Engineering a Conglomerate

Plus! Pretty Bad Privacy; Exercising the Whistleblower Option; Who Owns Streamed Games; Rebooting Transit; Rationalists and Thymos; More...

Byrne Hobart Byrne Hobart

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Engineering a Conglomerate

Conglomerates are a strange category. At one level, a conglomerate is  the industry classification equivalent of “Misc.”—a company whose  subsidiaries seem to have nothing in common. But every institution is  the product of constraints it faces. A conglomerate is some combination  of a) good at raising money, b) bad at returning money to shareholders,  and c) good at the disciplines of acquiring and managing companies,  independent of what those companies do.

“Management” doesn’t seem like it could be a real skill. Or, at  least, it seems like it could be a skill that someone might be terrible  at, but not one they could be sufficiently good at to offset a lack of  domain expertise. Can someone who knows a lot about fracking also  operate a company that sells dental hygiene equipment, insurance,  semiconductors, and steel?

This, as it turns out, is not a rhetorical question. The answer is:  yes, when Henry Singleton ran Teledyne it was involved in all of the  above. Singleton was unusually smart (he was on the MIT Putnam team with  Richard Feynman). So, Singleton was an exceptional case. But there are  other conglomerates that have put together enviable track records:  Danaher, for example, owns an assortment of specialty manufacturers,  diagnostics, and life sciences companies. And Berkshire Hathaway has  holdings in insurance, railroads, energy, manufacturing, and a long tail  of smaller holdings and minority stakes.

But most conglomerates are not so successful. In fact, Google’s  search suggestions—the absolute arbiter of the G- and PG-rated word  association zeitgeist—says “conglomerate discount” is one of the most  common searches. Historically, diversified companies have gone through  boom and bust cycles, and for financial-theory reasons they often  deserve a discount: investors don’t need to invest in diversified  companies, because they can get diversification themselves. If  management skill is constant, a diversified portfolio is a better  deal, because one bum investment can only go down 100%, while an  underperforming subsidiary can cost multiples of its original value.

Conglomerates came about in the 1960s, as a creation of three factors:

  1. Strict antitrust enforcement made it hard for companies to merge with competitors, suppliers, and customers.
  2. Flexible accounting rules around mergers made it possible for  conglomerates to report deceptively high growth rates, which gave them  access to capital, which they could use to fund more growth, and
  3. Business as an academic study got more respectable; it looked like there really was such a thing as general management skill.

These businesses were in vogue in the 60s, mostly fell apart in the  70s, and have periodically come back since then, usually at more modest  scale.

There are conglomerate horror stories. GE under Jack Welch was covered by several books, with titles like Straight from the Gut or Jack Welch and the GE Way, but the company’s subsequent performance led to Lights Out, which details how GE went from being the most valuable public company to being booted from the Dow.

For a long time, GE looked like a validation of the model where  conglomerates apply superior management skills to a variety of  industries, and always come out on top. From power equipment to jet  engines to appliances, GE’s superstar managers always hit their numbers.  But an increasing share of GE’s growth in the 80s and 90s came from its  financial services arm, and financial services are a good place to hide  bad numbers. GE’s financial services group encouraged a sort of Dorian  Gray accounting; in any given quarter, it could delay recognizing some  bad debt (or use its financial firepower to lend to customers, improving  performance in another part of the business). But those problems  accumulated until they were unavoidable; in 2008, GE had to recognize a couple decades worth of slightly bad quarters all at once.

GE isn’t the only case study in this. Earlier conglomerates played  fast and loose with their numbers, too. The first wave of conglomerates  in the 60s included National Student Marketing (which hit its earnings  target by forging backdated contracts) and Leasco (which competed with  IBM in the computer leasing business by buying computers from IBM and  depreciating them more slowly).

These conglomerates seem to be pure accounting fiction. They’re  diversified because it’s easier to run a shell game with more shells.

But other conglomerates have done better.

Can the best elements of the conglomerate model be copied? Berkshire  Hathaway may be the most-studied company in history. And many companies  try to copy it; there are two publicly-traded Berkshire cover bands  (Biglari Holdings and Boston-Omaha). Duplicating Berkshire is  straightforward:

  1. Be born right after a market crash so catastrophic that nobody gets into the equities business for two decades afterwards.
  2. Take advantage of extreme mispricings—stocks trading below net cash,  companies trading at 1x earnings, companies priced at a fifth of the  value of their real estate—to quickly build a fortune and a reputation.
  3. Get a captive pool of capital by buying insurance companies when  they’re cheap. Use this cheap capital to a) make money from capital  appreciation, and b) bail out distressed companies who will pay up to be  associated with your brand name.

Easy!

Part of the point of the Berkshire model has been that nobody truly competes with Berkshire. When a company is a week away from bankruptcy  and needs to sell preferred stock to stay alive, that company is either  selling to Berkshire or selling to its second choice, and Berkshire sets  the terms of the deal accordingly. The elegance of the company’s model  is that working with them is such a powerful signal: Berkshire is the  buyer of first resort for one set of high-quality, non-distressed  companies, and the buyer of last resort for distressed companies  experiencing a run on the bank. This model only works if Berkshire’s  underlying returns are good, and if it keeps lots of cash on hand. But the factors that make those returns  exceptional over longer periods are impossible to copy, and most companies can’t justify keeping so much cash on hand without their shareholders revolting.

If conglomerates have a competitive advantage at buying cheap assets,  that’s less of a benefit than it looks like. Suppose a conglomerate can  reliably identify companies that are priced at 80% of their fair value.  That’s great, but if those companies are public, buying them means  paying a merger premium that wipes out the price advantage. And even if  they can be bought at a discount, it’s expensive to buy and  sell companies. If it takes a decade for the company’s value to be  recognized, that 80% discount translates into about 2.3% excess return  each year. Nothing to sneeze at, but not the results out of which  fortunes are made.

And the buy-cheap model has another limit. There are many, many  misvalued private companies with a private market value of $10m or  so. There are fewer at $100m, fewer still at $1bn. And it’s  extraordinarily hard to find a public company worth $10bn or more that’s  trading at a wide discount to private market value, unless that  discount is explained by management problems, or the “discount”  represents a difference of opinion about the firm’s prospects. A  conglomerate can’t grow on underpriced acquisitions alone, before it  becomes a victim of its own success.

There is a conglomerate model that has some explanatory power:  conglomerates can win if they have a regulatory advantage. There are  large, diversified companies with solid long-term growth records outside  of the US. I’ve written about Samsung and Reliance  before. Both companies function well in many industries because they  have the ear of the government, and in some sectors the only way to do  business in the country is to do business with them. That factor  explains part of the success of one of the largest of the first-generation conglomerates, ITT. ITT was involved in basically every business—Avis,  Wonderbread, Hartford Insurance, Sheraton Hotels. They were also  involved in a fairly aggressive form of politics, offering large under-the-table donations to Richard Nixon and allegedly helping Pinochet’s coup in Chile.[1]

Conglomerates are relevant today because some big tech companies look  suspiciously similar to conglomerates, and for antitrust purposes would  like to look like them. But they’re organic conglomerates: Google didn’t buy its way into self-driving cars, fiber, and immortality research. It built  that. Most of its acquisitions have been more related to the core  business. These side businesses might be related to another part of the  big tech model. After a certain point, every major tech company needs to  have a comparative advantage at overhiring talent, just in case it  needs to deploy a thousand engineers to some pressing new problem. So  they’re generally overstaffed, and need to give their people something  to do. They also keep large capital buffers, also for emergencies, but  sometimes that excess cash burns a hole in their pockets. Large tech  companies conglomeratize mostly by accident, as a result of being  entirely too successful at their core business. To the extent that this  pattern shares anything with the original conglomerate pattern, it’s  that their diversification is driven by antitrust: even if aggressive  growth in the core market is the right business decision, it’s not worth  the legal risk.

At various times, in various parts of the economy, it starts to look  like the entire world will be owned by half a dozen faceless, soulless  companies. So far, that hasn’t happened yet. There are a handful of  successful conglomerates, but they all tend to be the work of one  person; ironically, a model that was originally justified by the idea  that management was a science floundered because the best examples all  required management by a particular auteur. Corporate growth is  mildly terrifying because corporations are, in principle, immortal, and  any immortal entity that compounds its size faster than GDP will  eventually swallow the entire economy. But the ones whose growth isn’t  bounded by industry happen to be very mortal indeed. When their creator  leaves, the growth stops, or it turns out not to have been real in the  first place.

[1] It’s unclear exactly how culpable ITT as a whole was, as opposed  to aggressive lobbyists and local managers working on their behalf. As  one piece of circumstantial evidence, I own a fairly positive biography  of Harold Geneen, who created ITT. The author of that book wrote one  other biography, also fairly positive, about Al Capone.

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Elsewhere

Pretty Bad Privacy

Motherboard has a lengthy piece about Phantom Secure, a company that sold encrypted phones used by criminals.  Encryption is a fraught topic; at one level, it’s just math, and at  another level, it’s a way for some of the worst people in the world to  do their worst. The line between helping political dissidents and  privacy nerds versus helping drug lords and terrorists is a blurry one  when the tools are available to anyone. But the cryptography world  teaches the same lessons the cryptocurrency world does: the onramp from  public to private can be monitored, and if you control the onramp you’re  liable for what your signage says. Phantom marketed itself to  “executives” who valued discretion, but the founder ultimately admitted  to undercover law enforcement that it was a pretty good product for  narcotics smugglers.

There are two parallel privacy debates right now: the one about how  the average person is losing their privacy over time, as more and more  companies mine their data to sell them things. And then there’s the  problem that some people have too much privacy, whether for pseudonymous  speech or for drug smuggling. Ironically, one of these problems is  solving the other. Phantom started losing popularity because it was a  Blackberry-based service, and Blackberries fell out of fashion. Google’s  relentless efforts to sell new Android phones (in order to sell more  Google ads) made the drug lord’s phone of choice look tacky and  unfashionable. There are, of course, Android apps that provide secure  privacy (at least as far as we know; presumably, some law enforcement  agencies have at least considered whether or not offering a subtly  broken encrypted messaging app is a good idea). But switching from one  platform to another leads to data leakage, and these users need their  systems to be airtight.

Exercising the Whistleblower Option

Usually, option exercises are reported on SEC.gov with a Form 4, but  sometimes there’s a press release. In this case: a whistleblower collected $114m for reporting a financial crime, beating the $50m record set earlier this year. As I’ve written before, whistleblower rewards have perverse incentives:

The money from fraud is a carry trade: a share of some positive returns, with an unknown risk of catastrophic blowups.

The whistleblower program is a somewhat exotic option, that  simultaneously a) closes the carry trade, and b) delivers a one-time  payout as a share of the SEC’s fine, which is a function of how big the cumulative fraud has been.

Who Owns Streamed Games?

A twitter thread points out that the rapidly-growing game streaming  business relies on some uncertain legal foundations. Posting a stream of  a TV show or a song without a license isn’t legal by default, and games  might fall in the same category:

Arguably, game streamers are closer to cover artists than to music pirates. They’re not streaming the game, they’re streaming their interaction  with the game. Nobody thinks they can split a streamer’s audience just  by playing the same game. But as eSports and streaming get better-monetized, game  companies may choose to start controlling their IP more strictly.  Monetization doesn’t just mean more money for them to go after. It means  more ads interfering with the stream. Since the stream is essentially a  free ad for the game, they don’t want it cluttered with ads for  something else.

Rebooting Transit

Aaron Renn points out  that many cities' public transit systems are struggling now, or will  face problems in the future, due to Covid. Functioning public  transportation is an important part of a dense city’s network effect,  because it’s a subsidy for the most economically marginal inhabitants.  If cities are going to survive, it’s because risk-seeking people will  move in now that the stodgier tax base has moved out, and they’ll make  cities interesting enough to be lucratively re-gentrified in a few  years. But that’s not going to happen to New York if it ends being a  city where everyone who lives there needs to own a car.

Palantir

The New York Times ran a lengthy profile of Palantir yesterday, perhaps most notable because it finally  has a definitive explanation for why the company’s name is not a sloppy  literary allusion, not a winking one, but actually an important point  about the nature of good and evil according to Tolkein:

The Tolkien point I always make is that at the end of the  day, it was actually a good device that was critical to the plot of the  whole story. The way it worked was that Aragorn looked into the  Palantir, and he showed Sauron the sword with which the One Ring had  been cut off Sauron’s fingers at the end of the Second Age. This  convinced Sauron that Aragorn had the One Ring and caused Sauron to  launch a premature attack that emptied out Mordor and enabled the  hobbits to sneak in to destroy the One Ring… The plot action was driven  by the Palantir being used for good, not for evil. This reflected  Tolkien’s cosmology that something that was made by the good elves would  ultimately be used for good.

This is not exactly the sort of thing that will change Palantir’s  critics' minds about deportation and the privacy/civil liberties  balance, nor is it going to find its way into Palantir’s other  critics' discounted cash flow models. But it’s a revealing point: for at  least one critique of the firm, there’s a sophisticated counterargument  that’s far less obvious than the surface-level complaint.

Tech Sees Like a State

Two examples of an ongoing Diff theme:

Rationalists and Thymos

Applied Divinity Studies asks why adherents to the rationalist online subculture aren’t more successful. It’s a good question: rationalists try to identify and improve on their biases (the group first gelled on Overcoming Bias before moving to LessWrong—avoiding  mistaken beliefs is their whole theme). Rationalists tend to be  well-educated, and they’re overrepresented in the high-earning field of  software. And yet, they don’t seem overwhelmingly successful. ADS has a theory:

Rather than general dishonesty, my theory is that  founders neglect one kind of reasoning very specifically. The same kind  most rationalists are obsessed with: taking the outside view.

…

Here’s a more concrete example: A rationalist has a good startup  idea, so they set out to calculate expected value. YC’s acceptance rate  is something like 1%, and even within YC companies, only 1% of them will  ever be worth $1 billion. So your odds of actually having an exit of  that magnitude are 10,000 to 1, and then you’re diluted down to 10%  ownership and taxed at around 50%. Of course, there are exits under and  above a billion, but back-of-the-napkin, you’re looking at an expected  $5,000 for 10+ years of work so grueling that even successful founders  describe it as “eating glass and staring at the abyss.”

This may be true. Rationalists are unusually likely to respond to  Fermi Estimates by agreeing that, for example, the impact of runaway AI  or nuclear war suggests that we should spend more time solving  existential risks, or that the high payoff from living forever offsets  the low probability that cryogenics will work. But they may have run the  numbers on founding companies and decided that it’s a poor risk-reward  tradeoff, and that they’re better off working for big tech. In that  case, rationalists may be very successful on a Sharpe ratio basis, but  under-levered.

There’s a collective action problem here. Many of the most successful  companies are somewhat ideological, which gives them a monopoly on  recruiting particular kinds of employees, and keeps the organization  motivated even when things are difficult. Odd shared beliefs are a  source of thymos. For any one person, starting such a company might be suboptimal, but for the group, the existence  of a rationalist-dominated startup would be a net gain. So the outside  view strikes again: rationalists are always in the habit of asking “why  would I be special?” but if nobody asks that question, nothing special gets started.

(Another possibility is that there are a number of highly successful,  rationalist-sympathetic people, but they’re discreet about their  adherence to rationalism. This could be a prudent choice not to draw  undue attention, or it could be because rationalists are much more  introverted than average, and simply haven’t gotten around to telling  people about their  views.)

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