No Thanks, I have enough “New”
It seems sad when 75 year old businesses go bust. They had something that worked for several generations of managers, employees and investors. And now they are gone. How could that be?
There are two ways that old businesses can come to their demise. They can do it because they stick to what they know and their product or service (usually) slowly goes out of fashion. Usually slowly, because all but the most ossified large successful companies can adapt enough to keep going for quite some time, even when faced by competition with a better business model/product or service. Think of the US auto industry slowly declining for 40 years.
The second way is a quick demise. This usually happens after the old company chooses to completely embrace something completely new. If their historic business is in decline, many large old firms are on the look out for that new transformational thing. The mistake that they sometimes make is to be in much too much of a hurry. They want to apply their size advantage to the new thing and start getting economies of scale in addition to early adopter advantages.
The failure rate of new business is very, very high. A big business that jumps to putting a large amount of its resources into the new business will be transforming a solid longstanding business effectively into a start-up. But rarely do the big businesses in restart mode deliver anything like start-up returns. So investors bare the risks of of the start-up with the returns only slightly higher than long term averages.
This is a clear example of when the CEO needs to be the risk manager. The established firm needs to have a limit for “New” businesses. The plan for the new business should reflect an orderly transition between the franchise business and what MAY become the new franchise. This requires the CEO to have a time frame in mind that is appropriate for a business that may have existed before he/she was born and that, if the risks are managed well, should exist long after they are gone.
There are good underlying reasons why the “New” needs to be limited for a company with long term survival plans. “New” involves several risks that a well established firm may have mastered a generation ago and have relegated to the corporate unconscious.
The first is execution risk. The established firm will doubtless be excellent at execution of its franchise business. But the “New” will doubtless require different execution. An example of this from the insurance industry, when US Life Insurers started into the equity linked products, man of them experienced severe execution problems. Their traditional products involved collecting cash and putting it into their general fund. They only provided annual information to their customers if any. Their administrative systems and procedures were set up within an environment that was not particularly time sensitive. The money was in the right place, their accounting could catch up “whenever”. With the new equity linked products, exacting execution was important. Money was not left in the general fund of the insurer but needed to be transferred to the investment manager within three days of receipt. So insurers adapted to this new world by getting to the accounting and cash transfers “whenever” but crediting the customer with the performance of their chosen equity fund within the legal 3 day limit. This worked out fine with small timing delays creating some small gains and some small losses for the insurers. But the extended bull market of the late 1990’s made for a repeated loss because the delay of processing and cash transfer meant that the insurer was commonly backdating to a lower purchase price for the shares than what they paid. Some large old insurers who had jumped into this new world with both feet were losing millions to this simple execution risk. In addition, for those who were slow to fix things, they got hit on the way down as well. When the Internet bubble popped, there were many, many calls for customer funds to be taken out of the equity funds. Slow processing meant that they paid out at a higher rate than what they received from their delayed transactions with the investment funds.
The insurers had a well established set of operational procedures that actually put them at a disadvantage compared to start-ups in the same business.
The second is the “unknown” risk. A firm that has been operating for many years is often very familiar with the risks of its franchise business. In fact, their approach to risk management for that business may well be so ingrained, that it is no longer considered a high priority. It just happens. And the risk management systems that have been in place may work well with little active top management attention. These organizations are usually not very well positioned to be able to notice and prepare for the new unknown risks that the new business will have.
The third is the “Unknowable”. For a new activity, product or business, you just cannot tell what the periodicity of loss events or the severity of those events. That was one of the mistakes in the sub prime market The mortgage market has about a 15 year periodicity. Since a large percentage of people operating in the sub prime space were not in that market the last time there was a downturn, they had no personal experience with the normal cycle of losses in the mortgage market. Then there was the unknowable impact of the new mortgage products and the drastic expansion into sub prime. It was just unknowable what would be the periodicity and severity of losses in the “new” mortgage market.
So the point is that these things that are observed about the prior “new” things can be learned and extrapolated to future “new” things.
But the solution is not to never do anything “new”, it is to keep the “new” reasonable in proportion to the rest of the organization, to put limits on “new” just like there are limits on any other major aspect of risk.