The Skill of Capital

This is Part 2 in a series on the expertise of capital in business. You should probably read the first part here.

One way to learn technique in a competitive sport — say, tennis — is to read about it, and then go experiment with it on your own. But a better way to learn technique is to watch it in action — either in competitive play, performed against you, or as a third party observer, watching it done to others.

I think the fastest way to communicate the expertise of Capital is to walk you through a bunch of examples, in order to illustrate the nuances of the skill in action. In each of the following narratives, ask yourself: why is this an advantage? Why does it work? Why is Capital just as important to understand as the Operations and Market sides of the Business Expertise triad?

Two caveats: don’t read the following stories for lessons. Treat them as concept instantiations instead. I’ll make some observations at the end.

Let’s get started.

An Unfair Setup

You run a small flour mill out of a second tier city in a developing country. At first business is good: you buy wheat from overseas sources, mill it, and sell the flour to distributors in your region. But soon you hear that a competitor is rising, seemingly out of nowhere. Your growth halts over the course of two years: packets of your competitor’s flour show up in your local grocery store; the businesses and distributors you sell to switch over to this other supplier, since — you quickly learn — this new business is willing to give them generous bulk discounts. Rumour is that the new business is backed by a prominent, politically connected businessman, based out of your country’s capital.

You run a commodity business, which means your flour isn’t any better or worse than your competitor’s. But you cannot win against this competitor. You cannot grow. You watch as this new flour company expands from region to region in your country — eventually, you find their products sold in even the remotest villages. A decade later, the company becomes famous for building the largest flour mill in the world.

Agustiadi is your friend. He runs a small instant noodle company in your city. At first he buys flour from you out of loyalty, but over time he switches to your new competitor — the discounts on offer are too great to ignore. But Agustiadi’s company is also doing badly. There’s a new competitor in the space, also linked to this same prominent businessman — an instant noodle company that seemingly appears out of nowhere and now grows like a weed. Agustiadi is boxed in. You watch, over the course of a few years, as this new instant noodle manufacturer grows its market share. Many other operators in the instant noodle market throw in the towel. Agustiadi is one of the few who doesn’t give up; you eventually learn that this large competitor owns 90% of the market.

Over time, you learn how this happened. This prominent businessman — the one who started both the flour mill company and the instant noodle manufacturer — was such good friends with the President of your country that he convinced the President to have your government sell him imported wheat at a subsidy. This is not too difficult to do — your country is a developing nation; the government is still heavily involved in import policy; it has many agencies with the capability to execute on this. But getting flour at a subsidised price wasn’t the full story. After securing this deal, the local businessman then convinced the President that the government should buy back the flour from his mills at a markup. This meant, effectively, that the businessman had guaranteed profits: it had a cost advantage and a guaranteed network of buyers, so no wonder it could lever up and build the world’s largest flour mill, stretching out over the riverbanks of your country’s capital city.

But that wasn’t the end of it. Oh no — shortly after, Agustiadi gives you his half of the story. Whilst this flour mill company was supposed to sell all of its flour to government-linked distributors, a surprisingly large amount ended up on the loading docks of a different company: an instant noodle business, coincidentally owned by the same businessman. And so now you understand what has happened: in both cases, the flour mill business and the instant noodle company enjoyed sustained cost advantages not available to any other competitor in the market. It’s no wonder that both you and Agustiadi were boxed in.

I tell this story for a handful of reasons. First, this is the nature of business in my part of the world, which has comparatively immature equity and debt markets. My fictionalised account is really the story of the Salim Group in Indonesia, the world’s largest flour mill Bogasari, and the rise of Indomie, the world’s largest instant noodle manufacturer. (Incidentally, a major contributor to student weight gain in universities all across South East Asia).

There’s a colourful, short snippet from Sebastian Mallaby’s More Money Than God on this particular episode:

[Event-driven hedge fund] Farallon’s target, Bank Central Asia, had been founded by Liem Sioe Liong, who had been Indonesia’s richest man and a firm friend of the country’s modernizing dictator, Suharto. Liem’s empire was said to account for 5 percent of Indonesia’s output, and the secret of his success was best illustrated by the flour business. Playing on his connections to Suharto, Liem arranged for Indonesia’s government to sell him imported wheat at a subsidized price and then to buy it back from his flour mills at a markup—nice work if you can get it. Untroubled by competitive pressure, Liem’s flour mill in Jakarta grew to be the largest in the world; the second-largest, in Surabaya, belonged to Liem also. And although the mills were supposed to sell their flour back to the government, an impressive quantity found its way to another Liem enterprise, Indofood, which consequently controlled 90 percent of Indonesia’s instant-noodles market. In similar fashion, Liem prospered mightily in coffee, sugar, rubber, cement, rice, and cloves. Naturally, a man of his standing needed his own bank. Naturally, the bank was the nation’s largest.

By the time Farallon came on the scene, Liem’s empire had imploded. The patriarch had hedged his political risk by awarding Suharto relatives large stakes in his firms. But the currency crisis that cost Soros and Druckenmiller a fortune triggered a slow-motion revolution in Indonesia, culminating in the fall of the Suharto government. From that moment on, Liem’s political insurance policy became a target painted on his chest—friends of the fallen president were now enemies of the people. Rioters broke into Liem’s compound, set his cars ablaze, and smashed his Chinese vases. Shorn of their political protection, Liem’s businesses went bust, and since many of their loans had come from Bank Central Asia, they threatened to bring the bank down with them. To stem depositors’ understandable panic, the government rescued it.

In reality, the story of the Salim Group is more complex and more interesting than the brief narrative painted here. It’s not, for instance, accurate to say that the Liems lacked expertise — after the Asian financial crisis, the Salim Group paid off its debts and pulled off a recovery, leading one commentator to write, of the post-98 period: “even its enemies would concede that the Salim Group had created better businesses and handled its debts in a more honourable fashion than many others”. The real story also differs from my fictional account in a few other aspects: flour milling was a government granted monopoly in Indonesia at the time, and the Liems financed the creation of Bogasari as a joint venture with Kuok Brothers of Malaysia (notably, they held Robert Kuok’s ownership for him, as the Indonesian president suddenly — and mysteriously — mandated that the business be 100% Indonesian owned; this despite Kuok putting up 75% of the starting capital). Perhaps the Liems were not so honourable after all? But I tell this story to make a different point.

Notice how neither you nor Agustiadi’s businesses were defeated by superior product or smart counter-positioning or better, more efficient operations. No: you were defeated by superior access to capital. When I put it in those terms, of course it’s clear what happened. I can already hear you saying “duh, companies with more money can beat companies with less money.” (This is not always the case, but sometimes it is the case, and this is one of those times.) But pay attention to the form of that access. In our previous piece we talked about Dell’s Capital expertise: I walked you through the skill that Michael Dell demonstrated as he navigated the equity and debt markets in America. That was also a story of superior access to capital, but one in which savvy capital expertise enabled business moves that Dell’s competitors did not see coming. This story is different. The point I’m making is this: it is not the case that a capital advantage may come only in the form of selling equity or taking on debt. Developing countries do not have mature equity or debt markets. That does not make expertise in Capital any less relevant, because a capital advantage may come in structurally different forms — as we’ve just seen with Liem’s flour mills. The expertise of capital in business lies in knowing that this is the case.

Also, and I guess this is obvious by now: sometimes a capital advantage does not come from expertise as we traditionally think of the term. Dell’s story (and John Malone’s story) was a story of sophisticated capital chess moves. This story, on the other hand, is a story of pure access. (And by access I mean corruption).

I can guess what you’re going to say next. “This is not a sustainable advantage!” you exclaim, and you would be correct. Yes, government subsidies can’t last forever. Yes, having the government be a guaranteed buyer of your goods will eventually bite you in the ass; commodity prices are volatile and government resources, while large, are finite. And yes, ultimately Liem’s empire took a blow thanks to the Asian financial crisis. But this is of no comfort to you, or to Agustiadi: in the real world, this state of affairs lasted for more than two decades. That’s long enough to drive any competitor out of business.

One last thing. Notice that in our story, Agustiadi’s competitor — the instant noodle business — was effectively funded by an ‘unrelated’ company. In reality, shares in both businesses were held by the same parent holding company, which in turn was controlled by the politically connected businessman. The parent company could reallocate capital from one subsidiary to another. We’ll return to this observation in a second.

No Funding Required

It is 1980 and you are 25. You want to start a startup. Venture capital in the 80s is filled with sharks who can be terrible to founders. ‘Founder friendliness’ as a concept is at least three decades away. Your first venture backed startup makes network routers. It fails. You have a nasty board member from the lead VC firm and your hair falls out in clumps over the next three years, viciously fighting over tiny operational details, before you get kicked out and the business winds down.

You take a break and recover. You ask yourself: is it possible to start a high growth, speculative company without venture capital? You conclude that it’s not possible, at least not in your particular niche: it simply costs too much to pay for engineers to come up with better routers, it costs money to buy components, it costs money to turn those components into routers, and it costs money to hire people to sell and service these routers. You need money today in order to do all of these things tomorrow. Where are you going to get that cash?

You could borrow money from a bank, but no bank is going to lend money to you before you have a demonstrably viable business. What about collateral? Well, you have no collateral to put up; the one bank who was willing to see you asked you to sign a personal guarantee. You briefly consider taking out a second mortgage on your house in order to fund your next venture, but decide against it.

No: the form of capital that is best suited to your needs is venture capital. A VC firm’s incentives are aligned with high growth, speculative businesses. You sell equity to a firm, they meddle in your business (this is, after all, the 80s), and then hopefully you turn out to be a hypergrowth company. You grow the business into hundreds of millions of dollars, you go public at the end of a 10-15 year journey (and it’s always 10-15 years, isn’t that funny?); the VC makes huge returns on their investment and then you, and the VC, and their limited partners, all return home rich.

With one major caveat: you need to find a high growth business idea, one that can possibly grow into a gajillion dollars. Most business ideas are not like that. Many ideas can turn out to be good businesses, perhaps, but on a much smaller scale. If you don’t achieve the high growth outcome after taking on venture funding, you fail, your company is taken away from you, it gets sold off for parts, you are pressured to merge with some other portfolio company, but oh well. No matter. You’re not financially ruined. If this is a lottery ticket, the only irrecoverable currency you lose is the years of your life you spend going after the jackpot.

As you spend the next year or so mulling this problem, you hear about a company growing like a weed in Albuquerque, New Mexico. Your cousin works there. “We make software,” he says. “Do you have investors?” you ask. Your cousin has no idea what you’re asking or why; he’s an engineer and cares only about writing kernel drivers or something. He scrunches up his face. “No? Or at least I don’t think so.”

You go digging. Software is a relatively new thing; nobody really knows what software companies look like. Turns out this little company makes operating systems for personal computers. Personal computers are the hot new thing. A whole bunch of IBM clones have emerged in the past couple of years, whilst you were heads down at your networking startup. You take a closer look and realise that this company is very different from your old company.

For starters, the software that this company sells is written just once, by programmers, and then copied onto discs and distributed. The cost of the disc is negligible. The real cost lies with the salaries of the software engineers who had to write the software in the first place. Where did the money to pay those engineers come from? You dig a bit more and learn that the company had bootstrapped that capital by taking on contracts in its early years. Second, the PC market is growing at a ridiculous clip, which is always a good sign. Third, every IBM PC clone sold needed to run an operating system; the OS made by this tiny company happened to be the winning choice due to some historical luck: when the IBM PC first launched, this OS was priced cheaper than the alternative (a mere $40 compared to $240); it was also the only offering that had OS, programming language and application software all bundled together.

You sit back and look at all the facts:

1. There is zero marginal cost to making and distributing copies of this product.
2. Normally this wouldn’t be remarkable on its own, except that the product happened to be a critical complement to another, rapidly growing market (the PC market).
3. Which in turn meant that the cash it earned from selling copies of its product would be more than enough to pay for all its expenditures, and the investments the company needed for its future growth.

You’re not sure if this company would win in the long term, the same way you’re not sure if personal computers represent a sea change that would go on forever, but you realise the implication of all these facts because it is in such stark contrast to your previous company: this is potentially a venture-scale business without the need to raise venture capital. It could fund all of its capital needs through product sales. It could do this because the costs were fixed, the margins were so large, and the growth rate of its market so steep. You know, from your past experience, that this combination of factors is very rare — possibly a once in a lifetime opportunity.

You give up your startup dreams to join the company. It goes public shortly afterwards in 1986, adding $61 million to its coffers at $21 a share. More importantly, your analysis turns out to be correct: the founders and its employees get rather rich, because they own the bulk of the equity; not diluting ownership because you can grow off the back of your own revenues is nice in that way.

This company is, of course, Microsoft. It raised one venture round in 1981, purely for fun, just so that they could get a venture capitalist on their board. Bill Gates said, much later:

“Software, if you can sell it in volume, has extremely favorable economics because the costs are quite finite, and you can scale the volume, in our case, to sell millions of copies – every Apple II Computer, Commodore PET, IBM PC had copies of our software, so our income went up a lot. We didn't have to build any factories, we were cash positive, and we didn't have a year where we lost money. The first few years Paul (Allen) and I worked for free, but after that we were just generating cash (emphasis mine). We eventually gave away, or sold, 5% of the company for a million dollars at a 20 million dollar valuation, just to get a venture capital company to join our board and give us some adult advice about various things, which was quite helpful. We picked one in the valley, a guy named Dave Marquardt came on our board and did a fantastic job.

That money sat in the bank, and it's still in the bank today, so it was not for anything to do with capital, but rather just to join the team ... he's still on the board of Microsoft and is still extremely helpful as a lot of important decisions get made."

Gates, it should be noted, kept a year’s worth of company expenses in the bank for many of the early years of Microsoft; he knew the cash demands of his company like the back of his hand. And from everything that I’ve read of early Microsoft, Gates understood the value of his equity; he also knew he had a business that demanded very little dilution. He could have just as well not raised any money.

It’s worth asking if you are capable of doing the same thing, if you were put in Gates’s shoes. Imagine that you are running a rapidly growing startup in the hottest industry segment around. Imagine that you are taking meetings with VCs, as Gates did, in 1981. “Companies lose when they’re undercapitalised.” these VCs would say. “Take our money, so you can beat your competitors. So you can hire better people. So you may gain access to our network. So that you can fend off Apple.” Sellers of capital will always come up with good reasons for you to take their capital.

But imagine that you’re 26 years old, as Gates was in ‘81, and you look these VCs across the table, and you say “Thank you, but no thank you, I’m just looking for one partner to sit on our board. We want advice. Your money is irrelevant; the cost of taking your capital is too high; my business is adequately capitalised. If I need capital I’ll go to the public markets in a couple of years. Their money is cheaper.” Would you be able to say that? And maybe you wouldn’t be able to say it, because you’re super nice and all, but would you be able to think it?

I know I wouldn’t. Not at 26.

Notice what I’m not saying, however. I’m not saying that venture money is necessarily bad. You cannot compare your options today with Gates’s back in the 80s: for starters, the cost of venture capital has come down significantly since 1981, and VC firms are considerably more founder friendly. What I’m asking is something more idempotent: do you know if your company is adequately capitalised? Are you able to reason — in a sufficiently sophisticated manner — about the capital needs of your business model? Do you even know what adequate capitalisation means?

The Business Model of the Money That Funds You

It is the early 90s and you are a venture capitalist. You’ve been a venture capitalist for close to 10 years now; you are in your late 30s. You have four kids, all under the age of 10, a modest home, and a mortgage. You drive a Toyota Camry. Your wife drives an ancient Chrysler minivan.

You are not happy with your venture career.

There are many reasons to be unhappy with a venture career, and I shall speculate about some of them. The first reason is that venture capital is a game of access and a game of luck. You have average access — your venture firm is one of the largest privately owned ones in Canada, but it’s in Canada, for heaven’s sakes — and therefore you’re exposed to the meh end of luck.

What does this mean? It helps to understand the shape of the game you’re playing. A venture backable business is a business that can take lots of capital, and then grow big fast. As we’ve just discussed, this is a rather rare combination — most companies cannot grow large; they settle into a much smaller natural size. Pumping capital into them often causes them to implode. So the problem here is that there are only so many venture-backable businesses that are raising capital in any given year, and you need to get into those deals. Then you need to help these companies grow large. You ignore, or write off, the companies that turn out not to make it. And when your winners finally get acquired or go public, you collect the returns, pocket around 20%, and return the rest to your investors. Oh, and you have to do this within 10-15 years, which is the average time limit of each closed-end fund that you raise.

Some people don’t like the ‘game of access’ part of venture capital. It implies competing, fiercely, to get into the small handful of deals that are venture viable. The problem with this is that good founders are more likely to accept money from VC firms with good reputations. “The best way to be successful as a VC is to be a successful VC” is a common saying thrown around the industry; venture returns are known to be sticky, which means that the firms that are most successful are the firms that have been successful in the past. But it turns out that you’re not displeased with the ‘game of access’ bits per se. Sure, you’re not in a top tier VC firm, but you’ve made a decent living so far, scrambling for deals in your corner of the world. What you’re really irritated by is, first, the crapshoot of returns in venture as a result of your position, and second, your inability to compound your winners.

What does this mean? Recall that every venture fund is a 10-15 year closed-end capital vehicle, which is a fancy way of saying that you lock up the capital of your investors for a period of 10-15 years. At the end of those years you must wind down the fund and return whatever results you’ve generated to those investors. In exchange for locking up their money for such a long period of time, your investors demand a high return: the commonly discussed figure is ‘3x’; that is, that you are expected to return at least 3x the capital raised by the end of the life of the fund. In practice, the best VC firms return many times more than 3x capital. They do not lack for potential investors: the best university endowments, pension funds, and family offices line up around the block to invest with them. You, on the other hand, have to grind out exceptional returns on every fund to prove out your worth.

(But in the meantime, the 2% fees you charge are extremely enjoyable).

You hate this, though. You hate the fact that you have a time limit to demonstrate a return, and you hate the fact that you need to find the tiny set of companies that can generate such returns, only to sell them and pass the captured bounty to other investors. Worse, these businesses are risky — and doubly so because you are often locked out of the best deals. This means that you have to bet on companies that are vanishingly unlikely to grow big. Of course, you don’t mind killing or losing the few that — in an alternate universe — could’ve been perfectly profitable, if small, companies. You are pushed by the structure of your business to push other businesses to swing for the fences. But you’ve noticed, over your decade in venture, that many high growth businesses simply fail to develop into businesses that generate high returns on capital.

Anyway. As a result of your above average position in the venture world, you have middling returns. In this you are not alone. The vast majority of venture funds generate erratic and unimpressive results. Most venture investors have no edge. You look over to some other investment styles and wonder what it’s like to compound returns over the course of decades.

In the early 90s, you are so dissatisfied that you begin searching for something better. At first you think “hmm, what if we find a great business manager first, and then find this manager a business to run? Then we’ll deploy some of the money from our fund into this new business.”

This is when you get lucky. You find a remarkable operator by the name of Steve Scotchmer. There is a problem, though: you can’t seem to find a business that is good enough by his standards. Scotchmer, as it turns out, has an incredibly high bar for business quality. He begins mentoring you. He teaches you what to look for in an ideal business, and feeds you letters from Warren Buffett and Charlie Munger. This begins to change your perspective.

At the end of the day, what is a good business? One way of thinking about business is that it is a box that provides something of value to a customer on one end and then spits some cash out the other. This is too simplistic, however: sometimes a business doesn’t spit out that much cash right now because it’s growing too quickly — so all the cash it may spit out goes back into growth, but at some point it should plateau, and then it would gush cash. Therefore: a good business spits out lots of cash, and doesn’t need that much money to grow. A bad business spits out a little cash, and needs lots of money to grow.

The key concept here is ‘return on invested capital’, or ROIC. You’re spending on growth — but is that growth good? Will the future returns from growth be above the cost of capital you’re spending on it? This is a subtle nuance to the ‘grow grow grow’ mantra of venture.

Sometimes a business has lots of high ROIC opportunities to expand, and is able to swallow a huge amount of injected capital to grow quickly. (In very rare situations, an amazing business has lots of opportunities to expand and doesn’t require that much capital to grow that quickly; this is Microsoft). But very often — most of the time, in fact — a business will hit its natural limit and find little to no opportunities for expansion, and no amount of capital poured into the company will ever make it grow. This makes it a poor fit for the venture model. But such companies can be good businesses! Scotchmer teaches you to see that good businesses, at maturity, are defensible — that is, ideally, the business’s returns are immune to competition — and so will spit out a stable stream of cash over the course of its life.

The key word here is ‘stable’. In addition to being defensible, good businesses have repeatable, predictable revenues. Selling toys can be very profitable, for instance, but if your toy falls out of fashion, your revenues take a nose dive. A better business is a magazine with recurring subscriptions ... assuming your readers continue subscribing. But the best business of all is something like the manufacturer of airbag valves that — thanks to regulation — must be installed in all airbags in every car ever manufactured around the globe. The valve is an extremely small percentage of the car’s total bill of materials, making most auto manufactures indifferent to your price hikes. Oh, and it turns out that you also own all the patents necessary to make this valve, so you have no competitors. Now that is a good business.

You take in all of these lessons, and then you take a long, hard look at your venture portfolio. You realise something interesting. There is a small group of software companies that your firm has invested in over the years, that had all failed to reach venture scale returns. These are businesses that make software for specific industries. You call them ‘vertical market software’ providers — companies that make things like dockyard management software or dentist CRMs or, say, the software that runs a public transit system. Obscure pieces of software; nearly impossible to rip out and replace, but too small to grow out of their industry niche. But through Scotchmer’s lens you see that these are good businesses! You particularly like the following properties:

• That these businesses are critical to the operations of their customers,
• Their products and services make up a small percentage of their customers’s wallet, giving them pricing power,
• Many of them serve small-to-medium sized businesses, which makes it unattractive for large competitors to enter their markets
• And they all have a dominant position in their market niche.

Sure, these companies can’t grow any further, but they have moats, and they’re throwing off lots of cash, and their moats cost relatively little to maintain (the magic of software, remember?)

You know that you cannot invest in these companies from your venture fund. The structure of the venture business would not allow you to reap such small, if steady returns. But what if you ... bought them? An idea begins to form in your head.

What would happen, if say, you created a company, raised some money, and then bought these types of businesses using the cash off your balance sheet? What if you then harvested the cash flows from each of these businesses and used the capital to buy other businesses of a similar type? Of course, occasionally you might come across natural opportunities for expansion, and may direct some of the harvested cash flow to those opportunities for organic growth, assuming the ROIC on these opportunities are higher than or equal to the ROIC of a new acquisition. But by and large the businesses you acquire have low capital intensity, spit out a stream of stable earnings, are defensible against its competitors, and aren’t likely to grow that much. There are other interesting questions, of course: what if you let the operators of these businesses talk to each other, copying best practices from each other? Perhaps these might increase the free cash flow generation of each business? How well might that turn out? And then, finally: what if you let this machine compound for a very, very long time?

You like the idea. More importantly: you feel like you’ve stumbled onto a secret here; something that others do not fully appreciate (and while this might change in subsequent years, it should be good for at least a decade). This insight gives you another reason to leave venture: competition with no edge is for chumps.

Many years later, you would write:

The most important revelation of my venture career was that vertical market software businesses have great economics but had been poor venture capital investments because they served small markets. To start CSI, I tweaked the normal venture capital playbook in an unusual way, concentrating upon the permanent ownership of many small vertical market software businesses that could share best practices. The rest, as they say, is history.

You quit your venture capital job shortly after this realisation. In 1995, you start your new company. You are 39 years old.

Some of you might recognise the story by now. This is the story of Constellation Software, and therefore the story of Mark Leonard. Constellation went public in 2006, and proceeded to compound at an average rate of 34% per year for the next 17 years. If you had bought at the IPO, you would have made 130x your money.

Why am I telling this story?

There is a Steve Blank line that goes “you take on the business model of the capital that funds you.” Venture capital has a certain set of requirements; Leonard knew he couldn’t adapt the structure of institutional VC to the kind of compounding business he wanted to build. And so he fashioned for himself a permanent capital vehicle — one in which he wasn’t required to generate returns on a 10 year timeline. The capital structure fit the strategy he intended to execute.

Second, notice the box analogy that I introduced in the middle of the story: a business is simply a machine that provides some value to a customer on one end, and then spits cash out the other. This is the capital allocation view of business. Every business is a box, and every business spits out a stream of cash. What you do with that stream of cash determines the long term value of your business. And you can really only do one of five things:

1. You can reinvest the cash into existing business initiatives, assuming the rate of return for existing business initiatives is higher than all the alternative moves
2. You can pay down debt
3. You can buy another company, either for growth reasons or for defensive reasons
4. You can issue a dividend
5. You can buy back stock
6. Or you can do nothing, leaving the cash in the business as dry powder for some future move (this probably doesn’t count as a move, but I’m including it for completeness.)

Many business operators reflexively reinvest free cash flow back into the business, even when the reinvested cash generates decreasing returns. And why wouldn’t they? It’s always worked for them in the past — on the way up, they’re hiring more people and expanding to more stores and spending increasing amounts of marketing dollars to grow. But when the rate of growth decreases, as it inevitably does, they continue doing more of the same, not understanding that they have to do something different. They do not realise that there are other options available to them. Or perhaps they do, but they do not realise that they have to think like an investor — that the stream of cash flow should be reinvested into the best of a palette of five options.

The idea that business managers have to reason like investors is perhaps the most paradoxical aspect of business expertise. This is why you commonly see operators who:

• Double down on growth, even when it’s not working.
• Believe that the only way to hit a large dollar outcome is to grow one business.
• When their one business stalls out, they grow discouraged, throw up their hands, sell off the company, and then start over with a new idea (often selling to somebody who has capital expertise, and understands the box model of business).
• At no point do they look at their business as a cash generating asset and go ‘hmm, that’s some nice free cash flow there, I wonder what other opportunities I might sock that cash into to replace the rate of return I used to have when growing the business?’

To put it simply, good capital allocators spend excess cash rationally; bad capital allocators repeatedly set it all on fire. And Mark Leonard? Leonard started Constellation with the knowledge that picking option three — acquiring a new company — would often be the highest returning option for Constellation over the long term.

Leonard is today considered a master capital allocator: over the past 28 years he composed various boxes together, funnelling cash from each business into the headquarters at the top, reallocating capital at each point to the highest returning opportunity available. Over time, Constellation became too big to manage, so he split the company into six fully autonomous operating groups, each OG a smaller version of HQ, and each fully empowered to execute variations on the same strategy in many more markets. As a result, Constellation’s velocity of acquisitions has gone up, at one point hitting a (presumed) rate of around 100 acquisitions or so a year.

This is not superior operations or superior market insight (although, yes, it is a little bit of both, because it always is at the highest levels of business). This is primarily the expertise of capital in action.

The Expertise of Capital

What is the underlying theme behind these three stories? What is the shape of the skill of capital?

I think there are three big ideas here. Perhaps you’ve noticed them already. When you boil it down, the expertise of capital consists of:

1. Knowing how to get capital (which includes knowing how much to pay for it and how much of it to get).
2. Knowing how to deploy capital.
3. And then, finally, understanding all the implications of (1) and (2) on the rest of the business.

Let’s talk a bit about each of these things, in order.

1) Knowing How To Get Capital

If you read a corporate finance textbook, you’ll learn that there are three ways to get capital:

1. You tap retained earnings
2. You issue debt
3. You raise equity.

This list is true but it is deceptive. First, this palette of decisions hides a lot of nuance, creativity, and skill. Second, as we’ve just seen at the top of this essay, there are other ways to get capital in the real world — and some of them are not entirely legal.

Let’s talk about the second one first. Why am I even talking about corruption? As I alluded to in the first story, capital shenanigans is the nature of business in my part of the world. It’s always easy to talk about clean, textbook examples of capital expertise in action. But if you’re not aware that capital expertise may be expressed differently — even illegally — then you may compete against a corrupt operator and get your face ripped off.

As an example, let’s say that you start a manufacturing business in a rural corner of a Communist country. A local businessperson starts a competing business, and very quickly proves to be much better capitalised: they hire better people, lock up distribution channels with better deals, and start building out larger, better placed factories than you can afford. “How is this guy funded?!” you ask, because you hear no news about equity sales or even know of any investors in the area. A few months later you learn that your competitor is a cousin of the local Communist party boss; the state mysteriously sells large holdings of land to the company for pennies on the dollar, and your competitor is either building his factories on this (effectively) free land, or funding expansion by selling parcels to hungry real estate developers that are taking advantage of an ongoing real estate boom.

Is this funding through equity sales, retained earnings or debt? The exact categorisation is an interesting academic exercise but otherwise irrelevant to the demise of your company; I’d just chalk this up to corruption and leave it at that. My point is that if you choose to do business in a developing country, you’re swimming in shark infested waters, and if you’re swimming in shark infested waters, you better study how sharks eat.

But let’s return to the first point that I wanted to make: that raising capital may involve nuance, creativity and skill. I think this is easier to see at this point. I opened this series with Dell’s Capital Expertise because I thought it was a masterful demonstration of capital skill in action; I included the story of Microsoft above because I remember learning that early Microsoft raised little-to-no capital, and marvelled at the team’s maturity around financing.

Why is raising money so important? The answer is the ‘temporality of cash flows’: most businesses must spend money today in order to make money tomorrow. You need to get that capital from somewhere. And you have to pay for it: selling equity means diluting existing owners (and sometimes giving up control) of your company; taking on debt is loading up your business with an interest burden. Knowing how much to raise, and knowing how to reduce the cost of the capital you raise is all part of the skill of capital. Equally important: understanding the incentives of the capital that funds you.

But there’s one other aspect of capital expertise that we’ve alluded to but not discussed yet. As we’ll see later on in this series, savvy capital operators are able to structure their businesses such that free cash flow generation fits thoughtfully into their growth strategy. After all, if you can fund ongoing expansion through generated cash, you have to take on less external capital. This tends to be a good thing.

2) Knowing How To Deploy Capital

We’ve talked a bit about the capital allocation playbook during Mark Leonard’s story, and we’ve already examined the idea that long term business value is largely affected by a CEO’s skill at capital allocation.

These are big ideas that we’ll take a look at in future instalments.

For now, I just want to point out that capital allocation was also present in the first story on the Salim Group. The parent company in that story reallocated resources (flour) from Liem’s mills to Indomie, and grew Indomie off the advantages enjoyed by the former business. If you read histories of various Asian businesses, you’ll notice that capital allocation of this type is common amongst Asian conglomerates. The other common capital allocation trope? Setting up joint ventures, especially amongst the various Chinese business families of South East Asia.

It’s a little funny once you realise the number of JVs and cross dealings between business families in the region. But then you don’t expect the families of Crazy Rich Asians to have just met through social events, did you?

3) Implications of (1) and (2)

What are the implications of raising capital and deploying capital on the rest of the business? Or, to phrase this differently, how does capital expertise interact with the other legs of the business expertise triad?

This is actually where the most interesting aspects of capital expertise is expressed.

The first idea is one we’ve examined in this essay: capital structure shapes company strategy, as per Leonard and Constellation Software. Leonard was savvy enough to pick a capital structure that fit his proposed growth model. Michael Dell pulled off a ridiculous series of complex financial moves because (in his words) ‘we wanted an efficient capital structure’ ... in order to perform what amounted to corporate reconstructive surgery. Conversely, startup founders in Silicon Valley raise venture capital and subject themselves to a onerous set of business constraints before they even begin. Whether this is a demonstration of expertise is left as an exercise for the alert reader.

A second idea is this: sometimes you are able to gain a temporary competitive advantage by acquiring a competitor, or consolidating in your industry, or taking a potential competitor off the board by funding their competition, perhaps in an adjacent industry you’re not directly involved with. In other cases you may use capital to prop up critical suppliers, or front cash in order to lock up supply and gain a stranglehold over some critical component you need for your products, again against your competitors. All of these are obvious things that don’t belong cleanly to any one leg of the business expertise triad; the point is that capital is a tool, just like any other tool, and it can be used offensively or defensively, on Operations or Market.

Finally, raising and deploying capital in tandem with all the other companies in your ecosystem leads to something called the capital cycle, which we’ll discuss in a future instalment.

This piece is getting terribly long, so I’m going to wrap things up. Hopefully by this point you have a taste of the skill of capital in action. Good businesspeople are great at operations and great at selling to their market — this much is obvious; I think it’s clear that you cannot be good at business without being good at both. But great businesspeople are also good at one other thing, and this is what that skill looks like.

This is Part 2 in a series on the expertise of capital in business. You may read Part 3 here: Fundraising Without Investors.

Originally published 20 July 2023, last updated 09 August 2023.