Cherry Orchard Instability Hypothesis, Part I
What The Cherry Orchard can teach us about risk: Parallel Security Bubble; VC, Hedge & Strategics
Programming note: Happy Thanksgiving to all of my U.S. based readers! This week’s letter is a bit shorter on the Risk Developments, since the risk philosophizing is a bit longer. After this week, I’ll be returning to more emphasis on Risk Developments. Please drop me a line or leave a comment to let me know what you prefer:
“The distant sound is heard, as if from the sky, of a breaking string, dying away sadly.”
― The Cherry Orchard, Anton Chekov
Risk Developments this letter:
Parallel Security Bubble
VC, Hedge & Strategics
The Cherry On Top
“The train's arrived, thank God. What's the time?”
The opening line of Anton Chekov’s The Cherry Orchard succinctly raises the three driving forces of the play: technology, debt and time. The train and the telegram feature throughout the play as signs of development that accompanies social change. Time is the most constant theme throughout the play as timetables, deadlines, remembrances, age and talk of the future are frequent topics of discussion. Finally, and most subtly, debt is invoked via the sacred. Rendered in English as, “thank God,” the Russian “cлава Богу” is closer to praise, glorify or honor God. To whom do we owe gratitude and how are they honored? The relationship between technology, time and debt is one of the most important ideas in risk and there is no better guide than Chekov.
Why is it impossible to talk about debt without discussing time and technology? “The essence of finance,” Matt Levine once quipped “is time travel.” Debt is a promise to pay back tomorrow, an amount given today, plus interest. In a static world, the only cause of interest would be time. If I own a cherry orchard, and lend it (or the equivalent amount of money) to you, I expect to get the orchard back, plus some portion of the cherries (interest) after the time it takes to produce fruit.
Now let’s imagine a dynamic world, in which you invent a preservative that reduces the spoilage of cherries. That technology will increase the rate of interest (share of fruit) I may charge. Another way of describing technology’s effect on prices is to say it is deflationary for consumer goods, but inflationary for assets.
This duality of technology upsets the social order, transmuting peasants into rich men and aristocrats into paupers. If the essence of finance is time travel, the essence of technology is alchemy. Alchemy has been described as the origin of both science and magic.
One way of reading The Cherry Orchard is as a conflict between scientific rationalism and magical romanticism. Science takes time, and debt can buy that time, but magic requires freedom and play, which cannot be bought by debt. The life of wanton play and licentious philosophizing is possible for the aristocratic classes because of the sacrifices made by their serfs. This shift in thinking about technological development as a step-by-step process rather than the eureka moment that emerges, like a rabbit from a hat, explains today’s paradoxical growth slowdown amid the seemingly faster and faster pace of technological innovation. That is part of why the modern world feels like a farce.
The play is subtitled “a comedy in four acts” and tells the story of an aristocratic family in decline. The widower and matriarch, Lubov Ranevsky, is returning home to her country estate from Paris, where she fled to forget her son’s death. With Lubov are her daughters and brother Leonid. Waiting for them are their servants and employees: Fiers, the old footman; Simeon Simeon, the clerk; Peter Trofimov, the dead son’s former tutor.
In Act One, we learn the unhappy backstory, and meet the pivotal character, Yermolai Lopakhin, a wealthy businessman and son of a serf. He informs us that the whole estate will be auctioned off to pay the family’s debts, unless they cut down the cherry orchard and lease the land for development of country cottages. Act Two takes place outside an abandoned chapel in front of telegraph poles, and is mostly character development. Act Three is a party at the estate, where we learn the fate of the orchard, and Act Four is the falling action.
Returning to the question of debt, let us address the various schemes and their respective proponents. A useful way to categorize financial schemes is Hyman Minsky’s famous Financial Instability Hypothesis:
Stage One - Hedge Finance: businesses which can fulfill all of their payment obligations based on their cash flows
Stage Two - Speculative Finance: businesses which can meet their interest payments, but not the principle based on their cash flows
Stage Three - Ponzi Finance: businesses which sell assets or borrow to meet their interest payments
The first scheme to discuss in these terms, is Lopakhin’s plan to chop down the trees and transform the orchard into villas for rent. His suggestion is met with derision and disgust by the aristocrats:
Leonid: How utterly absurd!
Lubov: I don't understand you at all...
The only alternative at the time is mumbled by the elderly footman Fiers:
Fiers: In the old days, forty or fifty years back, they dried the cherries, soaked them and pickled them, and made jam of them, and it used to happen that . . .
Leonid: Be quiet, Fiers.
Fiers: And then we'd send the dried cherries off in carts to Moscow and Kharkov. And money! And the dried cherries were soft, juicy, sweet, and nicely scented. . . They knew the way. . . .
Lubov: What was the way?
Fiers: They've forgotten. Nobody remembers.
Fiers is a former serf, who chose to stay on as a servant. Throughout the play he is ignored, scolded and mocked.
As the family gets more desperate, Lubov and Leonid suggest their own schemes. Lubov thinks to implore a distant relative, a wealthy countess, for money to pay off the interest. This appeal is important in two dimensions. First it is class and family based. Second, it only seeks to pay off today’s interest. The last resort is, Leonid’s attempt to get a new loan to cover the interest from a mysterious General. These schemes represent Minsky’s stages: Fiers and Lopakhin’s are hedge finance, Lubov’s is speculative and Leonid’s a Ponzi.
The empty headed aristocracy can only delay the inevitable. Tomorrow, or the day after tomorrow, but either way the estate will be sold. This brings us back to the only two schemes that can work, Fiers and Lopakhin. At first glance, they may appear equal, if opposing schemes, but notice how Minsky’s definition of Ponzi includes selling off assets. Here we must distinguish capital from land (for more on this point see Henry George). The cherry trees are a capital asset, while the land is a natural asset. To create villas the trees will need to be chopped down. The only scheme that would not destroy capital therefore is Fiers’, but here is the obstacle…
To see how the story turns out and learn why you can’t ever go home again, stay tuned for part II next week. Now on to the risk developments (after a quick favor)!
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Risk Developments
Parallel Security Bubble
I keep coming back to Byrne Hobart’s piece on parallelization in bubbles. Two interesting stories on the data and cloud parallel bubble are Datadog’s partnership with Google and cyber-criminals’ use of the cloud. While the two have the cloud in common, the most interesting thing about these bubbles is they both seem to continually beat expectations despite the incredible amount of hype.
More monitoring and server health data is needed with more servers to monitor, and more servers are needed to store and process that data. It’s a classic parallel bubble with data and cloud leapfrogging each other to levels one could not anticipate without noticing the massive growth in the other. It’s a kind of self fulfilling Ponzi Finance that actually works because expectations aren’t high enough.
That’s great news for Datadog and Google, but if our expectations for cyber-criminal use of the cloud is also insufficiently hyped, that’s terrible news. Cloud was supposed to help us fight cyber crime, not enable it. These two parallel bubbles are not only linked by their cloud commonality, but because private surveillance and crime are themselves a parallel bubble. The more crime we get, the more private surveillance. The more private surveillance, the less trust in society and the lower demand for public security. There is a sort of crowding out for public goods that get provided in the marketplace.
Maybe this is not so bad in cyberspace, where the risk is to data not lives, and private security is reasonably effective. Where it gets uncomfortable is on demand body guard apps and panopticon neighborhood watches. To be clear, I’m not criticizing these companies. They are stepping in to fill a vacuum, and if crime continues to shift online because it’s a better return, maybe we can have mostly private security with a public backstop just like in finance we have private banks and the FDIC. That’s not my idea of utopia, but it is the way things seem to be headed. If that’s not the future you imagine either, we will have to figure out how to delink the cybercrime and cloud bubbles, while leaving server health monitoring and cloud in place.
VC, Hedge & Strategics
In Minsky’s framework primary equity financing is most closely associated with hedge finance, but the world of equity financing has changed dramatically since the 1980’s when he wrote the Financial Instability Hypothesis. VC’s are pure equity finance, what Minsky would call hedge finance. Late stage private equity and public markets investors (hedge funds) are what Minsky would call speculative finance (confusing, I know). Companies that make strategic acquisitions believing they can afford to pay a premium due to synergies, and are Ponzi finance in Minskian terms.
Activist investing is what happens when speculative and Ponzi finance collide. Like Lopakhin forcing discipline on the aristocrats, Paul Singer, of Elliot Management, is taking an axe to the cherry trees in F5’s orchards. Activists are used to being disliked, but they play an important corrective role in our financial ecosystem, and as uncouth as they may be, the real damage was making reckless acquisitions in the first place.
Now, I’m not saying all corporate buying sprees are bad, but man has cybersecurity seen a run. Palo Alto snapped up more than a few companies in 2019, and 2020 isn’t slowing them down. Adding fuel to the fire(eye), incident response firm FireEye just got a big injection of capital to support its acquisitions.
So what’s going on in VC land? In some ways they are insulated or even benefit from the downstream effects. More acquirers is a good problem to have, but VC returns come from a handful of outsized returns, usually IPO’s, not near misses. It’s business magic, not business science, which implies the eureka model takes precedence over the vigilant activist investor. What is a VC to do in this environment? Well one solution, taken by 8VC as they leave SF for Austin, TX, is to find new cherry orchards.
Gratitude
Big thanks to my writing workshop Roger Farley, Tom White, Sachin Maini, Vinit Shah and Simone Keelah! Also to the writers and thinkers whos ideas I drew upon, like Marcia Pally, Stephen L. Baehr, Ikechukwu Egbuta, Rosamund Bartlett, Matt Levine, Byrne Hobart, Michael Gibson, Rachel King, Faith Bottum, and Liz Koblyk.