“Taking on a challenge” – STEP

Because there are so many entrepreneurial projects out there, and because beneficial owners are naturally attracted by projects that reflect their passions, most trusts and family offices are to various degrees involved in the management of direct stakes in private companies. The sums invested in this fashion tend to be a minor part of overall assets, but they nonetheless often add up to very significant amounts.

If we consider direct investments as an asset class, than it has to be said that the overall performance is rather poor. The stories that trusts and family offices tell are in fact depressingly similar. They speak of missing transparency, progressive estrangement, frustration, and ultimately, of value destruction on a massive scale.

Although not readily shared among trustees and estate practitioners, these “horror stories” from direct investments are so frequent that they have come to be seen as somehow unavoidable, the common destiny of what is often dismissed as pet investments by beneficial owners. But there’s little that’s unavoidable about value destruction in direct investments. There are clear, structural reasons why it happens, and therefore very concrete solutions that can be adopted by trustees and estate practitioners.

The basic reason for failure is that the inherent riskiness of direct investments is almost universally underestimated. This happens not only when the investment is made in young, entrepreneurial ventures, but also when the target is an established organization. In this last instance, the investor tends to overlook that his arrival as new owner is caused by big structural changes – founders retiring, big strategic shift requiring significant funding, etc – and that these situations have a major destabilizing effect on the company in question.

As a consequence of that misunderstanding of underlying risks, the mechanism put in place to monitor such investments is almost always very basic: have a representative of the trust, or of the family office, sit on the board of the company.  Now the idea here is not to mount an attack on the time tested way by which shareholders and management teams communicate.

In some cases, this set-up produces valuable results. But in most cases, it has to be said that when a private company bears an interesting – and therefore uncertain – project, the usual scope of information flowing between management and shareholders tends to be plainly insufficient, with communication either too focused on high level strategy or on narrowly defined control measures.

Why? First, because the centerpiece of information being communicated by management to board members is financial statements. As we all know, by the time a problem shows up in the financial statements, it has already had ample time to wreak havoc in the company.  Second, because whatever information is provided in addition to that is by definition structured by management and therefore cannot represent an objective view of how the company is faring.

Does this mean that management should not be trusted? Of course not. No investment in a private company would be made in the first place if the investor didn’t have a high degree of confidence in the people he entrusts his money with. But it is important to understand that a management team that takes upon itself to develop a new company, or to bring an existing one to a new level, faces multiple challenges. And herein in lies the key risk, and the main cause, of failure: That while dedicating their energies to tackle some issues, management teams lose sight of other problems that, if not solved, will cause significant damage to the company.

Where the main cause of failure lies, lies also the solution. The management of direct investments is too often impaired by assumptions that must be dismissed. No matter how competent and trustworthy management is, the reality demonstrates that it would be wrong to leave management teams to their own devices in situations that are inherently risky. It doesn’t make much sense either to simply rely on whatever information is communicated to board members by management as a basis for proper understanding of how the company is faring. And neither is it very helpful to believe that only elusive industry specialists can provide insight beyond run-of-the-mill corporate information.

The key to protecting the value of a company is to go back to how it creates that value overtime. The increasing disconnect between the book assets of publicly traded companies and their market value – a phenomenon that has been developing over decades and persisted through the ups and downs of the business cycle – is very significant in this respect. Analysts of public companies have a name for the difference between book assets and company value: intangible assets. Although there are some high level descriptions of what exactly is understood by intangible assets, things remain pretty vague. This means that, depending on the type of business, between 60% and 90% of the value of a company can only loosely be accounted for.

That is understandable when considering big public companies. They have been around for a while, are submitted to the discipline of financial markets, and have solid organizational structures. And anyway, analysts simply couldn’t perform their job if they didn’t make certain simplifying assumptions regarding the companies they monitor. But things change drastically with direct investments in private companies. Here, simplifying assumptions and vagueness are extremely dangerous.

If the investment is to be properly monitored, and its value protected, the whole of a company’s value must be accounted for. This is what Asset Dynamics®, the framework we have developed as a consequence of our longstanding involvement with trustees and estate practitioners in their management of direct investments, does. And it does so by first going back to a simple truth: it is the activities of the people within companies that are the fundamental driver of their value.

This might seem obvious, but it has deep consequences on what has to be done to properly manage direct investments. Focusing on what people do within companies implies taking a fully dynamic view of company value, and this is unprecedented.

Looked at from the perspective of the actual activities taking place within it, a company ceases to be an abstract entity and reveals itself as a living organism. One that has several clearly identifiable components – or organs if we want to continue using a biological metaphor – that each contribute to its performance. And as anyone that has witnessed company failures will be able to testify, companies do not fail by chance; they do so because one of these components – or organs – fails.

There is nothing mysterious about these “organs”. They are the management disciplines that academics and practitioners have refined over decades. Understanding market needs, developing products or services, optimizing production and delivery, managing human, financial or physical resources, etc. All constitute management disciplines, and all correspond to activities and outcomes that can be looked for and identified in any company.

Asset Dynamics®  is the framework we use when monitoring direct investments on behalf of trusts and family offices. It creates a comprehensive link between all major management disciplines, corresponding best practices and expected outcomes on the one side, and a set of intuitive components of company value on the other side. The present contribution is not suited to exploring in detail the structure of the Asset Dynamics® framework, but an overall description of is content is useful.

The first of these components is linked to the area of business management that deals with the development of products or services. We call it “offering”. It groups all the activities that could or should be deployed by a company in order to ensure that the offering it presents to the market is and remains in line with customers’ needs and expectations.

The second component has to do with marketing in the broader sense of the word. It represents all that a company can or should do to maximize its influence over its market, and therefore the solidity of its top line. We call this asset “market”.

Third is “operations”. This component is concerned with the general topic of operational efficiency and covers practices aimed at optimizing the overall costs of operations and ensuring that the company remains competitive from a cost perspective.

The fourth component, “competencies”, relates for the most part to human resources management practices and extends to the comparatively most recent practices that allow companies to capitalize on individual skills.

Finally, a fifth, “umbrella” component is added to integrate assets that appear in the financial statements of companies, and which value is also developed, maintained or impaired by specific actions taken within companies. That category includes the management of physical and financials assets as well as expenses typically capitalized by companies. That fifth component in the framework is called “book assets”.

Based on well founded and established knowledge, the Asset Dynamics framework can act as the basis on which a dialogue between shareholders of a private company and management can be renewed and brought to a whole new level. This is achieved by keeping on the table all the issues pertaining to the company’s ability to create value overtime. Monitoring implemented on that basis truly constitutes the best protection
against value destruction.

Because there are so many entrepreneurial projects out there, and because beneficial owners are naturally attracted by projects that reflect their passions, most trusts and family offices are to various degrees involved in the management of direct stakes in private companies. The sums invested in this fashion tend to be a minor part of overall assets, but they nonetheless often add up to very significant amounts.

If we consider direct investments as an asset class, than it has to be said that the overall performance is rather poor. The stories that trusts and family offices tell are in fact depressingly similar. They speak of missing transparency, progressive estrangement, frustration, and ultimately, of value destruction on a massive scale.

Although not readily shared among trustees and estate practitioners, these “horror stories” from direct investments are so frequent that they have come to be seen as somehow unavoidable, the common destiny of what is often dismissed as pet investments by beneficial owners. But there’s little that’s unavoidable about value destruction in direct investments. There are clear, structural reasons why it happens, and therefore very concrete solutions that can be adopted by trustees and estate practitioners.

The basic reason for failure is that the inherent riskiness of direct investments is almost universally underestimated. This happens not only when the investment is made in young, entrepreneurial ventures, but also when the target is an established organization. In this last instance, the investor tends to overlook that his arrival as new owner is caused by big structural changes – founders retiring, big strategic shift requiring significant funding, etc – and that these situations have a major destabilizing effect on the company in question.

As a consequence of that misunderstanding of underlying risks, the mechanism put in place to monitor such investments is almost always very basic: have a representative of the trust, or of the family office, sit on the board of the company.  Now the idea here is not to mount an attack on the time tested way by which shareholders and management teams communicate.

In some cases, this set-up produces valuable results. But in most cases, it has to be said that when a private company bears an interesting – and therefore uncertain – project, the usual scope of information flowing between management and shareholders tends to be plainly insufficient, with communication either too focused on high level strategy or on narrowly defined control measures.

Why? First, because the centerpiece of information being communicated by management to board members is financial statements. As we all know, by the time a problem shows up in the financial statements, it has already had ample time to wreak havoc in the company.  Second, because whatever information is provided in addition to that is by definition structured by management and therefore cannot represent an objective view of how the company is faring.

Does this mean that management should not be trusted? Of course not. No investment in a private company would be made in the first place if the investor didn’t have a high degree of confidence in the people he entrusts his money with. But it is important to understand that a management team that takes upon itself to develop a new company, or to bring an existing one to a new level, faces multiple challenges. And herein in lies the key risk, and the main cause, of failure: That while dedicating their energies to tackle some issues, management teams lose sight of other problems that, if not solved, will cause significant damage to the company.

Where the main cause of failure lies, lies also the solution. The management of direct investments is too often impaired by assumptions that must be dismissed. No matter how competent and trustworthy management is, the reality demonstrates that it would be wrong to leave management teams to their own devices in situations that are inherently risky. It doesn’t make much sense either to simply rely on whatever information is communicated to board members by management as a basis for proper understanding of how the company is faring. And neither is it very helpful to believe that only elusive industry specialists can provide insight beyond run-of-the-mill corporate information.

The key to protecting the value of a company is to go back to how it creates that value overtime. The increasing disconnect between the book assets of publicly traded companies and their market value – a phenomenon that has been developing over decades and persisted through the ups and downs of the business cycle – is very significant in this respect. Analysts of public companies have a name for the difference between book assets and company value: intangible assets. Although there are some high level descriptions of what exactly is understood by intangible assets, things remain pretty vague. This means that, depending on the type of business, between 60% and 90% of the value of a company can only loosely be accounted for.

That is understandable when considering big public companies. They have been around for a while, are submitted to the discipline of financial markets, and have solid organizational structures. And anyway, analysts simply couldn’t perform their job if they didn’t make certain simplifying assumptions regarding the companies they monitor. But things change drastically with direct investments in private companies. Here, simplifying assumptions and vagueness are extremely dangerous.

If the investment is to be properly monitored, and its value protected, the whole of a company’s value must be accounted for. This is what Asset Dynamics®, the framework we have developed as a consequence of our longstanding involvement with trustees and estate practitioners in their management of direct investments, does. And it does so by first going back to a simple truth: it is the activities of the people within companies that are the fundamental driver of their value.

This might seem obvious, but it has deep consequences on what has to be done to properly manage direct investments. Focusing on what people do within companies implies taking a fully dynamic view of company value, and this is unprecedented.

Looked at from the perspective of the actual activities taking place within it, a company ceases to be an abstract entity and reveals itself as a living organism. One that has several clearly identifiable components – or organs if we want to continue using a biological metaphor – that each contribute to its performance. And as anyone that has witnessed company failures will be able to testify, companies do not fail by chance; they do so because one of these components – or organs – fails.

There is nothing mysterious about these “organs”. They are the management disciplines that academics and practitioners have refined over decades. Understanding market needs, developing products or services, optimizing production and delivery, managing human, financial or physical resources, etc. All constitute management disciplines, and all correspond to activities and outcomes that can be looked for and identified in any company.

Asset Dynamics®  is the framework we use when monitoring direct investments on behalf of trusts and family offices. It creates a comprehensive link between all major management disciplines, corresponding best practices and expected outcomes on the one side, and a set of intuitive components of company value on the other side. The present contribution is not suited to exploring in detail the structure of the Asset Dynamics® framework, but an overall description of is content is useful.

The first of these components is linked to the area of business management that deals with the development of products or services. We call it “offering”. It groups all the activities that could or should be deployed by a company in order to ensure that the offering it presents to the market is and remains in line with customers’ needs and expectations.

The second component has to do with marketing in the broader sense of the word. It represents all that a company can or should do to maximize its influence over its market, and therefore the solidity of its top line. We call this asset “market”.

Third is “operations”. This component is concerned with the general topic of operational efficiency and covers practices aimed at optimizing the overall costs of operations and ensuring that the company remains competitive from a cost perspective.

The fourth component, “competencies”, relates for the most part to human resources management practices and extends to the comparatively most recent practices that allow companies to capitalize on individual skills.

Finally, a fifth, “umbrella” component is added to integrate assets that appear in the financial statements of companies, and which value is also developed, maintained or impaired by specific actions taken within companies. That category includes the management of physical and financials assets as well as expenses typically capitalized by companies. That fifth component in the framework is called “book assets”.

Based on well founded and established knowledge, the Asset Dynamics framework can act as the basis on which a dialogue between shareholders of a private company and management can be renewed and brought to a whole new level. This is achieved by keeping on the table all the issues pertaining to the company’s ability to create value overtime. Monitoring implemented on that basis truly constitutes the best protection
against value destruction.