The Business Times, Friday, June 4, 2010                                                                                  ...
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Corporate strategies the art is in the execution

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Corporate strategies the art is in the execution

  1. 1. The Business Times, Friday, June 4, 2010 EDITORIAL & OPINION 19 Shutting eyes on Dirty White Swans If a value-based approach to risk management is adopted, Black Swan hedges won’t be too expensive to be practical By CLAUDIA ZEISBERGER and DAVID MUNRO C HILDREN have a won- derful ability to shut out the world around them. Just watch as they close their eyes, cover their ears and howl their endless chant, “I’m not listen- ing to you!” Who would have thought that adult bankers, regulators, politicians and investors would employ the same method to avoid hearing the obvious about financial markets and later claim the existence of Black Swans as their defence? Black Swans are infrequent events of extreme consequence that cannot be predicted in advance, but are easi- ly explained with hindsight. Ever since author Nassim Taleb in- troduced Black Swans into our lexi- con and after the devastating finan- cial events of 2007 and 2008 support- ed his thesis, corporate risk depart- ments, hedge funds and individuals have been searching far and wide in a Don Quixote-esque hunt for the elu- sive bird. But most Black Swans are just Dirty White Swans. They catch us by surprise, but shouldn’t. This is due to our human bias to dismiss obvious ev- idence, restrict historic observation to our personal set of life experiences and refrain from hedging an identi- fied risk believing that it probably won’t occur. No One Would Listen is the title of a book about the Madoff Ponzi scheme written by the persistent REUTERS whistle-blower Harry Markopolos. He Identifying the unpredictable: In today’s corporate environment, there is not much career upside in identifying and hedging a risk that does not materialise. Those efforts will, in hindsight, caught on to Madoff’s ways 10 years be seen as a drag on profits. Yet, unhedged risk that takes the industry down with it can easily be explained as a Black Swan, thereby minimising personal responsibility ago by recognising the near mathe- matical impossibility of generating ing of potential disaster were ig- (Reinhart and Rogoff’s detailed histo- LTCM’s 1998 problems may have agement is adopted. In May 2007, it easily be explained as a Black Swan, the return series he announced year nored. No one would listen. ry of financial folly in their recent come to a head with the Russian de- cost just 28 basis points per annum to thereby minimising personal respon- after year. He shouted at the US Aside from ignoring the obvious, book This Time Is Different goes into fault, but their leveraged fixed in- buy Lehman Credit protection via a sibility. Securities and Exchange Commission we ignore documented history. The greater detail) Russia also defaulted come relative value spreads were the five-year credit default swap (CDS). In It is also difficult to take a contrary and served them documented evi- Basle II market risk framework helps in 1839 and again in 1885. real ticking time bombs. Oddly October 2008, 17 months later, Leh- stance when executive management dence of the fraud, but they closed us in this respect by requiring value- But it’s not just Russia. Latin Amer- enough, LTCM alumnae drank the man CDS owners received 9,130 ba- claims a risk is unlikely and therefore their eyes and tightly cupped their ican nations clearly had trouble with Kool-Aid a second time when two sep- sis points, a 16,200 per cent gain. (Le- need not be hedged. An outsider, at-risk calculations to incorporate a hands over their ears and shouted: creditors in the early 1980s, and arate hedge funds run by three mem- hman creditors received a mere 8.7 with credibility, is often needed to call minimum one-year historical observa- “I’m not listening to you!” Spain defaulted seven times in the bers of the original team lost over 90 cents on the dollar). a spade a spade. tion period. For many risk managers, To the regulators plus individuals, 19th century alone. Reinhart and per cent of their assets under manage- The cost of insurance is cyclical. It Most of what we call Black Swans, the minimum becomes the maximum unpredictable events with massive pensions, endowments, charities, cor- Rogoff counted nine French defaults ment 10 years later. will certainly be expensive to buy and historical means last year. consequences, are in reality just Dirty porations and funds which lost from 1558 to 1826 and as John Maul- The same highly leveraged rela- property insurance when the forest US$65 billion, Madoff was a Black In INSEAD’s Risk Management White Swans; entirely plausible and din notes, “the history of Greek debt tive value fixed income trades that led fire is raging across the street, hurri- Swan. To those who listened and con- classes, students analyse a case study hedgeable events if you study history, is not a good one. They have been in to their demise in 1998 came back to cane insurance during Katrina or ducted basic due diligence, Madoff on Long-Term Capital Management perform basic due diligence, employ default for 105 years of the last 200”. haunt them in 2008. The 1998 Rus- S&P puts when your broker is making was just a Dirty White Swan. (LTCM), the infamous hedge fund that value-based hedging and listen to Greece’s default in 1826 shut it out sian default Black Swan was just a daily margin calls. Value-based risk Why are we sometimes blinded by failed spectacularly in 1998. Almost of the international capital markets Dirty White Swan for history stu- management encourages the pur- those highlighting dangers. the obvious? The answer: profits. The all cite the lack of a previous Russian for 53 consecutive years. It’s déjà vu dents. The 2008 Fixed Income Black chase of long-term insurance when it Claudia Zeisberger is affiliate sellers of credit protection were more default as a reason LTCM’s risk mod- all over again, as Yogi Berra said. Swan should have been no more than is needed the least and cost is mini- professor of decision sciences at profitable than the buyers, the buyers els failed to consider sovereign de- Does anyone in finance recognise a chickadee for LTCM alumnae. mal. INSEAD. She started and teaches of houses increased their net worth fault as a possible outcome. that history predates their personal Is the cost of preventing or In today’s corporate environment, the Risk Management elective. faster than the sellers and the bank- But Russia defaulted on its sover- experiences? Do firms need to add a risk-managing Black Swans so high there is not much career upside in David Munro is a veteran of the ers with the most leveraged balance eign debt following the 1918 revolu- chief historian position? Apparently, that it would be better to accept them identifying and hedging a risk that alternative investment industry, has sheets took home much larger bonus- tion when the Bolshevik government for some seasoned investment profes- as an unfortunate consequence of do- does not materialise. Those efforts been trading derivatives for over 20 es than their more conservative peers refused to pay Tsarists’ debt, and did sionals, even personal Black Swan ex- ing business? Are Black Swan hedges will, in hindsight, be seen as a drag years and lectures on risk – until all asset prices collapsed. not reach a final resolution with its periences are excluded from their just too expensive to be practical? Not on profits. Yet, unhedged risk that management, derivatives and When the profits rolled in, those warn- creditors until 1987 – 69 years later. risk management scenario analysis. if a value-based approach to risk man- takes the industry down with it can alternative investments LETTER TO THE EDITOR Corporate strategies – the Restating DPU figures art is in the execution after a rights issue By ROBIN SPECULAND continues to fail (which it did more often than crafting it and overseeing its implementation) I N the last 50 years, man has walked on not), leaders have typically blamed the strate- 2. Biz Case – articulating both the numeri- WE REFER to the article “Sticking a foot in in- firstly, to some extent, a bonus issue of units the moon, split the atom and spliced the gy and not the implementation. (This has a cal and emotional reasons for the change in vestors’ eyes” BT, April 29). We wish to clari- and secondly, to some extent, an issue of new gene. In the last 20 years, in business, we certain irony, since leaders are responsible strategy fy some of the matters raised by your reporter units at their full value. As to how much the have discovered how to capture intangi- for the strategy and staff members for taking 3. Communicate – not just explaining the Emilyn Yap in that article. past DPU figures are restated depends on ble assets along with tangible by adopting the actions to implement it!) Leaders are in strategy but also telling staff members what Firstly, it is over-simplistic to conclude how much the rights issue represents a bonus a balanced scorecard, invented ways to im- fact shooting themselves in the foot. But I am actions to take and making sure they are moti- that it is always wrong for previously-an- issue versus how much it represents an issue prove productivity through “Lean Six Sigma” afraid to say it still doesn’t alter their habits. vated to take the right actions nounced distribution per unit (DPU) statistics of new units at full value. and are learning how to develop our next line Another part of the problem is that when 4. Measure – change the measures to track Such restatement of past numbers is a to be restated after a rights issue. In a rights of leaders through the use of assessment cen- strategy implementation does fail, leaders are the new strategy (not the old) well-accepted and well-understood treatment issue that gives existing unitholders the right tres. Why is it we still can’t implement our cor- seldom held fully accountable. To cover up 5. Culture – every implementation is in the case of earnings. Singapore financial re- porate strategy? the failure, they quickly adopt the next strate- to subscribe for say one new unit for every ex- unique as every organisation culture is differ- porting standards have long mandated the ex- We repeatedly fail to execute our strategy gy or blame market forces: “It’s the reces- ent isting unit held, a unitholder starts off with one unit and ends up with two units. If he pre- act manner of such re-computation and re- and deliver on our strategic promises to share- sion” or lower the targets to create an illusion 6. Process – eliminate non-value adding viously received one dollar of distribution for statement, and Singapore companies have holders. Maybe it’s unfair in asking this ques- of success. These factors have all contributed work tion today. Maybe we have not evolved his one unit, and now receives one dollar for regularly made such adjustments after rights to why there is such a high failure rate. 7. Reinforce – support the staff members enough in the strategy journey. Consider that The recession, however, is putting a stop his two units, it is overly simplistic to con- issues. who support you there is not even a global common definition to these bad practices as it places greater pres- 8. Review – every two weeks review part of clude that each unit is now worth half com- We accept that DPU statistics are not al- in business for strategy. sure on leaders to deliver on their strategy the implementation and by the end of every pared to when he bought it. Taking into ac- ways seen as equivalent to earnings-per-unit Today, hundreds of thousands of students promises. quarter review the whole implementation. count all units held, he still receives the same statistics, and it might not always be appropri- in business schools from Singapore to Stan- Another major contributor to the high fail- For leaders to address all of these eight are- ate for a treatment well accepted for earnings one dollar. To demonstrate this bonus effect, ford study the subject and they graduate with ure rate of implementation is that leaders as simultaneously is not easy, which is why to be similarly applied to distributions. In the it is general practice to make a distinction be- an understanding of its importance but not a have been habitually underestimating the im- there is such a high failure rate. Leaders must meantime, we are conscious that financial re- tween old units and new units, and restate all common definition. Therefore, maybe it is too plementation challenge. Some have treated identify the right actions they need the staff porting standards currently do not provide much to expect leaders to excel at the next crafting strategy like any other project and per-unit values. In stating the DPU, this will members to take and then make sure they are guidance for the accounting of distributions, stage and to execute the strategy. once they have completed it, they move on to mean that amounts are stated in terms of new taking them. Act fast. Don’t procrastinate in as opposed to earnings, after a rights issue. But do we have the luxury to wait any long- the next project (mostly ignoring the imple- meetings about what to do. As Louis Gerstner post-rights issue units, where each new unit As a result, it is possible that inconsistencies er? The global recession has dramatically re- mentation). Leaders are only paying lip serv- told IBM when he took over: “Move fast. If we is equivalent to half of an old unit. Your repor- in practice have arisen as a result. We are cur- duced the available working capital in many ice to the implementation and as a result the make mistakes let it be because we are too ter criticised this restatement; this in some rently reviewing the need for such distribu- businesses, made customers more demand- staff members only pay lip service to it. fast rather than too slow.” way equates apples and oranges as the new tions to be covered more explicitly by finan- ing and reduced the size of many markets. When a company has the ability to imple- I believe that this new decade will see strat- units are different from the old units. cial reporting standards. We hope this will, in This has placed additional pressure on lead- ment, what I refer to as “excel in execution” it egy implementation become the new field of Secondly, it is necessary to account for dilu- time, eliminate the inconsistencies and lead ers from shareholders (and, in some compa- is a competitive advantage. The Palladium business. Its time is now. An indicator of this tion in a rights issue where there is indeed to a better understanding of financial informa- nies, by their board) to deliver on strategy Group, for example, states that it has seen is the current recognition of the high failure such dilution. A unitholder who currently promises. companies excellent in execution create a 100 tion issued to stakeholders. rate. Another is the sudden growth of new holds one old unit needs to pay in extra capi- Due to the pressure leaders are now un- per cent increase in shareholder value in two books in the field and yet another is that busi- der, interest in the field of strategy implemen- years, grown revenue by 21 per cent and re- tal to be entitled to hold two new units. If the Janet Tan (Ms) ness schools are starting to offer modules in new capital is held by the trust as idle cash tation has dramatically increased. To support duced operating expenses by 14 per cent both the subject. Executive Director this interest, numerous articles, blogs and in two years. without generating additional profit, the Institute of Certified Public Accountants In the past, leaders were only taught how books have started to appear. Most have been To excel in execution, however, is not same amount of profit is being distributed al- of Singapore to craft strategy but there was no course on shouting about the high failure rate of strate- easy. Leaders must address many different implementation. This contributed to the high though unitholders paid in more capital. To gy implementation (implementation and exe- parts of the business simultaneously. For the failure rate (as well as leaders’ frustration show this dilution effect, DPU figures are com- Emilyn Yap replies: The commentary does cution are interchangeable) and quoting that last 10 years, we at Bridges (the company I and high blood pressure!) puted without restating previous figures. In a not object to the restatement of previously-an- nine out of 10 strategies fail to be implement- founded in Singapore and run) have re- In Singapore, for example, SMU today in- rights issue, it would make sense to compute nounced distributions per unit (DPUs) after a ed successfully. searched both failed and successful implemen- cludes a module on strategy implementation DPU without any restatement of past DPU fi- rights issue. What it disagrees with is how the This statistic is not new. This newspaper tations from both the public and private sec- as part of its executive training. gures only if the new units are being offered first published it five years ago in a previous restatements are presented. Real estate in- tor in Singapore (and the region). From the re- Companies which excel in execution out- at their full market value, without any dis- article I contributed. But it has taken time for search, we discovered that implementation re- vestment trusts should present the original perform their competitors. count. Your reporter’s comment, that such re- DPUs upfront, not the restated figures, so that the business community to realise the cost quired more than just sending everyone on a and implications of strategy failure. The writer is chief executive of Bridges statements are always inappropriate, would unitholders can see the effects of a rights is- training programme or inculcating new val- In the past when leaders were failing in ues or adopting new measures. We extracted Business Consultancy Int and author of be valid only if the rights issue involved no dis- sue more clearly. the implementation, they threw more money that there were eight areas of excellence: ‘Beyond Strategy – The Leader’s Role in count, which in practice does not happen. It is encouraging to note that a review of fi- or resources at the problem. The recession 1. People – it is the staff members who im- Successful Implementation’. Visit Taking these two points together, a rights nancial reporting standards for DPUs is un- curtailed this habit. When implementation plement strategy (leaders are responsible for www.strategyimplementationblog.com issue is a combination of two components: der way.

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