What ails the investors & firms?

Handing over the keys to CEOs does not do justice to the possibilities of each firm

The failure of FTX has raised new questions on the extent to which VC/PE (venture capital and private equity) firms are exerting adequate checks and balance upon their portfolio firms. In their defence, the funds say that taking high risks is their core business plan. The root cause of the difficulty is the great man theory in the world of business. Firms fail or underperform at such a high rate because they are, too often, controlled by one person. More firms would fare better if greater checks and balances were created.

Theranos, WeWork, and FTX all are firms where a lot of money was lost, and some of this was capital invested by some of the most famous investors of the world. In each case, post-mortem examinations show odd behaviour by the management, which investors failed to see.
 

VCs respond by saying that firm failure is part of their business model. One of the most respected investors, Temasek, lost $275 million in FTX, but this was just 0.09 per cent of its assets under management. It is interesting and important to ask what went wrong and how firms and investors should think differently.

This is not a matter of rules, laws, and required procedures. There was plenty of conventional diligence. As we know so well in India, layers of bureaucracy and thousands of pages of audit/ compliance/ forensic reports do less than is hoped for. Layering on more and more rules just generates income for lawyers and accountants, it creates career protection for a variety of persons including government officials, but it does not solve problems.

Illustration: Ajay Mohanty

The root cause is the “great man” theory, the adulation of individuals. This is the idea that some individuals command a unique insight into the world, and by giving them all the power, we will be led to a happy outcome. This theory — and the adulation of many individuals who have made it big — is drummed into our heads by the media and business schools.

Once this theory is ingrained, investors start thinking that the big issue is getting the right chief executive officer (CEO) and then handing over the key to them. This theory is what has given us CEOs with bloated egos who concentrate power. Once the media, business schools, and investors bought into this theory, oxygen is blown at the corners of bad character inside each CEO, and the best of people are tempted into concentrating power with its associated beliefs.

The trouble is, that theory of the world is wrong. In truth, the world is a complex place, and nobody knows the correct answer. Many individuals command pieces of the jigsaw puzzle: The path to success lies in creating conditions where we are able to bring these pieces together into winning combinations. Nobody can design the correct answer; the path lies in iterative refinement, in trying things, learning they are wrong, and improving.
 

Both these pathways work poorly with a strong CEO. Once the CEO achieves complete power, the path to harnessing the minds of multiple people is lost. It is hard for the powerful CEO, who owns a decision, to agree that it was a mistake and change course. Hence, mistakes linger for years and the firm pays the price for not continuously improving its strategy.

And so, when power is concentrated in the CEO, we often get firms that underperform. In each mediocre firm, the investors gripe about how the firm is faring, and seeing the entrenched CEO as the choke point. But most investors are not organised to solve this problem. How could things be done better?
 

Investors can do better by stepping back from the great man theory, from thinking that their main job is to find the right CEO. The gains from “the right person” are overstated; there is actually a lot of dumb luck which generates success. Stagnation or failure is not about having bad luck; it's about not having the feedback loops of iterative refinement.

One key element of this is the board. In India, boards have largely degenerated into cranking through the legal requirements of the Companies Act. This works poorly for two reasons. The text of the Companies Act is imbued with a low understanding of firms and economics. But even if the law were perfect, what is required is a human institution of governance, which cannot be legislated. It can, however, be created by the owners.

Firms work better when multiple minds are at work, when the CEO does not dominate decisions, when there is a greater ability to discern errors early and change course. Firms work better when the management team, which runs daily operations, does not control the strategy. Investors need to be present on the board, to synchronise the right collection of board members, and to make the board work correctly in a way that improves the working of the firm. Good boards can rearrange the power structure within the firm so as to reduce autocratic control.

These human institutions of checks and balances cost money. Investors will readily see that the money saved in numerous failed firms, and the underperformance of capital controlled by entrenched CEOs, amply pays for these checks and balances.

Investors are used to focus on one decision — to invest or not to invest — and then handing over power to an autocratic CEO. They are used to hiring “the best” CEO with an emphasis on credentialism and track record. There is a better approach. The choice of the CEO does not matter that much, but the design of the checks and balances surrounding the CEO matters more. More high-quality firms will be built out of this approach, of iterative refinement.

We have normalised the process of a few firms faring extremely well while most firms stagnate or fail. A shift in perspective is available, which will give good ideas, inside more firms, a fighting chance. More good ideas can flourish when freed from a strong leader and when ensconced in a better system of checks and balances.

The writer is a researcher at XKDR Forum