Avoiding the Institutional Imperative

One of the most valuable services a board of directors can provide, in my view, is helping management avoid that dreaded, value-sapping form of corporate inertia Warren Buffett calls the “institutional imperative.”

The institutional imperative describes any company’s inherent propensity to do dumb things (or avoid doing smart things) simply for the sake of doing them. It is to be fought at all costs, in my view. How do you identify when the I.I. is at work? The Oracle from Omaha long ago laid out four warning signs. Ignore these at your peril:

“An institution will resist any change in its current direction.”

This seems to be particularly true if the institution in question is a bank. Take, for instance, the industry’s love affair with auto leasing back in the 1990s. For a while, the business generated solid returns. Then, as is to be expected, competition intensified and returns fell to unacceptably low levels. Did most banks curtail originations or exit the business when profits began to dry up? Nope. Most hung on doggedly until profits turned into losses that eventually proved ruinous. Board members should insist on being regularly briefed on the profitability levels of various product lines and market segments, and should encourage management to make any needed changes before profit levels become unacceptable.

“Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds.”

Buffett believes that companies too often spend their money wastefully and fritter away retained earnings on acquisitions that don’t create an acceptable level of shareholder value.

I’ve never understood the argument that capital should be stockpiled to pay for potential acquisitions. Rather, companies should determine their optimal level and mix of capital, and return whatever is left to shareholders via dividends and share repurchases.

Some argue that companies should operate with a lot of excess capital to avoid having to rely on the capital markets for acquisitions. Hogwash! Only rarely (and briefly) do the capital markets become so irrational they’re not available to finance deals. A small amount of excess capital can be helpful in taking advantage of the opportunities that arise during times like thisu00e2u20ac”but only a small amount. Then again, on rare occasions, investors balk at backing a strategically “iffy” acquisition. But in almost every case, those investors will turn out to be right, and the acquiring managers wrong.

The point: Just because money is budgeted doesn’t mean it has to be spent, and just because capital builds, it doesn’t mean it must be squandered on marginal and overpriced acquisitions.

“Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops.”

When Wells Fargo was about to announce its hostile takeover of First Interstate in 1995, Wells’s CEO and CFO flew to Omaha to brief Buffett, their largest shareholder. After excitedly running through all their pro forma projections, the two were startled by Buffett’s response: “I’ve never seen a proposed deal that didn’t look good on paper.”

Exactly. Board members shouldn’t just accept the numbers as presented to them; they need to ask probing questions to get to the bottom of how the forecasts were determined. Too often, the projected cost savings and revenue enhancement assumptions, crucial to the viability of any deal, have been derived by a junior investment banker who’s been told to solve for a given IRR. Which is to say, they are plugs. Board members should determine which assumptions are realistic and which are CEO-pleasing fantasies.

“The behavior of peer companiesu00e2u20ac”whether they are expanding, acquiring, setting executive compensation, or whateveru00e2u20ac”will be mindlessly imitated.”

Understanding what competitors are doing is one thing, but believing what they are doing is correct (or even smart) is another thing entirely. Too many bank managements exhibit lemming-like behavior in running their businesses, and too many bank boards act as enablers in this regard. A company’s strategy should be determined by its analysis of its own competitive environment, not by mindlessly adjusting it to what some other (perhaps crazy) competitor is doing.

The institutional imperative can be a deadly weight on shareholder returns. If you can keep these four rules in mind, and do what you can to prevent them from taking root, you’ll be doing an enormous service to your shareholders.