VBM - Value Based Management™ is the Antidote to Corporate Fragility
6/16/2020
The coronavirus pandemic has brought back into the spotlight the works of Nassim Taleb on risk and fragility. Taleb, always smug and often right, lays out a compelling framework that can be used by corporations and executives to understand and navigate the complexities surrounding risk and fragility. Let’s examine how the principles of VBM - Value Based ManagementTM can be integrated with some of Taleb’s principal theses to improve corporate governance and finance.
Skin in the Game
Taleb’s latest book, Skin in the Game, explains how the presence or lack of accountability and “skin in the game” portends success and failure, fragility and antifragility, within systems. In the corporate context, this plays out most starkly in incentive compensation. The less that critical players in a corporation have skin in the game, the more likely they are to make suboptimal decisions and not properly hedge risk-taking. As the old adage goes, whose $100 will you spend more conscientiously: your own or that of your friend?
VBM incentive compensation schemes are by definition creating skin in the game for those whose compensation falls under the program. Those who create sustainable positive value, frequently determined by their Economic Value Added (EVA®) performance or contribution, get amply rewarded, and those who destroy value can accrue negative bonus bank balances that could reduce future awards. It’s not just executives and management who become accountable. Lower-level employees also benefit from having skin in the game with VBM incentive plans; by caring for the company’s resources as if they were their own, these employees can thereby reap the benefits of the excess additional value created. Employees are further incentivized through compensation that balances short- and long-term profitability, ensuring that rash decision makers who seek short-term profitability at the expense of long-term ruin pay for that recklessness.
Antifragility
According to Taleb, objects, systems, and processes that are antifragile are those that not only remain robust when exposed to volatility, but rather improve and thrive because of that volatility and added stress. In other words, corporations that are antifragile don’t just survive volatility and change, they need it; it’s the accelerant on the fire that keeps them burning.
VBM, when considered with this in mind, can be said to be based on the very premise of antifragility. VBM entices companies to look at the entire picture, to base profitability on a more comprehensive and accurate measure of economic profitability (EVA), and to not consider its operations profitable until they can repay the cost of the capital employed to create those profits. When corporations pursue and achieve positive sustained improvements in EVA, they are well on their way to becoming antifragile.
A key component to understanding antifragility is to understand its relationship with time. Only time, and the accompanying Black Swans that it inevitably brings, can reveal whether a corporation is truly fragile or antifragile. VBM lives this principle out. What really matters at the core of VBM is not the absolute value created, but the directionality of value over time. Steady and sustained creation of value over time—a difficult feat to accomplish—provides evidence that a corporation is indeed antifragile.
Tail Risks and Black Swans
Black Swans, or tail-end risks, are rare events that bring cataclysmic changes and disproportionally large volatility. Due to their rarity, they are difficult, if not impossible, to accurately predict beforehand on a consistent basis. Because of the difficulty of predicting them, antifragility becomes paramount to being able to survive and exploit the volatility brought on by these Black Swans.
If the 2008 financial crisis and 2019–20 coronavirus have taught us anything at the corporate level, it is that corporate strategy must acknowledge the downside risks of Black Swans to corporate viability and build antifragile systems that can thrive under volatile conditions. EVA, as a tool for capital allocation, is uniquely positioned to complement value-oriented strategy in mitigating Black Swan downside risk.
We like to say that EVA has a memory since capital previously employed does not get written off or discarded, but instead must earn a return. This is an advantage EVA has over Free Cash Flow, since in the latter, the bulk of the capital employed flows through at the beginning of the project, while with EVA, capital is charged a rental fee throughout the life investment. Therefore, it is much easier to hold people and units accountable for capital employed with EVA. It is also this characteristic of EVA that pushes companies to redeploy capital if it is not earning an appropriate return.
When a company is faced with the decision of taking capital out of an underperforming initiative and allocating it to projects with higher probability of creating value, it is more incentivized to do so. The fact that projects are continuously re-assessed for their continued value creation means that EVA allows corporations to pivot quickly and efficiently toward new value creating directions.
Sacrificing Resiliency on the Altar of “Efficiency”
Cutting corners to temporarily (seemingly) boost metrics and failing to envision second- and third-order consequences turn antifragile corporations into fragile ones. Perhaps the expense of maintaining that machinery will lower this year’s EBITDA, but skimping on that repair will destroy more value from the capital you had previously allocated toward that asset and expose you to serious trouble should another unforeseen problem arise at the same time.
Often what appears to be an optimization in efficiency is in reality the removal of an important and necessary component of a system’s antifragility mechanism. By implementing VBM and thus ensuring that management has skin in the game, decisions that diminish resiliency and lead to such catastrophic, systemic failures brought on by Black Swans are mitigated, since decision makers know that they will be held accountable.
Conclusion
Taleb has contributed a great deal to our understanding of fragility, risk, and optionality in many spheres of life. His lessons are becoming ever more important as the coronavirus has unmasked the fragility of many systems, economies, and corporations. VBM with EVA at its core will enhance the very antifragile characteristics that corporations need not only to survive, but to thrive off of volatility and uncertainty in the marketplace.