Vanderbilt Business

Category: Inside Business

Trade Secrets

The Chinese government recently announced an amendment to its Protection of State Secrets Law, forcing Internet service providers and telecommunications companies to share their information.

Amid growing uncertainty about the stability of the European Union, an increasing number of North American companies are looking to capitalize on opportunities in emerging markets. One such market that is particularly attractive is China, but setting up shop there is not as straightforward as these companies might perceive. Recent legal developments surrounding information management in China have the potential to dampen the enthusiasm of global investors.

A key to establishing business presence anywhere is building a local infrastructure, which includes data centers for hosting information. In April the Chinese government made this practice more difficult when it announced an amendment to its Protection of State Secrets Law, forcing Internet service providers and telecommunications companies to share their information. The state-owned Xinhua News Agency reports that the amendment requires these companies to “halt and report leaks of what the government deems to be state secrets.”

So what is the definition of a state secret? According to Xinhua, it is “information that concerns state security and interests and, if leaked, would damage state security and interests in the areas of politics, economy and national defense, among others.” The official Chinese government website posted a broad definition of what constitutes a commercial secret, defining it as covering information related to “strategic plans, management, mergers, equity trades, stock market listings, reserves, production, procurement and sales strategy, financing and finances, negotiations, joint venture investments and technology transfers.”

Outside of China, media reaction to the legislation has been critical. For example, The New York Times called it an obvious attempt to impose control over cell phone and Internet communications. The Wall Street Journal has opined that this amendment is simply a reaction to the criticism of the Chinese government’s handling of the recent Rio Tinto scandal, which led to the arrests of several of the mining corporation’s employees for espionage and bribery.

This discussion brings to mind the early 2010 decision by Google to move its servers out of mainland China and into Hong Kong because of heavy interference by the authorities. Although technically still part of China, Hong Kong has retained considerable autonomy under its designation as a special administrative region. The principle of “one country, two systems” has enabled Hong Kong to follow economic and political policies different from those of mainland China.

The Hong Kong Basic Law, which serves as the constitutional document of the region, went into effect in 1997 and will stay in place until 2047. Under this law Hong Kong’s diplomatic relations and defense are the responsibility of the Chinese government. At the same time, articles 27–38 of the Basic Law stipulate that “Hong Kong residents shall have, among other things, freedom of speech, freedom of the press and of publication; freedom of association, freedom of assembly, freedom of procession, of demonstration, of communication, of movement, of conscience, of religious belief, and of marriage; and the right and freedom to form and join trade unions, and to strike.”

Whether other companies will follow Google’s lead is not clear. Hosting companies like Rackspace that have data centers in Hong Kong have not experienced a noticeable surge in business due to this amendment so far. It is likely that companies are not making their intentions public for fear of antagonizing the Chinese government.

The April amendment does little to change the fact that there is a lack of transparency in the rules that organizations are expected to follow while doing business in China. But one thing is certain: For all those North American companies looking to take advantage of sales in the Chinese market without compromising on sharing their information, Hong Kong is a good option.

November 9, 2010
The Elephant Inside

Dick Daft

Whether you are the CEO of a Fortune 500 company or just trying to manage yourself, Dick Daft, the Brownlee O. Currey Jr. Professor of Management, says you must learn to control your “inner elephant.”

In his recently published book, The Executive and the Elephant: A Leader’s Guide to Building Inner Excellence, Daft combines research in management, psychology, neuroscience and Eastern spirituality to argue that everyone has two sides to his or her personality. The “executive” is objective, rational and responsible, while the “elephant” is emotion-driven, impulsive and habitual. Daft believes that truly successful leaders must recognize both sides and follow practical exercises to learn to control their inner elephant and ultimately change a weakness in their behavior.

“I find that virtually every leader has a bottleneck within them. If they could remove it—if they could be just a little less critical-minded toward other people or if they could be more focused and attentive—they could be a much better leader overall,” Daft says. “What this book does is help them identify that weak link and remove it.”

Daft says that almost every leader makes six mental mistakes: (1) reacting too quickly, (2) inflexible thinking, (3) wanting control, (4) emotional avoidance and attraction, (5) exaggerating the future, and (6) chasing the wrong gratifications. All of these are tied to a person’s emotional and impulsive side, or their elephant.

Daft combines research in management, psychology, neuroscience and Eastern spirituality in his latest book.

“The whole idea of the executive is to be objective and not to interpret things just based on your own likes and dislikes, your own hang-ups, your own issues,” he says. “You have to be able to detach from that and be able to see the other point of view, the big picture, with some level of objectivity. When people can be in that place, they make wonderful decisions. It’s when they get anchored in their own neediness, their own greed, that they get into trouble.”

Daft says that people can remove a lot of inner struggle by being in the moment and accepting their “elephant” but not letting the elephant control them or their behavior. Real change, he believes, can only come from practice. He describes more than a dozen exercises that are grounded in practical application to help leaders control their elephant and change bad behaviors. He then gives examples of leaders who tried each individual approach and how it impacted them. A few exercises include engaging and writing down your intentions, slowing down your reaction time to think, and repeating a mantra.

“I’ve worked with a lot of executives who know what they should be doing,” he says. “They’ve gotten feedback that they should do something differently or act differently with their employees, but they’re unable to execute the new behavior. I wrote this book not so much to tell them what to do, but rather how to change the behavior.”

Daft has published 12 books and dozens of articles and has presented at more than 45 universities around the world. He also developed and managed the Center for Change Leadership, is a former associate dean at Owen, and is a fellow of the Academy of Management.

Daft is currently studying high-performance mental models, which include cognitive models of high-performing managers, and is examining high-performance management systems. He is also studying transactional versus transformational communication to engage people in organizational change.

“I know it sounds touchy-feely, this idea of introspection and looking within, but it is so powerful,” Daft says. “Know thyself—that has real power because once you know yourself, you can manage yourself. As long as you’re blind to your own bad habits, you’ve got no chance to be a strong leader.”

November 8, 2010
Raising the Red Flag

Nick Bollen

A recent study co-authored by Nick Bollen, the E. Bronson Ingram Professor in Finance, and Indiana University’s Veronika Pool demonstrates that risk-based performance flags can accurately prescreen hedge funds for fraud. The study supports strategies currently in use at the Securities and Exchange Commission (SEC), thereby contesting arguments often posed by opponents of additional regulation that government agencies do not have adequate resources to avert financial market scandals.

The SEC added risk-based “examinations” to its regulatory procedures shortly after Bernard Madoff was charged with perpetrating a massive Ponzi scheme. These examinations—similar to the performance flags analyzed in the study—are part of a series of reforms aimed at detecting hedge fund fraud early, thereby reducing the chances that such frauds will occur or go undetected and lead to the type of financial damage seen recently.

According to the study’s findings, the performance flags—low-cost, statistical tools—allow regulators to successfully identify high-risk hedge funds that can then be subjected to more intensive investigation. The alternative to the prescreening approach is to examine all hedge funds using the same in-depth regimen. Given the large number of hedge funds and the very rapid pace of change in financial markets, this is at best a challenging task for regulatory agencies with limited professional and financial resources.

Performance flags—low-cost, statistical tools—allow regulators to successfully identify high-risk hedge funds that can then be subjected to more intensive investigation.

“The approach we’re validating for hedge fund monitoring is in some ways similar to the one used by the IRS to determine which tax returns to audit,” Bollen says. “By statistically parsing through funds and identifying ‘red flags,’ we demonstrate financial regulation can work without being prohibitively expensive.”

Bollen also notes that the performance flag approach has application beyond hedge funds. “Prescreening for fraud can be applied efficiently to deter fraud in a wide range of investments. The flags might be different but the basic strategy is the same,” he says. “And the information we are providing can also benefit investment advisers by making them aware that prescreening can be a very effective way to protect client portfolios. They will have additional means to identify potential investments that should require especially careful due diligence.”

To unearth the findings, the researchers reviewed 8,770 existing and defunct hedge funds in the Lipper TASS and Center for International Securities and Derivatives Markets databases between 1994 and 2008. A sample of 195 problem funds that had been the subject of SEC enforcement actions or investor lawsuits was identified. The researchers then compared the problem and nonproblem funds using performance flags that had been developed previously by Bollen. These flags focused on suspicious patterns in hedge fund returns, including random returns, too few negative returns and too many repeat returns. The team found that funds charged with reporting violations triggered the performance flags at a substantially higher rate than other funds. For example, 51 percent of these funds had random returns compared to just 23 percent for nonproblem funds.

Bollen notes that the critical role of databases in identifying potential fraud underscores the importance of requiring hedge funds to disclose key information to designated databases, such as those highlighted above. This is currently a voluntary procedure.

“Mandatory reporting can only serve to aid regulatory agencies working to root out fraud,” Bollen says. “The increased data would also promote additional research that could protect investors from future schemes.”

November 8, 2010
The Benefits of Bartering

A version of this article originally appeared in National Review Online on Aug. 12, 2009.

German Sterligov is well-known in Moscow, but unlike Roman Abramovich, Oleg Deripaska and other publicly flamboyant Russian billionaires, he is little-known abroad. Sterligov neither sails the Caribbean nor drinks in London’s Mayfair district; most of the time he lives a traditional peasant lifestyle deep in the Russian countryside with his wife and five children. In winter their farm is accessible only by horse-drawn cart, and the nearest house is seven miles away. Sterligov’s way of life makes a strong Russian Orthodox statement and amuses Moscow’s public.

Sterligov made his fortune in the 1990s running a large barter business. He founded a mercantile exchange where Russians traded products they were unable to buy or sell for cash. He lived the luxurious life of a billionaire and owned properties in Moscow, London and Manhattan. In 2004, after an ill-fated bid for Russia’s presidency, Sterligov sold everything and moved to the countryside.

However, the financial crisis forced him to put on a suit, get in a car and find his way back to Moscow. Today, when not milling his own flour or hatching his turkeys and chickens, he occupies the Russian capital’s newest skyscraper in the trendy Moscow City district. He rented “B” Tower’s entire 26th floor and injected $50 million into the new business.

Sterligov is an economic mastermind who’s helping Russians overcome their country’s lack of financial liquidity. His barter business model has been applied across Russia, particularly in Moscow. It may be the main reason why today, despite economic turmoil, Moscow’s roads get paved and its skyscrapers continue to rise.

Sterligov’s business model may appear confusing, but it’s basically simple. If a provider of goods or services cannot find a client with money, they can offer their product in exchange for other goods or services. But since straight-up exchanges are the exception rather than the rule, additional participants have to join the circle of exchanges in order to satisfy everyone’s needs. Stergilov uses an advanced computer system to match product with consumer.

Often the series of exchanges begins with a debt. When Sterligov described the process to the Moscow Times, he used a steel company’s debt of 1 billion rubles to a coal company as an example. The steel company might not have the money to pay its coal bill, but it will soon be able to put 1 billion rubles’ worth of steel into the exchange. The coal company can provide a list of goods or services it will accept to fulfill the steel company’s 1 billion ruble debt. Eventually another company—or a whole chain of companies—will bridge the gap, taking the steel and either providing products or services directly to the coal company, or bartering them to the coal company’s eventual benefit. When all is said and done, every player has made a fair exchange, and Sterligov’s business has taken 1 percent of each transaction’s value.

Russia’s barter tradition comes not only from medieval history but also from the Soviet Union’s latter days and the early 1990s, when workers wouldn’t get salaries for months or years at a time and had to become creative to feed themselves and their loved ones. Factories paid workers with products, and babushkas from toy factories could be found at train stations exchanging stuffed animals for stuffed cabbage.

Modern Russians have witnessed several financial defaults and were prepared for another crisis. Every Russian family lost its savings in 1991 during the Soviet Union’s implosion. In 1998 the banking crisis swallowed the savings that Russians had accumulated after the painful rebound of the mid-1990s.

As for the current economic conditions, common people in Russia joke that those who weren’t wealthy didn’t lose anything, those who accumulated billions during shady privatizations endured a fair adjustment of their fortunes, and no one became homeless or starved. This black humor comes naturally to Russians. Of course, the same could also be said about their longstanding tradition of barter. And like their humor, it has helped them survive centuries of hardships.

Moscow native Yuri Mamchur is President of the MBA Class of 2011. He founded and edits Russia Blog, directs the Discovery Institute’s Real Russia Project, and serves as the Executive Director of the World Russia Forum.

© 2009 by National Review Online, Inc., 215 Lexington Avenue, New York, NY 10016. Reprinted by permission.

May 3, 2010
In Safe Hands

According to a recent large-sample study, the extent to which medical residents—physicians in training—are involved in reporting safety incidents is limited, indicating a need for more institutional focus about how, when, why and where incidents should be reported.

The study was conducted at a major medical center in the Midwest, with the intent to explore whether residents are well-trained in reporting safety incidents and the hope that the findings would indicate how to do a better job in the future, says Vanderbilt’s Associate Professor of Management Rangaraj Ramanujam, who co-authored the study with Dr. Lia Logio of Indiana University School of Medicine (IUSM).

Their findings were reported in an article, “Medical Trainees’ Formal and Informal Incident Reporting across a Five-Hospital Academic Medical Center,” which appeared in the January 2010 issue of The Joint Commission Journal on Quality and Patient Safety.

Ramanujam applauded IUSM’s desire to understand and improve on incident reporting among medical residents. “The underlying goal of the study is to determine how best to train physicians to become more engaged from the get-go in improving patient safety,” he says.

The good news is that the researchers were able to recommend a number of steps to improve incident reporting by residents—from intensive role modeling by faculty to regularly informing residents about improvements resulting from incident reporting.

However, medical residents often do not know how to file formal reports of safety incidents, which, the researchers point out, are not all medical errors. (Incidents could range from patient care that was not as intended to occurrences that were simply inconsistent with routine.) Further, even when residents did know how to file formal reports, they did so at lower-than-desired rates (38 and 42 percent, respectively, within the two groups surveyed).

On the positive side, the study found that residents frequently discussed safety incidents with peers and some faculty on an informal basis, demonstrating awareness that even small incidents merit attention.

Ramanujam

The study involved two online surveys of more than 900 medical residents and fellows as they rotated among five IUSM-affiliated hospitals, including a large community hospital, a university referral hospital with expertise in tertiary care, a well-known children’s hospital, a VA hospital and a public county facility. The study—the largest of its kind—is also among the first to explore whether and how residents’ reporting behaviors change as they move among hospitals.

Ramanujam says a key way to involve more residents in the process of improving patient safety is for academic training to emphasize and encourage such engagement. At the same time, the study found that residents’ reporting behaviors also seem to be shaped by unique attributes of different hospitals—even within the same academic center. Therefore, individual hospitals must also encourage residents to report incidents and emphasize their roles in improving the whole system. Finally, Ramanujam adds, academic centers need to find a way to talk with hospitals about the specific behaviors that they would especially like to encourage in their residents during rotational training.

“The findings are important in an era of health care reform. While the main impact of better incident reporting by residents will be seen once they move along in their careers and have more responsibility for safe patient care, it will also mean fewer mistakes that can be costly for patient safety and the bottom line,” he says. “Some of the reasons residents don’t report more incidents are mundane. So the proposed solutions are simple, but their long-term effects are potentially profound.”

May 3, 2010
Poaching Allowed?

Tim Gardner

It is generally accepted among business leaders that “poaching” or hiring a competitor’s employees violates an unwritten rule of business and may be unethical. A new research paper concludes that as long as their actions are not deceptive or illegal, companies that intentionally identify, contact and offer employment to a rival firm’s employees are within the bounds of ethical behavior.

In “The Ethics of Lateral Hiring,” which was published in the latest Business Ethics Quarterly, Associate Professor of Management Tim Gardner suggests that the practice of poaching other companies’ employees should be an accepted or even encouraged form of business competition.

Companies that declare an ethical breach following the loss of an employee to a rival are claiming ownership of employees in a way that hearkens back to feudalism and indentured servitude, says Gardner, who co-authored the paper with Jason Stansbury of Calvin College and David Hart of Brigham Young University.

“When my colleagues and I started this project,” Gardner says, “the first questions we tried to address were: Where did employers get the idea they owned their employees’ energies, efforts and human capital? And why does that line of thinking continue today?”

Based on a review of historical and contemporary accounts of employment relationships, the authors concluded that modern employers don’t generally believe they “own” their employees. But by suggesting, even subtly, that lateral hiring is unethical, employers are misusing ethics to try to prevent rivals from using a common, fair and competitive business practice, the study says.

Instead, responsibility for entertaining or rejecting an outside offer rests with the employee in question, the authors suggest. Only employees can determine whether, for example, a current employer provides a collaborative environment or whether they have reaped the benefits of educational and training opportunities and owe their current employers more time.

“Another tactic is the so-called ‘gentleman’s agreement’ among firms that discourage lateral hiring. That is not much different from gas stations on the same street corner agreeing to keep the price of gas high,” Gardner says. Informal agreements not to hire each others’ employees benefit the colluding employers to the detriment of the employees. Since the employees are not party to these agreements yet are affected by them, the practice is clearly unethical, the authors say.

Gardner and his colleagues point out such agreements might also be illegal. In June 2009 the U.S. Department of Justice opened an investigation of Google, Yahoo!, Apple, Genentech and others for allegedly agreeing not to target and recruit each other’s employees.

May 3, 2010
Sudden Death
Parsley

When a homegrown politician dies suddenly, local companies show the loss of a valuable connection immediately in their share prices, according to research from the Owen School.

Stock prices for companies located where a politician lived or was born declined by an average of nearly 2 percent when the connection was abruptly severed, translating into millions of dollars in lost shareholder equity, says study co-author David Parsley, E. Bronson Ingram Professor in Economics and Finance.

Such connected companies also tended to see a substantial drop in key performance figures. For example, sales growth for the companies studied averaged just over 12 percent during the year prior to a politician’s death but dropped to less than 6 percent afterwards.

Parsley’s study has found that politically connected firms realize many benefits from their relationships with lawmakers. These include preferential treatment by government-owned agencies or access to credit, relaxed regulatory oversight or stiffer regulatory oversight for rivals, lighter taxation policies, and a greater likelihood of government bail-outs in the event of financial distress.

“Losing these benefits when a politician suddenly dies clearly has a significant economic impact on the companies and raises serious questions about the broader impact of these connections on long-term economic growth,” Parsley says.

The unexpected death of a politician yielded a greater drop (by more than 1 percent) in stock price for family-dominated public companies, which, as prior research indicates, tend to be more poorly managed with less stringent corporate governance, making them likely to rely more heavily on the value of a political connection. Among other key findings:
- Larger companies generally saw less impact, possibly due to a tendency to diversify their political connections.
- Companies with higher market-to-book ratios fell by a greater amount (by about half a percent), consistent with the view that connected companies trade at higher prices.
- The negative impact on stock prices increased by as much as 4 percent for firms in industries in which the politician had direct influence.
- Companies in countries identified as more corrupt by Transparency International’s Corruption Perceptions Index took a bigger hit (up to 1.7 percent), presumably due to the greater likelihood of corporate connivance with politicians.
- Companies in democratic countries dropped more (by over 3 percent) than the overall average, which Parsley attributes to generally greater levels of corporate transparency.
On an unconditional basis (before controlling for other factors), the largest stock declines occurred in companies based in Pakistan and Zimbabwe (more than 10 percent, though there were only a few companies impacted), where previous research shows that ties to an influential politician are worth as much as 10 percent of firm value.

The study examined 122 sudden deaths of politicians from around the world since 1973, for which the politician’s city of birth or residence could be identified, and then analyzed the performance of more than 8,000 publicly traded companies based in those cities at the time of death. Only politicians who died unexpectedly—from heart attack, stroke, suicide, assassination or accidents that resulted in death within 24 hours—were included, since financial markets likely anticipated and accounted for deaths from a longer-term chronic illness, such as cancer.

A politician’s city of birth or residence is a novel but logical base for determining corporate political connections, Parsley says. “Politicians systematically favor local enterprises due to their need for election funding, to stimulate job creation, links with family and friends, and a host of other issues,” he explains. “Quantifying the value of such political connections has been hard to pinpoint, but our analysis provides perhaps the clearest picture yet of just how much these connections are worth for shareholders.”

The study, “Sudden Deaths: Taking Stock of Geographic Ties,” appeared in the June issue of the Journal of Financial and Quantitative Analysis. It was written with Professor Mara Faccio of Purdue University’s Krannert School of Management, and partially funded by the Owen School’s Financial Markets Research Center.
November 6, 2009
Spy Satellite Office

Presiding over a multibillion-dollar spy satellite program for the U.S. government is difficult enough without having to endure the strain of shrinking budgets, engineering problems, schedule delays and balkanized customer relationships. However, those are exactly the problems that our team, the Space Systems Group at the National Reconnaissance Office, faced in 2006. They are also the reason why we sought the expertise of the Vanderbilt Executive Development Institute at the Owen School.

The three-day Executive Leadership course led by Dick Daft, Brownlee O. Currey Jr. Professor of Management, was the catalyst for an astonishing transformation in the culture and productivity of our team of roughly 250 government and contractor personnel. Daft reinforced a simple yet profound leadership principle: Leaders must connect teams to an ideal. In our case that meant delivering perfect reconnaissance systems to protect those serving in the military and the intelligence community.

Although working on a spy satellite program has exciting moments, the enterprise shares similar challenges to busi-nesses across the country. Our group was an acquisition organization sequestered in a comfortable office park in Northern Virginia. It was easy for employees to forget their customers and slip into the daily grind of a federal bureaucracy, keeping busy with staff meetings, budget battles and paperwork.

Daft

We combated this complacency by putting our vision statement—“We understand and appreciate the greater mission”—at the forefront of everything we did. This statement galvanized our team of engineers, program managers, financial analysts, contract specialists and technical advisors. It connected us to our customers—the men and women in harm’s way—and to the intelligence imperative of the Global War on Terror. Over the next two years we blitzed our group, and anyone else who would listen, with our vision.

More important, though, we lived this vision as well. We took our team on an overnight trip to the aircraft carrier USS Eisenhower, one of the ships we were entrusted to protect. It was a rare and riveting experience for the engineers, comptrollers and security specialists to stand shoulder-to-shoulder with the 3,000 crew members for a 9/11 commemoration ceremony rededicating us to the mission. In the following months we also visited the submarine USS Boise and invited Iraq War veterans to speak to our group about the challenges and spirit of America’s fighting forces.

The effects of our efforts were transformative. The vision statement helped us eliminate competition for limited budget and human capital resources by clarifying our priorities and acquisition plan. With a defined strategy we obtained resounding support from congressional oversight committees and unprecedented plus-ups in our appropriations. We also set a baseline for new programs and delivered a perfect satellite to orbit.

There is compelling quantitative evidence to back up this transformation. In 2007 our group participated in a team climate survey, which used data from three decades and 2 million respondents to define performance benchmarks for high-performing teams. Our team had participated in the same survey in 2000 and 2004 with fairly good results, showing that we had begun to eliminate negative behaviors such as competitiveness and power struggles. The 2007 data, however, surprised everyone. In 27 of 35 categories our team surpassed the benchmarks for A+ organizations.

In fact the data was so remarkable that the survey results were run again to be sure there was no error. The scope and magnitude of climate change was unprecedented. The Space Systems Group had connected to the greater mission and raised the bar for effective and successful organizations.

In a series of return visits to the Owen School, we have provided a living case study that shows how to manage a remarkable organizational transformation despite challenges and setbacks that erode the confidence of most teams. We did it by applying the fundamental lessons of leadership taught by Professor Daft, and our story is not only practical, but inspirational for anyone who wants to “be the change” they wish to see in the world.

November 6, 2009
The Dragon by Its Horns
Numerous experts and laymen alike expect the Chinese to realign their business operations, financial behavior and cultural ways to resemble those of the West. This attitude is quietly resented by the striving Chinese. It is also dead wrong. The Chinese want to become Westerners as much as Westerners want to become Chinese.

Now that Western companies, capital flows and business cultures have helped revolutionize China, it is China’s turn to revolutionize us. High-roller Chinese procurement delegations are flying around the world, signing billion-dollar contracts and purchasing energy resources, raw materials, technologies, intellectual property rights, real estate, and private and public companies. The Chinese have plenty of money to spend on smart acquisitions.

With Chinese ownership comes the increased influence of Chinese business culture. A growing number of businesses in the United States and Europe are subject to direct Chinese management decisions made in the towers of Shanghai and Beijing instead of New York and London. This is why we need to take the dragon by its horns and be proactive in understanding the ways and perspectives of our friends in China. Western business models will not apply in China as efficiently as some may think.

The business culture in China today is an unprecedented mix of traditional customs—hierarchical behavior, close family relationships and established power networks—and new Western concepts. Some of these new concepts include:
- unforeseen collective acceptance and support for getting wealthy
  Over 1.3 billion Chinese citizens are more or less free to chase their material dreams as they see fit. The success of many encourages others to work hard, creating significant macroeconomic growth.
- unprecedented urbanization
  According to the McKinsey Global Institute (Shanghai), 350 million rural Chinese will move to cities during the next 15 years, creating new jobs, spending power and huge demand for infrastructure and other support systems.
- new flexibility in attitudes
  Different opinions and perspectives are more welcome today. New ideas are subject to constructive curiosity, instead of immediate rejection.
- ferocious striving for better living standards
  Our Chinese friends are setting up new businesses, educating themselves and their children, looking for tools to get ahead in life, and creating huge economic value driving forces.
- proactive internationalization and global networking
  Chinese delegations around the world are even more common these days than the Japanese delegations were after World War II. China sells itself in many clever ways and is eager to establish friendly trading relationships all around the world.
Despite many problems in their society, like human rights violations, environmental issues and widespread poverty, the Chinese have been quick to develop innovative solutions to many other challenges. It is mind-blowing to consider what they have achieved in only the last fifteen years, even if it has been partly accomplished with foreign advice and capital.

Like it or not, the Chinese economy will probably grow quickly over the next three decades, creating future shocks in every industry. Those of us who take a proactive role in understanding China will have a better chance to emerge as winners in this new economic era. Those who resent change, on the other hand, will be left behind. The West must leap out of its comfort zone, embrace this situation and join—not fight—the economic evolution.
November 6, 2009
The cost of hedge fund restrictions

Hedge funds have long been considered among the most lucrative investment vehicles, employing a variety of often high-risk, high-return strategies for wealthy investors. But the news these days from hedge funds—estimated to represent nearly $2 trillion in assets—is no longer rosy, with funds down more than 17 percent in 2008 alone. The secretive world of hedge funds is facing unprecedented challenges as the global financial market turmoil continues and the industry rapidly heads toward its biggest losses in history.

In the face of such staggering losses, funds are liquidating in record numbers, with 693 funds going bust in the first nine months of 2008, or nearly 7 percent of the entire industry. And the worst may be yet to come, with one prominent hedge fund executive telling a conference recently that about 30 percent of hedge funds may fold completely as a result of the current crisis.

As the perceived risk of failure rises, investors tend to rapidly increase redemption requests to exit from funds. Standing in their way can be all sorts of redemption restrictions that can result in heavy penalties. In October 2008, about 18 percent of the hedge fund industry assets were subject to withdrawal restrictions, according to Singapore-based consulting firm GFIA Pate. And anecdotal evidence suggests that withdrawal restrictions are quickly gaining ground as funds attempt to curtail capital drain.

Although certain restrictions on the ability of investors to redeem their capital from hedge funds—such as lockups and notice periods—are well defined, the ability of managers to suspend withdrawals is often vague in partnership agreements. In some cases individual fund managers retain varying degrees of discretion when it comes to redemptions. “For instance, they may have the authority to process only a portion of a redemption request, known as a gate, retaining the balance of the investor’s capital, and some even have the right to suspend redemptions altogether,” says Nicolas Bollen, E. Bronson Ingram Associate Professor in Finance at the Owen School.

Bollen notes that it typically has been unclear exactly what withdrawal restrictions can mean in terms of cost to investors. Developing a research model that treats the ability of an investor to withdraw capital as a “real option,” Bollen—along with Andrew Ang, Professor of Finance at Columbia Business School—pinpointed the cost of liquidity restrictions by analyzing financial data for more than 8,500 live and defunct funds from the Center for International Securities and Derivatives Markets.

Bollen’s analysis discovered that withdrawal restrictions come with a hefty price tag for fund investors. According to the new study, implied costs to a hedge fund investor from such redemption restrictions can range from 5 to 15 percent at the time of the original investment, with exact amounts highly dependent on fund-specific attributes such as age, expected return and the loss generated by liquidation of fund assets.

Bollen has discovered that investors pay a hefty price for hedge fund withdrawals.

“Given that most hedge funds require significant investment levels to begin with, the resulting costs of liquidity restrictions—whether existing or newly imposed—can potentially be staggering for investors,” Bollen states.

For example, an investor who deposits $1 million in hedge funds—a relatively modest allocation for such financial products—is essentially paying an upfront fee of as much as $150,000 if his or her ability to exit is eliminated through future suspension of redemptions.

Funds whose managers have greater discretion when it comes to withdrawal restrictions should be of the greatest concern to investors, believes Bollen. “These types of discretionary restrictions on withdrawals have the potential to impose much higher costs on investors than standard restrictions such as lockups and notice periods,” he says.

Given his findings, Bollen suggests that hedge fund investors carefully scrutinize redemption rules—and fund manager discretion—before investing. “We are now seeing that, in a serious downturn, investors can face heavy penalties and even be prevented from retrieving their capital should they seek to liquidate their investments, and the implied cost of these restrictions can significantly reduce the return that should be expected from funds,” he says.

April 21, 2009
The ‘Fear Index’ and derivatives

As the world financial panic set in motion by the subprime mortgage crisis reached full steam in late September, Bob Whaley’s phone began ringing. Interest in what financial writers call the “Fear Index” was spiking as stock prices plummeted and major Wall Street firms collapsed, and much of it was directed his way. The Fear Index, which is more properly known as the Chicago Board Options Exchange Market Volatility Index (VIX) and which has offered a real-time gauge of market jitters since 1993, was, after all, Whaley’s brainchild.

Whaley, Valere Blair Potter Professor of Management and an expert in derivative securities, did some interviews, but became increasingly annoyed by the articles and commentaries he saw. One after the other contained assertions he saw as “utter nonsense”—that the VIX was a self-fulfilling prophecy, that it was at unprecedentedly high levels, that it was a contrarian indicator.

“People were saying all sorts of unsupportable things,” he says, “so I decided to write a short piece that puts everything in proper perspective and corrects misconceptions people have because they haven’t dug deeply enough.”

For most people, the VIX, like the wider world of derivatives it reflects, skulks in a back alley of the financial world until there is a crisis, when it is hauled in for questioning that amounts to hysterical accusation rather than rational information gathering. What’s more, the recent fates of even the biggest, most savvy firms make clear there was more than enough ignorance—coupled with greed—to go around. If ever a subject called for light rather than heat, it is this one.

“It is not new,” Whaley says of the index. “It is not at unprecedented levels. And it does not cause volatility.”

It is, he contends, simply “a measure of expected stock market risk” set by the actions of investors as they work to protect their assets. More fully, the VIX is a weighted blend of prices for options on the Standard & Poor’s 500 Index (prior to Sept. 22, 2003, it was the S&P 100). Those options are in essence insurance policies protecting investors against broad-based market swings. The premiums they are willing to pay indicate their level of apprehension—hence the term “Fear Index”—about the market volatility they anticipate in the short term.

Whaley is amused by claims that the VIX is a contrarian indicator.

Whaley is keen to debunk myths about the VIX.

“One commentator said in September that since the VIX was above 35 it was time to buy stocks,” he says. “The only time a contrarian indicator makes sense is after the fact. While 35 might have been high relative to its recent history, it increased steadily to a level of over 80 in the days afterward. If you’d taken his advice, you’d have lost your shirt. The stock market fell by nearly 30 percent.”

He is similarly dismissive of its power as a self-fulfilling prophecy that adds to market anxiety.

“This type of thinking is exactly backward. The degree of market anxiety is reflected in investor demand for portfolio insurance, which sets the level of the VIX. Saying that the market is better off without the VIX is akin to an ostrich hiding its head in the sand.”

As for historic highs, the VIX is in one sense nowhere near them—projected backward, it reached its peak during the October 1987 market crash, spiking to levels well above 150. Since September 2008—the month that marked the beginning of the stock market’s deep dive—the VIX has not exceeded 90. On the other hand, its recent sustained level of more than 35 marked only the fourth time the index had spent more than 20 days in that range.

“So, yes,” says Whaley, “we are experiencing abnormal behavior, but, no, it’s not unprecedented. We just tend to forget.”

This article is an abridged version of the one that appeared in the Winter 2009 edition of OwenIntelligence. To read it in its entirety, click here.

April 21, 2009
Thinking like a CEO

The two-day program helps CEOs think about successful strategies for their companies.

Imagine that you’re an NBA star instead of a stellar MBA. In fact you’re more than a star; you’re one of the top players. Then you make a dramatic career move, accepting a lucrative offer to be a head coach in the league.

Suddenly your job is to lead and motivate others who excel in the very skills you had mastered earlier. Your job no longer involves shooting, passing, rebounding, dribbling and playing defense. Instead you’re responsible for putting the right talent on the floor in the right situations. You have to manage a lineup of inflated egos while keeping everyone focused on working together. You have to map out winning strategies for every game and then communicate them effectively so your players can execute them. You’re also the most public face of the organization, with corresponding responsibilities in handling the media. Few of the skills that took you so far as a player will serve you in this new role. Now you feel all alone.

Burcham

Michael Burcham, Professor for the Practice of Management, uses the NBA analogy to explain the thinking behind a new program at Owen, Thinking like a CEO, that he helps lead. Like star players turned coaches, CEOs—especially those who are newly promoted into the position or who have grown an entrepreneurial venture into a more substantive, structured enterprise—often struggle in their new roles and make common mistakes that, to outside observers, seem to violate common sense.

The course is the creation of three Vanderbilt professors: Burcham, David Furse, Adjunct Professor of Management, and Kimberly Pace, Clinical Assistant Professor of Management. They recognized a market need for CEO preparation based not on research but on their extensive, hands-on involvement in the world of corporate executives.

Burcham has started and led three health care companies. (He carefully balanced the operation of one, in New Jersey, with his teaching duties at Vanderbilt.) Furse was an entrepreneurial CEO with two decades of experience before joining the ranks of academia. Pace, who directed marketing and communications for two international firms, continues to coach and advise CEOs on managing their “personal brands.” All three professors consult regularly with C-level corporate executives.

Furse

Even experienced executives make monumental errors. But basic mistakes, the professors observe, are especially common among CEOs who came into their position through growing a small startup company or through excelling in one area of an established organization. “Some chief executives, for example, came up through a particular area of a company, such as marketing, and have a less-than-thorough understanding of the rest of the organization,” says Furse. “So they may starve the parts of the organization they don’t understand.” Others, who were stars in sales or operations or finance, struggle to learn that “they don’t get to be the star player anymore.” The job, rather, is about empowering everyone else in the company.

“Some CEOs are phenomenal at strategy but not execution,” Pace notes. “Some are good at execution but not strategy. If you’re an elite organization, you have to be great at both. You need the whole package.”

Pace

Younger entrepreneurs, in particular, says Furse, set a trap for themselves by trying to be everywhere. Once the organization grows, these startup executives fall prey to their own success. “You can’t directly manage the whole company anymore. You have to develop people and build a management team. A lot of the work we do is helping CEOs develop their senior management teams. No CEO can do it all.”

Burcham recalls one successful technology entrepreneur who was still trying to run his 500-person company the way he did “when it was just him and 15 software programmers.” It didn’t work.

“Few schools teach people to be a CEO,” Burcham observes. “People are promoted into the role. They get there through different skills, and these aren’t necessarily the same skills they will need as a CEO. If you bring a VP’s skills to the position of CEO, you’ll probably make a lot of the same classic mistakes that other CEOs have made.”

This article is an abridged version of the one that appeared in the Spring 2009 edition of OwenIntelligence. To read it in its entirety, click here.

April 21, 2009
Untangling the Knot: Logistics in China

China is undergoing an infrastructure building campaign unrivaled in recent history. When the country first opened its doors to the outside world in fits and starts in the ’80s and ’90s, large transportation providers, like DHL, UPS, FedEx and Exel, began vying for a toehold on the mainland through joint ventures with the various government transportation groups, like Sinotrans, and newly-privatized enterprises. It was as if China had re-awakened when Deng Xiaoping, the late leader of the Communist Party of China, proclaimed, “To get rich is glorious!” during his famed Southern Tour in 1992.

A view of the famous Bund district in Shanghai.

Today the east coast highway and port system has reached or surpassed international standards around the centers of commerce in Beijing, Shanghai and the Pearl River Delta in Guangdong Province, and the government has slowly allowed international firms to operate independently of their joint venture partners. With China’s entry into the World Trade Organization in 2004, restrictions on foreign direct investment were officially loosened, but multi-nationals were still functionally required to navigate the bureaucracy of multiple layers of government.

According to Datamonitor, the Chinese logistics market is projected to grow in the low teens through 2010 after posting a remarkable 22.6 percent compounded annual growth rate from 2001 to 2005. Today China has 16 major ports and a shipping capacity of 50 million tons per year. It also has a network of over 30,000 kilometers of highways, second only to the United States in total kilometers. Despite this phenomenal growth, logistics costs remain high—representing 20 percent of GDP in China versus 11 percent in Japan—when compared to overall production.

Market Remains Fractured

One would expect rapid consolidation among logistics providers seeking to capitalize on China’s growth. Yet in the trucking world, a single provider has yet to emerge with a comprehensive network. There are over 5 million trucking companies, with each owning an average of 1.8 trucks. The top 100 logistics providers only comprise 5 percent of the total logistics market.

These smaller trucking firms are often the lowest cost provider with low overhead and expertise within a single area. Their expertise includes relationships with toll collectors and inspectors that give them an advantage over a trucking firm from another region. With such low barriers to entry and local protectionism, it is hard for larger players to compete. In the case of bulk commodities like cotton, factories will often manage the supply chain between the mill and the port because they can get the lowest prices with their existing carriers.

Level of Automation Remains Low

Although many logistics providers that move high-value merchandise have invested in the latest tracking systems, many of the bulk commodity shippers are not using available technology to provide shipment visibility. Much of the tracking is still done the old-fashioned way with a clipboard and a marker. If cost is the primary buying motivation and labor costs are low, there is not a short-term payoff for investing in automation. Why would you buy a forklift if you can hire a team to stuff a container by hand for a fraction of the cost?

Overloading Persists

In China it is common practice for truckers to overload their trucks by two to three times the legal limit to maximize their asset usage and eke out a profit in a fiercely competitive market. The central government has issued tougher laws to ensure the safety of drivers and reduce damage to roads, but they are lax in the enforcement of these regulations because they know many small truckers would go under if they adhered to the weight limits. Meanwhile the local government has an incentive to allow overloading to continue as tolls are collected on the total weight of the load and they are not responsible for road repairs. This practice reminds one of the Chinese saying, “The hills are high and Beijing is far away.”

What to Do?

There is no “one size fits all” solution. Instead of a China logistics strategy, have a unique strategy or partner for each region. Find logistics providers who have worked with firms that you trust.

Also keep in mind this is not the West. Proceed with caution and realize that corruption is widespread, contracts are hard to enforce, and management talent is scarce.

As in any business, logistics is a game of relationships. This is even more appropriate in China where a long-term relationship may mean the difference in your product being held up in port rather than getting delivered to a factory on time. Invest in a long-term relationship with a company that is willing to establish a mutually beneficial partnership.

Oscar Atkinson traveled with 19 classmates to China as part of Professor Ray Friedman’s Doing Business in China course. The highlight of the week-long trip was a visit to international logistics firm Mallory Alexander with Michael O’Brien, MBA’08, Jen Smith, MBA’08, and Scott Hall, MBA’08. Atkinson now works for SEACAP Financial, an investment bank in Memphis, Tenn. specializing in the sale and acquisition of family-owned companies. Atkinson can be reached at oscar.atkinson@seacapfinancial.com.

November 10, 2008
Headhunter’s Advice: Manage What You Measure

In his book Topgrading: How Leading Companies Win by Hiring, Coaching and Keeping the Best People, author Bradford D. Smart concludes, “With an average base salary of $114,000, the average total cost associated with a ‘typical’ mis-hire is $2,709,000—greater than 24 times the person’s base compensation.”

To rationalize these amounts, think about the opportunity costs that can result from substandard service, inadequate research, missed deadlines, failed marketing campaigns, missed sales targets, flawed accounting or investment strategies and more. Additionally you may directly absorb considerable recruiting expense, invest in orientation and training, or put up with mediocre performance and results for some period of time. And, adding insult to injury, you may have to pay a severance to get the employee to leave. Finally you may also incur hard executive recruiting costs for the replacement employee and absorb various additional costs to train that person.

CEOs agree that hiring and retaining high-quality executive leadership is crucial to achieving strategic business goals. However, very few CEOs have accurate data to openly discuss the true cost of a bad hiring decision. Yet when it does happen, it’s too personal and too painful to study under a financial microscope. But it’s not a question of guilt or blame. The real question is: How could it have been avoided and how can you reduce making mis-hires in the future?

You’re Thinking These Costs Are Overstated?

With more than 12 years in the executive search industry, I believe these numbers are close to the mark. But go ahead and cut these costs in half. Change 24 times salary to 12 times salary. Or if you’re really a skeptic, go ahead and cut them in half again. Even at a mere 25 percent of the researched amount, you’re still looking at a $684,000 cost for a bad hiring decision involving a $114,000-per-year employee. For a $200,000 executive, you’re looking at a $1,200,000 cost for a bad hiring decision. The numbers are too large to ignore.

Over the years I’ve had the opportunity to work with VC- and PE-backed health care companies to Fortune 25 organizations. I’ve found that many corporations avoid the calculation by simply not agreeing on an appropriate formula, despite the fact imperfect information exists in all decision-making processes. It’s too easily dismissed as just another “cost of doing business.” Across industries it’s reported that internal corporate executives consistently recruit and retain the “right” manager or executive for 12 months or longer less than 55 percent of the time. This seems low.

I’m convinced long-term candidate retention can be improved and that mis-hire costs can be materially reduced.

Three Ways to Improve Your Executive Recruiting Outcomes:

1. Recruiting firms are not always the right solution to hiring key leaders. Retained search firms are excellent resources at the right time. However, internal candidates, board members and industry colleagues can be valuable resources. These individuals may be candidates individually; they may be able to open their rolodex; they may provide comments about desired candidate characteristics; and they may recommend retained executive recruiting firms for you to talk with. If you use a retained executive recruiting firm, do appropriate diligence on more than one search firm.

2. Plan a thoughtful and well-prepared interview process. Each interviewer in your company’s process must have a clear understanding of his or her role in the assessment process. The absence of interview structure will be recognized by the candidate and may lead you directly down the path to a costly mis-hire.

3. Ensuring that the new executive is successful requires communication between the hiring executive, the successful candidate and specific, internal colleagues. Managing the individual’s integration into your company for the first 90 days will provide a foundation for long-term retention. Following the first 90 days, ongoing communication develops relationships, provides clear strategic direction and reinforces cross-functional interaction and discussion.

At an average cost of $2,709,000 per mis-hire, I encourage all business leaders to take a closer look at their executive recruiting processes, determine where and how these processes lead to false economies and then take steps to better manage these processes. A bad hiring decision can be a significant drain on the bottom line.

Paul Frankenberg is CEO, President and Co-Founder of Kraft Search Associates. In both 2006 and 2007, Modern Healthcare magazine ranked Kraft Search Associates one of the nation’s Top 25 Healthcare Retained Executive Search Firms. Frankenberg can be reached directly through www.kraftsearch.com.

November 10, 2008
Consumer Price Index: Unreliable Measure of Inflation

When inflation is considered, those who possess a more sanguine outlook relating to pricing pressures have pointed to the Consumer Price Index (CPI) to bolster their view that inflation is not a problem.

The problem with the CPI is that consumer prices themselves transmit all sorts of information unrelated to currency strength. So while rising prices can be a symptom of inflation, they can also result from all manner of things that have nothing to do with the value of the currency.

If hotel rooms in New York City become very expensive, some would consider this an inflationary event despite simple logic showing otherwise. Put simply, if New York hotel rooms suddenly cost $200 per night more than they once did, the broad impact on the price level would be zero owing to the fact that consumers would have $200 less to spend on previously attainable goods.

Furthermore, to the extent that there is a monetary devaluation, it shouldn’t be assumed that a weaker unit of account will immediately be reflected in all consumer prices. This is because there’s a way to increase the cost of a good without increasing the nominal price of that same good. As a recent USA Today story showed, ice cream makers, suffering under rising dairy costs, have in many cases reduced the size of standard ice-cream containers to 1.5 quarts from 1.75 quarts. Frito Lay and Dial have done much the same with bags of potato chips and bars of soap.

Ultimately it has to be recognized that the only true measure of inflation does not involve prices, but instead is transmitted through the value of the dollar itself.

And when we consider the dollar, the most reliable benchmark is not the greenback’s value versus the euro, yen or pound, but the dollar’s value in terms of gold. When the price of gold moves, this is not a signal that gold’s price has changed, but instead tells us that the dollar’s value is rising or falling.

Gold has risen 255 percent against the dollar since June 2001. Whereas a dollar used to buy 1/253 of an ounce of gold, as of this writing it buys 1/900 of an ounce. For those wondering why all manner of commodities, from gasoline to corn to meat have become so expensive of late, look no further than the dollar’s debasement.

And to the extent that some have great faith in CPI-like measures, they need only look at countries outside the United States to see that our version of CPI is greatly understating true inflation. Despite the fact that the euro and pound have crushed the dollar in recent years, government inflation statistics in both show it at 16- and 18-year highs respectively.

So while inflation problems around the world confirm that our government measures of inflation are faulty, the bigger story is what a rising dollar price of gold means for the average American. When gold rises, paychecks are emasculated; investment in innovative, job-creating enterprises subsides; and money flows to the relative safety of the “real.”

Rather than clinging to the CPI as false evidence of light inflation, and worse, targeting consumer prices, monetary authorities should instead target a stable gold price with an eye on bringing it down substantially.

John Tamny is Editor of RealClearMarkets, a Senior Economist with H.C. Wainwright Economics, and a Senior Economic Advisor to Toreador Research and Trading. He can be reached at jtamny@realclearmarkets.com.

November 10, 2008