Margin of Trust: The Berkshire Business Model
Moving toward Charlie Munger's "seamless web of deserved trust"
“Buffett trusts me so much with Berkshire’s money that I am even more careful in handling Berkshire capital than in handling my own.”
— Bruce Whitman, former CEO of FlightSafety International
Trust takes a long period of time to fully develop but can be destroyed in an instant.
This asymmetry is inherent in a world where trust continues to be the foundation of all human societies. The stakes could not be higher and, as a result, a sense of wariness is built into our evolutionary instincts.
Misplaced trust is extremely costly, but the flip side is that attempting to live your life in a culture of constant skepticism regarding the intentions of others is both exhausting and likely to lead to many missed opportunities. Finding the right balance is imperative in both personal and business relationships. In order to strike that balance in a business context, it makes sense to closely examine the successful trust-based culture of Warren Buffett’s Berkshire Hathaway.
Few writers are more familiar with Berkshire Hathaway than Lawrence A. Cunningham whose unique perspective was shaped by a 1996 symposium he organized in which Warren Buffett and Charlie Munger discussed Berkshire’s business and culture at great length. Shortly thereafter, Cunningham released his first compilation of Berkshire shareholder letters organized by topic and, more recently, he published a book specifically regarding Berkshire’s management succession plans.
In Margin of Trust, Cunningham and Stephanie Cuba take an in-depth look at the unique management philosophy that has made Berkshire so successful over the years and continues to allow an enormous conglomerate to operate without the type of command-and-control bureaucracies that exist at almost all large firms, and especially at large conglomerates. By demystifying how Berkshire ticks, Cunningham and Cuba uncover generic concepts that could help other organizations improve their culture.
Charlie Munger often speaks about how a “seamless web of deserved trust” represents the highest form a civilization can reach.
Why is this? Quite simply, when you have a culture in which the key participants can be trusted implicitly to do the right thing and act in the interests of the organization, you do not need to put in place the endless systems of controls that would be required in a culture where no one trusts each other. In other words, a company can run much more efficiently when trust is presumed to exist. The flip side is that in such a culture, a rogue individual can do a great deal of harm until he or she is finally detected. Clearly, some balance is required to harness the benefits of trust while protecting an organization from severe harm if that trust proves to be misplaced.
The culture of Berkshire Hathaway is one of extreme decentralization and autonomy, with power over operational matters delegated from the holding company run by Buffett to subsidiary CEOs. Until recently, nearly all subsidiary managers reported directly to Buffett who maintained compensation arrangements with the subsidiary CEOs personally. Recently, Buffett has put in place two Vice Chairmen, Ajit Jain and Greg Abel, to oversee all insurance and non-insurance subsidiaries, respectively. However, Berkshire remains extremely decentralized with no corporate-wide central functions and a bare-bones headquarters staff of about two dozen employees.
Trust is an extremely effective motivator, as we can see from Bruce Whitman’s quote leading this article. When one is given a great deal of trust, the level of perceived responsibility increases commensurately. It is often thought that personal loyalty to Buffett drives subsidiary CEOs to not want to disappoint him, but it is also the fact that they have been given remarkable power and trust and they seek to reciprocate by providing excellent results.
The Pillars of Berkshire Hathaway
Cunningham and Cuba set out to dissect Berkshire’s structure and what makes the company tick by examining the individuals presently involved in managing the company, the partnership mindset that permeates everything that managers do, and the specific methods used to achieve outstanding results.
At present, the key players are Buffett, Munger, Abel, and Jain, individuals who have been with Berkshire for decades. The board is structured not to oversee management but to provide an advisory role and nearly all board members have significant skin in the game in the form of stock that they purchased on the open market. Berkshire’s shareholders are an unusually stable and knowledgeable group, as evidenced by the tens of thousands who attend annual meetings. Berkshire shareholders are so devoted to the company that Munger often jokingly refers to them as “cult members“.
The partnership structure, which is not empty happy talk as is the case at many companies, completely permeates how Buffett has run the firm for decades. Cunningham and Cuba note that Buffett’s partnership model goes well beyond the legal definition of an equity owner in that he actually views shareholders as owners of the underlying business rather than merely the claimants on the residual after liabilities are subtracted from assets.
This might seem like a distinction without a difference, but it represents a mindset. The fact that many of Buffett’s partners have an unusually large stake in Berkshire as a percentage of their net worth clearly has influenced Buffett’s willingness to take on leverage and driven his preference for leverage in the form of insurance float and deferred taxes rather than explicit debt on the balance sheet. Much of the debt on Berkshire’s balance sheet is attributable to the railroad and energy subsidiaries and, importantly, are non-recourse to Berkshire itself.
Berkshire has grown through acquisitions over the years, necessitated by Buffett’s policy of retaining all earnings. Buffett is famous for making pledges to leave the firms that he is acquiring alone in terms of operational decisions and only requiring a subsidiary CEO to consult with him on matters of capital allocation and management succession. Additionally, Buffett pledges to the selling shareholders that Berkshire will be a permanent home for their business, and he has followed through on this commitment even in cases where the acquisition failed to live up to its promise. All of this builds the culture of trust which is vital when a family is selling a long held business and cares about what will happen to its customers and employees.
Compliance
In recent years, high profile scandals at individual companies as well as the effects of corporate mismanagement on the entire economy have led policymakers to put in place laws and regulations, such as the Sarbanes-Oxley and Dodd-Frank Acts, designed to improve corporate governance. These rule-based regulations seek to define, in much detail, exactly how companies must comply from a corporate governance perspective. As Cunningham and Cuba note, this trend is exactly the opposite of the approach taken at Berkshire Hathaway.
One key change is that regulators want corporate boards to take on the role of monitoring company management to a much greater degree than in the past. In order to accomplish this, standards have been set defining board member “independence”, among other things. In Warren Buffett’s view, a qualified board member must have business savvy and a substantial personal investment in Berkshire Hathaway. However, it is possible for such a board member to be deemed “not independent” by regulators if there are certain personal or business relationships involved.
It is easy to be cynical regarding Buffett’s intentions here because clearly he does not want Berkshire’s board to oversee his activities. Instead, he seeks an advisory board comprised of intelligent and engaged members who have skin in the game via Berkshire ownership and he trusts that that incentive is enough to ensure effectiveness. If not for the permeation of trust throughout Berkshire, cynicism might be warranted but, taken it its totality, Berkshire’s culture and board structure is congruent and has proven effective.
The Risk of Rogue Actors
Any organization that runs on the concept of a “seamless web of deserved trust” will inevitably be vulnerable to a rogue actor who is able, temporarily, to deceive the organization and proceeds to take actions that are not consistent with the culture. Buffett and Munger are not naive when it comes to this risk but consider it a risk worth taking given the many benefits that their culture provides.
Cunningham and Cuba go into some detail regarding the sad case of David Sokol who resigned from Berkshire in March 2011 amid controversy over the Lubrizol acquisition. Sokol took an ownership interest in Lubrizol prior to suggesting that Berkshire acquire the company and made contradictory statements subsequent to his resignation that caused shareholders to voice concern regarding management controls.
The authors suggest that Sokol’s violations of company policy were relatively minor compared to the outcome, wherein Sokol lost his job and the potential opportunity to succeed Buffett as Berkshire’s CEO. However, disproportionate reactions to violations of Berkshire’s culture may be a form of immunization against future attacks on the culture. Sokol was cleared of legal wrongdoing by the Securities and Exchange Commission but Buffett’s standards were higher than merely what was required by law. By eventually speaking out forcefully against Sokol’s actions, Buffett sent a very clear message to other managers at the company.
Time Will Tell
As of early 2020, Warren Buffett is 89 years old and Charlie Munger recently turned 96. Both men have had remarkable runs and their careers are not yet over as they have stated their intention to continue to be involved at Berkshire for the remainder of their lives or until they can no longer serve. Anyone who has attended an annual meeting will note that these men are able to answer questions for five hours in a format that would exhaust most executives half their age.
The last chapter has yet to be written.
But what will eventually happen when Buffett and Munger are no longer on the scene? Will Berkshire’s unique culture of trust continue or will it be attacked by outsiders who seek short term gain or wish to exploit the trusting culture for their personal benefit?
The truth is that we do not know for certain. It seems very likely that the culture of trust will prevail for at least a decade after Buffett and Munger depart the scene because the executives they have designated to succeed them are equally immersed and committed to the culture. Ajit Jain and Greg Abel will be responsible for maintaining this culture and passing it on to a new generation of managers who will one day succeed them. They both have very significant personal stakes in Berkshire Hathaway and can be said to have “skin in the game” in addition to the trust of Buffett and Munger. The management succession that is most worrisome is not from Buffett to Abel and Jain, but from Abel and Jain to whoever takes over after them.
It is likely that we are fifteen to twenty years away from the point where Abel and Jain turn the reins over to new managers. Obviously, who their successors will be is unknown at this point. The 2040s rather than the 2020s may be the decade when we discover whether Berkshire’s Margin of Trust will prevail or fall under attack.
Disclosures: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway. The Rational Walk LLC received a review copy of Margin of Trust from Columbia Business School Publishing.