Wednesday, March 30, 2011

Buffett’s Secret Deal Recipe

Dealpolitik: Exposing Warren Buffett’s Secret Deal Recipe

By Ronald Barusch

If KKR or TPG had called Lubrizol with a “Let’s Make a Deal” phone call, the board would have immediately formed an independent committee and hired independent financial advisors before pursuing it. If one of Lubrizol’s competitors had made the same call, it would likely have received a very strong message that the company is not for sale and they should go away. We used to characterize that kind of a message as “[expletive deleted] you; stronger message to follow.”

But when Berkshire called, according to the background section of Lubrizol’s preliminary proxy statement, everyone seemed to slobber all over himself to play the game the Berkshire way. No independent committee was created. The board even hired as a financial advisor the banker who brought Lubrizol to Berkshire’s attention. And a strange courtship began. How come? We will come back to that question in a moment.

First, let’s look at how strange this dance seems to be. If a rich guy called you saying he wanted to buy your house, what would be the first thing you would ask? I would ask “how much?” Well, apparently that kind of common sense doesn’t apply when Berkshire comes knocking at your door. Between December 17, when Lubrizol’s CEO first learned of Berkshire’s interest, and February 8, when the CEO met with Warren Buffett himself, no one asked Berkshire the simple question “how much?”

During that period, there were four formal and informal board meetings. During at least two of those meetings the board “engaged in an extensive and thorough discussion about Berkshire Hathaway’s possible interest.” No one seems to have wanted to ask Berkshire the big question. The board even asked management and its financial advisors to assess “the value that might be achieved through negotiations with Berkshire Hathaway.” But Berkshire was not asked the “how much?” question until the CEO met with Buffett on February 8.

There is little question that Berkshire received more favored treatment that another bidder would have. To some extent, that is understandable. Berkshire has an impressive balance sheet. But the favoritism toward Berkshire seems much deeper rooted than that. In the preliminary proxy statement it is signaled in code words that describe a meeting in mid-January between the CEO and David Sokol of Berkshire. The two of them “generally discussed the corporate cultures and philosophies” of both companies.

And in a meeting 10 days later when Sokol provided reassurance by saying Berkshire “would want Mr. Hambrick to continue to run the business.” The preliminary proxy repeatedly assures us that no employment terms were discussed. But of course they did not need to be. The Berkshire “culture” of retaining and rewarding existing management is well known and was obviously affirmed.

And, of course management does not have to completely rely on history and the soothing words of Berkshire executives. They have generous golden parachutes that will compensate executives with an aggregate of $100 million if they leave Lubrizol for “good reason” within three years of the Berkshire deal. That’s on top of the equity-based cash outs they will receive at the closing. More importantly, they know that, because of the “culture,” the bulk of those golden-parachute payments likely will be rolled into new employment agreements to compensate them nicely them for staying.

But of course no one wants to admit that Berkshire received favored status because of the “culture” issue. That is because it leads to this question: how does a deal with Berkshire differ from a leveraged buyout sponsored by a private equity fund?

Leveraged buyouts, which are frequently criticized because of the inherent self-interest of management, require much more procedural protections than the Lubrizol board decided would be appropriate for a Berkshire transaction. They typically involve independent committees, independent advisers, executive sessions and negotiations largely conducted by the committee. It is true that leverage is not a part of the Berkshire transaction and that distinguishes it from an LBO. But that is not why the procedural protections are invoked. The board needs those procedures because management may have a conflicting interest. And that is true whether management has a formal agreement with the private equity firm or not.

In that regard, as a practical matter, the possible conflicts for management are no different in a transaction with Berkshire than they would be in one with KKR. Berkshire and Buffett have just done a better job in perfecting a “brand.”

The Lubrizol board and its advisers seemed to have missed this issue entirely. In what may be a new world record, the proxy statement indicates that the lawyers advised the board at six separate board meetings of its fiduciary duties.

It is amazing that the potential conflict of management was either not identified or ignored. It may well be that the price is adequate and Berkshire may be composed of good people. Nevertheless, the independent directors should have done more to take control of the process.

(Note: the author owns shares of Berkshire Hathaway.)

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