Sunday, August 9, 2015

The Run Rate Conundrum - 'Or the beginning of The Great Depression'

Being a citizen of a country obsessed with cricket, the only run rate that I ever knew was the runs that a batsman makes per over and that i thought defined the run rate - till recently when I realised that even businesses (read new e commerce world) are getting discounted and valued on their run rates. It must be very interesting for those old brick and mortar industrial houses such as the Tatas in India and Walmart
in the US that flipkart and facebook are valued more than these over a century old business behemoths. What took billions of man hours to build has now been surpassed in value by young turks who took their ideas to fruition in a matter of a few years.

Hats off to these young companies for what they have created in such a short period of time.

But there is another side to this story of how the calculations based on ‘run rate’ have brought the world to the precipice of destruction and collapse.

And 2 sectors, one with which I am closely involved - hospitality, and one which I am closely watching lately, are perfect examples of how Bill Gates has done an immense disservice to the human mankind by inventing that little devil (thats what we will call it from now on), the ‘ + ‘ sign on the excel cell where you plot the run rate for the shortest period of time between the two cells, drag the cells to a time period of convenience, where the potential extrapolation of that run rate makes Walmart’s annual sale look pale in comparison to the run rate and get millions of dollars of funding for the idea that is yet to hatch.

In late 90’s it was as easy as registering a domain and coming up with an idea. And a couple of million dollars could be raised easily and the founders would start surviving on Dom Perignon in the hope of a Nasdaq listing just a few months from the conception of that idea.

What happened in early 2000 and the dot com crash merits no explanation or waste of time of the readers of this piece.

The consultants and investment bankers who had deployed trillions of dollars of funds (..of HNI’s , pension funds, 401K in the US etc) in these dot.com companies and earned and digested their deployment bonuses (because no one ever made any profit) suddenly became lecturers and advisors on topics such as how the chaos of 2000 could be avoided.

Relying on the perfectness of the short human memory, about 7-8 years later these investment bankers got a brilliant idea and a new scam of CDO’s emerged on the premise that house prices will go up infinitely and incessantly across the globe and a simple burger flipper ended up owning 3 houses because of cheap credit and loose control on credit checks and what followed consumed the likes of Lehman and over a hundred banks across US and Europe. But the investment bankers had already encashed their ‘deployment bonuses’ and share of the brokerage incomes by doing a circular trading of these Collateral Debt Obligations and who was left behind holding a carrot? The commoner who was enticed to buy his second or the third home and the pension funds and the hard earned money of HNI’s (that was siphoned off by the likes of Madoff and hundreds of fund managers of these Ponzi schemes).

And - Because many of these institutions were too big to fail, it was all eventually funded by governments thereby expanding the balance sheet of the respective central banks and during this time when people were losing their homes and losing jobs, interestingly the global sale of ultra luxury goods was at an all time high and there are no prizes for guessing who was stoking this insatiable demand of these luxury goods (Louis Vuitton, Hermes, Dom Perignon, Rolex and Cartiers of the world)

Almost 7 years later (I am convinced that collective short term human memory begins to fade after 5 yrs and is completely wiped out in 7) we are seeing a frenzy like never before where people say that ‘this time it’s different’ because the businesses have actual run rates and e commerce activity has actually taken off and the approx. 16-17 trillion dollars that’s conveniently printed by the US Fed needs deployment and therefore the same cycle all over again.

While we are yet to see many/any of these multi billion dollar companies churn any positive cash flow, the distribution of deployment bonuses is at an all-time high.

I was amazed to hear that a Japanese company paid out close to 135 million dollars in a year to one of its rockstar executive for deploying approx a billion dollars in the same time period. That’s 13.5% in deployment fees/bonus. (this example is over-simplistic but is being mentioned just to make a point)

Small companies selling salads, idlis, sandwiches, rotis are getting obscene amounts of funding because they are allegedly having an exemplary run rate and conveniently someone is seeing immense potential of growth because of a 15 day run rate which if you extrapolate using the devil ‘+’ on excel makes this company/portal worth a couple of billion dollars.

Why?? Because they sold 2 pieces of their product on the day of the launch and ever since they have been registering a 100% growth in the last 30 days. And none of the investment bankers want to miss this opportunity to own these growth stories. Is this sustainable? I don’t think so. And I am quite sure about it. On the 31st day of course the run rate isn’t the same but the funds have been deployed for accelerated value creation.

During the times of irrational exuberance everyone only talks of growth potential and entrepreneurs only look at their product and imagine that every single person on the planet is their potential customer and an infinite demand is assumed and therefore exuberance. No one realises that in the hyper competitive and efficient market with negligible barriers to entry any great idea is great only as long as it’s in the mind.

Hotels are an interesting case in point. The consultants make the owners spend humongous sums of money on the basis of the ‘little devil’ and suddenly large investments on land and building seem recoverable but oops only a handful of hotels in this country have been able to recover their investments and majority of the hotels chains are reeling under severe debt and a popular chain ‘Leela’ is almost bankrupt and many other hotels will take over a hundred years to recover investments going by the actual run-rate.

But consultants have taken their fees and are looking for new clients and there is no answerability.

This will continue for ever unless:

  • Every fund manager is made a part owner of the businesses where he is recommending investment.
  • 'change the consultancy model from all authority and no responsibility to all authority and all responsibility'
  • 80% and not 20% of the compensation of these deployment managers comes out of the positive cash flows of the businesses.
  • Consultants are made to move from the model of ‘all authority and no accountability’ to ‘all authority and all accountability’.
  • Consultants, investment bankers, and deployment managers aren’t allowed to ‘hit and run’ at the cost of the investor.

Till that historic instance in time some innocent child again shouts and says that the ‘emperor is naked’ this bubble will keep getting inflated and will consume the world all over again and if indicators are anything to go by and if the sum total of all present economic, political, financial, emotional and judgemental decisions could be plotted on some model to arrive at a result……

What lies ahead will make the depression of 1929 look like a walk in the park.


Manu also writes in Huffington Post

8 comments:

  1. Quite an interesting perspective especially with the flipping of 80:20 to 20:80 bringing the full accountabiity from absentia into the forefront.

    This passing the parcel in the circle has been going on for a while and the final victim target is the public (masses). Lets not forget that most of the IPO's over a period of time (once the excel misses the reality) have ended up eroding the wealth of the final investors with a handful few making a killing. What 's described above is akin to this old age scenario.

    Pass the ball (one VC exits another enters) , sometimes bailing each other out on reciprocal basis driving valuations over the roof till the business hits the public money. Few falter and stumble and this is taken as granted failure rate in the overall grand scheme of things.

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  3. Very interesting read Many! Insightful for those of us in actual 'brick and mortar' lines of work. Nice finish with the 'Emperor's new clothes' reference. You have enlighten us more the next time we meet! Bhavana

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  4. Superb blog as always...always a pleasure to read blogs by Manu my brother...awesome

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  5. I credit the Investment bankers or should I say the memory erasers who can bounce back every 5 years. Last time it was mark mobius who caused the dot com bust this time it is going to be Manu. Although I see 1 thing in common in both of them. Very well written Manu

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  6. E-commerce companies are being insanely valued by their number of transactions and their speed of customer acquisition. Totally agree with the metaphor of the "+" sign to the "devil"...LoL.

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  7. He writes the way he speaks ! with conviction ! from the heart !
    Yes , accountability the need of the hour !

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Your comment isimmensely appreciated and will be published for a discussion - soonest. Thanks. manu