Conflicted Interests
By Brad Thomason, CPA
July 2, 2015
According to a recent survey published by Fortune magazine, 84% of big company executives say that their company would be easier to manage if it wasn’t public. To point out the obvious, that’s not a small majority. The ceremony associated with earnings guidance, analyst calls and the short-term focus that they imply, can take up a lot of time that managers could otherwise spend on actually doing whatever the company does to make money.
One of the companies which likely doesn’t mind is Berkshire Hathaway. Warren Buffett is noted as being a public company guy who doesn’t act like one. He simply doesn’t do any of those “expected” things…and because he’s Warren Buffett he gets away with it. Other execs are not so lucky.
If being public is a pain for the managers, you might wonder why we still have so many public companies. The answer is simple, and not new. There has always been a singular draw for going public that in the end, very few things trump: money.
When a business owner gets ready to sell a stake there are two options: private sale or public. Despite the fact that there are all sorts of complicated and nuanced equations that are technically part of the small company valuation process, in practice (much to the chagrin of valuation theorists) you can usually guesstimate the private sale price at about 4 or 5 times earnings for a strong company in an unpressured transaction.
Public stocks on the other hand routinely carry price/earnings multiples either side of 15.
So when an owner has a chance to sell to either market, it’s not a mystery why the public route would be more appealing. If you were selling something and one buyer wanted to give you 3 or 4 times as much as the other guy, who would you sell to?
Owners sell to the public markets, despite knowing it’s going to make life hard on their managers. In large part this could be attributed to the fact that such problems are not going to be their problems, but the new owners’ (i.e. the investors who buy the shares). Owner 1, owner(s) 2, and the managers are all impacted differently by these decisions about going and being public, so each may view the matter very differently. But the conflicts of interest don’t end there.
Buffett’s pal Charlie Munger has pointed out that the practice of spinning a company out of a public stock to become its own new stock is the very thing the Berkshire would never do, because those top performers are one of the key drivers of the parent company’s long term growth. Present stock holders who demand the spin out so that they can “unlock the value” of the unit are in essence, according to Munger’s premise, working against their own best interest by limiting the appreciation profile of their investment in the original stock. In Munger’s view, this is another manifestation of short-term (short-sighted…) thinking.
Short-term focus leads to things like activist investors demanding billions in cash from GM just a few short years after its exit from bankruptcy. Paypal will again be a stand-alone company pretty soon once it’s spun back out of EBay; an action that might make some investors happy this year, but at what cost when in years to come the parent isn’t getting the benefit of the subsidiary? Berkshire’s parent company (a textile mill) quit operating decades ago; it is a 100% accumulation of subsidiary company value. Which is not to say that all a company has to do to become the next Berkshire is just hold on to its winners. But it does point out the lasting effect that holding (or not holding) a sub can have.
None of these dynamics are new. Nor are they news to staunch followers of the market. They don’t jeopardize the running of the market. But it never hurts to lift up the hood now and again and look at the forces bearing on the things you invest your money in. Just as there are a lot of ways to be an investor in stocks, there are lots of different camps who have their own agenda for what they’d like to see happen. Knowing who they are and what they want can put you in a better position to make decisions about how you need to manage the details of your own set of interests.