Blog postThe Capitalist’s Dilemma – and Opportunity


Investments to maximize short-term return on capital will not create long-term growth and jobs – and not even return on capital. This is a dilemma, but today’s super-dynamic tech industry might offer the unique combination of both fast capital returns, and simultaneous rapid new market creations from innovations.  

In 1997, Clayton Christensen published his influential book “The Innovator’s Dilemma”. Companies that focus on managing their existing business and customers well, will fail to meet new market and customer needs, which would require new ideas that challenge the existing business. The established company is usually not capable of internal disruptive innovation, i.e. to disrupt it’s own business. That’s still the dilemma. But a newly started company can capture new opportunities, and disrupt old companies. This explains how companies like Airbnb, Spotify and Uber quickly can disrupt established markets like hotels, music and taxis, that fail to innovate, while quickly building new successful companies. In a recent podcast, Marc Andreessen and Ben Horowitz explain how they, as a venture capital firm, invest in disruptive innovation. This is always at the heart of venture capital investing. Who are we disrupting? Who is disrupting us? Are we disrupting the disruptors? Is our business defendable? Are we investing in innovation?

Now, this raises the question about what kind of innovation the investor is actually investing in. Clay Christensen (together and Derek van Bever) turns his focus to a new dilemma in the June 2014 issue of the Harvard Business Review: Why do corporations with large amount of cash, and despite historically low interest rates, fail to invest in innovations that can drive growth? That’s the Capitalist’s Dilemma.

There are, according to Clay, three kinds of innovation:

1. Performance-improving innovations replace old products with new better products. Think of the car company that launches new models. This year’s Volvo XC90 is an improvement of the previous XC90. These innovations are substitutes for older products and generally do not create new markets or jobs.

2. Efficiency innovations help companies sell the same products or services to the same customers at lower prices. Take low-cost airline Ryanair as an example. By definition, these innovations raise productivity, deliver new customer value and free up capital for more productive use. But they do not create jobs, as they rather eliminate jobs.

3. Market-creation innovations, on the other hand, create a new class of customers and new markets. This usually happens when innovation makes costly products available to a mass market. Before, a computer was an expensive product, now billions of people can get access to a smartphone, a completely new product with both a lower price and a new set of services driving new behavior. Market-creating companies like Apple and Uber usually create jobs, but they also eliminate jobs in the markets they disrupt, making them controversial.

Clay Christensen asks why companies invest primarily in efficiency and performance-improving innovations, which eliminate jobs and growth. The reason, he argues, is the reigning belief that corporate performance should be focused and measured on how efficiently capital is used. This is at the root of the Capitalist’s Dilemma. Capital has historically been a scarce resource, hence the focus on maximizing its use. But today, we live in a world of “capital abundance”; it is not so scarce anymore. Consulting firm Bain & Co estimates that total financial assets today represent 10 times the value of global output of all goods and services, outlined in their report “A world awash in money”.

By measuring capital efficiency as ratios like Return On Invested Capital (ROIC) and Internal Rate of Return (IRR), investors have several levers to pull. The ratios can be improved not only be generating more profits, but also by taking take assets of the balance sheets through outsourcing, for example, or by loading on more debt to leverage your equity. Investments that pay off quickly would also make IRR go up. Performance-improving and efficiency innovations drives better short-term return on capital. And in a more insecure world, investors look for liquidity, rather than locking-up capital for decades.

Market-creating innovations are not only more risky, they also require longer term innovations, usually over 10 years, and load more capital on the balance sheet with investments in infrastructure, R&D, building organisations and production facilities. But these investments are probably the surest way to profitable economic and job growth.

For politicians around the world, with job creation as a top priority, it’s important to understand the relation between capital, investments and growth, and especially the jobless growth that we experience. The unemployment rate in the Euro zone is currently at 12% and youth unemployment is even worse at an average 23%. Still, most public policies, incentives and tax structures favours short term efficiency and improvements, rather than long-term market-creation innovations. Also pension funds and institutional investors focus on investments that drive short-term capital return to deliver on targets, rather than creating jobs. To manage capital for the greater good of society and future commitments, institutions make investments that are not always optimal for the longer-term prosperity of society. That’s another dilemma.

Also take a look at the huge private equity industry. Driven by demands by their investors, usually the same pension funds and institutions, for high returns and the need to meet high hurdle rates, buyout firms are forced to focus on investments that can generate a profit within 3-7 years. So it’s natural that the massive amounts of capital deployed in the global private equity industry go towards performance-improving and efficiency innovations that eliminate jobs. Not the creation of new markets, products and customers.

Venture Capital firms are expected to invest in disruptive innovations and new companies, looking past short-term capital efficiency and return, and instead focusing on market-creating investments that might take longer than 10 years. But the VC is industry is also forced to focus on performance-improving and efficiency innovations that can be sold within a few years.

The Capitalist’s Dilemma is that the right thing for long-term prosperity is the wrong thing for most investors short-term. As Clay put it, “In our attempts to maximize returns on capital, we reduce the returns on capital”.

So, what are the implications for the money managers like venture capital firms and buyout funds? How can we balance the need for financial returns, with the need for market-creating innovations that create real growth (not only capital efficiency ratios), jobs and prosperity?

Maybe the dynamics of the tech industry will make that possible. Market-creating innovations used to take a long time. Now they happen much faster. Companies like Tesla, Netflix and Facebook, and products like smartphones, streaming media and electric cars, create new markets and new customers at a spectacular speed never seen before.

New companies today create new markets and users, in some cases billion-user businesses, in a relatively short time, while at the same time making capital return for their investors. The positive outlook is that the need for speed in capital efficiency coincides with the spectacular current pace of new market-creation, and the resulting disruption of old markets. Health, public services, government and education are such markets waiting to be re-created, as Andreessen and Horowitz points out in another podcast. For any capitalist, this will not be a dilemma, but very exciting opportunities for years ahead.