Transformation Capital: A new investment logic for catalysing systems change

How the financial meta-regime drives self-perpetuating status quo dependency

Today’s capital markets are operating under a set of axioms that severely inhibit their transformative capacity. Axioms are propositions seen as widely accepted and self-evident, much like first principles in science.

One important axiom currently operative in the financial industry is that everything of value must be measurable in monetary terms. So capital markets cannot relate to—or engage with—sources of value outside our narrow definition of money. Another important axiom is an epistemological one, namely, that the future can be predicted. Investors engage with probabilistic models to forecast the evolution of the economy and of individual financial assets, neglecting that the world at large behaves as a complex adaptive system and thus, by definition, possesses non-deterministic characteristics.

There are other axioms worth highlighting: Nation-states as the guarantors of the rule of law, financial statements as the principal accountability ledger in the economy, the acceptance of the efficient market hypothesis and the rational economic agent theory, and the existence of markets operating on the principles of open access, supply/demand balancing and anti-trust protection.

All of these axioms are social constructs and thus contingent and fragile, yet investors take them for granted and assume that they will exist into perpetuity. As a consequence, these axioms set rigid boundaries around the inner workings of capital markets and strip them of the capacity to adapt in the face of exogenous pressures and discontinuous change.

From these axioms flow a set of financial mathematics which underpin the financial industry’s decision-making frameworks. One of the defining mathematical propositions is that the value of an asset is defined as the sum of the cash flows occurring in perpetuity, discounted at a rate that reflects the risk of these cash flows. This and other mathematical relationships endow the activity of investing with self-referentiality. Just consider how the financial performance of an investment is calculated: As the change in the value of such an investment over time. Based on this definition, stock (investment) and flow (change) relate to each other—and to nothing outside of this frame of reference.

To uphold its axioms and ensure conformity with its mathematics, the financial industry embraces and self-enforces a set of idiosyncratic structures and practices. Finance professionals are educated and socialised through highly homogeneous courses offered by universities and professional education providers. Many of the industry’s recruitment practices are geared toward maximising cultural and educational fit, which drives conformism and tribalism. Its incentive systems are geared toward short-term profits, which double as determinants of self-worth and social status.

In combination, these axiomatic, mathematical and structural idiosyncrasies create a dependency for the finance industry on retaining the systemic status quo. For today’s capital markets, systemic stability is beneficial, systemic volatility is detrimental. This status quo dependency is so large that it is self-perpetuating—capital markets prefer assets that conform to its axioms, mathematics and structures because anything else is simply not investable. And herein lies the problem: If capital markets depend on—and indeed nurture—the perpetuation of the status quo, they are unlikely to fuel the type of profound transitions the world needs to cope with the gravest challenges of the 21st century.

To illustrate these broader points, it is useful to consider some of the key paradigms traditional investors operate under. There are three interrelated paradigms that sit at the core of capital markets: Value, return and risk.

Value is defined exclusively in monetary terms. Capital markets can only operate under a money-in/money-out logic, unable to engage with other things society values such political stability, social equality, ecological sustainability, along with questioning the persistence of the orthodoxies that define economic practices.

Return is calculated as the money made or lost on investment—a purely self-referential definition that measures the magnitude of monetary flow relative to the initial monetary stock. Such self-referentiality also applies to the definition of risk as the chance that the actual outcome of an investment differs from the expected outcome. Because both return and risk derive from the (exclusively monetary) conception of value, neither can measure (let alone appropriate) gains or uncertainties of non-monetary origins. Further, insofar as risk is defined as the quantifiable chance of an outcome (the known unknowns), it cannot relate to or engage fundamental uncertainty (i.e. non-quantifiable chance or the unknown unknowns), including tipping points and non-linearities.

Other paradigms are of a more operational nature:

Investment thesis: Based on the view that the future is predictable, traditional investors form an opinion about the way in which the world will change. They then try to anticipate what investment opportunities these changes will generate, synthesising these anticipations into an investment thesis that serves as a decision-making framework for selecting assets. The deterministic nature of this approach creates lock-in effects, as investors are biased (or even contractually bound) to stick with their original investment thesis and typically have little capacity to adapt if the world changes in unpredictable and non-linear ways.

Investment selection: Based on a self-confident belief in their ability to pick winners, many traditional investors (except those pursuing a passive investment strategy, such as index investing) follow an active investment selection strategy. They pick from a broad range of assets based on their own probabilistic analysis of how these assets will perform. In doing so, they generally view each pick in isolation, and each potential investment must make sense on its own. Portfolio-level selection criteria are typically limited to considerations of risk (e.g. diversification through thematic and geographic spread) but do not include aspects of value. As a result, investors tend to disregard—both ex-ante and ex-post—any value emerging at the aggregate level of the portfolio.

Classifications: Traditional capital markets are segmented into specific categories. These categories serve to organise and make sense of investments and to lend identity to investment professionals. Examples of such categories are asset classes such as equity, debt, real estate, commodities and project finance, and instruments such as stocks, bonds, equity-debt hybrids and derivatives. Most investment professionals specialise in one or several of these categories, developing highly specific skills and knowledge and identifying with their peers and competitors in a tribal fashion (”I’m an equity derivatives trader!”). Categorisation is problematic because it creates views and behaviours that are siloed and thus mask the true interconnectedness of our complex world.

Temporal dimensions: For all major investment classes, there are commonly accepted investment horizons: 10 years for public stocks, 5–7 years for private equity and 3–5 years for corporate bonds, for example. These time horizons represent normative views of the period over which an investment is supposed to generate some acceptable rate of return. Originally, these time horizons were derived from the statistical analysis of the past performance of individual asset classes. Yet over time, they have become arbitrary heuristics that inform actions in the real economy that produce sub-optimal outcomes. Consider venture-backed entrepreneurs, who are forced to grow their business at a pace not dictated by what their technology or market could sensibly support but by the time-to-exit promises their VCs made to the investors in their fund. Such pressures can lead to recklessness and excessive risk-taking.

These paradigms combine to create a culture of short-termism, siloed thinking, and self-referentiality. The goals, structures, and behaviours that emerge from this culture severely constrain traditional capital markets from playing a productive role in starting or accelerating whole systems transformation.

Towards a radically new investment logic

What distinguishes Transformation Capital as an investment logic from long-term investment approaches (such as ESG investing and impact investing) is its strategic intent. The goal is not to reform capital markets toward new steady-state orthodoxies such as patient capital and triple-bottom-line investing. Instead, Transformation Capital seeks to instigate and catalyse a transformative change of socio-technical (sub-)systems in a specific direction and within the time left to prevent dangerous climate change. This means that Transformation Capital must identify and engage Sensitive Intervention Points (SIPs) — those places in a system “where a relatively small change can trigger a larger change that becomes irreversible, and where non-linear feedback effects act as amplifiers.”

Transformation Capital is rooted in the axiomatic understanding that today’s conception of money has outlived its ability to serve as a useful proxy for human prosperity. This not only implies a broader definition of value beyond monetary concepts. It also requires new approaches to sharing risk and reward, particularly between public and private actors, towards what Professor Mariana Mazzucato calls a “symbiotic innovation ecosystem” in which returns are shared fairly by the “collective group of actors that absorb the uncertainties that drive the innovation process through space and time.”

Implied in this notion is the necessity to reimagine the role of government and public policy. Transformation Capital embraces the state as a confident and bold entrepreneur, taking a position on the directionality of a system’s evolution and actively shaping and creating markets in pursuit of that direction. With the government playing an active role as one of the shapers of transformation, blending different types of capital (particularly public and private capital) becomes a self-evident operational paradigm—not just for the purpose of de-risking but also for coordinating and aligning different instruments with the strategic direction in which the system should evolve (strategic blending).

Transformation Capital acknowledges that societies—and the economies nestled within them—are complex adaptive systems. It understands that these systems are self-organising, have built-in feedback loops, and behave in non-deterministic and non-linear ways. It seeks to engage all the levers driving a socio-technical system—technology, policy, finance, skills, business models, citizens and production systems—and recognises that the most promising way of affecting systems change is through the creation of a portfolio of deliberate and connected innovation experiments. It also embraces the self-transforming properties of adaptive systems and tries to leverage these in pursuit of its intent.

The collectivity of strategic intent, axioms and systems views are baked into the paradigms under which this new investment logic operates. Transformation Capital de-emphasises categorisation and specialisation and instead embraces porosity, blurriness, and paradox. It formulates its goals as missions with clearly defined (systemic) outcomes, engaging those SIPs most likely to trigger or accelerate change along entire value chains—in combination with a complementary set of interventions sitting outside of an investment frame.

It selects specific investments based not on their individual merits but on the aggregate value they can generate at the portfolio level. This requires building capabilities to engage the relationships and feedback loops within the investment portfolio, make sense and learn from what emerges, and share portfolio-level risk and reward across different investor groups. It also implies working with and through multiple different types of capital—private, public, philanthropic—in a blended and coordinated way, using new mathematical frameworks and indicators to measure performance and inform decision-making, and operating within structures that promote diversity, multiple disciplines, and norms and incentive systems geared for long-term sustainability.