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Trevor Stone's Journal
Those who can, do. The rest hyperlink.
Profit as a Tool vs. Profit as a Goal 
5th-Apr-2014 01:25 am
currency symbols
Eric Garland has a collection of articles about Guitar Center, the company which set out to do for musical instruments what Circuit City did for consumer electronics. The first was a short post about how their business model is failing and their bonds were degraded to junk status. A few months later, he wrote a little longer article with a great title Guitar Center's real problem: their customers are broke, pivoting from the store to the disappearing middle class and the country's significant unemployment problem despite a nominal recovery from recession. His latest piece focuses on the byzantine financial structure Guitar Center's set up with private equity firms Bain Capital and Ares Capital Management and the parasitic effect these financial shenanigans have on the economy.
When I recognized how much the financial markets have become like 2006, I finally figured out why some other financier could shell out $50 or $100 or $300 million for Guitar Center junk bonds. For the customers of private equity, a few million isn't that much money. These investors actually need some higher-risk assets in their portfolio, rather than let their money sit around in a zero-interest rate environment. They might be like Warren Buffett and already have huge stakes in sensible things like Too-Big-To-Fail banks, railroads or Coca-Cola. This just rounds out their overall position. Make 6-9% with the chance that the company could finally go tits-up? Why not! If it pays out, then great, and if it doesn't – tax write off!

In the business reporting during the financial crisis of 2008, you might have heard the phrase "appetite for risk;" this is what they were talking about. When an investment is risky (which basically means the thing you're investing in is more likely to fail), you can charge higher interest rates (which basically means you get more money until it fails). So that's why a few big financial companies can spend the better part of a billion dollars on a company that's likely to have a fire sale and go bankrupt: they've got a budget spreadsheet that says "Spend $XX billion on investments at 6+%."

Imagine an alternate world where the same financiers took the same $3 million per Guitar Center retail store and invested, say, $1 million in each of 940 community music centers. A community music center could be something like a coffee shop of sound, with instruments for sale, music lessons, rehearsal space, and an "intimate" concert venue. This would help foster a local music economy and boost both supply and demand for music.

But now that it's run by equity firms, approximately nobody in the Guitar Center management or financing chain is involved because of a deep desire to increase the amount of music being played, expand musical literacy, build a community of musicians, or even necessarily because they really enjoy selling guitars. They're in it because they think they've got reasonable odds of making a significant return on investment and the pieces of paper making up Guitar Center's corporate structure and debt obligations are an available vehicle for the financial joy ride they want to take. The folks running the show would be just as interested if they'd bought a national chain of soup canneries.

Trevor's Rule for Running a Great Company

Use profit as a tool to grow the business. Don't use business growth as a tool to obtain profit.

One of the things I really love about Google is how it's run, from top to bottom, by people who care about what we're doing. We structure efforts to be profitable so that we can easily invest in improving their quality and bringing them to more people–if YouTube makes more money than it costs, we can keep making YouTube better and serve more of the world's visual stories. Yet not every effort must be profitable on its own; many projects are done because they're good for the Internet or good for the world, with the foresight that a better Internet and a more informed world will be a better world for Google to be in for the rest of this century.

By contrast, a business run by people who don't really care about what the business produces or the people it serves (which is basically the point of private equity firms) has no reason to foster the long-term ecosystem its customers live in. When profit is the product, anything that doesn't put money in investors pockets–no matter how relevant it is to the company's ostensible mission–is likely to be slashed and burned. The private equity firm doesn't care if it clear-cuts the spending power of its customer base or strip mines the market for its colonial products as long as it extracts the monetary resources it needs to fuel its endless quest of profit for profit's sake.
Comments 
5th-Apr-2014 01:56 pm (UTC)
This is also why you do not buy houses by national developers but by local ones.
5th-Apr-2014 05:45 pm (UTC)
This is a tremendous bit of writing and I'll be citing it in discussions.
7th-Apr-2014 03:47 am (UTC)
I see two major themes to this post, both of which I follow with varying levels of interest. The first is on investing and the effects (intended or otherwise) that investors can have on the business model and execution. The second is regarding business models and definitions of success.

While the private equity firms get lots of attention these days (and probably have most of the money), they are no longer the only option for investment. Thanks to the Internet, more and more alternatives are cropping up. Are you familiar with Lending Club? It's a peer-to-peer investment site that connects people who have money (and would like to earn dividends with it) to people who need money (to pay off higher-rate loans, fund small businesses, etc.). Currently, loans are capped at $35k, so you couldn't exactly prop up Guitar Center with it, but that might be enough to get a few events going at a community music center. Lots of financial bloggers have gotten into Lending Club, and you see the exact same argument about needing to invest some percentage of one's portfolio into high-risk, high-reward loans in the hope that one gets more payoff than defaults.

Regarding your second point about profit as a tool, rather than an end, there are ways to go even farther. Much of the problem with corporate structure is that historically, there have only been two options: make all the money you can or the board will fire you and find someone who will, or be a non-profit. Now, there is a third option that falls in between. With B Corporations or benefit corporations (not exactly the same, but close enough), profit is only one goal, balanced with social and/or environmental goals. IMHO, it's a much more human way to run a business. It's a much newer model, but one that is growing fast. Benefit corporation legislation just went into effect in Colorado on the first of this month (no foolin').

Anyway, sorry this got long, but based on some of the things you said above, I thought you might find these things interesting, if you didn't already know about them.
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