Throughout Billion-Dollar Lessons, we strive to help shorten the normal managerial learning cycle by reporting on the bad judgment of otherwise talented executives at good, and sometimes great, companies. Our hope is that awareness of common mistakes can help managers avoid them, without having to live them firsthand.

Unfortunately, telling someone to be more aware of a potential problem is not much of a remedy. Thus we also offer methods for changing how organizations assess big strategic moves, primarily by instituting safeguards against process failures that make even the best organizations susceptible to bad strategies.

In doing so, we try to be both pragmatic and revolutionary.

We try to be pragmatic by suggesting techniques that don’t depend on fundamental rewiring of how individuals think or how organizations make strategy. That’s not to say that some fundamental rewiring might not be appropriate in some cases, but we don’t depend on it because, quite frankly, it probably won’t happen. Our suggestions are, instead, designed to be overlaid on current processes.

At the same time, we hope our pragmatic techniques will spark several revolutionary changes. First, we hope to revolutionize the decision making process at the very top. Rather than driving for consensus, we hope to provoke chief executives, senior managers and board members to expect, accept and even demand frank discussion and robust analysis whenever bet-the-company moves are on the table. To help this happen, and to safeguard the organization when it doesn’t, we believe independent Devil’s Advocate reviews of such strategic moves should always be conducted before adoption. We think that such reviews can be powerful tools for clear-headed assessment, and that their mere presence in the planning process will serve to make the prior planning sharper.

We also hope to foment and legitimize a revolution in middle management. We’re willing to bet that in every failure that we studied, there were critical thinkers in the heart of the organization who saw the clear and present dangers of the proposed strategy. We hope to legitimize their voices to question and, when appropriate, to quash doomed strategies while they are still on the drawing board.

The place to start is with our former partners at Diamond Management & Technology Consultants—in particular, Adam Gutstein, the CEO; Mel Bergstein, the chairman; and John Sviokla, the vice chairman. They didn’t just offer freely of their thoughts and relationships. They also employ many, many smart folks and made nearly 20 of them available to us over the course of more than a year, to pound our data into submission and make it yield up its secrets. The members of the research team were: Teji Abraham , Ken Archer, Anitha Chalam, Michael Czyz, Devin Henkel, Vivek Khati, Prakash Natarajan, Ritesh Patel, Chris Rzymski, Paul Singh, Andrew Sofield, Ariel Soiffer, Lance Thomas, Sarah Warning and Sara Xi. We hope they learned half as much from the collaboration as we did.

A great many phenomenally bright and experienced people also helped to make this book better. They didn’t have the time to spare, but they spared it anyway. They read the manuscript in detail. They offered stories. They helped sand the rough edges off our ideas. They offered insights into how to make our ideas more practical and useful. So, we’d like to heartily thank: Bill Abbott, George Anders, Dan Ariely, Aamer Baig, Les Ball, Vince Barabba, Gordon Bell, Mel Bergstein, Paul Blase, Dan Bricklin, Caroline Calkins, Marie Carr, Charlie Carroll, Kim Carroll, George Churchill, Doug Collom, Morgan Davis, Paul Demuro, Bill Dentino, Craig Forman, Jon Friedman, John Erik Garr, Bob Gilbert, Jack Greenberg, Kevin Grieve, Bernie Hengesbaugh, Pegeen Hopkins, Beth Jenkins, Alan Kay, Andy Kessler, Lisa Laing, Rick Leander, Janet Long, Andy Lippman, Don Listwin, Mark Maltais, Roger McNamee, John G. Morgan, Dean Nicolacakis, Frank Orzell, Tony Paoni, Rachel Parker, Karen Patton, Toby Redshaw, Anand S. Rao, Wes Richards, Dan Roesch, Tim Rohner, Kevin Salwen, Scott Shaull, Alan Siegel, John Sviokla, Jennifer Thatcher, Barbara Ullman, Chris Veit, Tom Waite, Tom Weakland, Eric Wilson, Darin Yug and Marvin Zonis.

We also acknowledge the fine folks at Reuters, Thompson Financial and Bankruptcy.com, who provided the raw financial data that fed our analysis.

Special thanks go to our agent, Kris “Tough Love” Dahl, at ICM. She worked us through a couple of iterations of our initial proposal, turning a vague idea into the book you have in front of you. Thanks, too, to Adrian Zackheim, our editor at Portfolio, and to his assistant, Courtney Young. Courtney’s insights and enthusiasm helped keep us going in those dark days when we had seemingly been at the book forever but weren’t yet in sight of the finish line. Thanks, as well, to the rest of the group at Portfolio and Penguin, especially Allison McLean and Will Weisser. They have helped us get out the word about what we hope will turn out to be an important book.

Finally, thanks to our wives and children, who put up with us during this lengthy project, much more than we deserved.

To glean the lessons from those that have failed, we examined a broad cross section of the most significant business failures between 1981 and 2006. We defined failure as writing off significant investments, shuttering unprofitable lines of business, or filing for bankruptcy.

Working with leading information vendors, including Reuters, Thomson Financial, and bankruptcy.com, we built a comprehensive database of more than 2,500 such failures suffered by publicly traded companies in the U.S. We picked U.S. public companies because reporting requirements ensured uniformity and access to data while, at the same time, yielding a large enough universe from which to generalize the results. We picked the 25-year period because it was long enough to span multiple economic cycles but recent enough to be relevant to today’s business environment and management practices.

We also did a literature search to look for failures that didn’t show up in the vendors’ databases—for instance, companies that sold themselves before having to account for a major problem.

Then, aided by a team of researchers from Diamond Management & Technology Consultants, we spent more than a year poring over the data. We first applied several financial filters that narrowed the list to the 750 most meaningful. We narrowed bankruptcies to companies with $500 million or more in assets in the last quarter prior to bankruptcy. We narrowed write-offs and discontinued operations to those greater than $100 million, not including write offs for in process research and development. (Accounting rules during the years covered by our data required the immediate expensing of all recognized in-process research and development assets following a business combination. These write-offs were a mixed bag; the charges sometimes represented dead-end projects while at other times they were one-time charges against otherwise worthy, continuing projects. Given that it was difficult to distinguish between the two, we chose to ignore the category of write-offs. )

We then did a root-cause analysis, reviewing financial filings, business and popular press reports, and assessments from industry analysts to understand these failures. Using this analysis, we identified repeating patterns, where failures across multiple industries were variations on a theme. We homed in on failures that seemed to be because of strategic failures, rather than environmental factors beyond management control or mishandled implementation. Out of the 750 cases, we found 355 where strategies led directly to major failures. These cases are shown in tables at the end of this section, organized by failure type.

Next, we drilled further into 80 of these strategic failures, selected to give a representative sample across a broad set of industries and failure patterns. In this further analysis, we turned to a wider set of references including personal interviews, court documents, local newspaper coverage, and business-school cases. The personal interviews included principals involved in the failure, journalists and analysts who covered the events at the time. We also talked with many of those who were responsible for cleaning up the mess and who, for the sake of posterity, were willing to guide us through what happened, in excruciating detail.

From this analysis we drew the lessons about the common problems, the red flags that might alert management to impending failures, and the tough questions that might avert those failures.

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An Independent Devil’s Advocate Review

“More often than not, failure in innovation is rooted in not having asked
an important question, rather than having arrived at an incorrect answer,”
Clay Christensen has observed. Unfortunately, the internal process safeguards
that we proposed in chapter 10 are no guarantee that the important
questions will be asked about unfounded assumptions, unattainable
forecasts, untreated deal fever, or any one of the many other individual
and organizational tendencies that can lead to ill-conceived strategies. In
the heat of the moment, even the most experienced executives and the
strongest safeguards can fail.

Steve Hilbert, the CEO of Conseco who acquired Green Tree Financial,
is a testament to this hazard. Hilbert had successfully built Conseco
through dozens of acquisitions. He had a rigorous acquisition process
and a crack team, both honed through almost two decades of deals. Yet,
in Conseco’s biggest deal, Hilbert’s experience failed him. His vision of
taking Conseco “to the next level,” to create a broader financial-services
company— a financial-services Wal-Mart for middle America— led him
to pay an exorbitant premium for a company that was clearly in trouble.
He was willing to gamble more than $6 billion based on his vision and
just seven days of due diligence. Given that the investor and analyst skepticism
was immediate and overwhelming, he surely faced internal skepticism
as well. But that skepticism was muted. It is well nigh impossible for
someone inside an organization to tell the CEO that his rousing vision is
flawed and that he has fallen victim to deal fever.

To protect against the most dramatic strategic failures, we call for an
additional safety net— a series of rigorous “ second-chance” hearings by
an independent devil’s advocate.

Whenever an organization is embarking on a high-stakes strategy, it
should subject that strategy to an independent devil’s advocate review.
Ideally, as we described in chapter 10, this is a formal part of the strategy
development process. It is one of our “first, decide how to decide” process
safeguards: it should be well understood by all involved before the strategy
itself emerges. Just the anticipation of the review, we believe, will lead
to better outcomes. In addition, strategy developers would benefit from
the questions raised by the devil’s advocate throughout the process, rather
than see them as attacks on their hard-earned positions. The CEO would
also get feedback and challenges along the way, before making any sort of
public commitment and risking embarrassment if he later backed away
from the strategy. This independent devil’s advocate review would culminate
in a final “ last-chance” review, which should be done toward the
end of the strategy-formulation process but before it’s too late, before the
momentum is so great that almost nothing could stop the strategy. As one
executive put it, “Once the lawyers enter the room, it’s too late to turn
back.” In the event that, for whatever reason, the devil’s advocate review
is not initiated during the planning process, we believe CEOs should still
commission a formal review at the end of the strategy-setting process.

We find that a devil’s advocate review can build consensus among a
management team and can convince a board that it doesn’t need to probe
too deeply into a strategy; if a formal review from an independent viewpoint
can’t find a problem with a strategy, then it’s hard for the board or
executive team to object. Some CEOs have commissioned reviews even
after a strategy is set to identify the problems that might surface and let
everyone be better prepared if they do. We still believe the review should
happen before the big bet is placed, but we won’t argue with success.

Whenever a review happens, and for whatever particular purpose,
here is, perhaps, one of the most sensitive aspects of our recommendation:
The independent devil’s advocate process and, especially, the result
of its last-chance review, should be completely transparent to the board
of directors. Based on our research and consulting experience, many
CEOs are hesitant at adopting this suggestion. They suspect that such
transparency might disrupt their carefully managed board interactions.
Our experience is that, properly orchestrated, such transparency raises
the level of constructive discourse between management and board
members.

The key is to establish the right guiding principles, which we will lay out
later in this chapter. One ex-CEO, who retired a few years ago after a long
run at the top of a business with more than $20 billion in annual revenue,
helped us sharpen the design of this safety net in this key aspect. While
many CEOs are loath to do anything that would cede any authority, he said
that he’d accept a formal devil’s advocate review as long as we maintain a
key distinction: that between governance and management. He said he’d
resist any attempt to take over the management of the business from him.
But he accepted that, in the interest of good corporate governance, the
board had every right to understand and react to his decisions.

This is what we’ve been saying all along: that we’re not trying to take
decision-making authority from the CEO or anyone at another level of the
business who has earned the right to decide about a strategy. But we thought
it might be worth putting the issue in a CEO’s terms: The devil’s advocate
review is about governance, not about usurping management authority.

As for how to organize a devil’s advocate review: The review should be
orchestrated by someone with credibility, objectivity, and some level of
inoculation from organizational politics and pressures (acknowledging,
of course, that no one is completely immune). This might be an independent
director or some recently retired senior manager with no ax to grind.
The reviewers should consist of, in large part, credible, objective outside
reviewers with no stake in the outcome. The reviewers should be told to
argue the “no” side, with license to raise any question whatsoever to
ensure that the strategy is in the best long-term interests of the
organization.

Skillful orchestration is an imperative. The closest analogy to the
independent devil’s advocate is probably the formal due diligence conducted
in the course of acquisitions and joint ventures. In particular, our
reviews conceptually overlap with “strategic due diligence,” the stage that
probes the logic of the transaction to ensure that it is aligned with the
strategy of the acquirer.

Yet, by the time the strategic due diligence is reached, it is usually too
late to address the misaligned goals and flawed strategies that doom most
acquisitions, irrespective of the quality of the acquisition target. This
happens, in part, because by the time the due-diligence stage is reached,
the corporate strategy motivating the transaction is pretty much assumed,
and not an open topic of discussion. The due-diligence team is assembled
to assess the quality of the target and to assign the right price to it, not to
assess the motivating strategy or the target’s fit with that strategy. Even if
the motivating strategy were subject to inspection, due-diligence teams
are usually not equipped to address it. Due diligence requires extensive
investigation into every aspect of the target, including legal, financial,
accounting, tax, operational, human resource, technology, and organizational
issues, just to name a few. Team members are chosen for their
expertise and doggedness at ferreting out the details and skeletons in one
or a few of those areas. They rarely have the context, skills, or time to
relate the findings back to the original strategy. As a result, flawed strategies,
and even the lack of a strategy, are usually not flagged in the due diligence
process. For example, a study by Bain of 250 senior executives
involved in major acquisitions found that more than 40 percent had no
clear strategy of how the acquisition would boost profits and market
value. Of those who claimed that they did, half admitted that they discovered
that their approach was wrong.

The devil’s advocate process that we propose occurs earlier, when it
might still be possible to head off the issues that would otherwise not be
addressed until strategic due diligence.

Formal due diligence is less common for strategic moves that do not
involve outside transactions. For example, Green Tree’s mortgage loan
strategy, FLYi’s decision to become an independent carrier, or Kodak’s
decision not to pursue digital photography in earnest would normally not
have sparked a due-diligence review. Yet these sorts of decisions would
clearly have benefited from an independent devil’s advocate review.

The exact design of the independent devil’s advocate review will depend
on the context and particulars of the strategy in question. But, based on
our research and experience, here are five general principles to follow:

1. Establish a clear and limited charter.
2. Organize for success.
3. Focus on the strategy, not the process that produced it.
4. Deliver questions, not answers.
5. Come to closure.

To continue reading, down Chapter 11 “of Billion Dollar Lessons.”

Taking a Shortcut Through the Numbers

“The two most dangerous words in Wall Street vocabulary are ‘financial
engineering,’ ” said Wilbur Ross, the turnaround specialist. Warren Buffett
refers to derivatives as “financial weapons of mass destruction.”
It wasn’t always so. Originally, the term “financial engineering” evoked
images of Wall Street math wizards taming the vagaries of risk by conjuring
up esoteric financial instruments, in the process creating liquidity and
enabling markets to function well. From 1987 through 1996, the average
worldwide growth rate in the face value of the major forms of derivatives was
40 percent a year, according to CFO magazine. Paul Kasriel, director of economic
research at Northern Trust, says profits from the financial sector now
account for 31 percent of total U.S. corporate earnings— up from 20 percent
in 1990 and 8 percent back in 1950. Profits from this country’s financial
engineers now far exceed those generated by mechanical engineers.

As the wizardry spread, however, nasty surprises occurred— even
before the subprime mortgage disaster that shook the financial world
beginning in 2007 and 2008. Barings Bank, once the oldest merchant
bank in London, collapsed in 1995 because of $1.4 billion in losses by one
rogue trader, Nick Leeson. ING, a Dutch rival, bought Baring for one
British pound. Long Term Capital Management, a hedge fund founded
by legendary bond trader John Meriwether and whose partners included
Nobel Prize winners in economics, dazzled with 40 percent–plus annualized
returns in its first few years before losing $4.6 billion in the course of
a few months in 1998. (While LTCM claimed the market had become
irrational, it’s worth remembering John Maynard Keynes’s observation
that “the market can stay irrational longer than you can stay solvent.”)
In general, it only takes a few bad bets in the trading business to lose billions,
as happened in 2006 when the Amaranth hedge fund lost almost
$6 billion and was liquidated because it, essentially, lost some highly leveraged
bets on the weather.

The wizardry spread from Wall Street into the rest of corporate America,
where companies increasingly used financial and accounting techniques
to enable broad corporate initiatives, such as restructuring,
increasing financing available to customers, funding new ventures, and
hedging operational risk.

Problems have shown up in the non–Wall Street crowd, too. Companies
get sucked into the idea that they’ll indulge in some creative accounting,
but only briefly, until the business clears some hurdle and earns its
way out of the current difficulties. But the one or two quarters of aggressive
accounting can become three or four, then become a way of life—
until disaster strikes. That disaster can sometimes mean regulatory
censure and fines. In extreme cases, à la Enron Corporation, the aggressive
accounting can turn into fraud and jail terms. But even if the accounting
stays just this side of the line, once investors learn about it they can
still punish a company severely.

Every once in a while, you even see a company that manages to come
out the other side after a period of creative accounting. AOL’s profits for
years came from financial chicanery. The company blanketed the world
with free introductory CDs to get people to sign up for its service but
didn’t absorb the costs as expenses right away. AOL capitalized the
expenses, spreading them out over several years. The theory was that AOL
was attracting customers who would be with it for years, so it was fair to
defer much of the expense of acquiring those customers. The problem
was that the average person who signed up because of AOL’s free discs
didn’t stay with the company for even a year. The SEC investigated, eventually
fining AOL $300 million and issuing a stinging rebuke in 2005, but
by that point AOL had become a legitimate business.

But there have been enough failures associated with financial engineering
that it’s worth distinguishing, in Warren Buffett’s words, acceptably
aggressive accounting from attempts at alchemy. In the end, as
Buffett once wrote his shareholders, alchemy fails. Financial alchemists
may become rich, but gullible investors rather than business achievements
will usually be the source of their wealth. We’re interested in spotting
the alchemists and helping both executives and investors head off
inherently flawed financial engineering strategies before they wreak
havoc.

We’ll begin with a story that, had it been studied by subprime mortgage
lenders, would have warned of how mortgage lending can become so
addictive that financial institutions can stop paying much attention to
whether borrowers will ever pay off their loans.

To continue reading, download Chapter 2 of “Billion Dollar Lessons.”