The Skeptical Principal
posted by Deborah DeMott
As the Essays note, Berkshire is unusual in several ways. These include the diverse range of businesses that it controls or in which it holds a significant ownership interest, its large proportion of non-controlling equity held long-term by individual shareholders, and its no-dividend pattern. These characteristics—plus the enduring management success of its controlling shareholders—may well be linked to the skeptical voice evident in the Essays.
Consider first how the Essays recount the process through which Berkshire acquired Scott Fetzer. A “major investment banking house” had undertaken to sell it but failed despite offering Scott Fetzer “widely.” Learning of this failure Mr. Buffett wrote Scott Fetzer’s CEO (whom he had never met), expressing interest, and “within a week we had a deal.” But “[u]nfortunately, Scott Fetzer’s letter of engagement with the investment bank provided it a $2.5 million fee upon sale, even it had nothing to do with finding the buyer.” (Essays at 217).
To be sure, this account may slight the investment bank’s contribution because its unsuccessful marketing effort preceded Mr. Buffett’s awareness of Scott Fetzer as an acquisition target. Nonetheless the incident exemplifies the Essays’ skepticism of the value of external intermediaries and deal-facilitators, at least most of the time. Instead, identifying acquisition targets and determining the terms on which a deal might be possible can be handled internally and more simply.
Most of Berkshire’s acquisitions stem from referrals by owners of other businesses who have sold to Berkshire in the past. A principal-to-principal negotiation follows, with Berkshire assessing the target’s merit and worth using principles of value investing. With these internalized processes the Essays contrast the “auction process that has become standardized,” in which investment bankers develop a “book” to pitch each potential acquisition target to potential acquirors. (Essays at 217) As the Scott Fetzer episode illustrates, this process generates transaction costs, at least once a deal ensues that is embraced by an engagement agreement.
The Essays question the effectiveness of investment banks as marketers or match-makers more generally. As of 1991, “we have on four occasions made major purchases of companies whose sellers were represented by prominent investment banks,” but in only one instance was Berkshire “contacted by the investment bank.” (Essays at 213). In the others, either Mr. Buffett or a friend contacted the target after its investment bank contacted the prospective purchasers it had identified, as appears to have been the case with Scott Fetzer.
Thus, the skepticism running through the Essays encompasses concerns about skill, competence, and overall effectiveness, as well as the transaction costs associated with intermediation and third-party advisers. An extended passage introduces the reader to the concept of “‘frictional’ costs,” which stem from charges to owners of assets imposed by a cast of “Helpers” that execute transactions, manage investments, plan overall investment strategy, and culminate with hedge funds and private equity.
Overall, the hierarchy of Helpers may extract about 20% of the earnings of American business. (Essays at 172-74). Of course, this number’s rhetorical oomph doesn’t require showing how it was reached! This cast of characters is self-interested: “[f]riendly investment bankers” will assure a buyer of the wisdom of using its own stock to make an acquisition when this amounts to spending an undervalued currency to buy fully-valued property. (Essays at 201, observing “Don’t ask the barber whether you need a haircut.”).
The Essays emphasize the importance of correctly identifying the principal (or client) in any relationship with an agent or adviser. Thus, returning to Scott Fetzer, Berkshire’s compensation agreement with its CEO “was worked out in about five minutes” directly following the acquisition, “and without the help of lawyers or compensation consultants.” (Essays at 74). In contrast, directors of publicly-held companies “meekly” follow the recommendations of compensation consultants, “a breed not known for allegiance to the faceless shareholders who pay their fees.” (Essays at 76).
Likewise (and pre-Sarbanes/Oxley), auditors misidentified a firm’s CEO as their client due to the immediacy of day-to-day relationships with senior management as well as “the auditors’ understanding that no matter what the book says, the CEO and CFO pay their fee and determine whether they are retained for both auditing and other work.” (Essays at 79). And independent directors of most mutual funds engage in a “zombie-like process that makes a mockery of stewardship” in their mandatory annual selection of the fund’s management company. (Essays at 46). Comparable misunderstandings are unlikely at Berkshire. Indeed, the Essays themselves and the annual reports that preceded them should help minimize the risk that Berkshire’s externally-situated agents and advisers will misidentify the principal on whose behalf they serve.
At points the Essays celebrate the contributions of named agents and advisers and illustrate that a skeptical principal need not eschew the use of external agents. In Berkshire’s 1989 issuance of zero-coupon debentures, Salomon Brothers served as underwriter in “superb fashion, providing us helpful advice and a flawless execution.” (Essays at 134) Salomon also receives credit for its ingenuity in creating a financial instrument premised on stripping semi-annual coupons from Treasury bonds, another form of zero-coupon bond. (Essays at 135).
However, investment bankers generically engaged in “dagger-selling” by promoting junk bonds that were below investment grade when issued; “the Street’s enthusiasm for an idea was proportional not to its merit but rather to the revenue it would produce.” (Essays at 132) Indeed, Berkshire’s 1988 decision to seek listing on the New York Stock Exchange would “reduce transactions costs” for its shareholders when they exit or enter the ownership ranks (Essays at 175), and Berkshire later reported delight with the performance of the specialist firm assigned to it by the exchange (Essays at 176).
In short, a skeptical principal may use externally-situated agents and intermediaries, but only when warranted in its own assessment and, one suspects, on its own terms to the extent feasible. Berkshire and Mr. Buffett are distinctively (if not uniquely) skeptical.
Deborah DeMott is the David F. Cavers Professor of Law, Duke University, where she has taught since 1975, specializing in agency and partnership law, corporate law and the law of takeovers and acquisitions and fiduciary obligation. She has also taught at the London School of Economics and the Universities of Sydney, Melbourne, Texas, Colorado, and San Diego; the Hastings College of Law of the University of California; and at Osgoode Hall Law School, York University, Toronto. She is the author of a treatise, Shareholder Derivative Actions, published in 1987 and a casebook, Fiduciary Obligation, Agency and Partnership, published in 1991. Her scholarship can be found on the SSRN, here.