by Richard Robb
My second trade was in October 2001, in a market where I had plenty of experience. I shorted five-year Treasury-note futures, betting the price would go down. Although I’ve long forgotten my logic for this trade, I bought back the futures in November after interest rates rose and prices for Treasuries fell.
For the third trade, also in October 2001, I bought soybeans again and sold a few weeks later at a profit. The fourth was a purchase of cotton, which I noticed had fallen below 30 cents per bushel. This reminded me of a song from the 1960s in which Johnny Cash lamented, “cotton is down to a quarter a pound, I’m busted.” The overall price level had quadrupled since he sang those lyrics, making the current price of cotton around 6 cents per pound in 1960 dollars. The straits of cotton farmers must have been truly dire. I suspected that, as with soybeans, trend-following traders had driven down the price. I bought futures at 29 cents and sold in November at 36.2 cents.
While my experiment in trading contradicts a narrow definition of market efficiency, it does illustrate an efficient market in human skill and effort: by devoting about 10 percent of the time I’d formerly spent on my job, I earned about 10 percent of my former pay.
What advantages did I have over institutional investors? I wasn’t trying to achieve any particular target return. I took small positions to avoid risking too much. I didn’t try to live off the winnings. If there were no good trades to do, I didn’t have to do anything. I kept the trades secret; unlike a trader at a bank, I was free from worrying about how they might look to my boss or the risk management department. But that secrecy didn’t make me a rogue trader—I can’t be a rogue to myself! I had one more significant advantage: I had ridden the roller coaster enough times to develop some self-awareness. I didn’t panic or despair when losing or become exuberant and rash when winning. Together, these factors allowed me to take for-itself action. Lots of people probably shared the intuition that soybean prices were unsustainably low, but I was in a position to act.
Although these trades were accompanied by Adam Smith’s “anxious vigilance” to some degree, it took a bet on a wind farm to bring home the full (and sometimes grueling) implications of a for-itself leap under novel and uncertain conditions.
Thanet Offshore Wind: A Big Leap
There is a sentiment among traders that it’s a bad omen to win on your first trade. Early success can go to your head and foster an unhealthy lack of caution. I know the truth of this sentiment because when our fund first stumbled into wind energy, we started out winning. In 2005, we were analyzing a transaction tied to a bank’s loans to German wind farms, not such a departure from our normal business. But then we decided that instead of insuring loans, we’d rather own the wind farms themselves. Using money from our funds and debt from a security backed by the wind farms, we took a leap. We figured that investors would appreciate the lack of correlation between their other assets and wind farm returns, which depend largely on how hard the wind blows.
In late 2006, after construction was completed and the financing was in place, we sold the wind farms to a public company in the United Kingdom. So far, so good. We’d built enough wind farms to power 300,000 homes when the wind was blowing full blast and turned a solid profit in short order.
Then the wind changed direction.
In August 2007, we bought the rights to build a three-hundred-megawatt project, Thanet Offshore Wind, in the Thames Estuary. If constructed, it would be the largest offshore wind farm in the world. We had never built a wind farm that size but, as my partner Johan Christofferson and I said to ourselves, neither had anyone else. So we were, no question, acting out of character. (I should add that Johan and I don’t think of ourselves as thrill-seeking daredevils, an impression you might get from reading the rest of this story. We enjoyed working at a Japanese bank where the highest praise was to call a colleague “reliable.” Thanet was a gigantic break from the orderly lives we normally live.) We knew that in addition to the risks we’d identified, we would encounter unforeseeable risks once the project was under way, but we also calculated our expected returns with a large margin for error.
Of course, our leap was preceded by analysis. The site, in the Thames River Basin, could not be beat: it was sixty miles from the center of London and one of the windiest locations in the world suitable for offshore wind development. Auspiciously—or so we thought—we were able to buy the project company for what we believed to be a bargain price. Because of our winning track record and enthusiasm for Thanet, we were able to raise the money for the first phase of construction. What could go wrong?
Turns out, plenty. First, the prices of steel, copper, and oil surged. Wind farm foundations and towers are made of steel, and the cables that export the electricity to shore are made of copper. The spike in oil prices stimulated offshore drilling, raising demand for the specialized installation vessels that we needed to construct Thanet. Higher power prices boosted demand for turbines, and Vestas, our Danish supplier, raised its price by 30 percent. The project was growing more expensive by the day.
Delays set in. One of our barges capsized. A small airport in Kent, England, claimed that Thanet would interfere with its radar and demanded compensation in the form of extravagant new equipment. The fishermen’s association tried to hold us up, claiming that it, too, needed compensation, even though the project was far out to sea, the cables would be buried deep underground, and the footprint of the towers was inconsequential.
I was nervous. In March 2008, Bear Stearns collapsed, and the financial crisis deepened. By June, I had a constant worry in the pit of my stomach. So we decided to get out while the getting was good. We hired an investment bank to put Thanet back on the market in early summer 2008. We received three nonbinding bids from credible buyers, any one of which would have delivered a spectacular profit. We went with the highest bidder, Iberdrola Renovables Energía, the Spanish electric utility. Iberdrola assigned a large deal team to the project, hired technical advisers, and engaged outside counsel. Senior members of the deal team canceled their summer vacations to close Thanet on September 4. Iberdrola was doing everything expected from a buyer, but it wasn’t calming me down.
In late August, Iberdrola informed us that it wanted all documentation completed two weeks before funds were to flow. We moved the closing date from September 4 to September 30 to accommodate internal approvals within Iberdrola. The new date presented us with a serious challenge, since payments were due to various suppliers, such as Vestas, which was expecting a down payment of €125 million on September 6. Iberdrola contacted several of the affected suppliers directly to explain that the delay had resulted from its internal procedures and that it was committed to the September 30 close. All suppliers agreed to the revised terms except Vestas, which wanted €10 million for the delay. Otherwise, Vestas said, it would begin selling turbine slots to onshore projects.
In September, we negotiated the remaining contracts to Iberdrola’s satisfaction. We persuaded some contractors to continue working and others to delay enforcement on sizeable obligations—the Belgian manufacturers of the steel foundations were owed €46.5 million but agreed to continue rolling 50,000 tons so that installation could start in December. Johan and I put most of our own money into the project to keep it afloat a few more days. What else could we do?
Then came the collapse of Lehman Brothers on September 15. My overall terror that day was heightened by fear for this deal. On the afternoon of Friday, September 26, we were informed that Iberdrola’s CEO wanted to postpone the deal due to market conditions. The following Tuesday morning, he came to London to negotiate. We struck a revised deal, with our fund leaving its money in the project alongside Iberdrola’s. The new closing date was set as Tuesday, October 7. Between Friday, October 3, and Tuesday, October 7, the S&P 500 fell 9.4 percent, leaving Iberdrola in no position to announce a project that would ultimately cost €1 billion. It walked away for good, as was its legal right. I was angry at the time but don’t blame Iberdrola now. Its stock pric
e had fallen precipitously with the rest of the renewable energy market. With commodities collapsing, a recession imminent, and credit vanishing, the Thanet project was no longer a prize.
Our secured loan was in default. Payments to about twenty suppliers, including Vestas, were overdue. The directors of Thanet worried that they might have a personal legal obligation to put the company in bankruptcy. No fresh money was in sight. Similar projects around the world, including other offshore wind farms in the works, simply shut down.
We asked the suppliers to continue working even though we couldn’t pay them. We pleaded with the lender not to foreclose. Johan and I had to personally guarantee that the lawyers would be paid, risking everything, including our homes. DKB, the Japanese bank where we’d worked, was like a Disney movie by comparison—no matter what happened, it couldn’t get too bad because the head office in Tokyo would always bail us out. And if the bank ever got into real trouble, the Japanese government would step in. But this time, it was just us facing the abyss.
If all the stakeholders—suppliers, lenders, advisers—played along, we all had a chance. If any one of them tried to enforce its rights and jump in front of other creditors in line, everyone would lose. It was a twenty-dimensional game of prisoner’s dilemma.
My morning ritual after the Iberdrola deal broke down began with a call from the CEO of Vestas. “Richard,” he would say, “I can’t satisfy my board with talk.” “Anders,” I would answer, “if I had money, I would send it to you.” These exchanges were always polite. “Sorry if the tone above seems hard or rude, this is not the intention, but it is a fact,” he emailed. “Trouble is the common denominator of living,” I reminded him, quoting Kierkegaard, his fellow Dane. As my day wore on, however, Thanet stakeholders, including disgruntled investors, would call, and interactions became less civil.
But while our conversations were tense, the investors were somewhat placated by the fact that Johan and I always took their calls, and that we were at risk of being wiped out personally when the Thanet sale imploded at the end of September. The UK Energy Ministry helped by encouraging suppliers to cooperate. Ultimately, the stakeholders hung on. Even the Belgian foundries kept working. I don’t know how they paid for the steel. Probably the same way we paid them—with promises we hoped we’d be able to keep.
After Iberdrola backed out and threw the project into disarray, things got personal. Holding it together was not a task we could delegate. There was no chance of any outcome besides losing our shirts—the only real question was, how badly. We had dragged vendors and creditors into a giant mess and spent every day persuading stakeholders to give us another stay of execution. Some of them, by giving us a break, were acting out of character. On paper, we probably didn’t look like a good bet. But we were good at begging.
A Swedish state-owned utility finally bought Thanet in mid-November. The offshore wind supply chain soaked up the utility’s money like a desert in a rainstorm. The vendors and creditors were all paid in full. A little bit was left over for our investors, though not enough to recover our investment.
What did I learn from this experience? Maybe it’s simple: not to have bad luck. If commodity prices hadn’t zoomed up when they did, we would have been in stronger shape. If Lehman had collapsed six months earlier, before we spent so much money on Thanet, we could have delayed construction until markets recovered. If Lehman had collapsed three weeks later, our sale to Iberdrola would have closed, and we would have made a fortune. But when an investor asks me this question, answering in terms of luck feels disrespectful.
I doubt we’ll try a project this risky again, but not because the experience taught us to avoid risk. The common expression “it took a lot out of me” feels about right. Stepping outside my beliefs, subjecting them to harsh reality, and settling back down again—there’s only so much of that I can do. Even if I took a prudent risk and investors knew what they were getting into, I could still end up harming people who trusted me. My remorse shaped a new belief—that the emotional strain of risking other people’s money to this extent is hard to bear, no matter how willingly they invest. Now that I have felt what that emotional strain is like, I know myself better. I handled that one harrowing episode and a few others like it, but that’s enough. Since Thanet, our fund has stuck largely to our European credit business.
Construction of Thanet finished in 2010. Despite cost overruns, it is on track to deliver 8 to 10 percent annual returns for its new owners, including revenues from renewable subsidies. That’s not far below what we projected back in 2007, even though power prices have fallen significantly.
I have little taste for inspirational stories of entrepreneurs who failed at one business after another, dusted themselves off, learned from their mistakes, and eventually hit it big. Sure, it ends well for the entrepreneur, but what about all the stakeholders—the employees, vendors, investors—the first few times around? Where is their happy ending? My colleagues and I take a small measure of satisfaction in knowing that Thanet was ultimately built, but we must live with the fact that we lost other people’s money as well as our own.
Although I did once catch a glimpse of Thanet out of an airplane window, I have never been to visit it.
5
For-Itself Decision-Making
within a Group
Let’s revisit the impasse between the entrepreneur and the venture capitalist from Chapter 2. The entrepreneur walks into the office of the venture capitalist (VC) to ask for money to bring a new product to market. According to the entrepreneur’s business plan, the product will take one year to develop. In the second year, her base case predicts revenues of $2 million, and her worst-case scenario predicts revenues of $1 million. The entrepreneur believes her product will generate these revenues if the VC gives her the money. She knows she’s right. Her belief is based on first-hand encounters with the market she plans to address. Her actions confirm the strength of this belief—she has committed all her savings and exhibits an entrepreneur’s customary zeal.
After reviewing the business plan and meeting with the entrepreneur, however, the VC estimates that the product will take at least three years to develop and will probably fail. The VC knows this. Her belief is based on experience with entrepreneurs and their business plans. (The VC will not tell the entrepreneur exactly what she thinks to avoid insulting her. It would be an “insult” rather than a “disagreement” because the entrepreneur’s beliefs are personal.)
What the VC knows and what the entrepreneur knows cannot both be true. No one will ever discover the truth—if the entrepreneur gets the money and succeeds (or fails), maybe she was just lucky (or unlucky). Nothing either side can say will change the other’s mind.1
As the unfortunate entrepreneur illustrates, one person’s belief cannot automatically translate into a second person’s belief, no matter how strongly held. Her efforts are impeded by a lack of common experience and the rigidities intrinsic to belief formation. The difficulty of transmitting a belief is particularly acute when that belief is about a proposed for-itself leap into the unknown. In business and investing, such beliefs are the most important to communicate—if any profitable course of action can be broken down into readily transmittable rules, odds are it’s already been arbitraged away. Investors seem to be aware of this on some level. They say things like, “It’s not risky for you but it is for me.” It’s an acknowledgment that the promoter of the deal has a kind of understanding that can’t be fully shared.
This difficulty is compounded when many individuals must be convinced, making it a great obstacle to for-itself institutional investing. It’s a mistake to anthropomorphize institutions as if they could coordinate on a common belief or share information from a common perspective. Consider a hedge fund that specializes in structured credit and seeks to raise money from a pension fund to buy complicated bonds. The following chain of people would need to go along: the hedge fund’s managers, an analyst at the pension fund, the analyst’s boss, and the pension fun
d’s investment committee. And finally, the pension fund managers must consider how the investment would look to trustees and to federal regulators.
Working up the chain, each party is another step further removed from the detailed knowledge that made the hedge fund manager want to buy these bonds. Each link in the chain must establish belief in its own way in order to act responsibly. If the deal resembles one that lost money within recent memory, the pension fund’s investment committee is unlikely to be persuaded by the argument “This time will be different.”
Even when all the actors are perfectly rational, properly incentivized, and in control of their emotions, communication challenges on an institutional scale can cause markets to seize up. They certainly did during the financial crisis. The fall in asset prices could have been cushioned if the largest institutional investors had bought corporate bonds and mortgage-backed securities when others were selling. Immobility in the face of for-itself opportunity contributed to the run on the banks and elevated a weakness in the housing market into a crisis that tested nearly every financial institution in the world.
Rich family offices controlled by strong-willed individuals skilled in finance could theoretically have helped fill the void left by immobilized institutional investors. In my experience, some did. But many did not: the richer the family head becomes, the less interested she is in digging into the technical details that a person on the spot needs to know and that earned the fortune in the first place. And the larger family offices grow, the more they adopt the controls typical of institutional investors.