof, what we end up with is hyperbole.

Liquidity becomes important, because Investors have to believe they can sell out when they want to get out, either to reap their profits (if they guessed right) or cut their losses (when they guess wrong).

Liquidity gives us volatility and instability, not the predictability of reliable proofs.

For the economy in general, we get booms that always, eventually, go bust!