They’ve come to fighting words in that (historically) sleepy consumer packaged-goods category: laundry detergent. As recounted in a recent Wall Street Journal article, Tide®’s innovation into premeasured detergent pods is “killing the laundry detergent category,” according to one of Tide’s competitors. Of course, P&G sees it differently, summed up by a beaming CEO Robert McDonald: Tide Pods are “the ultimate perfect dose” of laundry detergent, and since P&G is “laser focused on making sure consumers get the right dose … that may have consequences for our competitors.”
How did tiny little pods of premeasured detergent lead to such strongly divergent opinions among the category leaders? It turns out that a key source of profitability for household goods companies has been the propensity of American consumers to use more than the recommended quantity. (Not just household goods, as anyone knows who’s tasted the new Sonic® Peanut Butter and Bacon milkshake weighing in at 1720 calories and 118 grams of fat!) Long after many consumers have made the switch to high-efficiency washing machines that require a fraction of the original detergent amount, they still habitually pour the same amount as before. Additionally, detergent itself comes in much higher concentrations than previously, such that overuse has played a critical role in protecting margins for producers and supermarkets alike.
All this got us thinking somewhat broadly about the purpose of innovation itself. Should firms pursue innovation for the purpose of securing higher and more sustainable margins for everyone in the category, or rather to enable them to steal share from rivals? What role do consumers play in the process? Is it valid to introduce an innovation that hurts profitability but helps consumers? What does a brief survey of recent financial innovation teach us?
All this made for consistent category profitability, until Tide Pods launched early last year. Since that time, P&G has taken over about 75% of the unit-dose market, but overall detergent sales have fallen more than 2% during the period. Premeasured detergent has its proponents besides P&G, most notably convenience-driven consumers who find it easier to travel with small pods or environmentally conscious customers who like reducing their overall detergent footprint. But rival brands argue, “What kind of a new product is good when it’s hurting the total category?”
Defeasance: In the real estate boom of the middle of the last decade, companies found themselves selling or refinancing buildings well in advance of loan maturity, requiring them to replace themselves in the existing debt with more costly portfolios of Treasuries. Advisors emerged to manage the defeasance process and arrange for the creation of a Treasury successor borrower portfolio, often for an upfront fee. However, they did not disclose the fact that due to date mismatches and early prepayment possibilities, there was substantial value in the successor borrower – until Chatham introduced the innovation of disclosing that hidden value and sharing it with clients. We actually had one competitor ask us why we were destroying the defeasance business by bringing transparency to the successor borrower value! In this case, innovation “hurt” the industry by reducing opacity and thus margins, but it helped clients.
Outsourced hedging: It wasn’t always straight-forward for regional or community banks wanting to offer their commercial borrowers the ability to swap floating-rate debt to fixed. If they swapped directly with the commercial borrowers, they would need to manage the risk of having a swaps book; yet for the vast majority of their loans, no market-making bank would find it financially beneficial to establish trading lines for a single swap with an idiosyncratic borrower. However, through the innovation of outsourced hedging, there’s an easy solution — the borrower swaps directly with the relationship bank, and the relationship bank does the mirror-image swap with a market-making institution. It’s difficult to find a loser in this innovative arrangement: the borrower has a known fixed rate, the regional bank offers a more desirable loan and has cashflows on the swaps that completely cancel, and the market-maker increases deal flow.
Exotic derivatives: Ever wonder why a publicly-traded company with a policy to use derivatives only for hedging would enter into a snow bear, or short an iron condor? Ever wonder why a municipal treasurer would take a relatively modest upfront payment for a derivative whose notional could explode to multiples of his county’s total balance sheet? We once interviewed someone whose previous role placed her in the structured derivatives desk of a financial institution. Because of pressure on margins elsewhere in the bank, she told us, her team was tasked with and incented to come up with innovative new derivative products. This innovation was borne not out of a desire to identify a genuine client need and then create the financial instrument to solve it; rather, it was to increase opacity and thus increase margins. This innovation might have helped the short-term profits of the institution, but it certainly hurt the clients and municipalities who paid more for an opaque product with unspecified downsides.
Covenant-lite loans: When lenders were fiercely competing to finance large buyout transactions eight years ago, they began to lessen the covenantal strictures required of their borrowers. The resulting innovation was the covenant-lite loan, which removed certain requirements including the need to deliver annual financials and to foreswear other third-party debt, as well as particular events of default. These concessions resulted in huge loan losses, and issuance lay dormant for two years before reemerging in 2010. The resurgence has been so strong that at the current pace, more than $85 billion of cov-lite loans will be issued in 2013, the most since 2007! So while its first incarnation brought lenders plenty of loan write-downs, and borrowers plenty of defaults, will the second coming of cov-lite be a positive innovation?
At Chatham, we’ve seen a huge dispersion of innovation over the years, including those that seem to benefit all stakeholders, to those that benefit clients but shrink an industry’s margins, to those that profit industry through opacity and information disparity at the detriment of clients. Financial innovators always have a specific motive for their actions, which may or may not benefit you. If you’re wondering whether or not that new financial idea you’ve heard about is helpful or harmful, please don’t hesitate to reach out to us – we’d be happy to talk through how to realize the potential, or avoid the pitfall, of each innovation.