Board of Directors and Corporate Governance - Making Dinosaurs Look Young

If you compare the transcripts from boards of directors' meetings over the last fifty years, you would see few differences over time. There would be commentary on industry trends, discussion of financial performance and future targets, and debate on potential mergers and acquisitions targets and offers. The belief that "business is business" and it is all quite standardized from the board's perspective started as a white lie fifty years ago and has now become a legendary myth.

Information, data, strategy, and technology get more complex every day and change at an ever faster pace. Competitors respond to pricing in seconds, promotions in hours, placement in days, and products in weeks. Even for the "non-technology" (does this exist anymore?) sector, a technological breakthrough can render entire companies nearly obsolete. The board should be the shining beacon of corporate governance and leadership, not a stodgy and archaic tangentially interested party.

How should an effective board of directors operate?

The board represents the shareholder and has specific functions to fulfill. 1) The board should act as the real Human Resources for senior management. This means motivating, recruiting, and evaluating performance. 2) The board is frequently one of the few or the only resource for unfiltered feedback for senior management. 3) The board should provide a unified vision with each other and the CEO on the company's strategy. The current structure is not effectively fulfilling these functions. Below are five significant changes that could be made to modernize and make the board of directors fit for the 21st century.

First, unless the CEO is also a significant owner, she should never be chairman of the board, ever. I can understand why the CEO would want to be chairman. Who wouldn't want to be their own boss, like an entrepreneur, but have someone else write the check? The board should keep the CEO in line and provide a reality check to a position that succumbs easily to ego and tunnel vision. The prevalence of the "CEO as chairperson" structure demonstrates how broken the current corporate accountability structure really is.

Second, board members should rarely be professors, senior managers in related industries, or "30,000 foot" investment bankers. Boards are not for networking. Boards are not "good work if you can get it" part-time jobs. Board positions are not status symbols. The livelihoods, and sometimes lives, of thousands, hundreds of thousands, or even millions of people are counting on the board's effectiveness. A board position should be a significant time commitment, and appropriate compensation should be paid accordingly.

Third, revamp the internal audit function. The internal audit department already reports directly to the board. Elevating the department into a formidable data and process center allows the board to directly access actionable and granular data without depending on the upward filters of typical management. The head of internal audit needs to be able to present data in, what I call, a multi-subjective fashion. Objectivity is incredibly hard to maintain. However, presenting data from two different viewpoints, acting as both prosecutor and defense attorney, allows the department to embrace putting on the alternate masks, challenging biases and encouraging critical thinking. This is far more realistic than trying to assume the difficult task of complete objectivity, or the far more dangerous behavior of superficial objectivity.

Fourth, kill the soul-sucking, data-overloaded PowerPoint presentations. Because of the adaptations in the internal audit function, the vast majority of data relating to company financials, mergers and acquisitions, and industry data will already have been studied, reviewed, and challenged. The board can then focus on critical items that need the board's attention. Data overload can also be a subconscious tool for CEOs to bamboozle a board to allow the CEO to be monitored less effectively and have more freedom to pursue his passions.

Fifth, consider alternative board structures. There are fewer legal hurdles to experimenting with a new board structure than one would think. Designated rotating full-time board members could be utilized. A strategic consulting firm could, in essence, be hired as a board member. A flat fee could be paid to the strategy consultants to provide strategic direction on a full-time basis, without being beholden to presenting items that the CEO would find threatening.

These five items are only a beginning of what is possible in the corporate governance Venn-diagram of "Realistic" and "Results." However, starting from a few basic premises, other corporate governance improvements, from long-term restricted stock unit compensation for board members to more transparent communications between board members and the public, can be considered.

This should happen, but who is going to change it?

To a large degree, there is a principal-agent and inertia problem. Who has the incentive and the power to truly fix this corporate governance issue?

Smaller private companies have hovering insiders, VC investors, or private equity funds that usually are looking after their investment. Large family-owned companies generally have hovering insiders and outsiders. Perhaps some of the general principles here could help, but most if not all of them are utilized on a consistent basis in these settings. The items listed above are not "new and revolutionary" in the sense of never existing. The concepts are somewhat common, but only in these limited spheres.

Large public companies have an incredible amount of inertia, legal hurdles, and dispersed ownership. Significant changes in board structure will be a non-starter, especially if it's viewed as a structure that only small private companies use.

After excluding these areas we are left with medium-to-large non-family private companies and public companies with a dominant owner, perhaps even a larger public company. Because there still is the inertia and risk-aversion element in public companies, the easiest method would likely be an innovative private equity firm. This private equity firm would be one with a "value add" mindset, rather than the "bargain hunters" or "pay and pray" types. The right private equity firm to innovate in this area would be one that has dedicated and qualified in-house staff to serve as board members. This practice would next scale to ever larger privately held companies, then to public companies with a dominant owner, and, hopefully, eventually to large public companies.

The degree of "brokenness" in corporate governance is frequently discussed and solutions are recommended. However, many of these reforms simply trim around the edges instead of resolving the underlying issues of board effectiveness.

Car Sharing - Tomorrow's Tomorrow

Over the last ten years I have watched respected publications go all in on the amazing future of car sharing. In the last couple years that fervor has died down somewhat, after expected successes have failed to come to fruition in even some of the most pessimistic scenarios presented. The arguments for "the rapidly approaching revolution" have never impressed me, and I've noted this here previously on Zipcar. The traditional (or current) form of car sharing simply doesn't work very well, and it's very difficult to see the profitable and socially disruptive changes from it in the near-term.

Car sharing as it exists today is car rental with more convenient locations. The car must still be washed, returned to a verified location, have regular maintenance, etc. The cost structure and customer experience is not all that different. Car sharing makes a product (off-airport car rental) marginally more convenient for customers. This is not to say that is a bad idea, but that car sharing today is a slightly improved version of car rental and nothing more. There can be strategic reasons for car rental companies to use car sharing as a tactic in the off-airport market, but it is not, by itself, a revolutionary and disruptive technology at least in terms of its impact outside the vehicle rental market.

Car sharing will remain a niche product and mostly non-disruptive until users can more seamlessly rent their cars. Three developments are necessary for this to happen:
1) Technology. A seamless car sharing experience requires the right technology (GPS, vehicle status, and vehicle access) in the car to facilitate the transaction. However, installing the technology post-OEM is expensive and not standardized. The car sharing technology needs to come prepackaged in the car. A few new models have this technology prepackaged, but this is currently the exception rather than the rule. As adoption increases, the potential market and scale of car sharing at least becomes a possibility.
2) Open Data Platform. OEMs must not only prepackage the technology in the car, but they must also allow their users to provide vehicle data to whomever the user wishes. A software and network need to be developed to aggregate the availability and demand for these cars across OEM platforms. Scale is needed for this to work. If there are various competing applications and the OEMs remain on segregated software platforms, scale will come much slower.
3) Culture. Are people ready for it? AirBnB had a lot of pushback in the beginning because potential investors thought that the vast majority of individuals were not willing to open their homes to "strangers." They were wrong. Are people ready to do this with cars? There are some of the same complexities and issues as turning over the house to a stranger, but with a bit more frequent, "I didn't cause that scratch!" Perhaps technology will eventually smooth over this issue as well.

Is car sharing going to arrive? If so, will it arrive before autonomous vehicles? If it is going to arrive, each of the three hurdles above will need to be overcome in a meaningful way. However, the potential for autonomous vehicles may be sucking the air out of the room and stakeholders' initiative might just not be there in terms of car sharing except within limited scopes.

Maslow's Hierarchy and Income Effects at the Margin (Draft)

Maslow's Hierarchy of Needs is reviewed in basic psychology and organizational behavior courses. At the most simple explanation, baser needs must be met before higher needs will be pursued.

Image source: wikipedia

Of course, in these same courses the instructor/curriculum then goes on to explain why it's not a very reliable framework. However, in terms of an economic framework for recessions, this can be a very precise framework.

What exactly happens as a recession occurs?

Income loss - Unemployment eliminates or drastically reduces the income of household members
Income reduction - Contractors, self-employed, and small businesses take a hit in income. Stocks and some bonds do worse in recessions, reducing payouts to retirees.
Expectations - Uncertainty of future income and job stability rises. Future income pessimism also increases
Tastes - A variety of tastes change in recessions. For example, conspicuous consumption (cars, clothes, jewelry, etc.) take a hit, even for those who do not suffer a fall in incomes. Evidently, it becomes more socially unacceptable or individuals develop more empathy so that consumers choose not to show or waste wealth in the face of those suffering.

Companies need to understand, ideally before a recession strikes, how will each of these factor into the industry and its products. But what does this have to do with psychology? More than one might think. Expectations and tastes are psychological, not physical changes. Also, the effects of income loss and income reductions cause individuals to readjust and prioritize their spending, either willingly or through asset or credit limitations. Economics is based on the concept of tradeoffs, but when consumers are "doing more with less," a company must know if its products are still part of the package. Nimble and successful reactions to income loss are becoming essential for businesses to survive in recessions. The previous recession saw more innovative and creative strategies than ever before, from creating more dignity and team spirit for temp work to Hyundai's policy of the right to return a recently purchased new car if you lose your job.

I'm not looking forward to the next recession, but the latest iteration of strategy and tactics to maneuver through it will be intriguing to observe. How much has been learned, and how much of it will be forgotten before the next recession?

Interest Rates Part 2 - A Closer Look at Debt

Previously I've discussed the unprecedented situation of across the board low interest rates and high valuations across a variety of financial markets. While equity positions were discussed previously, below I'll look at the interest rates across different types of debt markets.

Treasuries - Rates on US Treasuries have fallen significantly. Current yields stretch between zero (short-term) and <3% (for the 30 year). These are the lowest rates across all maturities in recent history. Acting as the gold standard of collateral, demand for US Treasuries has never been higher.




Retail banking rates - Accurate data on many retail banking rates across the market are surprisingly difficult, but certificate of deposit (CD) rates have fallen to near zero, checking account rates have fallen to zero, and savings account rates are averaging around 0.10%. Commercial banks are simply not vying to expand their deposit base. Even with near zero rates, once costs to attend the customer are taken into account the costs to borrow from many day-to-day customers is too high compared to other options.


 Credit card rates - There's been a general fall in rates but those who actually carry a balance have seen a slight increase in rates lately. This is an interesting pheneomenon. One potential explanation is an improvement in customer segmentation within credit card companies. Other explanations include increasing credit card limits in a play to potentially increase profits and increased demand for credit for consumers with lower ratings. Unfortunately, publicly available data is thin and there are not many recent publications to tease out which factors are having the biggest pull.



 Corporate high quality bonds - This category has been reduced to ultra thin margins. Expected real returns on two year high quality has flipped negative, and a five year bond has to be locked in before placing the investment outside of expected inflation scenarios.

 

High yield corporate debt (aka junk bonds) - High yield debt has been bid down and has tightly followed the performance of the general market. You might also notice that the earnings to price percentages and high yield returns have mirrored each other quite well in the last few years. The junk market has behaved essentially like the stock market under a different name.




Auto loans - Standard FRED auto loan data has shown consistently falling rates for auto loans that hovered between 4-5%. Take out defaults and operating costs, and the return falls to 2-4%. The subprime segment holds a similar story. Some have pointed out that the potential for a subprime autoloan bubble is overblown because of the percentages of loans to subprime is not quite as high as the '06-'07 peak, among other reasons. However, when I talk to those who operate within this industry they point to the non-public data sets showing subprime rates that have essentially never been lower and the volume is similar to the '05-'07 peak. Also, they point to the publicly available data showing an 18% increase in household autoloan debt since the previous peak in '07. Accordingly, when there is a sort of crash investors will be hit far harder, as the cushion is extremely slim. Furthermore, as subprime autoloan financial products have become more standardized and accessible to the general market, similar to mortgage backed securities but on a smaller scale, there is more likely to be more leverage behind the positions held by finance companies.

 

Grey and black market rates - These rates by nature are very difficult to measure. However, what is interesting is that there are some indicators that these rates have NOT fallen in line with the rest of the market. Complex information asymmetry along with barriers to entry (e.g., risks of gaming of regulations, moral reprobation, risks of breaking laws, etc.) set this market apart. Although, again, it is an area that is difficult to measure. I plan on writing more on what we do and don't know on this in the future.

Rates are down across the board. However, thinking of "the interest rate" as a single rate is an oversimplification. The concept of general market access and investment barriers will be expanded on further.