CHG Issue #171: Growing the Pie versus Dividing the Pie

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I listened to Shane Parrish's interview with Whole Foods founder John Mackey last week where they spent some time talking about the optimal growth rate for a company. Mackey relayed how he discovered that when they grew more than 24% annually (doubling revenues every three years) their culture would get diluted, and their results would suffer. He also found out that if they didn't grow fast enough people would struggle to buy into their culture and their results would also suffer. What he realized was there was an optimal level of growth where they could deliver results and keep their culture intact, but it was a delicate balancing act. This principle is true for much of life; there is a delicate balancing act we are always undertaking balancing family and work, our ideals and ambitions with reality, our desire for community with the necessary compromises to our freedom that come with it.

As I was noodling on that Kris A. shared this excerpt of a commencement speech by Bill Watterson, creator of Calvin and Hobbes, that I took as a great example of how we get swept away in the daily course of life until one day we find that life has got behind us and we run, and we run to catch up as Pink Floyd would say.

We need to do more than find diversions; we need to restore and expand ourselves. Our idea of relaxing is all too often to plop down in front of the television set and let its pandering idiocy liquefy our brains. Shutting off the thought process is not rejuvenating; the mind is like a car battery—it recharges by running. You may be surprised to find how quickly daily routine and the demands of “just getting by” absorb your waking hours. You may be surprised to find how quickly you start to see your politics and religion become matters of habit rather than thought and inquiry. You may be surprised to find how quickly you start to see your life in terms of other people’s expectations rather than issues. You may be surprised to find out how quickly reading a good book sounds like a luxury. your own indie band

This is the method by which we end up playing by someone else's scoreboard. We are told that we will find the love, safety, and belonging we seek by accumulating wealth, influence, and power. More money, more followers, more status, more votes; our unquenchable thirst for more distracts us with things we can do but never seems to give us what we need.??

Which brought me back to Shane's conversation with Mackey regarding the difference between professionals and founders. Mackey relayed not only the obvious fact that a professional will never love a company like a founder does, but also shared some insight into the difference in motivations between the two. Mackey pointed out that professionals are more likely to look at a company as a means to an end: how it will look on their resume and advance their career, whereas a founder will tend to focus more on the greater good of the company and its stakeholders. Shane called this the difference between growing the pie and dividing the pie, and it was what Mackey found when they grew too fast. Because they were comfortable and ensconced in their fiefdoms executives and employees would tend to resort to spending their time dividing and protecting their share of the pie instead of working together to grow it.

There is a natural life cycle to any company: They start out small, nimble, innovative, and disruptive. There is a common bond within the company as they seek to build something new together and realize they can't each do it on their own and need the support of their colleagues.? As they find success and the business grows there is less uncertainty, time to relax and enjoy the fruits of their labor. People get promoted up the chain of command, new employees are rapidly hired, and the mission shifts to maintaining that culture that delivered success with a larger employee base. The Peter Principle naturally kicks in at the same time the relative comfort of an established company finds employees with more idle time which leads to people finding things to do to justify their existence instead of solving real problems. Fiefdoms are erected within the organization and before you know it more time is spent in meaningless meetings, more energy is devoted to the political divides on the executive committee, and all or the sudden that innovative company has become just like the large and sclerotic companies it originally set out to disrupt.??

It would be a mistake to conclude that professionals are no good, selfish, political, creatures that will destroy your company; they are instrumental in bringing professionalism and efficiency to startups and helping them grow in the middle innings of the life cycle of any company. But it is vitally important to recognize that they tend to be extrinsically motivated and as a company grows you naturally bring in more extrinsically motivated people that may not share the same intrinsic motivation of the founder and original executive team.

Apollo co-founder Josh Harris recently commented about how the private equity has outgrown its roots and doesn't deliver as much alpha as it did in its early days. PE used to focus on good businesses that needed a change in management and an optimized capital structure. By acquiring a company and capitalizing it as efficiently as possible while also improving the efficiency of the operations through increased revenue and lower expenses they were able to deliver significant alpha. However, as that juice was squeezed out of corporate America, and executives learned to run their companies more efficiently, or be bought out and replaced; PE had to find a new way to generate the returns they promised to the new investors in their much larger funds. Not only was it harder to find undervalued and mismanaged companies but PE managers had to find more of them because they were managing larger sums of money. Instead of recognizing that the opportunity set had shrunk and returning money to their investors, PE managers chose to double down on financial engineering to produce returns. That strategy changed the return profile of PE into a more explicit bet on interest rates and the credit markets and today with rates moving higher there is an increasingly popular view that the heyday of PE has already passed.

This was plain to see for anyone who chose to inquire beyond the superficial marketing pitches of private equity and alternative assets. The PE managers are just like the professionals who operate under a different incentive structure than founders. One of the most intractable contradictions of the asset management industry is that there is an inverse correlation between returns and the size of the opportunity set. Said differently, above market returns have a way of attracting capital, and that increased demand consumes the entire opportunity set. Managers are supposed to identify this and move on to the next opportunity, but the reality of the fundraising cycle (money chasing returns) makes it nearly impossible for them to do so. A bigger fund means more money, influence, and power and it goes against everything we have learned to turn those away.

While it is extremely rare there are managers out there who return money to their investors when the opportunity set has gone away; case in point would be Seth Klarman of Baupost. Kris A. defines ambition as "being ruthlessly intentional about your compromises," and I believe that investors like Klarman are among the most ambitious and successful because they are so ruthless in their compromises. It goes against the conventional wisdom of Wall Street to turn away investors who are trying to give you money, but that conventional wisdom is short-term and extrinsically motivated. Great investors, just like successful founders, can see through the false compromises that conventional wisdom would impose to the longer-term, intrinsic benefits of doing the difficult thing today. Watterson talked about how quickly habit overtakes real thought and inquiry and how something as simple as reading a book becomes a luxury amidst the hustle and bustle of life. This is a great reminder of the virtue of vigilance against falling into our default patterns in life and business. When we look forward instead of litigating the past we are more likely to focus on growing the pie instead of dividing it.

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