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Stanford Closer LOOK series trust and consequences a survey of berkshire hathaway operating managers By David F. Larcker and Brian Tayan october 20, 2015 “The choice to operate in a decentralized manner from the beginning reflected a belief in the value of autonomy and a conviction that people properly entrusted with authority will generally exercise it faithfully.”1 companies so permeated with a good ethos that they don’t need a lot of direction and checking and so forth from headquarters. … What we’re trying to live in is a seamless web of deserved trust.”7 SURVEY OF BERKSHIRE MANAGERS – Lawrence Cunningham, Berkshire Beyond Buffett To better understand the Berkshire Hathaway management introduction system, we surveyed the chief executive officers of approximately For much of its history, Berkshire Hathaway has been regarded 80 Berkshire Hathaway operating subsidiaries. Responses primarily as an investment vehicle rather than a bona fide were received from CEOs representing a mix of insurance and corporation. One reason for this perception is Warren Buffett’s noninsurance subsidiaries of various size. Respondents have an success as an investor and the outsized contribution of investment average tenure of 12 years as CEO (broadly inline with the average returns to the company’s growth in its early years under his tenure across all subsidiaries) and include a mix of executives that leadership. However, as Berkshire Hathaway has expanded beyond were and were not CEOs when Berkshire originally acquired its core insurance operations—with investments in railroads, their companies.8 Responses were remarkably consistent across energy and regulated utilities, specialty finance, manufacturing, the sample. service, and retail companies—more attention is being paid to the The CEOs of smaller subsidiaries (less than $1 billion structure by which these entities are managed (see Exhibit 1). in revenue) report that one to two months passed between Two notable features of the Berkshire Hathaway system initial discussions with Berkshire Hathaway about a possible are its high degree of decentralization and the considerable acquisition and agreement to acquisition terms. The CEOs of autonomy afforded to the managers of its operating subsidiaries.2 larger subsidiaries report that discussions lasted longer: six to According to the company’s annual report, “There are essentially nine months. On average, smaller acquisitions also took less time no centralized or integrated business functions (such as sales, to close following a signed agreement (one to two months) than marketing, purchasing, legal or human resources) and there is larger acquisitions (four to five months). minimal involvement by our corporate headquarters in the day- Respondents report few governance changes following an to-day business activities of the operating businesses.” Vice acquisition by Berkshire Hathaway. The most frequently cited Chairman Charlie Munger describes the company’s system as changes are the elimination or change in composition of the board “delegation just short of abdication.” of directors and changes to the terms of CEO compensation 3 4 Other notable features of the Berkshire Hathaway system are contracts. Some insurance subsidiary CEOs report that changes its long-term investment horizon, its pledge not to sell subsidiaries, were made to the company’s internal audit and risk management and its emphasis on ethical behavior. As Buffett explains, “We give practices. Subsidiaries that were formerly publicly traded each [manager] a simple mission: Just run your business as if: 1) companies report that they eliminated their investor relations you own 100 percent of it; 2) it is the only asset in the world that departments. Still, changes appear to be modest. According to you and your family have or will ever have; and 3) you can’t sell or one respondent, “The only change is that I now discuss any major merge it for at least a century.”5 Separately, Buffett has said, “We capital acquisitions with Warren. We run the business the way we can afford to lose money. But we can’t afford to lose reputation, always have.” The data is largely consistent with public statements not a shred of reputation. … I tell [our managers] if anything is made by Warren Buffett about Berkshire Hathaway’s acquisition close to the line it’s out.” According to Munger, “We try and buy practices. 6 Stanford Closer LOOK series 1
Trust and Consequences Subsidiary CEOs provide monthly financial statements to and acknowledge that they are responsible for the selection of this Berkshire Hathaway headquarters. A few provide this information individual. They convey their views on succession in a letter to quarterly. For the most part, Berkshire Hathaway CEOs have Warren Buffett, which includes their primary recommendation infrequent contact with Buffett. Most report having phone for a successor, other potential successors, and the strengths conversations with him on a monthly or quarterly basis. None of and weaknesses of candidates. (By comparison, only half [51 the respondents talk to him on a pre-established schedule, and all percent] of public and private companies claim to have identified report that they initiate the communications themselves. a permanent successor to the current CEO.)11 In terms of oversight, there is strong agreement that Berkshire There is strong agreement among respondents that a common Hathaway affords its operating CEOs a high level of independence culture is shared across Berkshire Hathaway subsidiaries. The most in managing their businesses. There is also strong agreement frequently cited attributes of this culture are honesty, integrity, among managers that they would have less independence if their long-term orientation, and an emphasis on taking care of the business were owned by a company other than Berkshire. In the customer. Respondents also agree that the culture of Berkshire is words of one respondent, “No one else gives a company this kind directly influenced by the “tone from the top.” According to one of freedom.” respondent, the main messages conveyed by Berkshire Hathaway headquarters are: Subsidiary CEOs also agree that their financial performance is better than it would be if their company were owned by a company other than Berkshire Hathaway and—interesting enough— 1. Never lose reputation for the Berkshire Hathaway brand or the also better than if it were a standalone company. This supports company’s brand; a common conjecture that ownership by Berkshire Hathaway 2. Run your business as if it is the only family asset for the next provides financial benefits to subsidiaries. According to one 50 years; and respondent, the company’s operating performance has improved 3. Integrity comes first. under Berkshire’s ownership because it affords management greater freedom to operate independently and encourages a To this end, operating managers report being “very clear” about long-term focus. Another respondent cites Berkshire Hathaway’s which actions or activities within their business would be brand value, which it references in its marketing. The CEO of an condoned by Berkshire Hathaway headquarters and which would insurance subsidiary cites the parent company’s financial strength not. as removing surplus limitations on growth. Berkshire Hathaway operating managers also believe that consensus, on when Berkshire Hathaway headquarters would get ownership by Berkshire allows them to manage their businesses directly involved in their business were something unexpectedly with a longer performance horizon than would be the case under negative to occur. Operating managers tend to agree that different ownership. Respondents vary widely in terms of what Berkshire Hathaway headquarters would not get involved performance horizon they use to manage their companies, with following the unanticipated departure of one or more of the estimates ranging from 3 years to 50 years (median 5 years, CEO’s direct reports; labor disruption; supply chain interruption; average 12 years). This compares with an estimated 1- to 3-year complaint by a large customer; environmental, legal, or regulatory performance horizon if their business were owned by another action against the company; an event that impacts the product or company (median 1 year, average 2 years).9 service reputation of the company; or a modest decline in sales. For the most part, there is broad agreement, but not complete Most Berkshire Hathaway CEOs believe their compensation Respondents expect Berkshire Hathaway headquarters to become would be higher if their business were owned by a company other “somewhat involved” if the company were to experience a major than Berkshire. All claim that their annual bonus is calculated using decline in sales; a modest restatement of previous financial results; only two performance measures. (A typical large corporation uses or an event that impacts the subsidiary’s business reputation. The most frequently Still, this reaction is not universally anticipated. A minority of cited measures are earnings, return on equity, and operating or respondents believes that Berkshire Hathaway headquarters profit margin. One reports sales growth as a goal. The stock price would not get involved even in these circumstances. Respondents performance of Berkshire is not a performance measure for even agree that Berkshire Hathaway headquarters would become very large subsidiaries. “very” or “somewhat involved” only under two scenarios: first, if an event impacts the parent company’s reputation; and second, 2.4 performance measures, on average.) 10 All respondents have identified at least one successor as CEO Stanford Closer LOOK series 2
Trust and Consequences if the company were to issue a severe restatement of previously bemoan the short-term orientation of many publicly traded reported financial results. corporations, in part due to pressure from investors and Berkshire Hathaway subsidiary CEOs report communicating activists. Is it true that public companies are short-term infrequently with their counterparts at other subsidiaries. oriented? Why is Berkshire an exception to this trend? What Subsidiary CEOs interact with their counterparts on a semiannual actions can corporations take to extend the investment or quarterly basis. These communications are voluntary and not horizons of management? required by Berkshire Hathaway headquarters. 5. Berkshire Hathaway managers are also uniform in their Finally, the managers of Berkshire Hathaway subsidiaries belief that integrity is a critical operating principle for the widely believe that Berkshire Hathaway will experience few, if company. How important is integrity to business results? any, changes following the eventual succession of Warren Buffett. To what extent is ethical behavior influenced by “tone at the Almost all respondents believe the company’s culture will not top?” To what extent is it influenced by monetary incentives, change. Most also believe the company will not operate with recruitment practices, and other organizational features? more internal controls, that the subsidiaries will experience no change in independence, and that the company will not insert additional layers of management between them and Buffett’s eventual successor. Only a few believe that the structure of their compensation contracts will change. In the words of one respondent, “The more I interact with the board at Berkshire and other Berkshire managers, the more confident I am in the future of Berkshire post Warren.” Why This Matters 1. The Berkshire Hathaway operating system is built on the notion that managers will perform at a higher level if they are granted autonomy and allowed to run their businesses from a long-term perspective without intervention from headquarters. Survey data suggests that the company has been successful in creating such an environment. How important is this “trust-based” system to the company’s results? 2. Survey data suggests that Berkshire Hathaway headquarters takes a very hands-off approach to a wide range of business disruptions, including executive turnover, customer and supplier issues, sales decreases, and unexpected legal, regulatory, or environmental claims. When is it appropriate for corporate overseers to defer to the judgment of management in solving operational problems, and when is greater involvement warranted? Does Berkshire Hathaway “draw the line” in the right place? 3. Berkshire Hathaway claims to have “essentially no centralized or integrated business functions” and “minimal involvement” in business activities. Should such a system be adopted by companies more broadly? Would it lead to better or worse outcomes, on average? In which settings might it succeed, and Lawrence Cunningham, Berkshire Beyond Buffett: The Enduring Value of 1 Values, (New York, NY: Columbia University Press, 2014), p. 105. For a detailed review of the Berkshire Hathaway management system and culture, see Cunningham, op. cit. See also David F. Larcker and Brian Tayan, “The Management of Berkshire Hathaway,” Stanford GSB Case No. CG-16 (January 1, 2009); and David F. Larcker and Brian Tayan, “Corporate Governance According to Charles T. Munger,” Stanford Closer Look Series (March 3, 2014). 3 Berkshire Hathaway, 2015 Annual Report. 4 The DuBridge Distinguished Lecture Series, “A Conversation with Charlie Munger,” California Institute of Technology (March 11, 2008). 5 Berkshire Hathaway, 1998 Annual Report. 6 Transcript: “A Conversation with Warren Buffett,” The Charlie Rose Show, July 10, 2006. 7 Wesco Financial, 2008 Annual Meeting, cited in: Outstanding Investor Digest, (August 31, 2008). 8 Survey data collected between June and September 2015. Questionnaires were mailed to the chief executive officers and executive chairmen for each of the main operating subsidiaries listed in the company’s 2015 annual report. Responses were submitted anonymously. Although some executives identified the subsidiaries they manage, they were not required to do so. All respondents provided descriptive statistics of company size and the nature of their operations. Because responses were received from only a minority of companies, we consider these results to be descriptive rather than scientific. 9 These estimates are consistent with the results of a 2014 survey of investor relations professionals who believe that activist investors can shorten the investment horizon of a public company and that longer investment horizons benefit shareholder value. See National Investor Relations Institute (NIRI) and the Rock Center for Corporate Governance at Stanford University, “2014 Study on How Investment Horizon and Expectations of Shareholder Base Impact Corporate Decision-Making,” (2014). 10 Ying Huang, Ningzhong Li, and Jeff Ng, “Performance Measures in CEO Annual Bonus Contracts,” working paper, University of Texas at Dallas (June 2013). 11 Heidrick & Struggles and the Rock Center for Corporate Governance at Stanford University, “2010 CEO Succession Planning Survey,” (2010). 2 in which settings might it lead to more failure? 4. Berkshire Hathaway managers are uniform in their belief that their companies benefit from a long-term investment horizon. At the same time, prominent commentators continuously Stanford Closer LOOK series 3
Trust and Consequences David Larcker is Director of the Corporate Governance Research Initiative at the Stanford Graduate School of Business and senior faculty member at the Rock Center for Corporate Governance at Stanford University. Brian Tayan is a researcher with Stanford’s Corporate Governance Research Initiative. They are coauthors of the books A Real Look at Real World Corporate Governance and Corporate Governance Matters. The authors would like to thank Michelle E. Gutman for research assistance in the preparation of these materials. The Stanford Closer Look Series is a collection of short case studies that explore topics, issues, and controversies in corporate governance and leadership. The Closer Look Series is published by the Corporate Governance Research Initiative at the Stanford Graduate School of Business and the Rock Center for Corporate Governance at Stanford University. For more information, visit: http:/www.gsb.stanford.edu/cgri-research. Copyright © 2015 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. Stanford Closer LOOK series 4
Trust and Consequences Exhibit 1 — relative contribution of investment returns and earnings to growth yardsticks The first component of value is our investments: stocks, bonds and cash equivalents. At year end these totaled $158 billion at market value. […] Berkshire’s second component of value is earnings that come from sources other than investments and insurance underwriting. These earnings are delivered by our 68 non-insurance companies […]. In Berkshire’s early years, we focused on the investment side. During the past two decades, however, we’ve increasingly emphasized the development of earnings from non-insurance businesses, a practice that will continue. The following tables illustrate this shift. In the first table, we present per-share investments at decade intervals beginning in 1970, three years after we entered the insurance business. We exclude those investments applicable to minority interests. Year Per-Share Investments 1970 $ Years Compounded Annual Increase in Per Share Investments 66 1980 754 1970-1980 27.5% 1990 7,798 1980-1990 26.3% 2000 50,229 1990-2000 20.5% 2010 94,730 2000-2010 6.6% Though our compounded annual increase in per-share investments was a healthy 19.9% over the 40-year period, our rate of increase has slowed sharply as we have focused on using funds to buy operating businesses. The payoff from this shift is shown in the following table, which illustrates how earnings of our non-insurance businesses have increased, again on a per-share basis and after applicable minority interests. Year 1970 Per Share Pre-Tax Earnings $ Years Compounded Annual Increase in Per-Share Pre-Tax Earnings 2.87 1980 19.01 1970-1980 20.8% 1990 102.58 1980-1990 18.4% 2000 918.66 1990-2000 24.5% 2010 5,926.04 2000-2010 20.5% For the forty years, our compounded annual gain in pre-tax, non-insurance earnings per share is 21.0%. During the same period, Berkshire’s stock price increased at a rate of 22.1% annually. Over time, you can expect our stock price to move in rough tandem with Berkshire’s investments and earnings. Source: Berkshire Hathaway, 2010 Annual Report. Stanford Closer LOOK series 5