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.


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