The New York Times reported this week that BP, in spite of the multi-billion costs of the gulf disaster, is "staking its future more than ever on deepwater wells". ("With Sale of Assets, BP Bets More on Deep Wells, by Jad Mouawad, July 20, 2010. See: http://www.nytimes.com/2010/07/21/business/21bp.html?scp=1&sq=BP%20deep&st=cse) This enthusiasm for going off the deep end stands in stark contrast to the response of financial institutions to the recent financial crisis. Banks fell all over themselves to swear off risky lending, wanting to avoid any appearance of appearing to do what they had trumpeted as a key growth business just months prior.
Markets have responded quite differently, too. The equity value of BP has dropped by roughly $80 billion since the explosion of the Deepwater Horizon drilling rig, prompting some analysts to argue that the stock is oversold. Without commenting on the value of the stock, it is interesting to consider the fact that the firm’s equity capital remains at around $100 billion, in spite of what is largely considered to be the worst oil spill in history. As society grapples with this corporate disaster, we’ve recently been reminded of another: the Bhopal, India Union Carbide leak. Last month, seven former employees of Union Carbide in India were convicted of “death by negligence” stemming from the terrible industrial accident in 1984 that left thousands dead. Just as BP survives (to date, anyhow) with very substantial equity value, so did Union Carbide survive the Bhopal disaster, continuing to operate until it was purchased by Dow Chemical in 2001 for roughly $10 billion. Conversely, Lehman Brothers collapsed in 2008, unable to find creditors willing to keep it afloat. It declared bankruptcy in September 2008, having begun the year with the stock trading over $60. Lehman, of course, physically harmed no one, nor did they spill any toxic substances, and yet the firm’s value fell faster and farther than either BP or Union Carbide.
BP’s 40% market capitalization fall in one week, though, would be a move of 10-15 standard deviations (depending on the volatility assumption) – a decidedly non-normal, non-linear result that points to BP being a complex adaptive system (one of the characteristics of which is non-linearity and non-normality). Numerous researchers have written about organizations as complex adaptive systems, and each of these cases noted here show ‘emergent’, i.e., completely unpredictable outcomes that are a part of such systems. Strange, surprising things happen to complex systems – accidents, market collapses, etc.
Complex adaptive systems are also characterized by feedback systems, which is where BP and Union Carbide begin to deviate from Lehman Brothers. Manufacturing firms, or firms that traffic in hard assets, have substantial negative feedback loops, in that outside entities can assess the values of the firm. Oil reserves and manufacturing facilities are both readily valued and readily transferred – the external feedback is clear. However, firms that deal in intangible assets, such as Lehman Brothers, are based on social constructions. Lehman’s output and skill was clearly not readily valued – who could say how good or bad they were? Bernie Madoff, too, famously turned out to be a social construction – he had no value whatsoever.
Firms whose value stems from a social construction have powerful positive feedback loops, and, at times, little to no negative feedback loop. Social construction begets social construction, in that there is more value for me in buying something from Lehman Brothers if you value and buy it too. This type of complex adaptive system can see value perceptions get way out of balance. Even worse, they can correct very quickly: when socially constructed value perceptions turn sour, the negative feedback loop is reinforced, too, and can run unfettered. Thus, banks can’t survive a run on the bank, while manufacturers can survive terrible, terrible catastrophes.
What does this mean? Is there anything to be done for a firm dealing in intangible products and assets? Not much, actually. Where there are no hard assets or readily valued, transferable resources to anchor the firm, it can evaporate (thus, ROA is a meaningless figure for many service firms). Firms can seek to protect themselves with assets that can be valued and transferred, of course. Enron began as a firm dealing in hard assets, but grew its socially constructed trading empire until it dwarfed the hard asset businesses. Firms that deal primarily in intangibles should think about what hard assets they do have. If there’s no relief there, it’s essential to view each business opportunity with regard to both profit potential and reputational risk. Financial firms for years have spoken of "front page Wall Street Journal risk", but clearly many had forgotten about it.
Lastly, this is an area where diversification may offer some help. In fact, Lehman tried to sell its money management subsidiary, Neuberger Bergman, to generate needed cash, but it ran out of time, and it was sold after the bankruptcy declaration. A portfolio of brands can provide the firm protection against reputation loss in one brand, unless they’re linked too closely in the eyes of customers (Neuberger Bergman, as a brand, stood on its own). Of course, strong brands can help bring along weaker brands, so those associations have upside, too. The management of reputational assets is of the utmost importance for service firms, because of the nature of these complex system feedback loops. When those assets go up in smoke, as they can, it becomes, simply: "everybody out of the pool!".
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