Berkshire Hathaway manages Capital for its Business Units

Every year, Warren Buffett and Charlie Munger include an Owner’s Mannual in their annual report.  It rarely changes from year to year.

Near the bottom of the report, they discuss their philosophy on autonomous business units and on the role of the parent in managing capitalization.  Here is an excerpt:

Most of these managers are happiest when they are left alone to run their businesses, and that is customarily just how we leave them. That puts them in charge of all operating decisions and of dispatching the excess cash they generate to headquarters. By sending it to us, they don’t get diverted by the various enticements that would come their way were they responsible for deploying the cash their businesses throw off.

If this sounds similar to my preachings on stand-alone business units, I’ll clue you into why: I shamelessly steal my ideas from the Oracle of Omaha.

Elsewhere in the Owner’s Manual, Warrant Buffett writes:

Charlie and I mainly attend to capital allocation…  Charlie and I are exposed to a much wider range of possibilities for investing these funds than any of our managers could find in his or her own industry.

Berkshire Hathaway’s ongoing success depends in large part on finding great new acquisitions.  Though I couldn’t find it in my quick review, part of Warren Buffett’s pitch is that the manager, once part of Berkshire Hathaway, need not waste time on raising capital or managing their investor base.  They can focus on running their business.

So there you have it.  Warren Buffett and Charlie Munger don’t mess around with separately capitalized business units.  They leave the responsibility of running the business to the business unit leaders.  Corporate handles raising capital and allocating it among units.

Does this give you a clue where I come out?

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I’ve written a number of posts on how multi-faceted telecom companies should organize themselves as distinct stand-alone business units, with full accountability for their customers, revenue, and costs.   Unless a business unit has a balance sheet and bank account, they likely are not operating as a true P&L.

A few weeks back, the following question was posted:

Is your belief then that each business unit should be capitalized independently of one another? For example, a typical balance sheet for a network company and a managed services company would/could be very different. Yet there are pricing and flexibility benefits from doing larger financings at a holding company level if an entity owns both types of businesses. Should Level 3 Communications capitalize its SBUs differently with debt facilities at each SBU like Time Warner Corp. does?

I promised to address this question in subsequent posts, but have not yet done so. I will starting tomorrow.

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A bearonbusiness reader by the name of Kevin left this question on one of my blog posts:

Is your belief then that each business unit should be capitalized independently of one another? For example, a typical balance sheet for a network company and a managed services company would/could be very different. Yet there are pricing and flexibility benefits to doing larger financings at a holding company level if an entity owns both types of businesses. Should Level 3 Communications capitalize its SBUs differently with debt facilities at each SBU like Time Warner Corp. does?

This is a great question.  To fully answer it, I will need to spend some time over a two or three blog posts.   I will publish these during the week (I hope)….in the meantime, give the question some thought.

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Got Fiber, Business?

This is a continuation of Saturday’s post.  We just explained to a telecom consultant that we don’t have a centralized network organization.   Each of our businesses manage their own network, do their own IT, run their own NOC, etc.  The consultant was advising a private equity firm that is considering a Zayo investment, so he was absolutely correct to probe in this area.  He understood what we were saying, and the logic behind it, but he remained a bit skeptical.

“Let’s say you centralized the right way.  Wouldn’t you gain a profitability lift due to the synergies?”

I answered with a series of questions:

“Would Neutral Tandem be more efficient if it combined its NOC with Cogent’s?”

“Would Akamai be more profitable if it shared its engineering organization with Yipes?

“Would Cbeyond have a higher EBITDA if it’s IT department also attended to Megapath’s requirements?”

“Would Paetec gain synergies if it had the same provisioning system at Fibertech?”

You know my answer to these questions.  No.  Yet I will guarantee you every one of the companies above would lose its competitive edge as a result of pursuing the quest for synergy.

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I was meeting with a telecom consultant a little while back.  They were advising a private equity investor, who in turn is considering an investment in Zayo. 

We hit the part of the discussion in which we discussed Zayo’s organizational approach.  We explained what we meant by three separate business units.  “Down to the balance sheet and individual bank accounts!,” emphasized Ken desGarennes, Zayo’s CFO.

I couldn’t tell whether the consultant was buying into the discussion, or not.  He had a right to be skeptical, as what we were describing was counter to the path that all big telco’s take.  The consultant asked a clarifying question:

“Where’s the Network?”

John Scarano began to answer: “We have a intercity fiber between NY and Chicago; metro network in Memphis and”.   I jumped in, as I was quite certain the question had nothing to do with geography.  The consultant was asking which of our organizations was responsible for the network functions, such as engineering, NOC, and capital spending.  My answer:

“They all are.  That is, they each have responsibility for a certain piece of the network–the piece that is core to their business.  Some of them purchase services from their sibling business units, but only to the extent needed.”

I knew what question was coming next (tomorrow).

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In the prior blog entry, I shared thoughts on why we are dividing Zayo into three discreet businesses. The rest of this entry is a letter I sent to Zayo employees explaining the rationale. Note: this email was sent to employees within 10 days of the Zayo/Onvoy closing.

I know there is a fair amount of confusion of the three business unit structure. In the telecom world, people are simply uncomfortable with having separate businesses. Conventional wisdom is that it is more efficient to have one finance department, one NOC, one marketing organization. It seems nearly every functional person will insist that their group needs to look across the entire company.

Berkshire Hathaway is the most successful public company of all time. It is why Warren Buffett is the world’s 2nd richest man. They own multiple businesses. How many people work in corporate? Answer: a dozen.

“Yes but Berkshire is a holding company. They own businesses of all different types. That is why they are separate,” you might be thinking. “Zayo is different. We are one business.”

My answer: GEICO. B-H Reinsurance. General RE. National Indemnity Primary. U.S. Liability. Medical Protective. Homestate Companies and Cypress. Applied Underwriters. Central States. Kansas Bankers Surety. Lloyds of London.

What do these businesses have in common? One, they are all insurance companies. Two, they are run completely separate from each other, each with their own leader, each with their own accounting system, each with their own bank account, and each with their own IT systems. Three, they are all owned by Berkshire Hathaway.

Neutral Tandem just went public this month. The company, which was formed only a few years ago, provides wholesale voice services. Their revenue is about $70M. Their enterprise value is about $700M. Onvoy Voice has about $35M of revenue. To say I’d be pleased with a $350M valuation would be as understated as saying I’d be pleasantly surprised if, tomorrow morning, when I weigh myself like I do most mornings, the scale says 190 lbs.

Neutral Tandem doesn’t own any fiber; they buy bandwidth. They don’t provide managed services to enterprises; they focus on voice services to carrier customers. They have their own NOC; their own bank account and accounting systems, and their own customers. They have a clear business strategy.

What Neutral Tandem doesn’t have is a parent company that stands in the way of their ability to execute. They also don’t have to stand in line to get IT work done because the needs of other groups are a high priority. They will create value, or not, for their owners based on factors in their control.

Will Onvoy Voice have an advantage over Neutral Tandem because Onvoy gets to share a NOC, share a billing system and share a legal staff? I think not.

Substitute Cbeyond/Zayo Managed Services for Neutral Tandem/Onvoy Voice, the same points hold.

Zayo Bandwidth was the genesis of Zayo Group. Zayo Bandwidth’s path to value creation is to stay narrowly focused on being a bandwidth factory. Their implementation task is hard enough on its own; I do not want them bogged down by needing to coordinate systems, processes and corporate resources with two other business units. Over the past few months, I have seen several pure bandwidth businesses that are doing quite well—Hudson Valley Datanet, Fibertech, and Citynet’s Wholesale Unit in particular stand out. If Zayo Bandwidth does as well as these three, I will be thrilled. (Perhaps not as thrilled as if I saw 190 lbs on my scale, but pretty darn close.)

So there it is. That is why we are separating into three businesses. It is for this reason and no other: I want each of the three businesses to have a true leader, a clear strategy and the autonomy to execute their plan. I want each to be fairly judged on its financial results. I don’t want any of the businesses to be encumbered by being part of the same ownership group.

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Zayo Group is $125M in revenue.  Since its launch in early 2007,  Zayo has acquired five companies.  The first three were  companies that offer high capacity bandwidth over their fiber networks–not surprisingly since “bandwidth factory” was the focus of our investment thesis.  The fourth, Onvoy, also offered bandwidth over its fiber but also focused on two other lines of business–wholesale voice and managed services.  The fifth company, Voicepipe, offered similar services as Onvoy’s managed services.

We are faced with a challenge.  Bandwidth was our original mission–and a key to our investment thesis is to maintain a myopic focus on being a supplier of big bandwidth.  With the addition of lines of business that have very different profiles than bandwidth, how do we stay focused while also exploiting the new opportunities?

In telecom, the knee-jerk organizational structure is to centralize and functionalize.  All engineering and technology reports to CTO.   A vast IT organization develops a systems architecture to meet all needs.  One do-everything provisioning system is conceived.  One NOC “efficiently” oversees the entirety of the network.  A large and silo’ed finance organization tries to make sense of it all.

For telecom companies that have multiple lines of business, the drive to centralize and functionalize is, in my mind, fundamentally what makes everyone’s job exponentially more difficult.  Not only does this make day-to-day execution hard, but it causes them to lose complete sight over the economic drivers of both bandwidth and the many other very different things that they do.  Financials become increasingly unpredictable.  It is difficult to tell what activities/investments are creating value and which are destroying value.   Decision-making becomes excruciatingly slow.  Companies become internally focused.  Customers get frustrated with long service delivery cycles and poor information flow.

At Zayo, we cannot afford to get bogged down.  Our solution is to separate into three businesses.  Not channels.  No product groups.  Not lines of businesses.  Not even business units.  We are organizing ourselves as three completely separate businesses.

What does this mean in practical terms?   My answer might sound over-simplified (and perhaps even silly), but I am convinced it is the key.  The answer: each entity will maintain its own accounting systems.  I mean this is a very literal sense.   They will keep their own books.   They will have their own bank account.  They will be judged with how well they manage their financials up to and including the balance sheet and cash flow statement.

Most telecom people have trouble with this.  “How inefficient,” they reckon.  “What about all the economies of scale you’d sacrifice by having one NOC, one provisioning system, one head of engineering, etc.”   Or, they object: ”But everything is about how fixed costs are allocated.  Therefore, it is just arbitrary how you divide costs between units.”

In the subequent blog entry, I will post an excerpt from an email I sent to Zayo employees last week explaining what we are doing and why they should be confident.  Hint: Berkshire Hathaway.

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