“Strategy Follows Structure” — John Bogle on Investment Funds

Investment Fund Structures

Strategy Follows Structure

As “Form Follows Function…” In Investment Funds, “Strategy Follows Structure.”

“You are what you eat” is the common phrase about nutrition.  With investing, I think a corollary should be “you are where & how you get your capital”.  This is particularly true with any type of investment fund as John Bogle, the founder of Vanguard, stated in a New York Times article on Sunday when he said, “strategy follows structure” in investing.

Vanguard, Berkshire Hathaway, and my investment fund, Greybull Stewardship, have large structural advantages that allow them to implement superior investing strategies.  Vanguard is owned by its investors which creates a clear focus on low-expense mutual funds.  Berkshire Hathaway has a structure (certain types of stockholders, certain type of corporate structure) that makes it a preferred home for some of the best businesses in the world.  Greybull Stewardship also has a different structure than traditional private equity funds (no 10-year fund life, preference to invest in flow-through entities, investment capital coming from other business owners) that makes it a preferred partner for business owners who want a stable, long-term partner aligned with the interests of their business and themselves.

Investment Strategies Via Fund Structures

Let’s explore how the structure of Berkshire Hathaway is built to enable a certain investment strategy.  Buffett’s strategy is to attract to Berkshire great businesses that are often still managed by a large owner of the company.  Not by accident, these tend to be the businesses with the strongest competitive advantages and most owner-oriented managers, exactly the characteristics that Buffett wants.  Owners of the best businesses in the world are often as concerned with who buys the business as with the highest price.  It isn’t easy to build a unique, high-quality business and most owners of these businesses don’t want to sell to just anyone.  When an owner cares about the new owner, it is often a signal about the quality and staying power of the business.  Here are some observations on how Buffett does it:

  • Establish a stable, long-term oriented base of stockholders.  It starts with Buffett owning over 30% of Berkshire through most of his career.  After that, however, Buffett pursued a strategy of attracting long-term oriented shareholders by not splitting the stock, writing a unique annual report targeted to building a type of engaged, trusting shareholder base, not issuing quarterly guidance as fodder for investment analysts and short-term stock movements, and hosting an annual meeting also oriented to attracting certain shareholders.  All of this helped sellers know that Berkshire wasn’t going to change drastically from what they had seen previously based on a new Board of Directors, new CEO, or change in corporate strategy.
  • Establish a corporate culture that works for high-quality manager-owners.  Buffett intentionally keeps the corporate staff very small (less than 20 the last I knew) so they don’t get involved in management of the operating companies, do not attempt to create “synergy” across business units, do not require extra reports and meetings of the managers once they join Berkshire, and keep compensation agreements simple and solely based on the results of a manager’s business.  In fact, Buffet wants to have the manager of the business feel exactly like they felt when they owned their business outright themselves.  Many high-quality managers would prefer this structure over a traditional corporate structure with its reports, meetings, company-wide initiatives, and other things that sap energy and are a downside to selling your company.

Greybull Stewardship, my investment fund, also has some unique structural advantages that most investment funds cannot offer.

  • No forced growth rates or exits.  Greybull does not have a 10-year expiration on its fund, like most investment funds.  This means that we will not force a growth rate that is unhealthy for the business, or force an exit at the wrong time for the business or its management just because our fund is expiring.  The goal is to align Greybull completely with our co-owners in our portfolio companies so that we can make better decisions without external restrictions.
  • Prefer investment returns to come from both cash distributions and value appreciation.  Like our co-owners in our portfolio companies, the best situations are ones where our investment returns come from a combination of cash distributions and the value of the company appreciating — we are not solely focused on exits like most private equity funds.  This is because we are able to harvest cash tax efficiently by investing in flow-through entities for tax purposes.  Most investment funds need to invest in C Corporations to protect their non-profit investors from unrelated business income and therefore are not focused on annual cash distributions because of the inefficiencies.  Greybull’s strategy is a more reliable long-term strategy.  An investor overly focused on exits can create a binary result (home run or strike out) which is not aligned with the interests of an owner-manager who often has the bulk of their net worth in the business and therefore a double or a triple would be a fine result.
  • Greybull’s investors are business owners themselves.  They understand small and medium-sized businesses and are able to help when called upon.

When private equity funds use the same 10-year fund structure and raise money from the same institutional investors, it is not their fault that they all look and act the same.  Greybull Stewardship can act and invest differently because my investment fund structure is different, just as Vanguard and Berkshire Hathaway are able to pursue a different strategies because of their structures.