Berkshire’s Capital Charge Philosophy | The Acquirer's Multiple®

During their recent episode, Taylor, Carlisle, and Alex Morris discussed Berkshire’s Capital Charge Philosophy. Here’s an excerpt from the episode:

Tobias: It’s so different to the way that Berkshire does it, where, the $40 billion went to Apple, some of it goes to buybacks.

Jake: I think more importantly than that, and maybe Alex can talk about this, about how Berkshire has changed over time to sort of evolve with the environment. But this Holdco, where you can redirect capital to wherever is the most promising opportunity and even potentially starve business. I mean, the three businesses that started the whole thing diversified retailing, blue chips. And then-

Tobias: Berkshire’s fine spinning.

Jake: -Yeah, Berkshire’s coats, basically.

Tobias: Coat lining, all died. So, I mean, take it from there, Alex. How’s this all fit together with different business models?

Alex: Again, like I said to the part earlier, I think this is a big part of how Warren thinks about everything. And I have a decent chunk in the book on manager compensation at Berkshire, which you get some detail on in terms of how they think about particularly, well, good business, bad business, the comp structure is adjusted for that. We’re trying to basically single out managerial quality and we can do that in some rough way that makes sense.

And then there’s some base comp that’s presumably tied to something like earnings or some measure that’s directly controlled by the person running the business. But then the kicker on top of all that is the capital charges basically in terms of, if you want to retain capital or even ask for incremental capital from Holdco, that’s fine. There’s a charge against that numbers surely, change to some extent over time, but there’s a very clear charge in terms of how that investment is going to show up and it’s going to directly impact your comp.

And to your point, I think that’s kind of a key part of Berkshire, I think it shows up in certain investments they’ve made over time in terms of if we have enough certainty on duration and our ability to get the cash back. It’s something that we’re willing to do, and you contrast that with a lot of companies where the range of investment opportunities are things that can be done even to the extent that they’re really well understood by the CEO or the board or the C-suite collectively, which certainly doesn’t appear to be true in a number of cases based on the actions that they take. But you have to ask is there really an option for some of these businesses? What are the companies that we’re talking? About what is their ability to not play certain games? Now I just told you that I think Microsoft in some ways is choosing not to play certain games, but to not participate at all. It’s just something that a CEO at a normal public company is not going to be able to basically decide to do.

And again, who knows if it’ll be the right choice depending on the specific instance we’re talking about. But there’s just an inherent flexibility to the way that Berkshire allocates capital that has a ton of advantages. I mean, does it have disadvantages as well? I think is a really fair question. And I wonder if some businesses– Even as you think about a capital charge, well, how do you do that for something that may not have the clearest– At the utility, okay, it’s a 10-year investment, but at least we have an understanding of what that looks like. There are some five-year investments that do not have that clarity on what the input and output will be on given dates or points in time.

And I think there’s probably a fair argument to be made that Berkshire may be at times lacks for investment in situations like that. And maybe partly because the manager is looking at their incentive structure and thinking, “Hey, this actually, this may not be the smartest thing for me to do and Berkshire can go reallocate the capital elsewhere.” So, it’s really messy to measure those things because the three businesses you mentioned no longer existing is something that managed to work out okay for Berkshire and certain businesses today stagnating or going away could also be something that works out okay for Berkshire. It could still be the correct decision. It’s harder for that to be the correct decision when you’re the CEO of public company that is doing that and you decide to pay out significant dividends for years before you go bust. So, the incentives are–

Jake: [crosstalk] are not “pure play” anymore.

Alex: Yeah, I mean, Charlie gives the example of one way that things have changed is I think he specifically talks about France, but he talks about like a retailer where if you could buy it as a cigar butt and get control and shut it down and take all the cash out, it could work out as an investment. But that may have been something you could have done decades ago in certain countries. It’s simply not feasible anymore in a lot of places because the government or the stakeholders involved, but it just won’t be allowed to happen effectively.

Jake: He said it’s not your working capital.

Alex: Right exactly.

Jake: Even if you own the business.

Alex: Right. So, if you’re running GameStop or whatever it may be, shutting it down is not going to happen. Someone’s going to try to figure out a way to make it go. I mean, it might shut down because it goes bankrupt, but shutting it down as a investment strategy is most likely not going to happen. So, you got to be realistic about how these things are going to work in today’s world as opposed to something a couple decades ago.

Tobias: JT, 11:04. You want to– We’re five minutes past the hour.

You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:

Apple Podcasts