Abrupt ownership change
In my last essay on ownership constructs, I cover a special case. And make a few concluding remarks to summarize the 6000 words I've written on this topic.
Here’s the 5th essay of this series, trying to answer my most important question: Who am I backing here? What kind of controlling owner would be best for interests of a (long-term) minority shareholder such as myself? I started off with my ideal construct, one of a longstanding, focused, trustworthy promoter. I followed it up with sub-optimal ownership constructs that are generally avoidable. I got to backable exceptions within sub-optimal constructs. Current essay is the last leg of my framework, which deals with an abrupt change in owner, either before or after I invest in a business.
Sudden owner change
This is a special case, although I can no longer call it a rare case. This can be tricky, since the new owner is usually credible in a different setting but new to the one I am concerned about. So, it’s best to go back to first principles. My thinking on ownership constructs has to be internally consistent with my thinking on investing, in general.
So, what’s my investing approach? More-of-the-same. I invest in proven slow-changing understandable businesses, in established industries, with a long track record of excellence, achieved under stewardship of people who continue to run it. Any step change is anathema to me, whether or not it’s linked to promoter. I hate big-bang M&A, especially overseas. Ditto with unrelated diversification. Even an external hire as CEO is bothersome, as is sudden uptick in aggression under a next-gen promoter. While intent isn’t to flee right away, any step change is a big deal. I have to revisit my investment thesis to check if situation still fits. An abrupt change in promoter has to be seen in this light.
I clarify that I refer to change involving an external, new promoter, usually due to take-over. Sometimes an abrupt internal promoter change happens, due to ill-health or a squabble within a promoter group. In ‘internal’ changes, there is usually a sense of continuity. While this situation isn’t ideal, new promoter has already been part of the same system and imbibed the same values, culture, risk-appetite etc. As a first order of approximation, I don’t treat these as abrupt or significant changes, although I’ll be more watchful.
When there’s a sudden, ‘external’ change in promoter, short-term impact is usually negligible in established businesses. However, long-term impact could be significant since big judgment calls will be handled differently by a new person from a different system. Mindset around business direction, propensity for M&A, aggression, margin of safety, risk, capital allocation, values, culture can be very different. Ownership construct and focus could differ if acquirer has other business interests. My business can end up in one of the sub-optimal constructs that I discussed earlier (e.g. part of conglomerate).
Different owner doesn’t automatically mean worse owner. It could turn out better too. However, central question for me is “Can I reliably assess business risk and prospects, when it’s not more-of-the-same?”. Given the fuddy-duddy way in which I think about investing, my answer is NO. It’s not that I don’t know the answer. I don’t know what questions to ask or what evidence to study. Any situation where key input variables have materially changed, compared to long history, is outside my circle of competence. I act on the basis that it’s imprudent to risk others’ money behind my cluelessness. Naturally, I don’t suggest that others act similarly. I do suggest that others remain alert to the possibility that it is a different business under different hands, and that analyzing its prospects just became harder.
Lest it sounds like I am casting aspersions on all acquirers and business prospects under acquirers, I clarify that this isn’t about them at all. This is about certain situations falling into my ‘too tough’ bucket, due to my inability to reliably assess them. To quote George Costanza “It’s not you, it’s me”.
Since even Douglas Adams didn’t stretch his trilogy beyond five parts, let me append a few concluding remarks here, to summarize this essay-series.
For a permanent owner or long-term investor, “who am I backing here” is the most important question. The person in charge of any business has disproportionate long-term impact, since all consequential decisions bubble up to the very top. Consistently making the right calls isn’t merely a function of personal abilities. It is linked to the context in which the person operates. Whether business is standalone, part of conglomerate, subsidiary, government-owned or board-managed matters. Similarly, whether the person is part of an MNC system or private equity firm matters. Ownership construct, a combination of individuals and context, disproportionately influences business compounding and investment returns over the long run.
My ideal ownership construct is to back a focused, trustworthy, longstanding promoter with a track record of prudence and competence. Any other construct is less than ideal. I view bad promoters and PSUs as a strict no. Due to inherent misalignment of interests, my default setting for conglomerates, private equity owned, MNC subsidiary and no-owner constructs is ‘avoid’. However, there can be exceptions. ‘Lifer’ managers with a long history of owner-like behavior are backable. Another backable construct is a business within a decentralized conglomerate, where each group company has earmarked individuals as owners.
A special case is when business owners change abruptly, due to takeover. For a more-of-the-same investor who uses track record as primary input into decisions, central problem is that there’s no basis to figure out how long-run trajectory will differ under new owner. My decision on what to do is a function of my limitations rather than judgment on new owner.
(More generally, this is a robust way to handle complex systems, which are mostly unknowable. Stick to the few pockets that seem relatively steady and insist on continuity of input variables that have been associated with favorable outcomes over a long timeframe. I’ll dive into this in a separate essay, at some point.)
While developments over past few years prompted this essay-series, this is how I have always thought about the most important question for a permanent business owner. While other investors have different timeframes, constraints and preferences, we all have something in common. We are passengers with no control over our journey, hoping to God that the driver knows what he’s doing. To that extent, for any long-term fundamental investor, issues to consider are common. I have tried to share my thinking on these issues, along with implications for investors. As always, this is about a way of thinking on an important aspect of investing. Even if my answer isn’t relevant to your context, I hope that some of the thinking is.
PS. For benefit of masochists, I’ll upload this entire series as one consolidated verbose-form essay in a pdf file.