Berkshire Versus KKR: Intermediary Influence And Competition

Berkshire Versus KKR: Intermediary Influence And Competition

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Lawrence A. Cunningham

George Washington University

2015

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Forthcoming in University of Chicago Law Review Dialogue (2015)

GWU Law School Public Law Research Paper No. 2015-40

GWU Legal Studies Research Paper No. 2015-40

Rock Center for Corporate Governance at Stanford University Working Paper No. 210

Abstract:

Kathryn Judge of Columbia University documents how financial intermediaries persistently impose high fees compared to the value rendered, attributes this to political influence, and suggests countervailing policy strategies, including stoking competition and enhancing disclosure to reduce excessive transaction costs. In this solicited comment, I concur with Judge's findings and prescriptions by adding a paired example: that of Berkshire Hathaway versus Kohlberg Kravis Roberts. In the field of corporate acquisitions, these rivals are opposites, Berkshire shunning intermediaries and generating virtually no transaction costs while KKR feasts on multiple and lavish fees. The contrast reflects broader differences between Berkshire and private equity on several dimensions, including not only direct fees but also indirect costs from their respective attitudes towards financing (Berkshire eschews debt that private equity uses maximally); management (Berkshire believes in autonomy where private equity practices intervention); and time horizon (Berkshire holds forever whereas private equity flips companies as rapidly as possible). Professor Judge is right: enhanced disclosure of the fees that KKR and other private equity firms charge would increase competition in this market and neutralize some of the excess.

Berkshire Versus KKR: Intermediary Influence And Competition - Introduction

The American financial services industry employs innumerable intermediaries working for investors and savers, such as accountants, advisors, agents, bankers, brokers, consultants, directors, funds, lawyers, managers, and rating agencies. They charge considerable fees to facilitate exchanges by easing search and synthesizing or validating complex information. Their influence has been studied from numerous perspectives, including behavioral finance, industrial economics, and public-choice theory. Such treatments illuminate why financial intermediaries exist, what value they add, and what costs they impose, from the perspective of how clients act, how market structures work, and how laws and policies are formulated.

To this substantial literature comes a welcome supplement-Intermediary Influence-thanks to Professor Kathryn Judge. Providing a singular account of intermediary influence as a source of sustained pricing power, Judge’s article warns of excessive transaction costs, a net direct loss to the constituents of intermediaries (on both sides), and an indirect net social loss. Such an outcome is in tension with prevailing thought in microeconomics, which prescribes and predicts that market forces spontaneously and inexorably pressure for transaction cost minimization.

After all, as Professor Ronald Coase taught nearly a century ago, rational economic actors will self-rely when the costs of intermediation exceed the gains. This is the rationale for the existence of firms: they organize economic activity. Economists dating to the writing of Coase’s seminal work, The Nature of the Firm, assume that institutional arrangements evolve to minimize transaction costs, yet Judge highlights how the influence of financial intermediaries often produces persistently high transaction costs. Her intuition is that contemporary transaction costs are heavy with fees charged by intermediaries who seek to maximize economic gain in settings in which their expertise and positions enable them to promote institutional arrangements that yield high fees despite the existence of lower-cost alternatives.

Judge uses examples from several contexts-those of real estate agents, stockbrokers, mutual funds, and stock exchanges-to illustrate how intermediary influence is accumulated and wielded. While acknowledging that financial intermediaries often add value and earn fees commensurate with benefits, Judge simultaneously explains how the phenomenon of intermediary influence should be incorporated into theories of economic behavior and explores how market participants and policymakers might respond in high-fee environments. Among the various important responses are competitive or regulatory tools that increase transparency, enabling participants to shop comparatively in order to avoid excessive fees.

In this Essay, I offer an additional context—the acquisitions market—in which intermediary influence manifests itself yet is accompanied by potential competitive and regulatory pressures of the kind Judge envisions constraining excessive fees. In this market, acquirers are diverse, and they include financial bidders such as private equity firms as well as strategic buyers like rivals in similar sectors and diversifying conglomerates. These acquirers’ propensities to use intermediaries and generate costs vary: many incur significant and frequent fees, while others eschew them. Sellers of businesses—and others affected by the acquisition process, including shareholders, lenders, employees, and other stakeholders—face radically different cost structures.

The acquisition industry is characterized by the traits that, as Judge shows, typify intermediary influence: transaction constituents are often one-time players who rely heavily on acquisition intermediaries. These intermediaries are in turn repeat players in oligopolistic markets who engineer complex, opaque transactions that require specialized knowledge. But the industry is not limited to intermediaries wielding influence and earning high fees; it also includes rivals who keep costs low. This Essay highlights two powerhouses representing opposite ends of the spectrum of financial intermediation: Berkshire Hathaway, the conglomerate built by Warren Buffett that eschews financial intermediation, and Kohlberg Kravis Roberts (KKR), the pioneering private equity firm that thrives on such intermediation. The juxtaposition illustrates both the intermediary influence that Judge describes and the efficacy of her prescription to counter it with transparent low-cost rivals.

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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