The business planning mistakes we saw during a decade of irrational exuberance in the telecommunications industry show that Professor Shiller may have underplayed the illogic in corporate investment decision making. Professor Shiller attributes stock market investors’ exuberance in part to “the psychological principle that much of the human thinking that results in action is not quantitative, but instead takes the form of storytelling and justification … with no quantitative dimension.” Yet the decision making in telecommunications investment is full of quantitative analysis — analysis plagued with analytical fallacies.
The Financing Trap
In his analysis of investment manias, Professor Kindleberger established that booms are typically fed by an expansion of bank credit that enlarges the total money supply. Thus, the sources of financing often act as a stimulus for, rather than as a check against, investors’ irrationality. The telecommunications industry’s recent history supports Professor Kindleberger’s thesis. We have observed two occasionally overlapping financing effects, depending on whether funding comes from financial institutions or equipment providers. (See Exhibit 2.)
First, financial institutions, driven to secure a position with new companies and (as we’ve seen in recent revelations about the porous walls between financial institutions’ research and investment banking divisions) unburdened by analytical rigor, routinely extended credit without regard to the quality of a business plan. Herd behavior, in which private equity investors often ended up trusting and following another investor’s due diligence instead of their own, was also common. Another variant in this syndrome could be an adaptation of the well-known “IBM effect”: Nobody was going to get fired for investing in telecoms from 1996 to 2000.
Telecommunications equipment providers similarly fed the investment mania. Driven by the competitive imperative to build leading positions in the industry and pushed by sales forces eager to close deals, manufacturers overextended themselves, providing credit to finance equipment purchases by startup service providers and shortcutting the due diligence required by the treasury function to authorize the extension of credit. (Similar behavior by banks underlay the Latin American debt crisis in the 1980s.)
The tension between treasury and sales at equipment manufacturers during the recent telecom bubble was profound. In typical situations, competing equipment providers aimed at capturing business from a startup operator. In addition to selecting equipment based on functional requirements, new operators were particularly keen to reduce their capital expenditures, so the equipment providers competed not only to provide more elaborate equipment features and value-added services, but also to provide more appealing financing conditions. If the equipment manufacturer, on its own or with a financial institution as partner, assumes the lending responsibility, the financing application is examined in light of the startup’s business plan and the new company’s ability to generate free cash flows to service its debt.
Under these conditions, a conflict typically emerges between the manufacturer’s sales function and the treasury function. Treasury and credit need to perform the due diligence on the business plan to certify that lending conditions are in compliance with prudent credit risk management principles. The sales division, though, has an incentive to close the sale, and therefore sees the examination of the startup business plan as a perfunctory step “to keep treasury satisfied.” In periods of expansion, the sales function tends to hold the upper hand and in many cases is successful in selling to a startup despite the credit risk. This situation is reinforced by short-term pressure on quarterly earnings, when revenues become more important than customer profitability. In other words, the due diligence process fails to act as a check against irrational exuberance.
Indeed, the bubble has shown that due diligence, instead of serving as a rational, analytical, and objective restraint on the natural tendencies of internal competitors to fall prey to exuberance, actually serves in some cases to amplify, or at least validate, the irrational behavior. Interaction between decision makers (e.g., founders or managers leading the entry into the new business) and lenders becomes fraught with peer pressure, group thinking, and moral superiority (derived from presumed “visionary thinking”), deployed in the context of what Professor Shiller calls “a complex social and psychological environment.”