IT is primarily a business of people solving problems during the creation of assets that increase Ebitda. Problem solving requires talent, and most IT organisations have to contend with a shortage of talented people. To some extent this reflects limitations of the labour market. It’s also economic: highly capable IT professionals aren’t inexpensive, and most firms struggle with budgets and costs. To get by, the experience and capability of a core few is expected to support a very large number of staff. Because IT projects are work effort delivered in time, this is, in effect, a leverage of people’s time.
Consider how leverage works. If we invest $4 of our own capital and $6 of borrowed capital into a $10 asset, and that asset increases in value by 20% in one year, we’ll yield $2 of profitability. That will considerably eclipse the $0.80 that our own capital earns in that investment, provided the interest rate on the debt doesn’t exceed 20% annually. The same thinking applies to how we invest the time of our highest-capable IT professionals: if we create teams to take the burden of rote coding off the shoulders of the most capable people, we should be able to produce more IT assets and thus drive greater returns from IT. This can be very attractive, especially if IT is engaging in labour arbitrage, sourcing staff globally at lower costs. Indeed, the cost per hour may permit contracting staff in multiples of 2x, 3x or even 4x. There is also quick impact: the income statement improves as costs drop dramatically, and the notional value of the IT assets that our core (and expensive) capability is producing is quite high relative to their total numbers. There is a powerful temptation to overload on leverage: the higher the leverage, the bigger the payday if our bets pay off.
But our bets don’t always pay off. Suppose that $10 asset drops in value by 20%, to $8. We’re still on the hook for the $6 we borrowed. When assets erode, debt holders will require additional capital as a sign that we’re good for the loan. This is what is known as a margin call. Suppose the margin requirement is 30% - that is, suppose that our broker requires that we cover no less than 30% of a position with our own capital. The erosion of our investment to $8 would mean that our $4 original investment is now worth $2, and our own capital is 25% of the total value of the investment. We need to put up more capital to restore this to a margin minimum of 30% of the now $8 asset, or $0.40. We may have to liquidate positions in other investments to come up with that 40 cents. The higher the leverage, the greater the pain: our own capital in the asset has eroded, and we’re still on the hook for the loan at whatever interest rate we’re paying. We now face a difficult decision: cashing out this investment now will post a loss, while re-investing to maintain our position in the asset might be throwing good money after bad.
Consider this again in operational terms. Suppose a “leveraged team” fails to meet expectation, either because functionality delivered is wide of the mark, or technical quality is sub-optimal, or both. Time has been invested with the expectation that this team would succeed, and that time has been lost. We now need to invest additional time to bring that particular asset into an acceptable state. Most likely, we're going to call on more talented people to do so. Since they are few in number, we're going to have to liquidate a position in another investment, directing those people’s time to shore up this investment. The operational decision is just the same - and every bit as painful - as the financial one: walk away or reinvest.
A leveraged IT project that fails can trigger a capability liquidity crisis. The more we need to invest to rescue this project, the more capability we'll need to draw down from across the portfolio. When this happens, the IT income statement very rapidly sours and the high notional value in the IT portfolio is obliterated.1
To prevent a rapid de-leveraging, we may need to make a capability "injection.” Ideally, this is an exercise in sourcing top IT talent in a project rescue mission. In addition, the rescue team will very often get that which it needs to succeed: co-located facilities, access to business partners, hardware and tools, etc. Capability injections can be costly, but they prevent a greater disaster across the portfolio.
This assumes, of course, that a project can make effective use of capability. Even when the business domain and underlying technologies are relatively simple, IT projects can become situationally complex if there’s been a team in over its head for a long period of time. Decisions made inexpertly compound over the life of a project. Very often, this means a lot of esoteric knowledge must be mastered before a person can contribute to the project. The more esoteric, the more time it takes for people to become fluent in how to get things done, the less penetrable the project. Top talent will be frustrated in attempts to get work done in an (unnecessarily) complex environment. Meanwhile, those who “get things done” do so through mastery of a set of circumstances (that is, abundant esoteric characteristics) that cause more harm than good for the business. Such a project is capability illiquid and is resistant to rescue efforts. This creates a worst-case scenario in the IT portfolio: maintaining the status quo is perpetually expensive, while the price of rectifying the situation may be staggering. Either way, yield on the asset this team produces will fall far short of expectations.
There will always be some degree of capability leverage in IT projects, if for no other reason than there will always be incongruities in talent, skill and experience among members of a project team. Leverage is most effective when it is used to develop the capability of the entire team through transfer of knowledge and structured skill acquisition, so that individual team members are capable of independently taking competent decisions that are aligned with governance expectations. An investment in people's capability reduces the risk and impact of a margin call. Of course, this doesn’t just happen by itself: skill transfer is a mission objective, and teams don’t necessarily engage in this type of behaviour naturally unless that expectation is clearly set. Simultaneously, capability development isn’t something that can be taken for granted. There is no “capability index” in IT, so it is essential to have a sense of what the desired future state of a leveraged IT team should be once it unwinds – and to have objective criteria that define that state. Otherwise, there is little assurance that any given delivery team is not a margin call waiting to happen.
There are no shortage of opportunities to leverage IT capability, but there are few opportunities to wield it in a risk responsible manner. Prudent governance requires that IT manage itself and its suppliers to mitigate capability risk so that a project isn’t over-leveraged, to be at the ready to source capability to bring to bear on a situation, and to maintain projects to be in a position to do so. Failing to do so is a lapse in governance. Doing so successfully balances risk and reward.
1 The great de-leveraging we're seeing in the financial world is both rapid and devastating. By way of example is Carlyle Capital: leveraged to 32 times equity, they couldn't meet margin calls as asset values cratered. breakingviews.com produced a splendid bit of analysis titled Carlyle's Comeuppance.