This has been asked to many other conglomerates including Kraft, News Corp., Fortune Brands and Vivendi. As these businesses have split up or threatened to do so the valuation of their respective stocks have moved in one direction – up. Wall Street seems to prefer fast growing businesses be siphoned off from the more mature or slow growing ones. Kraft did just that as it sliced off its mature American business from its fast growing overseas business.
The CEO of Vivendi most recently announced he would be stepping down and this was met with a 10% gain in the stock as investors expected the next CEO to offer less or no resistance to a breakup of the company. Already the company is trying to hawk its 60% stake in Activision-Blizzard.
If breaking up the company will yield a higher stock valuation then why shouldn’t Berkshire split off a couple businesses? Most businesses Berkshire holds on its balance sheet are certainly worth many times more than that of their recorded book value. But the reason the companies stay is directly tied to Berkshire’s business model. Berkshire is in the buyout business, and included in its value offering is the freedom for the business owners that sell out to retain control despite their minority interest.
Every year Buffett writes in his annual letter that he is looking for businesses with a certain amount of earnings that are interested in selling, retaining personnel and continuing management of the business. When an owner of a large business decides they want to cash out, few opportunities present themselves. Going public is one such option. But when you go public your new boss becomes Wall Street bankers and their vision of the business may contrast significantly from your own. In such a scenario the investment bank pockets approximately 7% of the total funds raised, and if you’re as lucky as Mark Zuckerberg you may convince investors your company is worth 100x earnings.
Buffett is looking for business owners that are willing to sell for less than they might otherwise get by going public (and also much less than 100x earnings). But in lieu of this discount the owner will be able to have carte blanche in regards to running their business, something most other financiers are unwilling to offer. The notion that Buffett would spin off Burlington Northern Santa Fe after having just purchased it would diminish his reputation for being committed to the businesses he buys.
Private equity companies are notorious for this type of business turnover. In this scenario a business either gets taken private and/or saddled with large amounts of debt so that private equity investors can pay a higher price and minimize the amount of equity the profits will accrue to (raising return on equity). In doing so they encumber the business with debt and raise the earnings bar which the company must meet in order to survive. If you’re a proprietor concerned only about money then you may be indifferent to what happens to your company after you sell. Private equity transactions are most always followed with an exit strategy such as an IPO. For the proprietor that is interested in long-run planning, loves their business and does not want to be subjected to such financial constraints, selling to Berkshire would be a better option.
Buffett is a notorious deal-maker, but even in life after Buffett, Berkshire may be able to retain its reputation as a “buy and hold” buyer of businesses. In choosing his son as director tasked with maintaining the culture of Berkshire, this could very well be what Buffett had in mind. Liquidating businesses and returning capital to shareholders would not be consistent with the historical culture of Berkshire.
In a scenario where Berkshire were to take public Geico, BNSF, Dairy Queen, See’s Candies and others it could yield a huge payday for shareholders. But in doing so it would immediately diminish the company’s reputation as a buyer of businesses. Berkshire would then hold little differentiation from private equity companies, and it would be that much harder to attract quality businesses at fair prices.
For this reason the loss of Buffett may not be as great as people imagine, though indeed it will still be quite great. Sure he is one of the greatest capital allocators in history and that will be a big loss to the company, but with respect to Berkshire he manages about 35% of the firm’s assets. Berkshire counts some $392 billion in assets and Buffett manages the approximately $75 billion in equities and roughly $60 billion in cash and fixed maturities. The other 65% is managed autonomously by the managers of GEICO, Iscar, Dairy Queen and so on. These businesses shouldn’t miss a beat. The managers often provide Buffett with valuable information as well as dividends, but they likely get very little in return from him except a paycheck and praise in the annual report.
It might be argued that Buffett holds these businesses not for reputation, but because he likes to buy and hold “great” businesses and let compounding do its work. That may be so some of the time, but if that were truly the case the stocks he owns would never be sold. Witness the sales of Kraft (as management fumbled), Petrochina (as the stock skyrocketed) or Moody’s (as the future economics of the business became hazy and impaired). Certainly the Berkshire subsidiaries have faced any one of these situations and yet they were never sold.
The reputation Buffett has built in Berkshire will not be easily replicated elsewhere. It took decades to build and it won’t simply dissipate after the passing of Warren Buffett. Whoever the successor will be will likely have to emphasize Berkshire’s commitment to sticking with the businesses it buys. This commitment has been an integral and valuable part of Berkshire not enough investors appreciate.
Disclosure: No holding in Berkshire Hathaway