Friday, July 29, 2011

Metrics and Incentives - Some Examples Part 1

In his most recent post, James Evanoff discussed the Lean Consumption Harvard Business Review article by Womack and Jones.
This article cites an example that is relevant to our prior posts on Metrics and Performance Management. In those posts we concluded that “you get what you pay for” and “we measure what is easy”.
In the article it discusses an IT firm who wins a call-center contract. Under normal terms in the call-center industry, these contracts take the form of price per call or complaint basis. This, however, creates no incentive for the call-center provider to innovate or suggest solutions to problems. If we are paid on a per-call basis, we want more customers to call with more problems – we make more that way. In truth, since not all people are ethical, we should not be entirely surprised to find that the call-center firm’s repair dispatches were confusing or incorrect in some manner. If the repairman does not show up, the customer will make another call!
In this case, by restructuring the contract as more of a fixed fee, the call-center firm actively contributed to solving customer problems since the fewer calls would mean lower costs and therefore higher income since revenues were set. The firm hiring the call-center provider did indeed get what they paid for.
The prevalence of the per-call contract basis in the industry vs. the set-fee contract is indicative of a change in the nature of work, which I will tackle in another session.
Another quick example is investment banking fees. If we hire a firm to advise us on an M&A transaction as a buyer, and the investment bank is paid if the transaction is successful on a percentage of purchase price basis, is it to the investment bank’s benefit to advise us to overpay or underpay for the transaction? If we bid too little we will not win the bid and there will be nothing for the bank. If we bid too high, the bank wins. How can we consider them to be aligned with our interests in this scenario?
I would love to hear your thoughts about incentives or your stories on this topic if you have them.
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Thursday, July 28, 2011

CAPM Interlude - The Theory of Theory

A theory’s purpose and objective is something I happened to learn in the psychology field rather than business.

The Two Objectives of a Theory
A theory needs to be:
a)      simple enough to be tractable yet
b)      robust enough to explain a lot of things.
If it accomplishes these two things it is “elegant”.
The theory’s power is its explanatory ability. It does not have to be real. For instance, while Freud’s theory involves an Id, an Ego and a Superego, these things do not actually exist in real life. They are created so that we can conceptualize these entities and intervene appropriately as the theory dictates.

On To Finance
A lot of economic and financial theories are criticized because they do not work in real life. However, as discussed above, that is not the purpose of the theory. It is to explain.
And the financial theories do this. Diversification reduces risk. There is a tradeoff between risk and return. Whether the beta of a stock is a good measure or not is quibbling about the details. There is a risk vs. return tradeoff, and it generally holds, in enough situations.

Diversification mitigates extreme portfolio swings, on average, in enough situations.
We asked why auction rate securities yielded more than variable rate demand notes in 2003. “There is a risk of failed auctions, in which case the investor would need to hold the security and would not get their funds back. But there hasn’t been a failure in over a decade”
Theory leads us to conclude “Fine, it hasn’t happened, but the risk is there”. It is up to each of us to determine whether that 10 basis points of return is worth it.

Those investing in auction rate securities in 2008 got to experience the actual reprucussions of that "theoretical" risk.

Key Takeaway
Learn the principles the theories teach us so we don’t have to learn them the hard way, but don’t believe reality can be made out of them either.

·         How has learning a theory improved your perception?
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Wednesday, July 27, 2011

How to Be a Corporate Revolutionary in 50 Easy Steps

Soon after getting my Chicago MBA I was gung-ho to implement a lot of the cutting edge strategy and finance techniques that I had learned.
The problem here was that there was a lot of organizational resistance. My boss at the time gave me some timeless words of advice:
“Incremental change”
Thus, if you want to sponsor a revolution, you need to do it brick by brick, room by room, block by block. Organizations are not usually ready for big change unless there is some kind of crisis. So if you want to be a change agent, you need to do it slowly and steadily. Too much at once is a bad thing, it scares too many people off.
When we wanted to implement some capital discipline, we did it incrementally.
The first 6 months we came up with a cost of capital, working with business units and strategic planning, exploring and ultimately bridging differences.
The second 6 months we worked on capitalizing the business units in appropriate fashion, again working with different areas of the company to arrive at an acceptable-to-all solution.
Finally, in year two we implemented the Return on Invested Capital concept, which became a factor in the performance metrics and bonus compensation for the various groups.
Each of these stages we focused on the issue at hand, and only at the end did it all work together.
So, figure out what makes sense at the time, what is relevant to the highest current organizational priority, and play the game for the long-term. Make the change in 50 increments. One day you will wake up and find that you have achieved the revolution you were advocating.
I would love to hear your thoughts about the pace of organizational change or your stories on this topic if you have them.
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Tuesday, July 26, 2011

Book Review : Trust Agents

This book, by Chris Brogan and Julien Smith, was an accidental pick-up by me. In prior postings I noted that part of the Vision and Mission for Treasury is to be an approachable and dependable partner. The title of this book conveyed the impression to me that it would provide some information in that regard.
Turns out this book is about Trust Agents on the web as opposed to within an organization. However, given that the tools of Web 2.0 and beyond are becoming weaved into our work and personal lives, I decided to give it a spin anyway.
Following is a chapter by chapter look at the book with bullet point style comments from me about what each chapter contains:
Trust, Social Capital and Media
While we live in a world that is more mistrusting, there exist online those who we view as credible and relevant. These people have been able to build trust by being present, in a very human way, on the web and continuously mastering the digital highways. The internet is a powerful medium because it works 24x7 - you give a live speech to an audience once, you put it on YouTube you give the speech over and over again to new audiences. This chapter has some useful tips for continuously monitoring the web for items of importance to you.
Make Your Own Game
The internet provides a way to change the rules of the game. The internet is an opportunity to change the rules, or in the authors terms “gatejumping” the current “gatekeepers”. Games have three stages: playing, hacking, programming.
One of Us
The trust equation (which ironically the authors cite from the The Trusted Advisor, a book I thought this would be equivalent to)
(Credibility x Reliability x Intimacy) / Self-Orientation = Trust
Lots of suggestions in this chapter about on-line etiquette, how-to make friends, making public discourses, and how not to be scummy.
Archimedes Principle
Leveraging the power of the internet, things to stop and start, some useful sites.
Agent Zero
This is the principle centering around connecting otherwise unconnected groups, being the force to get two others together in beneficial ways. How-to, do’s and don’ts about connecting others.
Human Artist
How to be human in a digital way. The Golden Rule is still important. Tips on how to use popular social network services like facebook, twitter, etc.
Build an Army
The power of the internet to leverage information, social networks, and other items. Written before the events in Egypt and others, but the content in this chapter speaks to those situations.
The Trust Agent
Final listing of tips, suggestions, and activities to further on-line activity in the spirit of the preceding chapters.

My Take On The Book:
This blog exists is due to this book, in that it was basic enough for relative web novices such as myself to feel confident enough to begin exploring in far greater depth what the web might and might not be able to accomplish.
Each chapter contains suggestions and recommendations which can be acted upon almost immediately, without any complicated or lengthy preparation or prior activities.
The author’s underlying tone throughout the book is focused on the positive aspects of simply being human, being who you are, and coming to an understanding on what to do with that information is apparent, and this indeed makes them Trust Agents in my opinion.
I rate this book 5 stars out of 5
I would love to hear your thoughts about Trust Agents or your stories on this topic if you have them.
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Monday, July 25, 2011

Performance Management – Part 1

Since it is a little past June, many of us are involved in that ritual called mid-year reviews.
Today on LinkedIn I ran across a posting making the argument for a strong “performance management” system. What exactly does this mean – performance management?
It has the feeling of one of those consulting buzzwords.
What is Performance Management (in theory)?
According to Wikipedia – “Performance management (PM) includes activities that ensure that goals are consistently being met in an effective and efficient manner.”
That being said, I am all for performance management. We do our jobs in order to achieve a result. Some of us do our jobs better than others. Some of us do better in some areas, some do better in others. Some of us are not doing as well overall and need to do better. I get all that.
Upon thinking about it, who can be against that? Ensuring goals are being met…that has got to rank up there close with apple pie and momma.
What is Performance Management (in practice)?
In some companies it boils down to setting a series of “SMART” goals for all of its employees: the acronym standing for Specific, Measurable, Achievable, Realistic, and Timely. This sounds good too – in theory.
Problems with Performance Management
Why is this a problem? For one, most of what goes on in a company is not measured. Not even close.
So when faced with a choice of “should we measure something new in order to have a goal” or “should we set a goal around something that is already being measured”, what is the default? Go with what is already being measured.
After all, this is the most “efficient and effective” route, isn’t it? So we limit the universe of goals to that which is easy to measure - the fallacy of measurability.
The second problem can be termed the “Fallacy of annual prescience”.
Let’s say that at the beginning of 2008, when we did not yet know we were in a recession, we had a specific goal of improving our return on invested capital by 10%, measurable by NOPAT / invested capital, at the time of the establishment considered achievable and realistic over the following year’s timeframe. Put a checkmark on all the elements of SMART.
Say we ended the year where we started, with bank capital still relatively available, able to access the public markets if we dared, and our operations performance throughout the last quarter break-even or better?
By almost any measure, given what went on during the financial crisis, that would have been an astounding success, passing by far the median corporate performance and probably landing us in the top 20%. But what would it say according to our “SMART” goal? “Did not meet expectations”. No accolades (let alone bonus) for you!
Other problems to come….
I would love to hear your thoughts about performance management or your stories on this topic if you have them.
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Sunday, July 24, 2011

Keep It Simple – Part 1

Back in my early asset based lending days, a couple of colleagues and I were talking about the difficulties one of our portfolio companies was having, and what it might take to turn them around.
After fifteen minutes where all of us newbies were busy coming up with one clever idea after another, our well-seasoned VP finally commented:
“it’s not rocket science - you either need to increase revenues or cut your costs”.
And there you have it - we can get bogged down in strategy niches or six sigma efforts, phrases and terms that ultimately mean increasing revenues or cutting costs.
If the business is trouble, one of those two needs to happen quick, no matter what we call it. It really can be that simple.
I would love to hear your thoughts about this view of keeping it simple in business or your stories on this topic if you have them.
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Saturday, July 23, 2011

Will the Real Capital Asset Pricing Model Please Stand Up? – Part Two

By the end of our last episode on this topic we had 108 combinations of alternatives to arrive at our cost of equity.
Peer Groups
When assessing our cost of capital, we are usually making these cost of equity calculations across a group of relevant peer companies. So there is the issue of who is included in this peer group?
Again, going to the extreme at either end - you can keep this peer group small and narrow or you can make it broad and wide. And again, arguments both ways.
Example - our group project in one of my University of Chicago classes was to evaluate the acquisition value of a grocery store firm. Are grocery stores considered grocery stores – so we should just use comparables involved in that business? Or are they retailers, so we should include other “big box” type players? Should Wal-Mart, who has some stores with no grocery, yet some stores with grocery, and is in the top 5 in grocery sales, be included in a comparable group or not?
So assuming only two extremes (no matter where you put Wal-Mart), we now have 216 combinations.
The next step in the process is to “unlever” the Beta. By this we mean the following chain of logic – the Nobel prize winning Modogliani-Miller theorem in finance holds that the financing of assets does not matter; in other words, the risk of the assets of a business is the same no matter how they were financed.
One of the primary critical assumptions is “a world without taxes”. Hmmmm….I wish we could all assume that in real life!
With taxes, because interest is tax deductible, debt financing actually adds value. So then the thinking goes “if debt adds value why aren’t firms 99.44% debt financed? Because this doesn’t happen, people thought about it and concluded that, since defaulting on debt causes bad things like bankruptcy, and prior to that the terms of bonds and bank debt can inhibit your operations, there exists something called “cost of financial distress”, which offsets the interest deduction on your tax form at some point.
So we unlever our Beta or equity cost of capital to reflect the fact that our comparison group consisted of some companies who might have had little to no debt, and other companies who had fair to middlin’ debt, and other companies who had loads of debt. We take them all back, no matter where they started, to no debt. It is the financial analyst equivalent of making the playing field level and fair.
Why have I gone on so long about this unlevering issue? Because again we have a choice.
Is the risk of debt Beta?
Remember from the previous blog that our beta calculation reflects “how much equity risk is shared by the market”. Well, if there is debt in our capital structure, doesn’t that debt share some market risk as well? After all, if inflation is expected to go up, doesn’t this impact the bond market as well as the equity market?
So, for our group of comparable companies, we need to decide that if there is debt in their capital structure, should we add some amount of beta due to the debt when we go through this unlevering process?
Again, using extremes (and there are arguments to both sides), we have two choices, and how we decide – yes, add some beta for debt, or no, assume no beta for debt – our 216 choices now expands to 532.
Unfortunately, we are not done yet. Look for a future blog to cover where we go from here.
I would love to hear your thoughts about this view of the cost of capital or your stories on this topic if you have them.
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Friday, July 22, 2011

A Food Network Star Lesson

The Next Food Network Star is one of the few television shows my wife and I watch. In each episode, the contestants are subject to a challenge where they need to demonstrate both camera and cooking skills, and at the end of each show one of them is eliminated from the competition. The last one remaining at the end of the series will become the network’s next “food star”.
This past week’s show involved the contestants hosting a dinner party where the famous chef Wolfgang Puck would be in attendance along with all the regular judges. Jyll, one of the contestants, presented risotto. Mr. Puck did not like this dish, so in the middle of this dinner party, with all the judges and other contestants, he takes Jyll back to the kitchen to give her a cooking lesson about how to make a proper risotto.
This was, understandably, quite an embarrassing and traumatic experience for poor Jyll, but I would wager it came with one benefit – she will know from now until the end of time how to make risotto.
No Pain, No Change
Unless a person is operating outside of their comfort zone, there is likely little change going on. Change involves destruction of the old and making way for the new; not a pleasant process. Some now claim that how our brain is wired makes change painful.
In addition, there are studies that have been done that show that when we are in heightened emotional states we have higher memory retention. This is what happened to Jyll. This is what happened to my grandmother, who lived some formative years under the Great Depression. She was frugal ever since, as were many in her generation. The pain of that era caused changes that lasted a lifetime.
Any of us Finance and Treasury professionals that were around in 2008 went through a painful and stressful time that will likely make an imprimatur on our professional activities for our entire careers.
Remember You are a Nuclear Power
Nuclear reactions can be used two different ways: productively, like a nuclear power plant, or destructively, like a weapon of mass destruction.
Productive use of nuclear power is characterized by a controlled and contained reaction.
Destructive use of nuclear power is unleashing the uncontrollable reaction.
Managing organizational change is analogous – for our employees and us to grow, change and evolve, they and we will need to be at times uncomfortable, anxious, depressed and hopeless.
If we control and contain this process, then people’s discomfort, anxiety and pain will operate somewhere between acutely boiling to a low simmer, not staying long at any one setting.
If we unleash the process, they are boiling non-stop.
One Person at a Time
I do not believe there is a single development and growth recipe for everybody. Some can be pushed hard and seemingly be ready for more, and some the slightest nudge can almost be too much.
There is no substitute (that I have found) that will make the task any easier than consciously sitting down and thinking – hard, and often - about each individual you are leading, where they need to develop and grow, and how might be the best way to get them there…and then talking with them about it in an open and honest way.
Is it Worth It?
The consequences to the alternative - playing it safe, staying in the zone of comfort - are that our employees and we will not evolve with our times and organizations in a meaningful way, and we will contribute less and less value and move to the sidelines of the playing field. We do not want to place ourselves in a position where we are encouraging and producing an excellent buggy-whip function.
Is that painful enough to do something about?

PS – Congratulations to Jyll who was able to tolerate her experience and handle it in a manner such that she was able to move on to another week of the show, cooking skills enhanced and everything!
PPS – I do not believe this is the only method of change. Is it possible to change without the negative feelings and all that? Yes. Is it always possible? No. The perspective offered here in this particular blog should be considered as “just one turn of the kaleidoscope” and not an absolute, 100% pure belief on the part of myself.
I would love to hear your thoughts about this view of the role of pain in change or your stories on this topic if you have them.
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Thursday, July 21, 2011

A Willingness to Stand Out

I was reminded of the need to be different today when I ran across a blog identifying factors that go into determining whether an employee is a superstar.
The need to be different in order to be the best was mentioned by me in a prior post.
Let’s contrast this with the stereotypical view of a finance and treasury person: boring, analytical, and conservative. The stereotype makes a lot of sense; no business owner wants someone who handles every dollar that goes in and out of the company to be some rebellious radical who will likely bring the whole enterprise down due to their wild nature!
Let’s contrast this with the Vision we laid out earlier: “to inspire confidence…” Miscreants and misfits do not inspire a lot of confidence in most folks.
Being similar and not too different is what Cialdini would call “social proof”. People who are like us we trust. People who follow the crowd are not dangerous, because everybody else is doing the same thing, so it must be the correct thing to do. The term conservative in some contexts means “not too different than anybody else”.
The riddle then of a treasury and finance group who aspires to be top-tier is: how do we act in ways that are different and better so that we are perceived as being different while simultaneously being perceived as doing what everyone else is or not “going off the reservation”?

This has the feeling of one of those Zen type situations – “what is the sound of one hand clapping?” – we must comprehend the incomprehensible.
Be different but don’t be different.
Don’t be different but be different.
Stay tuned...

I would love to hear your thoughts about this view of the willingness to be different or your stories on this topic if you have them.
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Wednesday, July 20, 2011

Will the Real Capital Asset Pricing Model Please Stand Up? – Part One

Part of the Treasury and Finance role is to help our companies come up with its cost of capital, which is a technical term for “how much do you want to make on your investments?” This of course needs have major caveat added: “within reason”.
I would love to make 100% on my investments, but that is not a very likely outcome for some investments, and merely impossible for others. So while I might like to make that much, it is not a realistic number to target.
The Capital Asset Pricing Model (CAPM) is one of the classic methods to determine cost of capital, and it enjoys wide-spread academic and corporate application. There are those who say it is wrong and not applicable, and they are probably right, but we use the tools we have, and this is one of the better ones.
The first step is to determine your cost of equity through the following equation:
                       re = Be x rp + rf
           re  = the cost of equity capital, what we are solving for,
           Be = Beta of the equity, which is how much equity risk is shared by the market, or how much
                   risk is caused by the market,
           rp = the risk premium investors expect to receive over the risk free rate to take on equity
                  market risk,
           rf = the risk free rate, what you can earn in the market if you invest in something 100% safe.
There is a whole host of possibilities for calculating beta, which is the amount of risk equity shares with the market. First question is: what is the market? From the purely theoretical, the market is supposed to contain the entire universe of potential investment alternatives.
However, there are a lot of categories of investment that are not readily measurable in terms of periodic returns: private equity, venture capital, a lot of real estate, some bonds, commodities, etc. Usually a US based stock index considered broad enough to constitute “the market” is used as a proxy for this total universe of investment alternatives, but even there a choice has to be made.
For the sake of simplicity, let’s say there are three to choose from, some version of the S&P, the NYSE, or the Russell. This is the first choice involved.
The second choice has to do with the calculation method. Beta is measured by using linear regression (you can get fancier here if you want, but we won’t in this blog) of the equity’s returns vs. the market. Which return do we use? Daily, weekly, or monthly? And over what time period do we perform this regression? One year, Two years, Five years?
We have so far covered one factor in this equation, and we already have 27 potential combinations (three indices  times three return periods times three time horizons), assuming that we restrict ourselves to the choices mentioned (of course, in real life we do not have to do that so there are even more than 27  combinations, but this is a blog and we need to end this in a reasonable amount of time).
The second factor is the risk premium, the amount investors expect to receive from an equity investment vs. a risk-free one. The key word here is “expect”. This is really not measurable. Even if you surveyed investors about this you probably wouldn’t get a true answer – what we actually expect vs. what we say we want will vary. Because it involves expectation, there is also a probability distribution involved – if we get $1 for heads and nothing for tails, we “expect” $0.50, but behavioral finance tells us that we humans have flawed perceptions of gain vs. loss. In a situation such as this one, where equity is not as simple as a coin flip, where all outcomes are not known vs. known, are we confident that investor expectations attribute the correct probability of a 75% market decline, or a 75% market increase?
One approach to solving this puzzle is to assume that what investor’s have gotten in the past is what they will expect in the future. However, we have already discussed how outcomes are not necessarily a good determinant of the decision we face.
Another approach is to use something that exists as a proxy. This “something” can be lots of different things, investment analyst’s growth forecasts, cubic spline analysis of yield curve steepness, volatility-smile analysis of option prices.
For the sake of simplicity in our example, we will assume the two extremes – historical experience vs. market proxy. So our 27 alternatives now grows to 54.
The final term in the above – risk-free rate – is also not entirely free from debate. What investment is truly risk-free? None. The closest people agree on is US Treasuries (though we will see if that is still the case come August 2nd or thereabouts!). Even if we agree on US Treasuries, should we look at short-term (90 days, 1 year) or long-term (10-year +) as the appropriate measure. There are arguments both ways.
Again, simplifying matters to a choice of the two extremes (short-term vs. long-term) for the risk-free rate, our 54 scenarios has now grown to 108.
Unfortunately, we are not done yet. Look for a future blog to cover where we go from here.
I would love to hear your thoughts about this view of cost of capital or your stories on this topic if you have them.
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Tuesday, July 19, 2011

Metric Mania

Back in the early 2000’s, we looked at tax-exempt options for our corporate debt. If we wanted short-term rates, we could issue our bonds in “variable rate demand mode” (or VRDN’s) or in “auction rate mode” (ARS).
At the time there was a slight difference in rates; the auction-rate securities were a little bit more than the VRDN’s. “Why is that?” I asked my friendly banking institution. “Well, there is the risk of a failed auction with the ARS’s, but that has not happened in the past decade”. For more on evaluating decisions based on outcomes, refer to the earlier blog Moccasins.
Now, it is a main tenet in Finance 101 (no matter where you went to school) that we do not get return without taking risk. So investors were taking the risk, in exchange for a higher return, of an auction failing and being stuck with the securities. But hey, that hasn’t really ever happened in recent memory, so how much of a risk can it be?
Fueling this thinking, in a lot of the mid-decade Treasury literature, the industry talked about measuring performance with one of the primary metrics of efficiency and effectiveness touted as how much we were earning on our idle cash balances.  Many “portals” sprung up where we could take our pick of hundred of money market funds, generally sorted by yield. So most treasury managers, responding to the incentives and “what gets measured gets done”, would duly pick the highest yielding money-market funds or securities in order to look better on their metrics…and feel good about it.
Hmmm…remember Finance 101? No return without greater risk.
Come 2008-2009, these investors re-learned the lesson the hard way…the money-market funds with the better returns, or the direct investments they made,  involved auction rate securities that have been failing ever since, and they still haven’t seen their money.
I know that people hold different opinions about the financial crisis in 2008 – greedy banks, loose regulation, etc. – but I have to say that people thinking they were getting something for nothing was a contributor. What’s that saying – “if it seems too good to be true, it probably is”? Where was that thought as they went through the portal screens with the highest yielding money-market funds?
Part of the reason it was nowhere to be found was the metrics they were subjected to. Nobody wants to be below benchmark!
Every metric, because it incents certain behavior, encourages us to disregard other behaviors. In the case of the financial crisis, it rewarded return while it ignored the risk involved to get it. Bad decision? Maybe, maybe not (see the blog about Moccasins). But don’t be surprised something bad happened, because the risk was plain to see all along in the rates that people were getting. We don’t always get the empty chamber in Russian roulette.
In other cases, by incenting individual performance we encourage others to ignore team performance. In the systems where ratings are forced to a curve or there are targets for each category, we are going to encourage some Machivellian behavior. What better way to ensure I get that “Exceeds Expectations” than to make sure everyone else fails and ends up in “Needs Improvement”?
Can this be managed? Maybe…but maybe not. One of my bosses bosses talked about how our company did not have to worry about undercurrents of dissatisfaction or disagreement because of our strong “open door” policy. I ask you – how many open doors have you passed by where you thought “if I go in and tell them x it will hurt my career or their perception of me”…and kept on walking?
Personal opinion: anyone relying on an “open door” policy to ascertain what is really going on and reassure themselves that all is well with the world is fooling themselves unless backed up by at least 25% of their time being spent re-enforcing it.
So, beware of establishing metrics – we will get what we measure, and we won’t get what we don’t, even if we don’t know it. Don’t let the carrots you bestow let your employees take you down a rabbit hole where you do not want to be.
I would love to hear your thoughts about this view of metrics or your stories on this topic if you have them.
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Monday, July 18, 2011

Why Does Evaluating Decisions Require Moccasins?

There are a lot of books about leadership and making business decisions. I have some of them, since once I buy a book I never part with it, even if I am not particularly fond of it. My library is bigger than average as a result, much to my wife’s chagrin. She’d like to use some of that shelf space for something else. Maybe someday I will let go.
Often books that purport to carry wisdom about great-decision making derive this knowledge by evaluating a sample of successful decisions and then identifying what they had in common. I am not sure this is a valid method. If you want to question a lot of business conclusions out there I would recommend “The Halo Effect” by Phil Rosenzweig. My wife was happy I read this book because I got it from the library and therefore had to give it back.
The halo effect stems from a two-fold process: 1) much of the business studies that are done use interview and survey methodologies and 2) performance is the primary driver of how people respond to and interpret information. Therefore, since companies had good performance, they are attributed by people with good business qualities, like “strategically focused”, “operational discipline”, “strong collaborative culture” and the like.
Let me repeat – performance is the primary driver of how people respond to and interpret information. If we have outstanding performance, people respond by attributing positive adjectives, characteristics and traits to us – we are strategically focused, customer-centric, and exhibit principled leadership, etc. If our performance is lousy, the opposite occurs – we are floundering, inwardly-focused, and have a poor governance structure.
Further adding to the problem is that we get to judge decisions already knowing the outcome. If the outcome is good, then we conclude someone made the right call.
For an Analytic (read “lots of math and equations”) Finance major from the University of Chicago (read “a place that really gets into math”), there is nothing more fun at work than to run a few hundred thousand Monte-Carlo simulations in order to assess your risk exposure to commodity or foreign exchange rates, pension investment performance, asset investment performance, growth outcomes, potential budget variability, operational strategy, corporate strategy, or hundreds of other potentialities. After you do this for awhile, you realize that there is pretty much uncertainty everywhere and certainty nowhere (even though the proverbial death and taxes are certain, the timing is not!).
With this fine tuned sense of risk and uncertainty, an appreciation of the uncertainty of the decision-making environment is obtained. Just this morning, Border’s Books is on the verge of being ordered by the bankruptcy court to liquidate, and they are scrambling to find a buyer. So, looking at the outcome, and thereby attributing qualities, some guru can come along and begin touting Barnes & Noble’s superior strategic decision to expand their scope through things like the Nook reader and their online capabilities as being future looking, bold and courageous,  while Border’s kept their head in sand and committed to the antiquated bricks and mortar book retailing.
With hindsight, this seems like a no-brainer, but when these companies were actually making these decisions, up to a decade ago, it was a lot less clear where things were headed. Look at other industries – what happened to Webvan compared to Safeway or Krogers? Bricks and mortar retailing survived in that industry while the web approach did not pan out. So can we say that there was no probability that would happen in books as well? If that happened, then Border’s would have had the great strategy developed by prescient leaders and been in the researcher’s sample.
Business decisions are too complex to be able to use outcome alone to assess a bright line “correct” or “incorrect” assessment, or “good” or “bad” qualities. It just ain’t that easy. And outcomes can be deceiving.
How about “We studied football teams over the last decade to evaluate the decision-making process of the players making the coin-toss call. We have found several traits associated with the most successful of these coin-toss callers – they were leaders on their team (isn’t that why they were one of the three to go out to midfield at the start of the game?), yet they were humble about it - all the successful coin-flip callers dressed just like their teammates.”
Nassim Taleb in his book “Fooled By Randomness” (another library book - my continuing part in keeping family life harmonious) talks about problems with judging decisions based on actual outcomes; we have to have an ability to conceive of the world that has not happened as well as the one that has. His dramatic example (paraphrased and no guarantee that I haven’t butchered it): A game of Russian roulette pays the player $1 million if they play the game and are able to walk away afterward. Someone plays this game and receives $1 million. If we are evaluating outcomes, we would call this a great decision! However, I would wager not many among us would ever make the same decision as that person, because we appreciate the uncertainty and the risk that is inherent in the decision. Based on outcome evaluation alone this would have been a bad decision, though most of us would be ok with it.
Sometimes, great decisions were made even though a poor outcome resulted. Not many people study those.
Since outcome alone does not tell the story, and each decision has its own peculiar mix of probabilities , uncertainties, and magnitudes of danger, I think an adaptation of a phrase learned in childhood can sum it up: “Don’t judge a decision or its maker before you have walked a mile in their moccasins”.
I would love to hear your thoughts about this view of decision making or your stories on this topic if you have them.

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Sunday, July 17, 2011

“Best” Practice

One of the most inaccurate phrases we often run across is “best practice”. Let’s be clear, I am not opposed to best practices - I want to employ them.
However, most often it appears in comments or questions such as “Let’s hire a consultant so we can incorporate best practices” or “what is the best practice in our industry?”
In these examples, my contention would be that “best practice” is really a euphemism for “common practice” or “what a lot of other folks are doing”. For example, one might hear that “best practice for grocery stores is to scan items after the customer has finished shopping and then collect payment”.
It seems like the fundamental concern in the context of the statements above are “let’s do what most others do so we don’t stick out like a sore thumb”.
Sometimes, the phrase can be used to beguile or mislead. I remember being in a conference room where a lean / six-sigma event had been recently held. Still hanging on the walls were the large sheets of paper with terms like ‘current state’, ‘future state’, etc. On one of those sheets of paper, …under a forecasting heading…for the future state…was the statement “best practice in the industry is multiple regression analysis”.
Now, I do not pretend to be an expert in whatever area was holding this event, but as an avid student of statistics I do know that there are a lot of different statistical tools you can use to analyze past data and forecast future data. Multiple regression is one out of thousands of possibilities, just as a hammer is one out of thousands of possible tools. However, a hammer is only the ‘best practice’ tool when you need to pound in a nail.
So, I imagined someone getting that statement onto that piece of paper, and thinking it must have gotten there through the following train of thought: “if I use the term best practice it will convey some authority and imply that lots of others are doing this and therefore we need to in order to keep up, and if nobody in this room knows better it will shield my little part of the process from needing to change, since this is what we are doing now.”
Best practice can be a useful term in organizational warfare.
As most athletes will tell you, only one can be the best. There is only one World Cup, Stanley Cup, or Olympic Gold champion. Therefore, to truly have a best practice is to have something that nobody else does. This means being willing to do things differently than others. It means having the courage to say – “we are different”.
This implies that we may have a competitive advantage in something, assuming it is related to our business (i.e. if a tech firm has a best practice in janitorial services it may not help much). It is going to arise from the knowledge, talent and experience of your team, not from a consultant or others in the industry.
It can be difficult to develop and maintain best practices, since it does involve a determination to go against the crowd. We need to be a contrarian if we are going to excel.
So applying this philosophy to my Treasury and Finance area, we start with industry standards and norms with respect to our operations (most of which are the “best practices” that are touted.). The work does not stop there. It is a foundation, but in order to truly be best at something we then need to decide specifically what that something is, given our group and the organization it works within, and then it is up to us to figure out exactly how to do that.
I would love to hear your thoughts about this view of best practices or your stories on this topic if you have them.
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Saturday, July 16, 2011

The Treasury Vision

Ever since first becoming part of the executive ranks, one of the questions I have continuously pondered is “what is the vision / mission of Treasury?” For me, that is a question that has an amazing variety of answers, or variations on a theme, and is worth re-visiting from time to time.
When I first moved into this role, my cash management staff suggested that it was “protecting company cash assets”. That certainly seems plausible, and indisputably it is a worthy objective, but I was never convinced that it was the overriding mission. Shouldn’t it be a little more lofty? A little more awe-inspiring?
Later, one of my former bosses suggested we conceptualize the mission as “being in charge of the balance sheet”. This view is somewhat more appealing as it covers, to a large extent, activities that we perform:
·         Short term assets and liabilities fall under the cash management and cash forecasting headings, as well as capturing the very trendy concept of managing working capital (maybe this isn’t so trendy anymore, it has been a topic for at least 6 years now - but it still generates its share of magazine article, free whitepaper offers, and industry award contestants).
·         Long term liabilities and equity are an important treasury focus. Debt issuance and structuring is almost always under its purview, and equity is probably a toss-up - 50/50 - whether it is a Treasury or a separate CFO function.
·         Long term assets is where the company’s investments lie, and in practice this is the most shared category. The company operations (or business units in larger organizations) certainly is the operator of these, and in general would like to add more. The performance of the assets fall under the finance field (CFROI, EVA, shareholder value, corporate performance, ongoing value, etc.) and play into the finance area’s valuation capabilities more than any other function in the company. In addition, if your debt is rated, then the performance of the assets has as much to do with your company’s credit rating as its capital structure.
Logical? Yes. Mystical and transcendent? No.
Perhaps looking externally would add something to the mix. Finance is a profession, and there is a certain camaraderie that exists amongst us across all fields and industries. Sometimes you can sense more of a common purpose from your professional peers than you can from those within your company.
Viewed from this angle the vision needs to include professional as well as company acceptance. Are you actually involved with working capital since it has been such a hot topic for what seems like the last decade, or are you not? Have you achieved straight-through-processing for a significant portion of your activities or have you not? While the company may not care, or have its reasons for not pursuing - these objectives, the answers to these questions - still determine whether your head is held high or your tail is between your legs when you show up at the Association of Finance Professionals annual conference, or the next local chapter meeting of Finance Executives International, or at your quarterly meeting with your savvy commercial banker.
The final thread I’d like to pull into this is as follows: one of the companies I worked with had an entire area called “Decision Support”. However, what this area’s primary function entailed was comparing budget data to actual results. You can certainly find links all over the web that deal with the fact that focusing on past performance, i.e. stale data, is like driving in reverse using a rear-view mirror!
Finance professionals are trained from school onward to produce pro-forma (that is, future) models. This is an important component of a comprehensive decision support function, which attempts to answer the question of how do we deal with what is going on now and will likely occur tomorrow versus what happened last month and how did that compare to we thought was going to happen a year ago when we set the budget?
Decision support connotes just that – a support function. Finance’s role is not necessarily to decide, it is to provide information and inputs that are important factors in the decision from its professional perspective.
At one time I went through the “develop the vision and mission exercise” with my staff, and they managed to incorporate most of what has been discussed in this blog into two simple sentences:
·         To inspire in others confidence in our abilities, knowledge, and expertise
·         To serve as an approachable and dependable partner
The first bullet addresses both the internal organization and the external professional aspects while simultaneously incorporating the ongoing, functional aspects of Treasury work, while the second item addresses the decision support and advisory functions.
I would love to hear your thoughts about this take on the finance function’s vision and mission if you have them.
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