When it comes to finances, acquisitions, and management, Berkshire Hathaway does things differently
Trust is the essence of the business model Warren Buffett developed at Berkshire Hathaway. This trust fuels the most consequential recurring activities that define Berkshire’s business methods: self-reliant finance, internal capital allocation, decentralization, and acquisitions.
The value of trust explains Berkshire’s preference to finance operations and growth internally rather than through third-party lenders. They trust themselves more than they trust bankers.
Trust is a sine qua non for Berkshire’s decentralized autonomous approach as well as a primary reason for this model’s success. Trust is earned and must be nurtured, which explains many preferences Berkshire has in the acquisition arena. It also explains Buffett’s preference to look to personal networks over brokers when hunting for acquisitions, as well as his unusually minimalist due diligence.
Buffett brags of employing only a couple dozen people at Omaha headquarters in a conglomerate brimming with nearly 400,000 employees.
Berkshire finances operations and acquisitions primarily through retained earnings, with leverage contributed by insurance float and deferred taxes. Berkshire generally does not use banks or other intermediaries. In the few times when Berkshire has borrowed funds, mostly for use of its capital-intensive and regulated public utility and railroad business, loans are long-term and fixed rate. Use of traditional debt could juice Berkshire’s results, but borrowed money is costly and creates risk of default along with collateral damage.
Berkshire’s preferred source of leverage is float in its insurance operations. Float refers to funds that insurance companies hold between the time premiums are received and the time claims are paid. So long as insurance underwriting breaks even (total premiums received equal expenses plus total claims paid) the cost of float is zero. With an underwriting profit, an insurer can effectively be paid for holding float, and even with modest underwriting losses, float is usually cheaper than bank debt.
Deferred taxes are also a cheap and riskless source of leverage. They arise when tax laws require accruing obligations on appreciated assets but do not require repayment until the asset is sold. Although a real liability, there are no interest costs, covenants, or due dates. The timing of repayment is optional.
When done well over long periods of time, the amount of float can grow massively. At Berkshire, float rose from a mere $39 million in 1970 to $1.6 billion in 1990 and has soared in decades since — to $28 billion in 2000 and to $66 billion in 2010 — and is estimated to reach $125 billion by 2020. Berkshire’s deferred taxes stand at around $50 billion, pushing the total of these unconventional leverage sources toward $175 billion (representing the lion’s share of total liabilities).
These obligations are real liabilities, of course, so Berkshire’s insurance subsidiaries hedge against disaster. They use compensation plans designed to encourage underwriting discipline, with bonuses tied to underwriting profit and to the cost of float rather than to premium volume.
Unlike float (or deferred taxes), bank debt comes with covenants, stated interest, and due dates. Loans are marketed by agents whose interests conflict with those of borrowers, whether concerning a loan’s size, duration, cost, or covenants. Berkshire’s approach thus provides the leverage benefits of debt without these downsides. Berkshire’s model underscores the value of fiscal self-reliance and self-discipline. Ultimately, Berkshire trusts itself rather than lenders.
Internal capital allocation
Berkshire’s conglomerate structure enables internal cash reallocation to businesses generating the highest returns on incremental capital. Berkshire’s success at capital reallocation has vindicated its conglomerate business model, otherwise denigrated across corporate America. It also skillfully avoids third parties.
Cash-transferring subsidiaries distribute cash to Berkshire without triggering any income tax consequences. Cash-receiving subsidiaries obtain corporate funding without frictional costs of borrowing, such as bank interest rates, loan covenants, and other constraints. Some subsidiaries generate tax credits in their businesses that they cannot use but that can be used by Berkshire’s other subsidiaries.
Subsidiary managers prize the effortless source of funds. Outside Berkshire, a chief executive needing funds faces layers of approvals that tend to reflect skepticism rather than trust. This process starts with a board to obtain authorization and financial advisers on the best sources and types of funding. These, in turn, involve underwriters for equity securities or banks for debt.
At each step, fees are incurred as well as haggling over terms that limit the company’s flexibility. Berkshire’s subsidiary managers avoid all of that: When they want funds, they tell Buffett, the friendliest banker you can imagine — no interference, contracts, conditions, covenants, due dates, or other constraints of intermediation.
Decentralization — pushing autonomy and responsibility downward throughout the business organization — pervades Berkshire. It starts at the top, with Buffett and Berkshire headquarters, and trickles down. Buffett keeps Berkshire simple: There is not even an organizational chart. If Berkshire had one, it would resemble the figure below, which we created.
Hypothetical org chart for Berkshire Hathaway.
Buffett brags of employing only a couple dozen people at Omaha headquarters in a conglomerate brimming with nearly 400,000 employees.
Buffett makes almost all Berkshire-level capital allocation decisions, including acquisitions. Formal oversight of Berkshire’s subsidiaries concerns financial matters, led by five officers in Omaha. The only other officer is the corporate secretary, overseeing the outside lawyers handling Berkshire’s acquisitions and securities work.
Each Berkshire subsidiary is self-contained, with all traditional corporate functions, and defines its own departments. The result is overhead at Berkshire headquarters of approximately $1 million annually and salary expense under $10 million. For context, Berkshire’s annual revenues run around $250 billion.
For additional support, each subsidiary has a small board — typically five members, consisting of the CEO, and other directors supplied by Berkshire’s board, the Omaha team, or from among other Berkshire subsidiary CEOs. All other corporate functions remain at each subsidiary after acquisition, as before, with their own organizational structures.
As Berkshire has grown in the past two decades into a gargantuan conglomerate, and Buffett’s attention has spread thin, the company has decentralized not only by maintaining acquired businesses as autonomous units but also by sustained decentralization, meaning further pushing functions down at the subsidiary level; segmented decentralization, by splitting acquired businesses further; and reporting decentralization, increasingly pushing senior managers up.
Sustained decentralization is illustrated by Berkshire Hathaway Energy (BHE). Since 1998, there have been 15 major acquisitions, to turn it into a conglomerate, now generating some $25 billion in annual revenue, with five utilities, two pipelines, numerous renewables, and hundreds of real estate brokerages, operating under the BHE brand.
As often happens with growth, centralization crept in, with many functions at headquarters and related overhead costs. In recent years, BHE aggressively decentralized, pushing all functions down. The head office employs a couple dozen people compared with 23,000 company-wide personnel. The logic for this decentralization runs along both geographic and product lines: The businesses are in specific regions and face different pricing environments, regulatory oversight, and labor markets. Each unit gains from autonomous local leadership with specific infrastructure and personnel.
Decentralization by segmentation often occurs at Berkshire upon acquisition. For example, in 2000, Berkshire acquired Justin Industries, a mini-conglomerate composed of a few boot companies and several brick companies (called Acme Brick) operating under centralized management.
Boots can be produced anywhere and generally are manufactured abroad and shipped worldwide, they’re sold through retail outlets to individuals, and with Justin’s strong ad-driven branding — generally a uniform Western look — Justin Boots commands some pricing power. Boots wear out naturally, so loyal customers buy again. As an organization, these features tended to warrant a relatively centralized approach to design, manufacturing, and marketing.
Brick production, on the other hand, is constrained by weight and geography and is produced and distributed more locally. Buyers primarily include commercial parties in competitive markets that put a premium on relationships. Acme offers 100-year warranties. These features make Acme more effective when organized regionally, with production and sales operating as independent businesses, while investing centrally in quality control.
Buffett, therefore, separated the boot businesses from the brick businesses. Each became a direct Berkshire subsidiary, with each chief executive responsible for the entire P&L from operations through administration. This decentralization has enabled both Acme Brick and Justin Boots to prosper far more than they would have under the same corporate roof.
Reporting decentralization occurs by reducing the direct reports of senior managers without adding layers of bureaucracy, chiefly by collecting logical business units into group portfolios. A good example is Berkshire’s Marmon Group, a diverse manufacturing powerhouse. In 2005, before Berkshire bought Marmon, CEO Frank Ptak oversaw 10 divisional direct reports, which he thought too many. Therefore, he segmented the 10 divisions into four companies, with four direct reports, as the figure below illustrates.
Decentralization of Marmon Group. The number of direct reports for the CEO went from 10 in 2005 (top) to four in 2015 (bottom).
The rationale is simple: As a company grows ever larger, no manager can master everything. Senior managers must constantly regroup and delegate to levels at which junior managers, in aggregate, can do so.
All organizational structures pose trade-offs. Decentralization allows for efficient and effective decision-making by managers closest to the issue. It runs the risk, however, of erroneous decision-making, too. But Buffett justifies it: “We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly — or not at all — because of a stifling bureaucracy.”
A commonly cited advantage of centralization is avoiding duplication of resources. But at Berkshire it seems to work the other way around: There may be 60 legal departments instead of one, but the alternative would likely be a general counsel’s office far larger than the sum of those existing at the subsidiaries.
Efficiency follows because each manager has economic and cultural incentives to minimize the size of their staff. And that is a significant advantage of Berkshire’s decentralized model: Each CEO can design the structure best suited to their specific operations.
Unlike most corporations and conglomerates, Berkshire has never had a department or formal plan to scout for and seize acquisition opportunities. Instead, Buffett calls Berkshire’s acquisition strategy “haphazard” and “serendipitous,” neither “carefully crafted” nor “sophisticated.” The approach helps to avoid costly value-destroying acquisitions, one important factor in Berkshire’s sustained success.
In the acquisitions market, companies commonly hire investment banks and brokers to vet deals. Berkshire generally avoids these hires. Deal brokers often charge high fees that are contingent on closing, giving brokers an incentive to close even when the deal is not in the client’s best interests.
Buffett sizes people up in minutes; deals are sometimes reached in an initial phone call, often in meetings of less than two hours and invariably within a week.
So rather than rely on brokers, Berkshire has long used an ever-growing network of associates, partners, colleagues, and friends to bring acquisition opportunities. Consequently, Berkshire rarely initiates the process, but rather responds to proposals from others.
Consider Berkshire’s 1986 acquisition of Scott Fetzer, where a “major investment banking house” tried unsuccessfully to find a buyer for the midsize diversified conglomerate. After a hostile raider targeted the company, Buffett contacted the latter’s CEO to discuss a deal, which they quickly closed.
Reprovingly, Buffett noted that the company still had to pay its banker $2.5 million, even though it did not find the buyer. As Berkshire’s experience suggests, Buffett believes it is better for sellers and buyers to find each other directly than to retain bankers or brokers. A favorite Buffett line admonishes: “Don’t ask the barber whether you need a haircut.”
And unlike typical acquisition processes that are heavily intermediated and can take months, Buffett sizes people up in minutes; deals are sometimes reached in an initial phone call, often in meetings of less than two hours and invariably within a week. Formal contracts are promptly negotiated. Deals — including big ones involving billions of dollars — can close within a month of initial contact.
Benjamin Moore was a family-controlled company whose stock was also listed on the over-the-counter market. Having decided it was time to sell, the company retained financial advisers who, upon study, suggested a price. But the firm could not find a buyer at the sought price. Directors contacted Buffett, presenting Benjamin Moore as a Berkshire kind of company. Asking only a few questions and for public documents, Buffett made a proposal within a week. He offered to acquire Benjamin Moore for $1 billion cash and the board accepted — aware that seeking a higher price from Buffett was probably futile. Related investigations consisted of Buffett meeting with the company’s CEO and Berkshire’s outside lawyers conducting basic due diligence.
Buffett’s commitment to staying within his “circle of competence” enables him to make such momentous decisions based on moderate digging.
For one, his prodigious business reading provides significant knowledge and familiarity with many companies and their leaders. And his intensive focus on industries he comprehends and business methods he embraces has added discipline. When he lacks competence — whether in the business, about the business method, or to judge the people involved — he passes. Concerning trust, in particular, if Buffett has any doubt about the trustworthiness of a prospective business colleague — seller, manager, or otherwise — he usually politely declines interest. This is the essence of the margin of trust: It’s not enough to be an excellent judge of business, business methods, or character — although Buffett has honed those skills. It is, above all, a disciplined aversion to misplaced trust that must rule.