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The Bottom Line

Evan Davis gets to the heart of the big finance stories at The Bottom Line.

"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to heaven, we were all going direct the other way."

The most well-known passage of Charles Dickens’s novel, A Tale of Two Cities, seems an appropriate starting point to discuss private equity, one of the topics of the latest BBC/Open University The Bottom Line broadcast. Belief and incredulity appear to characterise our present epoch of financial booms and crashes, during which private equity firms are painted as the pantomime villain in capitalism’s triumph and fall: asset strippers in name and deed.

The relationship of Dickens’s tale of London and Paris, at the time of the French Revolution, to the financial centre of the City of London seems metaphorical and real. Joseph Addison had described London as an “Emporium for the whole earth” a century earlier, and in the emporium that is the global financial entrepôt of today, private equity firms are as much a part of its landscape as the trader of the 17th century. In the late 20th century, the leitmotif of the City of the furled umbrella and the bowler hat gave way to the yuppie and the mobile phone; the gentleman giving way to the player. For some commentators, these changes represented a revolution whose genesis rested on private equity firms and their ilk.

Businessmen shaking hands.
photo © copyright Jupiterimages Corporation

Private equity firms operate on the basis of buying and selling a portfolio of companies to extract returns of 20 per cent on their investment over a three-to-seven-year period. They institute cost cutting and disposal of parts of companies in order to sweat the assets they have invested in. For defenders of private equity firms, they create long-term value. For critics, they are the manifestation of the UK-based asset strippers of the 1970s; Jim Slater, John Bentley and ‘Tiny’ Rowland amongst others, whose activities were called the “unpleasant and unacceptable face of capitalism” by the then Prime Minister, Edward Heath. The language of private equity activities are, in this view: a climate of fear; downsizing; the casualisation of work and so on. This litany is universal to these firms, whether expressed in the English or any other linguistic form. For the famous economist Joseph Schumpeter, entrepreneurship represents the revolutionising of the economic structure which enables new activities to be born, phoenix-like, from the ashes through the process of “creative destruction”.

It is the important question of language that formed the second topic of The Bottom Line discussion. English is claimed to be the universal language of business, with its own cross–national dialects, so that knowledge of other languages is deemed not to be as important as it once was. But language is like football, the rules of the game may be pretty much the same but the variants are as numerous as the array of cities in the world. It is a linguistic truism to say that language affects the way in which one thinks. Knowledge of local customs may be useful upon introduction to a client, but knowledge of the rudiments of the local language is an important part of business engagement and sustainability. For example, in China, saying yes to a question does not signal agreement but rather that the speaker has been heard. These are important considerations for companies that engage in international transactions. It can be argued that globalisation will only be completed if the law of one price operates. That is, all prices in the world converge with the only differences being accounted for by transport and administration costs. Similarly, if English became the first language of everyone in the world it would become truly global.

Capitalism, as Schumpeter and others remind us, is a revolutionary system in which “all that is solid melts into air, all that is holy is profaned…” Private equity is part of that system and provides a vehicle for “revolutionising the conditions of production.” A single global language would be part of that revolution, and if that is not generally understood then change does need to be made. Blaming private equity firms and hedge funds for the financial crisis is a bit like Canute blaming the Moon for his failure to control the tides. There are compensations with more than two cities and more than one language in the world which makes us all richer, whether materially or culturally. The globalists, in whatever guise, make us all poorer as heterogeneity is sacrificed for homogeneity.

Find out more

Sovereign wealth to the rescue

Faith in fakes? Travels in hyper-mobility

OU courses

Financial strategy

Making a difference

Capacities for managing development

Beginners’ Chinese

About the author

Leslie Budd is Reader in social enterprise at The Open University Business School. He is an economist and has written extensively on the relationship between regional and urban economics, and international financial markets.

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If there’s one constant in these turbulent times, it’s change. The huge shifts in political, economic and social factors that strategists call the “remote environment” are changing the behaviour of customers and competitors, the so-called “task environment”.

To survive, companies have to adapt to their new conditions. People like me study how some do and why some don’t, so we can help companies survive in the business equivalent of the great extinctions that led to the demise of the dinosaurs.

Two recent and contrasting news stories illustrate both the need for change and the barriers to it. British Airways, along with most of its rivals, has reported an 8.2% drop in passengers and an operating loss of £150m. The main cause of this is a decrease in the profitable long-haul, premium customers in business class. As I know from the firms I work with, many executives are now discouraged from travelling unless really necessary and, when they do, have to fly economy. Worse still for the airlines, this doesn’t look like a short-term market blip but a permanent shift in customer behaviour.

BA planes. [image by Matt Hintsa, some rights reserved]

This compares with Intel, the big chip-maker. It too has suffered from the economic conditions, reporting a huge reduction in profits and announcing the closure of 5 plants as both firms and individuals buy fewer computers. Unlike BA, however, Intel is showing some signs of adapting to the future by looking for new markets. One example is its recently announced tie-up with General Electric’s medical division. Together, they plan to create new technology that will reduce healthcare costs by allowing doctors to monitor and diagnose patients remotely.

Since most healthcare spending is on patients with chronic (that is, serious, long term but not life-threatening) conditions who are at home, this looks like a business opportunity that will only grow and be relatively immune to market conditions.

BA and Intel, both global businesses staffed by bright people, seem to have very different abilities when it comes to adapting to the market. In the jargon of academics, they exhibit different adaptive capacities. Why  is this so complicated and interesting? Simply put, adaptive capacity is a combination of obvious practicalities and less obvious embedded habits.

For instance, BA’s primary assets are its planes, routes, airport slots and brand. Intel has some of these “fixed assets” of course but it’s really a “knowledge-based” company. Its biggest asset resides in the kilo or so of grey mushy cells that sits between the ears of its employees. In practice, this means that, whilst Intel can switch where to apply its assets relatively easily (from one area of computing to another in this case). It’s much harder for BA. To attack a new market, they would need to scrap or adapt planes, sell slots and routes and reposition the brand, all of which is difficult and expensive. And those are just the obvious difficulties.

A computer chip. [image courtesy of Intel]

Adaptive capacity is also the result of organisational culture, the embedded habits of the whole company. Intel, for example, is committed to technical excellence but cares less about where it applies that excellence. BA’s culture is all about a premium service, especially on long-haul. This shows in everything it does and would be difficult to change.

Academics have studied the idea of adaptive capacity for many years. They identify as important things like having time to think about change and the ability to make sense of the market. However, as even the best companies find, the complex mix of fixed assets and organisational culture make changing to fit the market a very difficult challenge.

Further reading

BA to Miss 2008 Revenue Targets 

Intel works with GE on healthcare

Formulating adaptive marketing strategies in a global industry, an article by Tung-lung Chan in the June 1995 issue of International Marketing Review.

About the author

Dr Brian D Smith is a Visiting Research Fellow in The Open University’s Marketing and Strategy Research Unit. He is the author of over 100 books and articles and runs PragMedic, a specialist strategy consultancy.

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Money Programme

Get the facts behind the big business and finance stories from around the world – and down your street, in The Money Programme.

Globalisation of trade has resulted in huge trade surpluses in many countries, particularly in Japan, China and other Asian nations. If you combine this with the build-up of foreign reserves in oil exporting countries, thanks to soaring prices, then you find some countries sitting on piles of US dollars, Euros and Sterling.

What do the governments of such countries do? They set up Sovereign Wealth Funds (SWFs) as vehicles for investing their foreign currency reserves. And looking for investing opportunities, they turn their attention to western European and the US financial markets (that provide a wide range of investment opportunities in financial and real assets). The main objective of most SWFs is to maximise returns on their investments.

In theory we can explain the phenomenon of state owned SWFs investing in foreign securities and assets in fairly simple terms. The financial markets exist to bring together the funds surplus units and the funds deficit units.

The recent crisis in banking industry illustrates this well. The consequences of sub-prime and credit crunch left many multinational and large banks needing fresh capital to bolster their capital base. In the UK, for example, HBOS and Royal Bank of Scotland tried to raise capital through rights issues. Both could not get enough subscription from their existing investors.

“their investments have helped stabilise the global financial markets”

SWFs have stepped in, and are injecting large amounts of money in multinational banks, including the British bank Barclays. Since the US sub-prime mortgage crisis their investments have helped stabilise the situation in global financial markets.  

A turbulent international financial system has an impact on the economic growth of the developed world. The developed world is the major market for manufactured goods (exported from China, Japan, South Korea) and oil (exported from the Middle-East, Russia and Nigeria). So an unstable global financial system can seriously threaten the economic progress in developing countries. And, of course, the investments that bring this stability are in the interests of source countries’ interest!

SWFs are not new, but they’ve attracted more attention in recent years. The Kuwait Investment Authority (KIA) was set up in 1953 and the Norwegian government set up their Global Pension Fund in 1990 to manage the surplus revenue from oil and gas exports to provide for future generations. So SWFs are not the preserve of fast growing countries such as China or South Korea. They’re been set up by Australia, Canada, Angola, Russia, some states of the USA, Ireland and even East Timor.

However, the western world is becoming concerned about the lack of transparency of SWFs, and the possibility of SWFs gaining control of domestic companies. Advised by the US, the International Monetary Fund is engaging with the major SWFs to agree on voluntary standards for transparency and governance mechanisms in order to allay these fears.

“governments are not known to be good managers of assets”

It seems worth bearing in mind that governments are not known to be good managers of assets, be it financial assets or public enterprises. And SWFs are essentially state owned financial institutions. Will sovereign wealth funds prove to be exceptional in the long-term? Data about these funds is scarce, so it won’t be easy to find reliable empirical evidence on their performance. Meanwhile, we can only watch and wait.

Weblinks

• Join the discussion
• Watch the Who's Buying up Britain trailer
• Calling companies to account
• Gold...always believe in?
• Sovereign Wealth Fund Institute
• International Working Group
• Equity finance  - OpenLearn unit
• The financial markets context - OpenLearn unit

Courses

• Issues in international finance and investment
• Financial strategy

About the author

Devendra Kodwani is Lecturer in Finance at the OU Business School. His research interests include the economic regulation of utilities and he has written several papers on privatisation and regulation.

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