Creative destruction: redesigning the corporations for discontinuity

“The right of any corporation to exist is not perpetual but has to be continuously earned” (Robert Simons).

Only the paranoid survive

The frequency and speed with which firms grow, and decline, is accelerating due to the globalization & digitalization trends. In the 1970s, we had the “Nifty 50” - invulnerable companies that couldn’t possibly lose, and of course they all did. It will be the same today; there will be surprising losers, and survival will come down to simple things, like cash and margins. If you’re a low-margin company without a lot of cash or perhaps with too much leverage, you will not make it. Someone will figure out how to do better.

Consider these statistics from the Harvard Business Review (2012) :

  • Nearly two-thirds of companies now destroy value. Of the 70,000 companies with market data available, more than 42,000 earned shareholder returns (dividends + stock price appreciation) below inflation. Of course, the ‘great disasters’ of the past two decades were part of this list, such as Vivendi, General Motors, and AOL/Time Warner. But next to those there were thousands of relatively small companies that simply failed to create any value for investors. And those small companies add up: altogether, they destroyed $16 trillion.
  • Only 9% of companies achieved even a modest level of sustained and profitable growth. In the past decade, the percentage of companies achieving even 5.5% real revenue and profit growth and earning their cost of capital has steadily declined. Yet almost every business aspires to do this.

Corporate culture kills

Most of the corporations suffer from the inability to change the corporate culture even in the face of clear market threats. This cultural lock-in explains why corporations find it difficult to respond to the messages of the marketplace. Cultural lock-in results from the gradual stiffening of the invisible architecture of the corporation and the ossification of its decision-making abilities, control systems, and mental models. This barrier result from the inherent conflict between the need for corporation to control existing operations and the need to create the kind of environment that will permit new ideas to flourish – and the old ones to die a timely death. The corporations face three general fears – the fear of cannibalization of an important product line, the fear of channel conflict with important customers, and the fear of earning dilution that might result from a strategic acquisition.

The heart of the problem is the formation of hidden sets of rules, or mental models, that once formed are extremely difficult to change. Mental models are the core concepts of the corporation, the beliefs and assumptions, the guidelines for interpreting language and signals, the stories repeated within the corporate walls. Mental models are invisible in the corporation. They are neither explicit nor examined, but they are pervasive. Mental models can become self-reinforcing, self-sustaining, and self-limiting. And when mental models are out of sync with reality, they cause management to make forecasting errors and poor decisions.

Reengineering  the corporation

Corporation must therefore be redesigned, from top to bottom, on the assumption of discontinuity.

The market has pointed the way to a solution. In response to the tension that builds between the potential for improved performance and the actual performance of large businesses in an era of increasingly fast economic change, there are certain kinds of firms – particularly private equity firms – that have demonstrated the ability to change at the pace and scale of the market, and they have earned superior returns for doing do. The two kinds of private equity firms – principal investing firms and venture capitalists – are quite different from each other, but each looks somewhat like the holding companies of the late 19th century. They have been able to outperform the markets for the last two or three decades, longer than any other kind of companies.

The difference between these partnerships and the conventional corporation is their approach to organizational design. These financial partnerships have discovered how to operate at high level of efficiency and scale while engaging in creative destruction at the pace of the market, exactly as Joseph Schumpeter envisioned.

These firms never buy any company to hold forever. Rather, they focus on intermediate (three-to-five-year) value creation. Corporations, in contrast, concentrate on the very short term (less than 18 months) for operations and the very long term (greater than eight years) for research. Private equity firms make as much money by expanding the future potential of their properties as they do by increasing the properties’ operating income. Finally, private equity companies think of their business as a revolving portfolio of companies in various stages of development. They realize that they will sell some of their properties each year and buy others.

Source: Why Companies That Are Built to Last Underperform the Market- And How to Successfully Transform Them - by Richard Foster and Sarah Kaplan

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