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Ethics

Quaker Capitalism

By December 11, 2014No Comments

Carl FerenbachI was recently invited to offer observations on the evolving role of “values” and incentives in businesses, particularly from the perspective of a so-called “financial buyer.”  The convening was organized in London by the Center for Enterprise, Markets and Ethics and was titled “Quaker Capitalism.”

I graduated from university a bit over 50 years ago, and after a brief tour in the armed forces, several years at a commercial bank and business school, I ended up on Wall Street.  I came to advise corporations on merger and acquisition transactions, working for one of what were then a number of small, high quality investment banks.

It was the ‘70s, and not a good time for economic growth or for the capital markets.  But behind that public backdrop (Business Week declared “Stocks are dead!” in the late ‘70s) a lot of interesting developments were occurring: the first leveraged acquisitions by small buyout funds created for the purpose; a rethinking of the role of public markets for common stocks; a recognition by certain institutional investors that direct investment into private companies or funds created for that purpose could produce better returns than a portfolio of listed companies.  The regulatory framework in place at the time had emerged during the Great Depression following the crash of 1929 and its evolution had taken place largely in the courts and not through additional legislation.  A great deal of what was transacted was based upon trust backed by a common understanding of the importance of values such as honesty, ethical behavior, collaboration and cooperation, and truthfulness.  All of these values, which could be associated with the Quakers in Britain and Colonial Pennsylvania, were essential as these firms bet what capital they had in the markets for underwriting securities every day.

In 1978 the firm for which I worked was acquired by Merrill Lynch.  The capabilities in corporate finance were what they wanted, and while new opportunities opened with the additional resources commanded by Merrill, the ability to execute them was still based on shared values.  As we moved into a new decade, it began to be understood in the capital markets that private acquisitions by funds created for the purpose had some meaningful advantages.  During the ‘60s and ‘70s, western capitalism had evolved conglomerate structures that resulted in large corporations diversified into various unrelated industries.  You may recall the acquisitions of Sir James Goldsmith, or of Jimmy Ling of LTV and Harold Geneen of ITT.  They worked as investments as long as the acquisition game could continue to be played.  But it turned out that the entity at the center of the activity, the conglomerate and its management, didn’t have the skills to make so many disparate companies work effectively under one corporate umbrella.  Capital was used inefficiently and in the ‘80s it began to become apparent that these structures weren’t working.

The private leveraged buyout funds, today referred to as private equity funds, stepped in to fulfill the need for a fresh approach to corporate ownership and brought important new advantages.  They aligned the interests of managers and investors.  They used capital efficiently and they focused only on that at which they were good.  Interests were aligned through ownership structures.  Institutional investors owned an interest in each business through investment in the private equity funds; the partners in the fund manager were also investors and they owned an interest in each company as well; and the managers of each company, unlike in the conglomerate structure, owned an interest in their business.  Finally, the board all were owners.  Everyone was focused on achieving the same outcome.

The capital structure of each acquired company consisted of a significant amount of debt in addition to the equity purchased by the investment fund, management and other owners.  This ensured a focus on the part of management on the use of excess funds to retire the debt, while also avoiding the temptation to invest excess funds outside the core business they understood, a key failing of the conglomerates.

Into this rapidly evolving world came a new firm, one of a growing number, organized by five of us and called Berkshire Partners.  Over the ensuing thirty years, Berkshire Partners was to acquire over 125 businesses, raise $12 billion of capital for investment and to earn for any investor that invested in every fund an annual return of 27%.

Thus emerged from many corners the thesis that businesses could be most successful when proper incentives were in place, when those incentives were aligned through ownership at each level of control.  Researchers like Mike Jensen at HBS concluded that the incentives combined with the debt disincentive to spend (Jensen called it the control effect of debt) resulted in focused and successful management.

As in the earlier period, there were not many rules governing this business evolution leaving the marketplace to also rely upon values of trust, honesty, ethics, and collaboration.  At Berkshire, in fact, we decided we should write our values down, govern ourselves by them, and include them in our communications with corporate managers, bankers and investment bankers, employees, even customers and suppliers of portfolio companies.  Today’s version (below) differs little from the original of 25 years ago.

Thus we came to believe that values and incentives could coexist well in a business environment and that it was important for them to do so.  But as more private equity firms came into being, and as they succeeded, others, mainly listed companies, adopted new incentive plans.  For managers of those companies this meant share options, bonuses, benefits, golden parachutes and the like; but not the common risk shared with the owners of having their own capital on the line in the company, and generally without the credit risk of an efficient capital structure; and without a board consisting of owners or share owning non-execs.

With time these incentives became the norm, were incorporated into other organizations such as banking houses, which then felt incented by them to grow through merger and the creation of new, riskier trading vehicles.  But the values and the alignment didn’t come along for the ride.  The outcome of this evolution, as we came into the new century, was more speculation, risk taken without sufficient pain of loss, massive financial leverage and, eventually, a large downward realignment in financial markets (in 2009) requiring government intervention with financial support and even takeover, particularly of the banks.  With this government support has come rules, regulation, and law resulting in far more oversight by outside parties, mostly in governments.  Because of the need for government finance, laws, rules, and regulations have come to replace values and incentives.  With their arrival has come a new person now common to all kinds of organizations:  the compliance officer (Barclays, Goldman Sachs, JPMorgan, universities all have hundreds, even thousands of people working on compliance).

The academic work to establish what this last evolution in the business and financial markets has produced has yet to be done. Will it, on the one hand, demonstrate much improved outcomes with little of the former abuse; or has it created much increased costs, lower growth, higher unemployment, less individual initiative in business markets, and less risk-taking. We can assume, but as yet we don’t know.  If we wish to return to marketplaces exemplified by Quaker values, where those values guided behavior and balanced human excess while leaving ample room for success, we shall have to find our way beyond the maze of rules, laws and regulators we have created for ourselves today. This will not happen easily, and the only means I see to their elimination is through their failure.  But how that might look and occur is for another time.

 

Berkshire Partners LLC

We seek to act in a manner consistent with our core values:

Honesty, fairness and the highest ethical standards.

Analytic rigor, open debate and logic-based judgments in our investment process.

Enduring relationships with our investors, management team partners, outside capital sources and service providers.

Teamwork, inclusiveness and consensus decision-making.

Longevity and continuity of our team, attracting and developing talented individuals who contribute to the firm’s performance and culture.

Professional development of our staff and balance in their lives through commitments to family, community service and other outside interests.

 

-Carl Ferenbach, Chair, High Meadows Institute