A TRUST-BASED ORGANIZATION faces two major problems. The first occurs when senior managers abuse trust. The second involves pitfalls of self-reliance in such areas as improvident acquisitions. Although the challenges are real, Berkshire has generally overcome them. With scores of acquisitions and executive appointments over six decades, the conglomerate offers only a few examples of error in judgment.
Acquisitions
For decades, Buffett has called all the parent-level shots at Berkshire, with limited investigation and no oversight, especially those concerning acquisitions and investments. Unlike most sizable public companies, Berkshire does not rely on its board of directors or senior executives to approve acquisitions; and it does not use outside advisors to vet deals.
Buffett explains his general philosophy to the board but rarely seeks its approval; he often consults with Munger, and lately with Greg Abel and Ajit Jain, but he does not do so inevitably and does not always heed their counsel. Berkshire rarely uses business brokers or investment bankers to identify acquisition targets, but rather relies on an informal network of friends and business associates. Most of the suggestions he is given work out well, but not all, entailing some costs of error.
One of Berkshire’s most unusual acquisitions occurred in 2001. Buffett’s friend, Julian Robertson, founder of the preeminent Tiger Management (the Tiger Fund), signaled to Buffett his willingness to sell a large stake in XTRA Lease, the truck leasing company.
Buffett upped the ante, proposing to XTRA’s board the making of an all-shares tender offer to its shareholders, which it endorsed, and Berkshire soon closed. Contrary to Berkshire’s usual practice of maintaining both management and operations after an acquisition, within three years, XTRA’s CEO was replaced, its headquarters was relocated, and the company divested a large part of its asset base.
Although such significant changes are commonly part of many corporate acquisitions, they are normally avoided at Berkshire. Berkshire likes to acquire well-running businesses, not those that need fixing. It is anomalous for a Berkshire acquisition to entail such efforts. But Berkshire sometimes accidentally buys troubled companies needing such changes. It is a by-product of the informality of Berkshire’s acquisition process, especially when spontaneously acting on tips from friends and conducting limited due diligence.
XTRA turned out to be a profitable acquisition, but another unusual deal posed disastrous financial results: Berkshire’s 1993 acquisition of Dexter Shoe. Berkshire paid $443 million—all in Berkshire stock—for the dying New England cobbler. The company had been a dynamo, producing millions of shoes in local factories annually. Dexter maintained production in the United States, paying higher wages than rivals and outdid imports from low-wage countries in terms of quality and style.
Despite these positive traits, Dexter had a big latent negative: manufacturing costs in the United States were ten times those in China. Eventually, rivals produced shoes as good as Dexter but at one-tenth the cost. By 2007, Buffett confessed that acquiring Dexter was the worst deal he ever made, as Berkshire shuttered it. The cost was the value of the Berkshire stock surrendered, which by 2020 exceeds $8 billion. This revealed another lesson about the perils of using a high-quality stock like Berkshire to acquire businesses.
Buffett alone made the mistake—without input of the Berkshire board or any inner circle. Even the greatest investors and decision makers commit costly mistakes. Buffett is aware of this, of course, which is why he often vets proposals with Munger. Although Buffett values Munger’s counsel to veto a deal—earning Munger the nickname the “Abominable No Man”—Buffett has not always listened, as the even more costly 1999 acquisition fumble of General Reinsurance Corporation (Gen Re) attests.
Berkshire paid $22 billion for Gen Re—all in Berkshire stock (the lesson from Dexter to avoid paying in stock was not evident until 2007). Buffett and Munger knew that Gen Re, a large reinsurer, maintained a significant derivatives business that posed considerable risk.
Munger suggested avoiding the deal, but Buffett figured managers would unwind that business unit promptly after closing. Once Berkshire acquired Gen Re, however, the managers did not do so and, consistent with Buffett’s hands-off approach, he did not push them (such reluctance underscores how unusual the postacquisition shuffles at XTRA were).
In addition to the patent problems of the derivatives business, more latent challenges also beset Gen Re’s operations. Buffett had known Ronald Ferguson, Gen Re’s chief executive, for many years, and he relied heavily on that relationship and Ferguson’s experience. What neither Buffett nor Ferguson knew, however, was that Gen Re’s underwriting discipline and reserves had slipped.
Gen Re had under-reserved for risks it covered, which it translated into low prices on subsequent policies. Underwriters also pursued business they should have rejected and concentrated their risks excessively. From 1999 to 2001, Gen Re incurred underwriting losses adding to $6.1 billion. Unwinding the derivatives business was both costly and protracted, causing Buffett angst for many years.
Munger is not only influential, sometimes vetoing deals, but also deferential when Buffett wishes to proceed anyway. In 2007, Buffett invested $2 billion in the debt of a leveraged buyout of Texas electric utilities. It soon busted amid the financial crisis, costing Berkshire almost $1 billion. Ironically, the deal was arranged by the private equity firm KKR (formerly Kohlberg Kravis Roberts), in one of its biggest ($44 billion) and worst deals to that point.1
Reporting this in 2013, Buffett wrote, “Next time I’ll call Charlie.” Although investment committees, common at most businesses even fractions of Berkshire’s size, limit opportunistic capital allocation, deals like this underscore the cost of having a one-man investment committee.
A final example concerns 3G, and Buffett’s trust in its principal, Jorge Paulo Lemann. As noted in chapters 4 and 7, Berkshire’s partnership with the private equity firm—in 2013 to acquire Heinz and in 2015 to merge it with Kraft—gave Berkshire a 27 percent stake in Kraft Heinz Company. Alas, 3G’s business strategy, focused on cost cutting, has stumbled. In late 2018, the company drew a subpoena from the Securities and Exchange Commission over certain business practices.2
Buffett understands the appeal and limits of the model and seems to believe that others can execute it as he has. Conversely, the Berkshire succession plan envisions splitting the roles of chief executive and chief investment officer and the roles of management from board chair. Accordingly, the Berkshire succession plan envisions a somewhat tighter leash on Buffett’s successor (chapter 12 considers succession further).
For other firms, insisting on a capable decision maker based on core competencies and a proven track record seems imperative before opting to follow the Berkshire model. At a minimum, firms should embrace the fundamental Buffett-Berkshire tenet of the circle of competence defined cross-functionally: industries and business, business methods, and people playing multiple roles, such as managers as well as partners.
Berkshire’s preference to pay cash not stock is helpful but, as with most solutions, it poses minor problems of its own. The cost to Berkshire is most acute in the context of targets that are publicly traded family business. Family businesses appeal to Berkshire as they often bring a sense of legacy and permanence, which are prominent fixtures in the Berkshire business model.
Many families prize Berkshire’s commitments to autonomy and permanence, moreover, often selling to Berkshire for less than rival bids or intrinsic value. For family businesses owned solely by close-knit groups who all wish to sell to Berkshire, the cash preference at a discount creates no problem.
Problems arise, however, for publicly traded family businesses. When directors of such companies sell control, they are duty-bound to get the best value for shareholders.3 In a stock deal where all holders share gains in future business value, those directors could consider Berkshire’s special culture in valuing the transaction.4
But with cash, all such future value goes to Berkshire’s shareholders, not to the target’s public stockholders, who gain nothing from the autonomy or permanence that family members prize in a sale to Berkshire. So target directors will resist an all-cash sale at a discount. They will seek rival suitors at higher prices, even stimulating an auction to drive up the price—repelling Berkshire, which avoids auctions.
An example can be drawn from Berkshire’s 2003 acquisition of Clayton Homes, a publicly traded family business bought for a modest (7 percent) premium to market. Certain Clayton shareholders objected: one, Cerberus Capital Management, told Clayton it wanted the chance to make a competing bid; another sued.5 The result was a six-month delay in getting to a shareholder vote, which narrowly approved the Berkshire deal.
Some Clayton shareholders were disappointed, but Cerberus opted not to outbid Berkshire, and the court dismissed the lawsuit. The scenario remains unattractive to Berkshire, however, given the risk of litigation, delay, and rival bids—wary that courts might require target directors to take affirmative steps. The risk of an auction would be enough to deter Berkshire from bidding at all. The upshot: the publicly traded family business is outside Berkshire’s acquisition model, amounting to an opportunity cost for what would otherwise be a sweet spot.
Executives
The challenges of Berkshire’s trust-based structure are most dramatic when senior executives depart after being ensnared in widely publicized imbroglios. Buffett pays close attention to manager identity when acquiring a company but then relies on such mangers to appoint successors. At the same time, there is no middle management, so in modern management parlance, a single person may have eighty direct reports. The chief costs result from mistakenly releasing or retaining senior executives in circumstances that suggest crisis.
Crisis was the hallmark of a series of executive shuffles at Berkshire’s NetJets subsidiary, which involved two managers on the short list of Buffett successors, Richard Santulli and David Sokol. NetJets, which Santulli founded and led through 2009, is a competitive and capital-intensive business with a unionized employee base. Selling fractional interests in private aircraft to the elite, Santulli conceived of the business as a luxury brand and operated it accordingly.
But the company struggled and, amid financial adversity following the 2008 financial crisis, Buffett made a change. Why he did so remains a mystery and certainly an anomaly, however, as Buffett rarely second-guesses managers, especially company founders like Santulli.
As NetJets’s new CEO, Buffett appointed Sokol, who perceived NetJets to be bloated and forthwith cut costs aggressively. Unionized employees were furious and a sense of crisis soon engulfed the company. Why Buffett chose Sokol to run NetJets is also a curiosity. Sokol was running Berkshire Hathaway’s energy business (then called MidAmerican Energy) and troubleshooting as board chairman at Johns Manville.
Buffett has almost never moved a CEO from one Berkshire company to another. Having the same CEO run two Berkshire companies was unprecedented. But Buffett had grown to trust Sokol immensely, having been introduced to him by one of his most intimate confidants, Walter Scott Jr., fellow Omaha denizen and Berkshire board member. Buffett’s faith, however, was misplaced, as Sokol resigned from all of his Berkshire jobs in 2011 after allegedly trading stock in a public company ahead of pitching it to Buffett as a Berkshire acquisition.
At NetJets, Sokol’s successor was Jordan Hansell. Sokol had recruited Hansell from Berkshire’s energy business, where Hansell had served as general counsel. NetJets’s pilots loved Santulli and lamented his departure. They opposed both Sokol and Hansell, and especially their cost-cutting strategy.
After Santulli left, management-labor relations deteriorated, and during 2013–2014 the pilots’ union hurled invective at Hansell in aggressive campaigns from the Internet to the Wall Street Journal and Omaha World-Herald. Pilots picketed outside Berkshire’s annual meeting in 2014 and 2015. Amid mounting turmoil, in early 2015, Hansell resigned and two Santulli-era senior executives who had left NetJets earlier that year were recruited back to lead the company.
From these circumstances, it is tempting to infer that Berkshire’s acquisition of NetJets was a mistake. Perhaps it belongs in the prior section’s list of troubled acquisitions due to having a single decision maker. But it also speaks to the lack of any formal programs at Berkshire concerning executive recruiting, review, promotion, or grooming. Sokol had no experience with fractional aviation or much else relevant to leading NetJets, such as consumer or union relations. Sokol selected Hansell, a young lawyer at the energy company, who likewise lacked obviously relevant credentials or experience.
The executive shuffles at NetJets resembled successive shuffles at Berkshire’s Benjamin Moore paint manufacturing subsidiary. When Berkshire acquired it in 2000, as noted in chapter 4, Buffett personally promised to continue its longstanding practice of selling only through independent distributors, not through powerful big box retailers such as Home Depot and Lowe’s. By 2012, after five years at the helm, Denis Abrams was ousted for planning to sell paint through such retailers. To find a replacement, Buffett turned to his newly hired management assistant, twenty-eight-year-old Tracy Britt Cool.
The recently minted Harvard MBA suggested Robert Merritt, who was installed. But not two years later, Merritt succumbed to the same fate due to relentless pressure from big retailers. He resigned amid concurrent criticisms about a new culture of chauvinism at the venerable paint company. Surrounding both episodes was an atmosphere of crisis. Distributors and other constituents complained about the company’s decline. How such a great company could take such a plunge befuddled them.
The Benjamin Moore departures reveal two variations on the challenges of the Berkshire model as it relates to executive oversight. The first concerns the wisdom of Buffett’s commitment to maintain Benjamin Moore’s old-fashioned distributorship in the first place. Two successive CEOs intuited the difficulty associated with exclusively selling paint that way given contemporary distribution channels. Yet they were handcuffed by a commitment made solely by Buffett.
The second variation of the Benjamin Moore challenge concerns how executives are chosen at Berkshire. Although Buffett delegated the executive search function when finding Merritt, the power was exercised by just one person who was young and new to Berkshire. And Cool identified Merritt from among her own professional circle, not through a national search.
The private network approach is consistent with the Berkshire model—seen in Santulli’s recruitment of Hansell and Buffett’s recruitment of several other CEOs. But it does present risk and therefore a challenge compared with formal programs for recruiting, vetting, and promoting executives.
The risk of this type of managerial succession crisis could be mitigated by modest expansion of corporate bureaucracy (like asking a board committee’s opinion on executive personnel decisions) or slight adjustments to the trust-based culture (such as conducting background checks or adding periodic reviews and evaluations).
In the early 2010s, Berkshire began to move in this direction: holding regular annual meetings of the subsidiary CEOs, sometimes joining the board without Buffett’s presence. More formal and frequent meetings have been occurring and are likely to become regularized. Such gradual changes would maintain the trust-based model Berkshire prospered on while guarding against errors the approach poses.
For all of that, again, the record remains strongly in favor of the Berkshire business model. Each of the challenges chronicled here is important and may offer lessons. But aggregating the scorecard over six decades and hundreds of such decisions, these are dwarfed by the achievements.