Productivity Crisis

What is capital engineering and why is it unproductive?

Growth-at-any-cost era, spurred on by easy-money for fifteen years, is over. We turned a great and necessary idea of privately funded companies into an unproductive, artificially inflated asset class. Let’s internalize the harmful distortions caused by the pervasive tendency to focus on capital engineering.

John Oommen

I feel like a veteran. This is my second boom-and-bust cycle. I was actively involved in the housing crisis autopsy at Capital One. For the last few years, I have been actively involved in addressing growth challenges at mid-sized private equity-backed and venture capital-funded companies.

In a 2021 Axios Momentive Poll, 2309 participants answered the question, “Do you think the evidence for capitalism, as an economic system, is now better, worse, or about the same, when compared with 50 years ago?” 41% of that group answered, “worse than 50 years ago.” In that same poll, the same respondents were asked, “Do you think the evidence for socialism, as an economic system, is now better, worse, or about the same, when compared with 50 years ago?” 43% answered, “worse than 50 years ago.”

What is your interpretation of these responses? My interpretation is that most people don’t internalize the essence of either economic principle and biased conversations in society sway folks easily.

Through these two economic cycles and working with dozens of companies and their executives, I learned that our team sport of capitalism is crumbling under the weight of 8 billion people playing this game with no rules of engagement or clarity on what even the most basic words mean. Even a few decades ago, this game was actively played by only a small fraction of those people. Rest were passive participants focused on value creation. Today, most doctors focus on moving patients through an assembly line, billing for services, and their personal brand than patient health. Even farmers are far more focused on marketing their creations than even a few decades ago.

There are two fundamental gaps in how we practice capitalism. In this series, we will discuss one of them - the lack of focus on productivity and value creation. Meanwhile, I recommend you read my series on holistic companies to learn about the second key pillar of capitalism.

Acumes | The Productivity Crisis - What is capital engineering and why is it unproductive? | Summary | John Oommen | #TheProductivityCrisis #HolisticCompanies #TheSpiralStairway #PrivateEquity #VentureCapital #Technology

What is capital engineering?

Let’s start with capitalism's definition. Here are three definitions from three distinct sources.

  • The International Monetary Fund defines capitalism as… an economic system in which private actors own and control property in accord with their interests, and demand and supply freely set prices in markets in a way that can serve the best interests of society.
  • Columbia University defines capitalism as… a system of largely private ownership that is open to new ideas, new firms, and new owners—in short, to new capital.
  • TeenVogue defines capitalism as… an economic system where private entities own the factors of production. The four factors are entrepreneurship, capital goods, natural resources, and labor.

There is a very important takeaway hidden in these definitions. One word that is pervasively used by everyone these days is not in any of these definitions. That word is GROWTH! Everyone is harping on about growth in every corner of our economy. The word growth doesn’t even appear in capitalism's definition. Understanding the mutated inclusion of growth as the goal of our economy will reveal the biggest flaw in how we practice capitalism.

Capitalism should provide access to capital and create incremental value with that capital. Return on capital must come from our ability to create intrinsic value with the capital. Capitalism is not intended to artificially inflate the sourced capital by constructing an extrinsic illusion of value. Inflating capital without value creation is called capital engineering.

Capital engineering explains every single scandal in our ecosystem. When we colloquially use the words Ponzi scheme or a pyramid scheme, we are referring to capital engineering. But capital engineering is everywhere if we look carefully enough.

Make a list of the top ten company-level scandals or sector-wide disasters in history. Whether the actions were embraced by a single individual, executives in one or more companies, or all operators in an entire sector, we can trace the root cause of scandals to the tendency to inflate monetary value of an asset significantly higher than real world value that the asset is creating.

But this is a collective behavior and not just the actions of a few. On the back of my Kellogg MBA, I spent a couple of years working at Capital One to help unwind the mess we created in the 2000s through mortgage-related assets. When the depth of that mess came to light, there was no hesitation in blaming “Wall Street” for causing the bubble and calling mortgage assets “toxic.” It’s convenient to blame everything on a street. But Wall Street did not cause that bubble. Every stakeholder group in the ecosystem took part in causing the crisis.

  • Loan originators all over the world milked their incentive to originate mortgages for fees from each new mortgage without considering ramifications of their actions. Originators never hold on to mortgages for more than a few days.
  • Underwriters failed to assess the value of homes under each mortgage.
  • Rating agencies became pay-to-play operators and gave every concoction with mortgages the highest possible rating.
  • Securitization firms took the good money available to create asset classes with new acronyms and sold those assets to the next buyer in the chain without considering their responsibilities to assess risk.
  • Real-estate agents convinced many to buy properties and artificially inflated the prices of homes without prudent negotiations.
  • Home buyers got in over their skis and overpaid for homes or over-bought homes outside their affordability.

We all played a part.

Why is capital engineering a systemic problem?

The systemic problems start at the very top. In the democratic rich countries, Gross Domestic Product (GDP) has been the measure of quality of life for decades. Although metrics are important, using the same measurements for decades imply we focus on making the numbers look good while allowing the underlying behaviors to fall off. This phenomenon is called Hawthorne’s Effect and every living thing falls for it.

The chart I have included shows that the United States GDP has been rising like clockwork for decades now. In fact, the near-perfect smoothness of the line is concerning. Like the adage of not trusting someone without flaws, this GDP curve's perfection is manufactured. Why? If this line isn’t rising so perfectly, how can elected officials claim they are improving the quality of everyone’s life consistently?

Our unhealthy focus on this GDP curve is the starting point of capital engineering trickling down through every aspect of our economy. In 2022, US GDP shrank for two quarters in a row. This is the technical definition of a recession. Elected and appointed US officials went through weeks of propaganda to claim that the US was not in a recession. Why does it matter whether a number that is unrelated to any practical realities goes down by a tiny margin?

It doesn’t. GDP numbers only have the importance that we give it. It’s akin to associating happiness with money and then engaging in high-risk illegal activities to make money. We choose to give GDP figures a lot of importance and choose to prop it up by any means necessary.

Governments have three tools to prop up the GDP number. Rich western countries have expired these options to maintain our easy money era. Let’s use the US data to explain the predicament we are in.

The first tool is the interest rates at which banks can borrow from the US Federal Reserve. All societal conversations about interest rates stem from this single blunt instrument. The federal reserve lowers this number to encourage more borrowing and spending in our economy. When banks can borrow money cheaper from the federal reserve, it lowers interest rate for companies and consumers.

Here is a shocking reality that will only sink in by looking at the chart I have included. The US Federal Reserve has kept interest rates at 0% through most years since 2009. This interest rate was never close to 0% between 1955 and 2009. Never! Internalize the reality that zero interest rates inflated the growth over the last decade.

Low interest rates mean folks with excess cash and wealth need to look for risky mechanisms to find a return on investment. Is it a coincidence that high valuations for cryptocurrencies, NFTs, and unprofitable companies were rampant in the last decade? Not at all. It is a very predictable outcome. But the government doesn’t collect or report data on these aspects for us to see the complete picture.

What else happens when interest rates are zero? Everyone borrows to spend. Individuals and companies can get cheaper loans and that triggers more spending. The US government reports this data. Consumer debt in America in 2022 is 33% higher than in 2010. US Corporate Debt is twice that of 2010 levels. Again, look around and ask yourself where all the spending is coming from?

You might say—we have dealt with this before. But we have not. Remember, governments only have three economic tools. We have consumed the other two tools as well.

The second path for the US government is to spend money on government-led projects. We call this fiscal spending. We accelerated fiscal spending to a point where the US national debt in 2022 is three times the debt levels in 2010. The US national debt to GDP ratio, which indicates the ability to pay back the national debt, is 130%. As a reference point, when the Greek government needed a bailout over a decade ago, their debt to GDP ratio was at that same level.

The US government could deploy its third tool and just print more money and devalue our currency to pay back our debt. But wait a minute! We have already done this too. The technical way governments print money is called quantitative easing. Since the financial crisis, the Federal Reserve has increased its balance sheet tenfold, from $1 trillion to $10 trillion, which equals the amount of printed money in circulation.

The Productivity Crisis Capital Engineering QE. Source: Acumes

The overuse of these three tools has fueled the good times over the past decade. But it comes at a cost. We have used up all three tools. Our economy barely grows even by GDP measurements. Inflation is very high for a stable economy. Although policymakers want to call the current inflation “transitory,” it’s a result of 10 years of zero interest rates, fiscal spending, and quantitative easing. It’s not because of supply chain problems or high oil prices because of the war in eastern Europe. Those are convenient distractions to blame.

High inflation means the value of each dollar that a consumer or company has will decrease. This means one of two things must happen. Either we all must bring down our standard of living as a consumer or the expenses as a company. Cutting spending means it decreases US GDP, which has an unhealthy dependence on everyone spending excessively.

If individuals and companies want to keep spending on everything we currently do, then we have less money to pay back all those loans we racked up. This will cause more loan defaults on personal and corporate loans. Loan defaults imply that the institutions holding the loans are at risk and they hand out fewer loans for future spending and the number of people working at those lending institutions will shrink, which means fewer jobs. This path also leads to lower spending in our economy and GDP shrinkage.

I have looked at charts with similar data many times. But even as I look at them while writing this article, the shortsightedness of folks who have the power to control macroeconomic factors shock me.

In sum, the US economy is largely capitally engineered for short-term outcomes. Now that the US government has expired these three tools over the last 15 years, we will have to increase interest rates significantly and recall all that printed money to keep inflation at bay and cut fiscal spending massively to control government debt spiraling out of control. We have never done all three of this or at this scale ever before and there is no playbook for it. Even if we can do all this, it means that our economy will have to shrink significantly.

In this section, we didn’t talk about value creation through new technologies or sustainable energy sources and for good reason. To inflate GDP numbers artificially, we don’t have to create value. We just have to pull on these three levers. This same paycheck-to-paycheck mentality is reflected throughout our capitalistic economy.

How did capital engineering influence companies in the easy money era?

With all this easy money pumped out to maintain a meager GDP growth rate, let’s look at what has transpired below that macroeconomic surface. Young children mimic their parents. Companies reflect the overarching behaviors encouraged by their governments.

Social outlets, conferences, and teaching forums gave all its airtime to fundraising, valuation hikes, and non-stop hiring conversations for the last several years. As the season ends, it is appropriate to take some time to check the results.

When I started working with private companies on the back of my experience dealing with the fallout of the mortgage-led financial crisis, I felt a sense of déjà vu. It wasn’t unfounded. During the financial crisis, the assets we engineered and inflated in value were complex mortgage packages. Newly created companies are the assets we systematically inflated in value and then sold during this boom-and-bust cycle. This was the 2010-2022 season’s version of capital engineering.

The behavior is sector agnostic. This tendency to hyper-scale, the approach used to inflate a company’s value quickly, has infiltrated consumer-facing and business-facing companies across sectors, including software, hardware, packaged goods, cryptocurrencies, services, and the list goes on. By nature, value creation in these sectors is absolutely necessary and we need sustainable companies to do so. But owners of capitally engineered companies focus primarily on short-term market valuation and selling ownership stake to someone else at a high valuation as opposed to profitability, value creation for customers, and the incentives of employees, partners, and society at large.

The chart I have included tracks the valuation trajectory of a real consumer apparel company. From its founding in 2016 through 2021, the company’s shares were owned by the founders and a handful of private investors. During that period, only these individuals sat on the company’s board. The market valuation ticked up like clockwork because these few owners who put money into the company decide the overall worth of the company. Conversely, the valuation was not based on profitability or sustainable customer value creation. Each valuation round is celebrated with fanfare. Public relations and selective data shared about the company paint a picture of guaranteed future growth and prosperity. All the good news was directed towards potential future owners of the company’s shares.

Valuation challenge due to capital engineering. Source: Acumes.

Then such a company goes through an exit. One exit path is an initial public offering (IPO) where a company’s shares become available for the public to buy. Another option is to sell the company to a private equity firm. The third option is to sell the company to a large strategic buyer, which is typically a publicly traded company. In any of these circumstances, we must expect the company's valuation to continue to increase after transferring ownership based on the prior valuation increases and positive stories spun about the company’s prospects.

However, the reality is predictably not so. As with this consumer apparel company, the value of capitally engineered companies craters after the ownership transfer because new owners have access to the full story behind the company. Within 8 months of its public listing, this apparel company’s value decreased by 73%. Suppose the original owners of the company sold $100 worth of shares to Average Joe who doesn’t have all the information or have the experience to inspect the information. This Average Joe who bought $100 worth of shares at the time of public listing, had $27 worth of shares after 8 months. Note that this is a company that I have tracked closely since 2018 and I didn’t select this one-off example for shock-and-awe.

This is the problem with capital engineering. It’s the underlying theme behind the Ponzi schemes.

Let’s consider the overarching measurements that illustrate the effectiveness of companies we created through this boom-and-bust cycle. There were 1035 IPOs on the US stock market in 2021, a record. This figure was 120% higher than the 480 IPOs in 2020, which was also a record. These figures include Special Purpose Acquisition Companies (SPACs), which are a shortcut to list immature companies publicly.

Easy money conditions helped private companies hyper-scale and go public with frothy valuations. However, over 60% of those that went public since 2019 are now trading well below half their first day’s trading value. SPAC listings have a far worse track record. Furthermore, 65% of companies that became public over 3 years ago are still not profitable. These are unsustainable companies which lead to massive investor losses, negative net value for customers, poor experience and growth for employees, and risk for partners. After all this, they finally leave taxpayers to bailout related institutions when the engineered ecosystem crumbles.

2022 Private Company Valuation Scorecard. Source: Acumes

Private companies play a very important role in capitalism. But irrational exuberance around good ideas leads to market destruction. The fate of rapid-scaled companies in the easy-money era has been obvious for years because the actions that go into capital engineering are easy to discern.

What will be the fallout and what can we do?

Many finance people will argue that the 2007/08 crisis is bad as it can get. I disagree. The next one will be far worse once it takes effect as we run out of duct tape.

First, we are defenseless. Fifteen years of low interest rates, quantitative easing for many years, and unfathomable amounts of fiscal stimulus have ballooned most rich countries’ debt to unserviceable levels. We can no longer support an easy-money era or offer back-stops for poorly run companies. Historically, we had never arrived at a crisis with an empty arsenal.

Second, the next bust will affect every sector and everyone who cannot afford to fly over the chaos. For the financial crisis, most of the problems were associated with on-paper valuations of a single asset type. But now, the dominos of real-life weaknesses are so precariously set that commodities, utilities, and necessities like basic healthcare are likely the only sectors that will avoid significant pain.

Third, leaders of almost every territory have misled constituents with the theme that we can break laws of nature and have perpetual free lunches. We cannot. But, what’s wrong with some motivational speaking? The problem is that change management is extremely hard. As someone who has tried a fair number of turnaround efforts, it is nearly impossible for multiple stakeholder groups to change behaviors without cathartic actions. When failure points become apparent, 15 years of free lunch mentality across our ecosystem will prove hard to reverse. This means we are heading into a prolonged crisis.

Given this prospect for the next few years, let’s take some time to assess our roles in the catastrophic avalanche that capitalism is becoming. Are we convinced that our individual actions are helping to focus on practical value or are we contributing to capital engineering distortions? Even bankers and private equity or venture capital investors who are brand ambassadors for capitalism don’t seem to believe in it anymore. But we can harness the genuine power of capitalism. Here are some questions that we must ask ourselves to improve the current unproductive use of capital.

Putting our investor hat on:

  • What are my investment habits?
  • Am I an active participant in inflating the value of questionable assets?
  • Do my words and actions give wings to questionable assets that might mislead others, especially those with less information?

As a member of society:

  • What is my unique value proposition to our ecosystem?
  • Do I create as much tangible value as I consume?

As an employee:

  • Am I selling or marketing items or services that have net positive customer value?
  • Am I creating goods and services that align with the sustainable journey of customers without leading them astray or providing short-term satisfaction that leads to buyer’s remorse?
  • What do I bring to the table for my peers? What are my differentiators if I were to be objective? Have my skills improved substantially in the past few years?

As a consumer:

  • Are my habits in line with my income and wealth?
  • Do I have a strong understanding of the difference between necessary and discretionary spend, given my means and needs?
  • Are my spending habits bordering on overconsumption? Am I skewing prices for others who might not have the same affordability as I do? Am I expecting others to carry the burden of my habits?

The essence of capitalism is to build holistic companies—companies that exist to balance the incentives of all stakeholders—investors and owners, customers, employees, partners, and society at large. Capitalism is a sport best played with transparent rules and fair play. It is time for grown-up conversations about companies. Let’s move towards a sport that is fun to play and entertaining to the audience; not designed to benefit folks that just bet on the games.

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