NetJets Shuffle: Costs of Deviations from the Berkshire Model

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The following is adapted from “Berkshire’s Blemishes,” a working paper delineating the costs, rather than the vaunted benefits, of Warren Buffett’s Berkshire Hathaway as a management model, including its elements of subsidiary autonomy and corporate decentralization.

 

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Warren Buffett oversaw an executive shuffle at Berkshire Hathaway's NetJets this morning. He accepted the resignation of Jordan Hansell, CEO since 2011, and hired into the top jobs two company veterans who had resigned last month, Adam Johnson and Bill Noe. Two narratives are emerging: that the shuffle strengthens the case that Berkshire's original acquisition of NetJets was a mistake or that they illustrate flaws in Berkshire's model of decentralization and managerial autonomy. Here's a third alternative: the acquisition was sound and the circumstances show the strength of the Berkshire model, with pitfalls revealed by deviations from it.

As background, Richard T. Santulli, who in the 1980s pioneered the fractional aviation industry at NetJets, by 2005 had joined the short list of people widely seen as a likely successor to Buffett. A mathematics whiz, Santulli built NetJets by selling fractional interests in planes to multiple owners. In exchange for customer fees, NetJets operates the fleet, as well an additional fleet of company-owned planes necessary to make certain that there are always enough planes to meet customer needs at any time. The business model is challenging: capital intensive and competitive with unionized pilots and a demanding clientele (the likes of David Letterman and Tiger Woods).

In the early 1990s, Sanutlli personally guaranteed NetJets' loans to escape bankruptcy and in the mid-1990s sold 25% of the company to Goldman Sachs to obtain capital. In 1998, he sold the company to Berkshire. Despite thin margins due to high costs, NetJets had relatively low debt, an impeccable safety record, and growth prospects as a first-mover. While NetJets produced profits in most of its first decade with Berkshire, the recession that began in 2008 throttled it. NetJets took a $700 million write-down on its fleet, erasing years of profits and tallying a large loss that year. Yet it had also incurred considerable debt to expand its fleet.

By late 2009, Buffett decided to change course, and turned to David Sokol, another Berkshire executive on the short list of candidates to succeed Buffett. Sokol, who built and was then running Berkshire's energy business, was a ruthless cost cutter, and perceived NetJets to be bloated. Taking over as CEO, while still running the energy business, Sokol slashed expenses right down the income statement. But Sokol, who stands out as the least Berkshire-like CEO—he built the energy business by hostile takeovers and used brokers to scout for acquisitions—soon resigned after being caught front-running (wounding Buffett, whose deep trust in Sokol had proven unworthy in a public humiliation).

At NetJets, Sokol left behind both his thrifty business model and a successor, Hansell, whom Sokol had recruited from Berkshire's energy business. NetJets' pilots love Santulli and have always lamented his departure. They detest both Sokol and Hansell, and especially their low-cost strategy. After Santulli left, management-labor relations deteriorated steadily, and lately the union hurled invective at Hansell in aggressive campaigns from the internet to the Wall Street Journal and Omaha World Herald. Pilots picketed by the hundreds out front of Berkshire's annual meeting in 2014 and 2015.

Amid mounting turmoil, in early 2015, two Santulli-era senior executives resigned from NetJets and today the company announced that they are returning to lead NetJets: Adam Johnson, a 20-year company veteran, and Bill Noe, who is also a pilot. Their stated goal is to reengage NetJets' employees in the business and return the company to greatness. In other words, they appear poised to abandon the Sokol business model in favor of Santuilli's original concept.

From these circumstances, it is tempting to infer that Berkshire's acquisition of NetJets was a mistake. Apart from first-mover advantage, its business moat was insubstantial and Buffett's usual rationality may have been colored by his devotion to NetJets as a customer. Yet NetJets was profitable during most of its first decade with Berkshire and continues to show strengths. NetJets may well belong on the short list of costly acquisitions that are due to Buffett being Berkshire's sole decision maker, with limited input from one or two trusted insiders, such as vice chairman Charlie Munger. But I think there is another lesson to discern, also about Berkshire's managerial model.

Today's shuffle seems to recognize and correct two mistakes that involved deviations from the Berkshire model: replacing Santulli and installing Sokol. After all, Buffett does not usually second-guess subsidiary CEOs, especially not company founders, so intervening against Santuli violated the Berkshire model. Nor does Berkshire usually move executives from one subsidiary to another, especially not assigning two companies to a single CEO, so installing Sokol at NetJets also deviated from the Berkshire model. The pair of highly unusual moves amounts to the sharpest instance of exceptions to the Berkshire model in its history. They are also costly, given Santulli's departure and Sokol's fate, but measurement is elusive.

Lawrence A. Cunningham, a professor at George Washington University, has written numerous books on a wide range of subjects relating to business and law and appeared today on Bloomberg TV with Betty Liu to discuss the NetJets shuffle. In connection with his most recent book on Berkshire, he interviewed Richard Santulli, became acquainted with Jordan Hansell, and spoke with numerous NetJets pilots and union officials.

 

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About the Author

Lawrence A. Cunningham
Larry is a professor of law at the George Washington University Law School. He joined the GW Law School faculty in 2007, having previously taught for 6 years at Boston College (where he served a 2-year term as Academic Dean) and for 8 years at Cardozo (where he served a 5-year term as Director of the Heyman Center on Corporate Governance). He also taught courses at many other schools in the US and abroad, including Central European University, Columbia University, Hebrew University, University of Navarra, and Vanderbilt University. Before entering academia, he practiced corporate law for 4 years at Cravath, Swaine & Moore. He earned his BA from University of Delaware and his JD magna cum laude from Cardozo. Larry writes extensively in corporate and securities law, with a special emphasis on law and accounting and investor perspectives. He teaches courses in those fields as well as Contracts. He has published a dozen books and 50 law review articles. His recent books include: Contracts in the Real World: Stories of Popular Contracts and Why They Matter (Cambridge University Press 2012), The AIG Story (Wiley 2013), The Essays of Warren Buffett: Lessons for Corporate America (Carolina Academic Press 2013), and Berkshire Hathaway’s Value of Values (Columbia University Press 2014). Areas of Interest: Accounting, Auditing, Contracts, Corporate Law, Finance, Investing, Legal Education, Securities Regulation

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