The Uncertainty Arbitrage

There is a simple principle the underlies the relationship between client and consulting firm. It is something I call the Uncertainty Arbitrage.

While uncertainty is self explanatory, if you're not from a finance background, the concept of arbitrage may be new to you.

In its usual context, arbitrage is a financial trading strategy design to exploit goods that are inefficiently priced.

Here's a simple example:

Let's say the price of 100 oranges in Los Angeles is $100, and the price of 100 oranges in San Francisco (about a 5 hour drive away) is $1,000.

There is a discrepancy in the price of oranges in these two locations -- in this case a substantial one.

Now let's further say that the cost of transporting 100 oranges from Los Angeles to San Francisco is $50.

Here we have a geographically based arbitrage. You could buy 100 oranges in Los Angeles, ship them to San Francisco for $50, and sell them in San Francisco for $1,000. Your profit would be $850.

This is of course a pretty extreme example (designed to illustrate a point), but arbitrages happen around you all the time.

The price you pay for water in a bottle at a store is wildly more expensive than water from the faucet. That too is a form of arbitrage.

The price of a cupcake at the bakery is substantially higher than the price of the flour, sugar, butter and labor that went into baking it.

In the business of consulting, there is one major arbitrage that you should be aware of.  It concerns how a client perceives risk and uncertainty.

In short, many clients have a (relatively speaking) poor  ability to either absorb or reduce uncertainty in making big, high stakes decisions.

In comparison, consulting firms with high caliber consultants who are great at structuring very amorphous business problems have a disproportionate advantage in reducing uncertainty.

This sets up the Uncertainty Arbitrage.

The reason clients pay consulting firms seemingly enormous fees is directly proportional to:

1) What's at stake for the client if they make the wrong decision

2) Their dislike for uncertainty.

The greater the uncertainty and the greater the consequence of a wrong decision, the greater the anxiety the client feels.

When a consulting firm comes and can legitimately reduce the uncertainty the client faces, the consulting firm charges a fee that on a relative basis is a small portion of the anxiety to be relieved -- even though on an absolute basis might seem like a very high fee to you and me.

For example, for those former F1Ys who are now on the partner track, one of the things I will teach them is this:

If you solve a client's $1 billion problem, then charging them $10 million (about 1%) is a relatively small fee.

If you only solve a client's $10 million problem, then charging a $10 million fee (100%) is an outrageous fee.

The reasonableness or outrageousness of the fee you charge has nothing to do with the fee itself. It has to do with the magnitude and severity of the problem that disappears once the fee has been paid.

Lesson: Go find clients with BIG problems, and solve them.

So how does this relate to you?

Let me explain.

At the end of the day, clients hire consultants because the consultant is more confident that she can solve the problem than the client is about his ability (or his organization's ability) to solve it himself.

In short, what clients are really buying is confidence… paying consulting fees to transfer confidence from the consultant to the client.

By the way, this is why case interviewers evaluate not just what you say, but also how confidently you say it.

Because at the end of the day, clients are buying not just your analysis, but your conviction about your analysis.

And because this is what clients buy, this is what Partners and Engagement Managers look for when hiring new first year consultants.

Until next time, I encourage you to look for arbitrages around you -- they exist everywhere -- and especially pay attention to the uncertainty arbitrage that exists in consulting.

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1 comment… add one
  • Krzysztof Aug 23, 2014, 7:28 am

    Great job Victor, you killed three birds with one stone (or article), i.e.:
    1) Provided an excellent example why consultants must be confident;
    2) Explained/ reminded how arbitrage works;
    3) Explained how value is created (and thus fees are justified) using the example of consultants reducing uncertainty for their clients.

    Each of the points above calls for an article. You covered all at once in a relatively brief and very interesting way – I dare to say masterpiece.

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