Limited Liability is a Cheap Call Option Factory

The Feynman Lectures on Physics opens with a wonderful, thought-provoking question: if you could compress as much human knowledge as possible into a single sentence, what would it be? What Feynman settles on is:

I believe it is the atomic hypothesis (or the atomic fact, or whatever you wish to call it) that all things are made of atoms — little particles that move around in perpetual motion, attracting each other when they are a little distance apart, but repelling upon being squeezed into one another. In that one sentence, you will see, there is an enormous amount of information about the world, if just a little imagination and thinking are applied.

If we were to perform the same exercise for economics, we’d probably go with: needs are infinite, wants are finite. But we’d have to elaborate a bit to get anywhere useful, as humans are more unruly than subatomic particles. Our first elaboration would sketch out the laws of supply and demand, both heavily-footnoted with exceptions. And then we’d spend the rest of the discussion talking about transaction costs.

Transaction costs are the bridge between Econ 101 and the real world. A huge majority of the violations of simple economic models boil down to the cost of actually buying or selling something.

One way to think about transaction costs is that they play the same role as the weak and strong atomic forces: the high cost of hiring people encourages individuals to form companies (you could run a store by hiring customers as freelance, temporary cashiers and butchers and stockboys, but it’s cheaper to hire people for months or years, not for hours). But at a larger scale, and on a longer delay, transaction costs tug companies apart. A large company in multiple industries can’t effectively align incentives; if your company is a farming/ranching/trucking/warehousing/grocery selling/loyalty card owning/advertising/transaction processing conglomerate, it’s probably mismanaged and corrupt in dozens of interesting ways.

Part of what explains the dynamism of corporate America is that shifts in transaction costs can, at different times, subsidize vertical integration, horizontal integration, large scale, or small scale. The cash register, for example, was a big subsidy for horizontal integration: it made it more cost-effective to systematize your retail operation, but required additional focus, so owning anything higher or lower in the supply chain was a bad idea.

Mobile apps and branded credit cards increase the rewards of diversification within a company, by making it more lucrative to control more of a given person’s spending. If you see 0.1% of their spending, you can offer them a couple coupons here and there; if you see 20%, you can basically sketch out a live demand curve for everything they buy, and customize your discount-and-subscription offers accordingly.

Transaction costs answer many questions about how many independent companies should be involved in a given industry, and how they should specialize. But there’s another force at work, and it’s getting stronger: optionality.

I’ve dinged optionality in the past. My point was not so much that one should never be implicitly long options, but that one should be aware of the cost of those options — and that in a world where everyone’s a buyer, all obvious options will be overpriced.

But that doesn’t detract from the utility of options as an intellectual framework. Every economic decision can be cast in terms of options, and when transaction costs get low enough, the relative importance of option dynamics goes up.

To take a stylized example, let’s consider an integrated oil company. It drills for crude, transports it, refines it, and sells it; the company also finances its operations, and hedges its risk. There are companies that do all of the above, and there are companies that do exactly one of these things exclusively. From an optionality perspective, one way to look at this is that each company is a bundle of put and call options on different kinds of hydrocarbons:

  • An exploration and production company has the right to drill on some land (a call option that gives them the right to transform inert land into an oil well, whose exercise price is the current price of drilling). If it has producing wells, they’re also a call option; think of them as a series of European options (i.e. exerciseable on only one specific date) that allow the company to pay one day of opex in exchange for one day’s worth of production.
  • Depending on what deals it’s signed, a pipeline company can be long a call option to sell oil at one end, and short a call option to buy it at the other end. If it has a long-term fixed-price contract on both ends, it’s actually short a put on the credit of its counterparties: normally it collects a risk premium, but if either party defaults it loses, possibly a lot.
  • A refiner is long the “crack spread,” i.e. the difference in price between crude oil and the refined outputs.

Some of these options correlate, or at least are exposed to the same factors: if the economy heats up, oil consumption rises, and every part of the supply chain becomes a bit more profitable. On the other hand, some of the bets correlate inversely: if crude prices rise due to a supply disruption, but that supply disruption slows the economy, then you could end up with a situation where the supply-side factor dominates the cost of inputs, while the demand-side dominates outputs; expensive crude plus cheap gas equals a lower crack spread and a less profitable refinery.

This presents an opportunity: any time you have two assets that don’t perfectly correlate, an option on each one is worth more than an option on their collective performance. And equity is an option, specifically a call option on a given firm’s free cash flow, whose strike price is the value of the firm’s debt.

This doesn’t imply that every company would be worth more if it split off non-correlating businesses, but it does imply that there’s a countervailing force to one of the big reasons for scale: big companies can handle more disruption at different parts of the supply chain. A small company selling a single product in a single market can be totally wrecked by bad luck, but a diversified company is safer. And while a single-product company can get hammered if the price of one of its inputs rises, a vertically-integrated company is a seller as well as a buyer of the inputs.

If you’re thinking purely at the level of what makes the firm a better risk-adjusted prospect, you’d prefer diversification until the cost of running a complicated company exceeded the benefits of hedging. But optionality implies that specializing is worth more, especially if you’re levered.

Which makes the rise of private equity a sort of natural experiment in proving this model: private equity companies:

  1. Often buy divisions of larger companies, or buy larger companies but sell different parts separately.
  2. Use leverage, which means the “strike” price of the option is higher and thus its option-y-ness is more important to the final valuation.
  3. Often sell to public equity markets, meaning they capture the upside of the optionality.

As a result of this, PE valuations have steadily marched higher. (See page 10 of Bain’s annual Private Equity Report.) This will likely continue unless there’s some additional countervailing force that prevents PE companies from buying the cheap call options created by single-industry companies. (It’s a topic for another post, but one of the roles PE plays in a portfolio is that it’s an asset class that is high-risk but illiquid, which means it’s infrequently marked-to-market. This is in effect a stealth bailout for long-term investors like pension funds, and explains why the PE model is still attractive at high valuations.)

This trend does bring up a useful question: are the higher asset prices engendered by this system good or bad? Financial engineering doesn’t create real-world wealth directly, but it does so indirectly by raising the rewards for running a valuable business. And this indirectly increases savings.

It’s tricky to parse the morals of an increase in the savings rate: if you’re homo economicus and you want to maximize net worth, you want everybody else to be bad at savings. (You are in the position here of someone who was long US equities at the start of the 80s.) But if you want to maximize your consumption, you want to live in a world where everyone is good at saving money — there’s lots of capital equipment, which is the complement to your labor; meanwhile, high savings create demand for borrowers, and if people save more than they produce, that lowers the bid on material goods. So if you’re an altruist and you like savings, this is good; if you’re an egoist and you want to consume, it’s also good. Only if you’re an egoist whose goal is to maximize your own net worth, not your own enjoyment, is it bad.

But, more than good or bad, it’s interesting. Portfolio theory means that diversification between firms is as rewarded as diversification within a firm; transaction costs push firms to grow so they can coordinate activity up and down the supply chain; but the math of options pushes firms to split up into levered uncorrelated bets that can trade separately and thus experience higher volatility. As more capital gets allocated to PE instead of public markets, the future of American business might be a collection of highly-levered, loosely-coupled, hyper-specialized businesses, all using financial engineering to replicate the levels of riskiness that equity investors want. Not a perfect system, but it gets the job done.

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