Playing To Win
The Wrong Kind of Capital
Five years ago, I proposed an article to Harvard Business Review that the editorial staff didn’t think was on an important enough issue and turned it down — even though I have a track record of publishing more HBR articles in the 21st century than any other author. Much as I may wish, I am not right every time but on this one I was. This is a big and growing problem, and it isn’t going away anytime soon. It reared its ugly head at a client last week — a Fortune 250 company — so I decided to write, for the Playing to Win/Practitioner Insights (PTW/PI) series, the piece I wanted to write five years ago: The Wrong Kind of Capital: Breakthrough Innovation Needs ‘West Coast Capital.’
Shareholding of the Modern Company
Modern large-scale companies — think S&P 500 companies — are dominantly financed by what I will call east coast capital. The biggest investors by a wide margin are the money managers (Vanguard, BlackRock, State Street, Fidelity, etc.) and the top ten are all headquartered on the east coast (five in NYC, four in Boston, and one in suburban Philadelphia). In size, they dwarf the next biggest class of investors, the pension funds. The biggest pension fund (Federal Retirement Thrift) would rank 16th among money managers and is less than one-seventh the size of the biggest money manager. Interestingly, despite the fact they represent pensioners across the country, half of the top ten are east coast including three in NYC. Next are Private Equity (PE) investors, which are growing and the 800-pound gorilla of that field, Blackstone, at twice the size of the number two player, would rank 10th if it was a money manager. And yup, five of the top seven are based in NYC.
Hedge funds, despite the ability of the activist hedge funds — the hyenas of finance — to wreak havoc, are tiny in relative terms. The biggest hedge fund, Bridgewater, is one fortieth the size of the biggest money manager and one sixth the size of the biggest pension fund. And I don’t have to say it, nine of the top ten are based in the NYC area (with one in Miami).
That is east coast capital — money managers, pension funds, PE funds, and hedge funds based largely in NYC and Boston with small presences in Philadelphia, Miami, and Washington DC. Are they investors in the true sense of the word — i.e. do they put their own money at risk in hope of an attractive return? For the vast majority of the dollars of east coast capital, the answer is a definitive no! For 100% of money manager and pension fund dollars and most of PE and hedge fund dollars, the entity acts as a fiduciary which invests other people’s money. The exception is the general partners of PE and hedge funds investing alongside their limited partners, but in the totality of the funds of east coast capital, that is a rounding error.
Thus, for the two biggest suppliers of east coast capital, money managers and pension funds, there is little upside to stellar investment performance and big downside to poor performance. Those making the investment decisions don’t share in the upside, but they risk being fired if their investments experience a meaningful downside. For PE and hedge fund capital, the formula is to encourage or force (by pressure or buying control) the investee company to do what it is currently doing, but more efficiently and effectively to generate higher returns from existing activities.
Thus, east coast capital loves exploitation and fears exploration. As I have written before in this series, exploitation means doing more intensively, something at which you are already expert. Exploration means working on learning to do something at which you are not already expert. The overwhelming message from east coast capital to large companies is clear: please stably increase earnings, faster than inflation or GDP growth or your industry’s growth (depending on the investor in question), but don’t do anything risky — i.e. focus on exploitation. And if you don’t listen, the PE/hedge fund folks will take you over, slash any and all innovation activity, and hold your nose firmly to the exploitation grindstone.
But growing faster than inflation/GDP/the industry while only engaging in riskless activities is a pipe dream. The delusion shows up in revenue and earnings guidance. As my friend Craig Wynett from P&G Innovation once pointed out to me, if you look at the guidance of most big companies, it features earnings growing considerably faster than revenues — e.g., our top line will grow 3–5% and our bottom line 8–10% — and if you extrapolate that out, in due course the implied bottom line is greater than 100% of implied top line — a difficult trick.
It is no surprise that my late friend Clay Christensen wrote about the declining investment in transformative innovation, the funding of which has been rerouted to efficiency and sustaining innovation. East coast capital doesn’t like investment in innovation/exploration. In part, it is because the biggest players in east coast capital own the index (literally in the case of the biggest, Vanguard). It is likely that if successful, one company’s transformative innovation will hurt the performance of a competitor that is as big a component of east coast capital’s portfolio as the successful innovator. So, company innovation is at best a zero-sum-game for east coast capital.
The consequence is that large public companies have transformative innovation opportunities that they can’t finance because their east cost capital won’t stomach the risk. So, companies shrink or delay or shelve the innovation opportunities. That is fact not speculation — as famously revealed in a terrific article by Graham, Harvey and Rajgopal in the prestigious Journal of Accounting and Economics (2005), which revealed that 40% of public company CFOs surveyed openly admitted to doing just that — i.e. delaying or shelving innovation spending to meeting their guidance. And my experience tells me that in the two decades since that research, the problem has gotten way, way worse.
Another Kind of Capital
There is, of course, another kind of capital that funds innovation in companies, and that is venture capital (VC). I call it west coast capital because eight of the top ten firms are based on the west coast — in fact the biggest are all in a tiny patch of land in and around Palo Alto/Menlo Park.
The pool of west coast capital is much, much smaller than east coast capital. When VC became a consequential thing in the late 1960s/early 1970s, $25 million was a sizable VC fund. But they have gotten a lot bigger and are continuing to get ever bigger still. A number of VCs are now in the $25–50 billion size. And tech-oriented west coast PE firms (like TPG) are even bigger.
Their risk philosophy is completely different. They focus primarily on start-ups/early-stage and want to find the next Apple, eBay, or Uber. They expect a goodly proportion of their investments to fail and expire worthless. But they are looking for breakthrough, discontinuous growth and the small fraction of investments that achieve it pay for all the failures — and much more. In short, they seek out and fund exploration.
The Unfolding Situation & My Prediction
As the VC capital pools mushroom in size, there is a mismatch taking shape between the start-up funding opportunities and the magnitude of capital that the VCs need to deploy. And they need to deploy it, or else the limited partners will crucify them because VCs can’t generate returns on undeployed capital contributions. And some successful start-ups don’t even need the capital. I was on the board of the Skoll Foundation for 14 years and remember Jeff Skoll, eBay’s first President and Skoll Foundation Chair, telling me that when he got the Benchmark check — the first $2 million of the eventual $6.7 million — he put it in his desk drawer. He didn’t need the capital. He just needed the Benchmark cachet. And for bestowing that cachet on eBay, Benchmark made a 750-times return.
I think that west coast capital is going to increasingly see that the biggest and best uses for its innovation capital are in innovations within S&P 500 firms. Because of their market positions and go-to-market capabilities, S&P 500 firms have some of the biggest opportunities to invest in innovation. West coast capital is going to figure out how to invest within S&P 500 companies in AI, gene editing, fintech, etc. They will invest in a specific project (think funding the creation of the Boeing 797) with a preset buyout by the host at a specific price when it achieves a prescribed set of benchmarks.
There is a clear arbitrage opportunity. There is a price that enables both west coast capital and east coast capital investors to earn returns that are attractive to each. West coast capital takes the innovation risk and earns (on average) a high return, while east coast capital earns a decent return without taking any innovation risk. The latter is like acquiring a successful company for a premium price — something that east coast capitalis almost always happily supports. The activities are lined up with the right capital — exploration for west coast capital and exploitation for east coast capital.
Remember that all good projects can be financed. Never accept that yours can’t be financed because you have exclusively east coast capital investors, which is almost certainly the situation you face if you are in a big company. The thing to remember is that if you don’t figure out how to get your good project financed, a west coast capital-financed venture will do what you already knew was a good idea and potentially destroy you — as fintech, medtech, edtech, etc. are doing. There are plenty of historical stories of how this happens — think Xerox or Kodak.
The insurgents often don’t have better ideas or capabilities. They just have capital that is suited for their innovation. Great strategy is problem-solving. Your problem is not that you don’t have a worthy innovation. Your problem is that you currently have the wrong kind of capital. Figure out how to fix that problem. Your future may well depend on it.