In the 1980s many Conglomerates were built on the back of leveraged buyouts (LBOs) financed by Junk Bonds. These were the times of Michael Milken and Barbarian at the Gates. Many of these stories did not have happy endings as the companies suffered under the weight of their debt burdens and many acquisitions proved to have been done more to “do the deal” than for any strategic purpose.
This leads us to the Conglomerate Discount. It was noted that many conglomerates traded at or below the “sum of their parts”. If you broke them up, some of the pieces would fetch higher valuations, causing the company to be worth more as separate entities than as one.
Multiple reasons were given for this:
1. Previously mentioned issues with LBOs
2. Lack of transparency in conglomerate structure
3. Lack of operating focus
4. Overall slower growth versus certain pieces of the whole
5. Lack of strategic coherence among companies
I have been asked why, when beginning AH, we did not focus on one specific industry. Why not pursue a roll-up strategy that could command a higher exit multiple? Why build a conglomerate/Holdco when the market discounts them for a reason? How are we going to ensure we do not fall trap to the issues mentioned above?
1. We are very careful not to overleverage our business. I have written about this ad nauseum, we are very careful about how much debt we take, and the terms associated.
2. Studying the history of conglomerates, we find the issues of lack of transparency and focus are often associated with bloated corporate structures. By remaining lean at the top, assigning all expenses to the operating business, and allowing them to operate independently, we achieve focus and great transparency. The only centralized decision is capital allocation and in our experience, it is the one skill nearly all CEOs lack. They are great delegators, operators, and/or marketers. But rarely are they great capital allocators. They have not worked that muscle in their climb to the top. We make the investment decisions for our companies.
3. Some pieces of our company grow faster than others and could command a bit higher multiple than the whole. To realize that value we would need to sell that unit. Overall, we believe we are better off not entertaining these thoughts. Once we begin to look at selling a business, our underwriting may change. If we sell a business, how will our CEOs, with whom we have promised long-term relationships, react? Will the monetization of one opportunity be worth the possible disruption for what remains?
4. I agree from the outside our collection of business may appear to have a lack of strategic coherence. They are not supposed to interact with one another, and no synergies are assumed when an investment is made. I do see strategic coherence in our Holding Company. It is a collection of cash-flowing businesses, operating geographically and industry-independent, with the goal of allocating their cash flows to the best risk-adjusted opportunity.
The discussion of a Conglomerate Discount focuses on multiple paid for a business. This brings me to my final point. Investment returns are determined by growth in earnings and the multiple paid for them.
Example A: If a company’s earnings do not grow, but you bought it for 6X and now someone will pay you 10X, you have a positive return.
Example B: If you bought a company earning $1 for 10X and it now earns $2 but you can only sell it for 4X, you have lost money.
The Conglomerate Discount is a discount on what someone will pay you for your business. Trying to predict what multiple someone will pay in the future is a tricky game, and one we look to avoid. We focus on the results of our underlying businesses and count on them to determine our returns. By focusing on the underlying results of our businesses, we determine the future worth of our company.