The Interconnectedness of Things
September 7, 2011 § 6 Comments
This past week the company I work for, Nimbus Partners, was purchased by a larger software company, TIBCO. I can’t comment on the process of due diligence of the deal, but as any large acquisition is considered, a great amount of analysis must be performed. To value any software company, the acquirer must value the assets for product technology, position in the market, product position within the existing family of assets, the company’s existing financial state as well as projected earnings potential.
This acquisition is one of many major decisions that executives at TIBCO and other corporations go through every year. Some investment options require incredibly in-depth analysis while other investment decisions may be made quickly with far less due diligence. There are plenty of reasons for performing an analysis on an investment to a given level and not to a finer level. When purchasing a stock or making a trade on an existing holding, how much information is driving your decision? Did you read the prospectus of the latest 10-Q? Did you attend the recent investor conference calls with management? Did you get all the answers to your concerns of the latest one-time charge to net income? The odds are you didn’t. The odds are you’re trading on gut feel of the situation or you’re trading on some limited understanding and you accept that risk based on the fact that simply don’t have the time to do all of the research you would have liked. Now, you might also put your trust with money managers or fund managers; expecting they are doing all the analysis required to make good value judgments that are in line with your risk profile and your investment objective. Again, are you sure they are going down to a depth of analysis that ensures risk is minimized?
A Hedge Fund Legend
Recently, I read about a very successful investor named Michael Burry. For those of you who haven’t heard of Mr. Burry, he gained a degree of notoriety for wisely betting against banks’ mortgage holdings and cashing in massive returns for his hedge fund when the credit crises hit full tilt in 2007. His brilliance wasn’t just that he recognized a good bubble when he saw one, it’s the way he figured out how to capitalize on this realization that a spectacular amount of mortgages were doomed to fail. The fact is, when Mr. Burry first became convinced that the type of lending that banks were engaged in was destined to result in large numbers of defaults, there was no real instrument for wagering against the performance of these notes. The various tranches of subprime mortgage bonds could not be sold short. Even with his conviction that the subprime mortgage bond market was doomed, he could not capitalize on it.
Then came Mr. Burry’s discovery of the credit-default swap. It was basically an insurance policy that could be purchased against corporate debt, but that was only useful for betting against the companies that would likely default such as home builders. Ultimately, he convinced a number of big wall street firms to create them including Deutsche Bank and Goldman Sachs. Now, what made his work absolutely brilliant was the fact that he would spend untold hours poring over each bond prospectus, only investing in the most risky of those assets. He was performing the due diligence on each of the loans, such as analyzing the loan to value ratios, which had second liens, location, absence of income documentation, etc. Within each bond, he could sort out the riskiest of the lots and incredibly enough, Deutsche and the other banks didn’t care which bonds he took positions against. He essentially cherry-picked the absolute worst loans (best for him) and found the bonds that backed them.
Mr. Barry would ultimately bring his investors and himself astronomical returns at a time when the vast majority of investors lost roughly 50% during this crisis. If you read about Mr. Burry, you’ll find there is much more to his story as he is unique in many ways, but one key point that separates him from the pack is that he does his homework. Details matter. How these loans were structured matter to all that were connected to them. In these bonds were real loans that represented real value. Understanding the risk factors would immediately point to a very low valuation on these bonds.
I’m not going to delve into the full issue of responsibility relative to loan originators, banks, Fannie Mae, borrowers, etc, but suffice it to say that solid due diligence reduces the risk of any transaction. The more you understand about the asset under consideration, the better you can predict its performance. It’s as simple as that.
So, what’s with my title, “The Interconnectedness of Things?” Well, it got me thinking about just how interconnected we all are. Without getting all Jean Paul Sartre on you, let me point out the most common difficulty in all of management: interconnectedness. That’s right, interconnectedness. The fact is; executives hate it. But it exists. We have the tendency to measure performance of an exact metric; of an exact process step, or an exact person. We like to think that sorting out the specific items of measurement can enable us to understand what is strong and what is weak. Fix the weak bits, keep the strong bits, and voila, you have Lean. But, from the work I’ve been involved in, it’s not so simple. Similar to the difficulty of sorting out all the bits that make up a good loan from a bad loan; a good mortgage bond from a bad mortgage bond; business processes can be extremely complex and highly interdependent.
How do we get our arms around the complexity of process? Mostly, in very distinct ways. How many of us love to look at organizational charts, value chain analysis diagrams, system architecture diagrams? If you are shaking your head “yes”, I’m deeply sorry. The fact is, we are trying to ensure we understand the interconnectedness of things, but we often do that work in silos. In efforts to diagram process or entity relationships of systems or people relationships, this work is most often performed as one-off attempts with a singular purpose or project in mind. They are not done to ensure a wider scope of understanding is gained and maintained. And therein lies a serious shortcoming of those efforts. With islands of understanding, there may be some level of interconnected understanding, but the silos remain silos and whenever we look at those groupings within a map or chart or a diagram, there is too much lost information. The value of what you have is just as quickly defined by what it does not have. (Perhaps some Camus?)
Devil’s in the Details
So, how do we connect all these silos and how do we know when we have enough detail? These are big questions to which there are no silver bullets. During a recent engagement, I was working with a global IT organization who brought together four business units to define standard global processes. Ultimately, the idea was to consolidate where possible, but initially they needed to capture how each unit was operating. I’ve done this type of work a number of times and what still amazes me each time is how often we find gaps in processes, areas that are not understood, as well as overlaps where steps are replicated and no one knew what the other one was doing. As we embarked on the journey of process design, the key question that this team asked of me was, “how many levels down do we need to go?” My answer was pretty simple: go down to the level of detail that someone from outside this process area can read and understand what is happening without any ambiguity.
Imagine if you will an organization that has documented down to that level in a consistent way across their organization. Further, imagine a singular map with diagrams that connect to all appropriate related process steps, to all related electronic content and within a platform that provides instant feedback from the personnel that perform the operations. Now, that’s getting your arms around complexity and it tells the story of the interconnectedness of things.
Finally, once we gain perspective on this interconnectivity we can truly understand what is working and where risk lies. For it is risk that we are constantly managing. The banks that held large amounts of mortgage credit were blind to what was in the big bag of bonds that contained smaller bags of loans that contained all kinds of facts, some of which were never gathered (such as income verification). Did they completely understand the interconnectedness of things? Did they get down to a low enough level of detail to really understand the assets that so much was riding on? To reduce operational risk, the devil’s in the details. Get your arms around process, get your arms around the details and know what you’re buying into.