A simple test for whether or not you understand an organization

Can you identify the implicit leverage in that organization?

Most (not all) organizations have forms of leverage which are built in and which do not show up as debt on the balance sheet.  Banks may have off-balance sheet risk through derivatives, companies may sell off their valuable assets, and NBA teams may tank their ability to keep draft picks and free agents in their future.

Or a university may have ambitious plans, or payroll commitments, which require an ongoing stream of tuition increases or admissions boosts, usually from out-of-state students.

None of this has to be a bad thing — many growing organizations should have leverage.  Nonetheless leverage it is.

So take your favorite organization.  Do you know where the hidden leverage is?

If not, you probably don’t understand it very well.

Comments

Do you?

In your 2nd para, you seem to confuse financial leverage with diminished optionality [NBA reference]

Clarity is how we separate the men from the boys, TC!

But what diminishes the optionality? What is leveraged to get that optionality? Ability to pay is pretty straightforward. What about something like promotional opportunities that are very lucrative for players, and the opportunities come from something the team doesn't own, like a vigorous media market that gives wide exposure to players? The tab could leverage that to get their choice of players.

The team. The great stagnation continues in abilities to edit comments.

Kind of hilarious that TC offers an unclear concept he's claiming you have to really understand in your organization. Classic example of something...

Heh. Felt like this post was written by a bot.

This is just bizarre:

"Or a university may have ambitious plans, or payroll commitments, which require an ongoing stream of tuition increases or admissions boosts..."

Something very "cart before the horse" here. Not a recipe for successful long-term organizational viability imo.

Universities are subsidized and not strictly ruled by market forces, the cultural imperative of "college for all for the future" can be intangible collateral for leveraging. I've seen this at the university i went to, non-district students (foreign) are highly coveted and treated well (maybe better than marginal Americans.) It makes financial sense, and the H1B and other college visa programs incentivize this. And the reality of debt ridden lazy American students not paying the full market price does have a bearing on professors' attitudes and treatments.

Thanks for helping me connect the dots. So we're talking about catering to "the paying customers" here? Yes, the person willing to pay the most for something commands some leverage over sellers.

Similarly, in the labor market for example, being underpaid is a form of leverage.

Still not sure of the point.

I agree, though I wouldn't have fallen on my sword and admitted it, so thanks. The college example: the university is leveraging .. what? The financial demands of its long-range plan, to justify seeking foreign students, who pay today? Or leveraging its ability to attract full-freight foreign students? Lever, and thing levered, that's all I'm asking.

Is another definition of leverage something of value that your organization depends upon but doesn't own?

I think of my company, which has assets and a small amount of short term debt, all necessary for maintaining operations. Then there is goodwill, reputation and the like, the systems and defined workflows. All straightforward assets and liabilities. But something i don't own, pay dearly for, and leverage are the skills and abilities of my workers. They are very costly to replace, hard to find, but utterly necessary and irreplaceable. They can't be automated away except by massive decrease in the costs of the equipment they work on making it cheaper to manufacture a replacement than maintain and repair. Which is happening in some of our market segments.

So to understand my business in large part would be to understand what makes the technicians valuable.

That makes sense.

Using something you don't own is characterized by externalities and public goods, not leverage.

There could be some equivocation in TC's presentment. Leverage in an accounting framework is incurring a liability in order to fund assets. To grow equity, the assets must have a higher yield than payment on the liability.

In a different sense, leverage means a tool that increases output by several factors from a given input, e.g. leveraging technology. This could intersect with the former definition, e.g. incurring student loan debt to obtain a degree and hence a high income stream used to repay the debt.

In the implicit sense, the firm owes a debt that is not visible on the balance sheet. It will come due. For example, working your workers, team, soldiers very hard enhances output in the short run, but in the longer run you suffer attrition, burnout, dissatisfaction or injuries. None of this is on the firm's balance sheet but eventually comes due.

Your example is not apt. You pay for your worker's skills. You hired them for that. Each hour of labor is a trade of salary for skilled work. You might be incurring an implicit debt in promotion and pay expectations. That is, workers expect more than just pay for work but increases in real wages over time. However, while that is off balance sheet, I dont think it is implicit. It is explicit because pay should increase along with experience, earned loyalty, and proven performance. Firms should properly account for expected increases in payroll costs but often don't.

Is this in the context of negotiating a higher salary?

Not necessarily. It could be as simple as leveraging proximity to a market.

As I state above, I think that is explicit. Firms and employers both know and accept in advance that pay will increase with increased experience, job acquired skills, and observed performance.

An example of an implicit liability is a management style that squeezes out high output in the short run but has longer term consequences, none of which are accounted or compensated for. Picture a coal mine that presses its workers and doesn't have concern for their safety. If these workers later go on strike after years of abuse, or if government steps in to impose stronger wages and safety, the bill has come due.

Well, considering how Prof. Cowen just seemingly recognized the leverage that federal workers have in ending the current government shutdown, it makes one wonder if Prof. Cowen recognizes that organizations that represent workers have leverage that is considerably more obvious than merely using the word 'implicit' to describe it.

Which just might be the reason for a generation long attack against unions, so as to remove their leverage in representing worker interests above that of owners.

Or is equating leverage with power too gauche when having such discussions?

Or maybe it is because unions are a cartel of labor which is recognized for having wages that are inefficiently high and labor hours that are inefficiently low. This raises worker wages at the expense of entrepreneurs, owners of capital, consumers, and workers who are unemployed. It also causes a deadweight loss in total welfare.

Or maybe because labor unions have a long history of being associated with organized crime and communism, I.e. stealing resources from others and using violence and fear to pursue their objectives.

The worst abuses in a capitalist system don't require unions to curb them. And unions stick around long after those abuses have disappeared forever.

Workers are voluntarily leaving unions in the US recognizing they are nothing but parasites with political objectives.

Unions do not have preferences. Union bosses do. Why do you think they have “workers” interests above their own interests? Did you actually experience it, you being “a worker” and member of a union?

The experience on my side, as employer, is that if the members may be left in ignorance about the deal, union bosses are easily corrupted, even more than government bureaucrats.

'Unions do not have preferences. Union bosses do.'

Guess it depends where you live. In the U.S., unions are quite appalling (the only thing worse than American unions are American owners/management), and to talk about union bosses is quite accurate.

In Germany, the organization with the most power to represent workers is the Betriebsrat, which is company specific, and where the workers can replace any (or all) of the members every 4 years. Of course the union plays a large role in things like worker pay scales or politics, but broadly speaking, German companies don't deal with unions much (outside of something like a Manteltariffvertrag, or industry wide pay scale), but they have to deal with the Betriebsrat, which has significant legal power.

'Did you actually experience it, you being “a worker” and member of a union?'

I have never been in a union - but working in a company with a Betriebsrat is something I have decades of experience with.

'is that if the members may be left in ignorance about the deal'

Well, when IG Metall (large union representing metal workers) negotiates with Gesamtmetall (the employer association of those involved with metal working, such as the car industry), it is major news (certainly in those regions where the car industry is important), and before any contract or major strike is agreed to, the workers have to vote on it - and the contract they are voting on is not secret either. And it definitely happens that the workers will vote down a proposed contract if it does not meet their needs - at which point, the union bosses need to worry about being replaced.

But then, Germany is a socialist hell hole, full of environmental regulations. Which undoubtedly explains why the U.S. is such a leading industrial nation, compared to Germany. Just look at the difference between the U.S. and (West) Germany in 1969 compared to today - the German industrial economy has been completely ruined by the unions and the Greens.

As a former boss would say, “If you’re not taking an asset-liability view of the firm, you’re missing the point.” And, for him, it was the implicit assets and liabilities that often mattered most.

Might be helpful to know if implicit leverage can fall into the concepts or operating or financial leverage or if the suggesting is for a 3rd source of leverage that differs fundamentally from the more common two types.

Regulators with their risk weighted capital requirements for banks hid the real leverage and therefore banks that all said were well capitalized, turn out to be leveraged over 50 times. The not distorted leverage ratio for banks is still much hidden.

Yes, I have seen the future and it is bleak. It is bleak because we (our country, the world) have enormous off-balance sheet obligations, from aging populations to a warming climate. We discount the future and thereby ignore the growing off-balance sheet obligations. Of course, Cowen believes we ought not discount the future. Maybe if the world's balance sheet included a footnote that quantifies the obligation, we would take heed.

So we should be investing now in preparation for our sun becoming a red giant? Saving mankind from that fate is important, so we best spend 90% of world production on the problem. It is coming.

No, silly. We need only concern ourselves with global warming, because its catastrophic consequences are only five years away.

And always have been, since at least 1995.

I'm baffled by the notion that an organization's payroll commitments, or the fact that meeting the payroll depends upon revenue coming in, are *implicit* somehow. Even "ambitious plans" had better be explicitly disclosed, if the organization is a publicly-traded company.

I don't think the term "implicit leverage" is clear at all, mostly because I don't think "implicit" is what TC really means, and I don't think "leverage" is what he means, either.

And I don't like guessing what people mean when they've used an odd terminology.

I had the same sense but was hoping for a bailout.

I feel the same way. Leverage has a fairly precise definition. I think of "hidden" leverage to maybe be something like operating leverage in the sense that a gold mining company has leverage against the price of gold, or an asset manager has leverage against equity returns.

Using leverage to describe off balance sheet assets such as reputation just seems wrong.

In software development the concept of "tech debt" is very popular. There are short cuts that programmers can take to get a feature out marginally faster at the cost of making future development slower. At high levels it can become costly because it makes onboarding new developers slow and affects retention rates.

I don't claim to fully understand TC's point, but if I do, then I think the most significant implicit liability of a corporation is a lack of ethics.

In government, it is a lack of duty.

In Amazon it is lack of worker satisfaction.

Ladies and Gentlemen, here I give you Tyler Cowen, a guy who actually gets paid to teach economics to impressionable young people.... and he has no idea that payroll commitments show up as debt on a balance sheet.

By all means, let's take him seriously on all matters!

Next year's staff salary is shown on the balance sheet?

Yeah, that's a head scratcher.

TPM - it's the "require[ment of] an ongoing stream of tuition increases or admissions boosts, usually from out-of-state students" that's the hidden leverage, not the payroll commitments.

I would like to propose that "implicit leverage" as used by TC means both "hidden asset" or "hidden liability." Yes, it makes no sense from an accounting perspective to say it could be both, but to the extent an NBA team has future draft picks, they are assets that could become liabilities if mis-handled. So bear with me, as I get to an example of "implicit" (not in the fin stats) "leverage" (asset or liability) for a consulting firm, specifically McKinsey, where I worked for two decades. (I will not assert that the following applies to other firms, but I will guess it does.)

Here we go: McKinsey is a machine for making alumni, all of whom could be future clients (thus future revenue streams). This is implicit because it is never mentioned by The Firm, whose explicit mission is client service.

First, let's skip all the deserved and undeserved critiques about Enron, South Africa, insider trading, etc. That is all for another day.

Now, on to Alumni Factory. It is a brilliant, brilliant system. The parts mesh perfectly.

Part 1: everyone knows The Firm tries to discard about 20% of the consulting staff annually ("up or out"), which is a policy that ensures explicit results such as rapid career progression (making recruiting easier) and high quality standards (no deadwood is left on board, to mix metaphors). But the implicit value is that UorO also creates unblemished alumni: recruiters know about the policy, know that as a result (start multiplying .8 by .8 over a few years) most McK hires will leave McK through no fault of their own. As a result, there is no stigma attached: no one will infer you were fired for some dire cause. Kind of like leaving the Marines: no one would say "So after 7 years, you failed at being a Marine I guess?"

Part 2: The Firm treats this steady flow of alumni royally. The old in-joke is that the two best times to be at The Firm are when you are hired and when you are fir--- I mean, when you leave. Free job search support, free use of office and all facilities, uninterrupted pay for a long time, most investment plans vest at once, etc. And then once you have left, there is a formal alumni support network, with advanced websites and directories and numerous staff, that puts to shame any university's alumni program I have seen.

Net result: The Firm churns out masses of alumni who (because they are never seen as failures, but more as graduates) go on to influential positions at corporations, and who (because of the royal treatment) are very favorably disposed to The Firm. (A typical view from an alumnus: "They gave me incredible OTJ training, paid me handsomely, let me go with no hard feelings, and treated me wonderfully as they did so: what's not to like?")

Thus McKinsey literally manufactures its own future customers (I will GUESS 20-40% of revenue is from alumni), and that is an amazing implicit asset... or liability, if The Firm screws it up. Which could happen. I would be interested in hearing of other companies which manufacture future customers this way, there must be some.

But one last thing, to emphasize how important this all is: when business turns down (at least in the decades I was there), Director comp is cut most, then Partner comp, and lastly that of the regular consultants. You can argue The Firm is just putting the burden on those who can best afford it, but it also reinforces the alumni factory: the people most likely to leave (those in pre-Partnership) are treated the best. I don't know that this happens in most major corporations.

Okay, now back to Enron and "borrow your watch to tell you the time" jokes.

Good comment, thanks

Partner at a different consulting firm here -

Yes, the McKinsey model is legendary. And other firms try to replicate it, though often not quite as well because there’s no substitute for having the McKinsey reputation when seeking external positions.

There’s a different implicit risk / leverage that I see in my world. My own firm is quite strong in one industry sector and mostly unknown in other industries. That means we have significant risk exposure to the decline or serious disruption of the industry where our customers are.

Another source of leverage is the mandate for growth. In the absence of the tremendous outplacement that McKinsey offers, a consulting firm must grow rapidly or else it risks serious decline because absent growth, the only way to mint new partners is to dilute current partners. We (the current partners) don’t like losing money and non-partner talent doesn’t want to work at a place where opportunity is capped. My firm’s historic growth has been a tremendous advantage in retaining talent. If we can’t sustain it, we’re in trouble. But none of that shows up on a balance sheet.

Very good point on the growth imperative / liability. Same at McKinsey, outplacement excellence notwithstanding. (BTW, did you know we implanted a microchip under the skin of every departing consultant? Just kidding! Probably.) What amazes me is that these firms just keep on growing. Every year at McKinsey I assumed would be our last year of growth. Were we going to open offices on the moon? And didn't advanced IT and telecomms and all the rest make it easier for any client to learn anything, and so why would a client need the "pollinating bees" of consulting? (Let's face it, at least half the value consultants add is taking best practices from company W or industry X, and bringing them to company Y or industry Z.) And every year the damn firm grew. When I joined in the 1980s the entire firm was the size of what are now the CLE/PIT/DET offices. I gave up trying to predict the end of the growth stage. An older wiser person told me, and he might be right: "Glenn, the day any client says to me, 'You know, the world is a lot simpler than it used to be,' THAT is the day I bail out."

I guess consulting will stop growing at the same time that videoconferencing replaces business air travel.

Hehe. I’m pretty sure there’s no chip implant since my firm employs some ex-McKinsey folks and I’m pretty sure they’re not under deep cover.

Some of the very large outsourcing shops (eg, Deloitte and IBM) do face the capped growth problem along with, at least sometimes, a whole bunch of dead weight at the very top who are getting paid for past production (more hidden leverage). My firm can hire great senior talent from those places since we don’t have nearly the same constraints on growth trajectory of good people. For now at least.

Over the very long haul, arithmetic dominates. My firm is 35 years old and has had double digit CAGR to get to 6000+ people from 2 (I’ve been there for 15 of those years). Can’t maintain it forever, even if we can for a bunch more years. I’m not worried about industry needing less consulting help, but the pool of services $ doesn’t grow as fast as any single firm needs to grow to sustain the model.

An example of leverage might be “off the books” and unfunded future retirement and health care costs that are included as part of current compensation packages. See for example Chicago school and public employees.

Many public firms have reduced their leverage in this sense by dropping these commitments.

Hidden leverage is 'stickiness' the economists call it. The implications is that their DGSE models will fail, which they know.

My favorite organization, the millennials, and they have this monster leverage, boomers, retired, will have to beg the millennials to pay interest charges on 21 trillion in leftover boomer debt. Millennials never voted for it, and have no moral to pay. They are beginning to denounce the debt. Like a big whoops, especially since the boomers were fine in abandoning their gold obligations in 1972, the Nixon shock. It will be a mess, but the millennials control the path, they are the only ones left who have not evaded the interest charges, one way or the other.

Sometimes TC writes something which shows how little about business he knows. This is one such examples. Qualitative risks are captured in annual reports.

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