Overview
The modern Koch Industries began when Charles Koch became CEO of his father’s businesses after his passing. Koch Industries started with a few separate energy-related assets; Charles used this base to acquire additional businesses that were largely tangential to what Koch Industries already owned. An emphasis was placed on buying and owning cash generative assets, financing them conservatively, and running them in a largely decentralized manner, all with an eye on generating high long-term returns on invested capital. This is the exact playbook that has distinguished many of the companies that have used M&A as a tool to compound shareholder value at high rates over the long-term.
Koch Industries has had one large advantage over some of its public Outsider-like brethren - it’s privately held and only has two controlling shareholders. Charles and his late brother David were both long-term thinkers and so Charles was able to make decisions based on returns estimated over decades, not months. Koch Industries historically has reinvested 90%+ of its profits to fuel expansion and has generally financed itself very conservatively. It would have been difficult to make these decisions as a public company, and Charles Koch regularly used these attributes to Koch Industries’ advantage.
Koch Industries has always been intently focused on M&A and, surprisingly, has followed a policy similar to Constellation Software (disclosure: long) of pushing responsibility for finding M&A deals down the organization. Charles Koch would tell the operators of the different business units that a big part of their job was to find good M&A opportunities. There are some differences in the approaches - namely Koch seems to screen more deals at headquarters than Constellation does - but I found them remarkably similar. Koch largely grew through M&A, and targets were generally found by employees of different Koch businesses, usually helped along by their intimate knowledge of their industries. The CEO of one of Koch’s refineries, in fact, was able to use knowledge of another refinery’s feedstocks and outputs to realize that the refinery could be optimized by changing the output. Koch did the deal, changed the outputs to increase profitability, and thereby made a fabulous investment.
Operationally, Koch preached a management strategy known as Market-Based Management, which preached continuous operational improvement. Managers would use a data heavy approach to find areas in the business that were being run inefficiently and aggressively attack excess costs. One manger, using these principles in a very data intensive way, took a collection of maritime barges from a money losing operating to operating income margins of 33% in short-order. Impressive, especially since ocean freight is a notoriously difficult business. As we’ll see, while this method could produce excellent profitability and ROI, there would prove to be significant drawbacks to market-based management if left unchecked.
History
Charles Koch started as CEO of Koch Industries in 1967. After a strong start which saw him buying out minority interests and completing their first significant M&A deals in the late 1960’s and early 1970’s, the mid 1970’s proved to be a difficult time for the company given their heavy energy exposure and the volatility in energy markets. Koch’s earnings were generally weak and debt ratios were high. Charles decided that going forward Koch would be financed conservatively so that the company could benefit from periods of economic weakness, not be hurt by them. During this time, Koch decided to invest heavily into new technologies - in this case, computers for their refinery operations - in order to optimize operations. Over the decades, Koch would continue to invest heavily into new technologies to ensure that its companies were running efficiently. Even with some volatile end markets, in this period Koch Industries acquired a significant amount of companies, thereby growing its assets and earnings power.
The 1980’s and 1990’s would prove to be a defining period for Koch Industries, with safety, compliance, and environmental lapses overshadowing an incredible amount of business growth, largely via further acquisitions. By this time, Charles Koch had drilled his management system, Market-Based Managment, deep into the culture of Koch Industries’ different operating groups. The system called for continued improvement in all aspects of a business, sort of like the Kaizen system made famous by the Japanse car companies. Koch Industries’ managers across these businesses pushed hard to improve profitability and returns on capital over time.
The problem with this approach, which became apparent over these 15-20 years, was that a maniacal focus on controlling costs can lead to underinvestment, especially in business units that don’t produce immediate ROI, like safety or environmental compliance. When the majority of your business units operate in the energy sector, compliance and safety lapses can kill people.
While Koch Industries was a serial compliance abuser at this time, Kochland doesn’t discuss much in the way of summary statistics; instead, it details a few larger cases of corporate malfeasance. Two of these stuck out to me.
The first involved Koch Industries’ midstream oil and gas division, which was under-reporting the amount of oil that it was transporting for years. The workers who went to physically collect the oil would be pressured to deliver more oil to Koch’s pipelines than they paid for. In other words, these workers were pressured to steal. If they didn’t, their managers could and would fire them. Management knew that the upstream oil and gas firms (like Exxon or Chevron) didn’t have any other options for takeaway capacity, so if Koch was skimming 1-2% off the top, there wasn’t much that the upstream companies could do about it. The whole situation only came to a head because Koch, by underreporting how much oil they were taking, was underpaying royalties to some Native American tribes who owned the land, which prompted an FBI investigation. Importantly, Charles Koch himself was aware of the situation, confirming the numbers with an FBI investigator but going through some mental gymnastics to imply that nothing was wrong.
The second example came from Koch’s refining operations, where a piece of key waste-water treatment equipment malfunctioned, and the engineers couldn’t easily find the solution. Instead of shutting part of the plant down to find and fix the problem, management kept running the plant and using stop-gap measures to temporarily dispose of the still-polluted refinery byproducts. When these measures failed, management decided to release these pollutants into nearby fields and forests when the wastewater engineer was absent.
During this time period, there were large scale safety lapses at many of Koch Industries’ companies. In most cases, it cannot be definitively proven that Charles Koch knew or condoned each specific lapse. It is clear, however, that Market-Based Management culture pushed executives to do everything they could to improve ROI, which led to managers of the different business units underinvesting in safety and resorting to illegal activity to “make the numbers.”
On top of these compliance and safety failures, in the late 1990’s Koch Industries struggled in its clear area of expertise - M&A. As the book says, Charles Koch went from “applauding” expansion through M&A to “requiring” it. One top executive said that during this period “I think Charles got cavalier,” perhaps because of 30 years of great success buying companies. Koch expanded its corporate development team, which focused on analyzing potential M&A deals brought by its various operating executives, largely by hiring recent MBA’s from some of the nation’s top schools. Previously, Charles and a small group of top executives evaluated deals, discussing the long-term merits of the deal. With the influx of younger talent, the people making decisions were more worried about receiving a large bonus for closing a deal than on the merits of the underlying economics in 10 or 20 years.
This cultural shift culminated in a disastrous deal for Purina Mills. Purina had huge exposure to hog prices which went undetected in due diligence, and after hog prices plummeted, the company lost a huge amount of money which, on top of the debt put on the company to fund the deal, put it in extreme financial strain. Eventually, the company went bankrupt, and when lenders asked Koch to contribute more equity to make them whole, Charles refused. Ultimately, the lenders pierced the corporate veil and Koch was forced to inject even more money into the business.
The 1980’s and 1990’s forced a reckoning at Koch Industries - investigators were hammering the company in multiple directions because of compliance and safety lapses and the company had also made a big mistake in its purchase of Purina Mills. After this period, Charles Koch decided he had to fix both of these areas. Although Market-Based Management espoused continual improvement on profitability and ROI, Koch began to preach “10,000% compliance,” or 100% compliance, 100% of the time. Importantly, Koch meant it - instead of the safety and compliance officers reporting to business heads, business heads now reported to safety and compliance officers. If a compliance lawyer didn’t like something in a plant, they had the power to shut that plant down until they were satisfied with operations. During this period, Koch Industries would re-audit all safety and compliance practices at newly acquired companies and aggressively invest to bring these companies immediately into compliance after an acquisition.
Around this time, trading operation started to become a real moneymaker for the company, with traders competing with wall street banks, large oil companies, and Enron. When traders started abusing power markets in California, Koch Trading initially participated in a small manner, then decided to pull back from what they were doing just as Enron and others stepped up their efforts. Koch was fined a small amount of money 14 years later, spared a harsher penalty because of its small participation and because there was never an established pattern of illegality. While they didn’t behave perfectly, this was another example of the “new” Koch Industries learning from its past misbehavior and prizing compliance over profits.
Koch Industries also redoubled its centralized private equity efforts in the early 2000’s. This time, the corporate development board only consisted of Charles Koch and a few of his top lieutenants. Their advantage as a private company was that they could focus on long-term ROI while ignoring short-term noise. They also had access to detailed information on many industries that were tangential to their current businesses. They focused on distressed opportunities with good long-term ROI that fit with Koch’s core businesses and capabilities, which helped them stay in their circle of competence where they would only buy something if they knew how to run it better than it was being run. They did an iconic deal for fertilizer plants that were unprofitable at the time because of high natural gas prices (which is a feedstock for fertilizer), but which were indispensable to their farmer customers because of location and logistical costs. When the market cyclically recovered, Koch made a fortune.
Another interesting example of this long-term oriented advantage came from their huge deal to acquire Georgia-Pacific. Koch would invest huge sums of money into acquired businesses if they thought they could earn a good long-term return on investment. Previous to Koch’s acquisition, Georgia Pacific had a high debt load, which led to years of underinvestment, leading to wear and tear on company machinery. After Koch bought it, the head of the pulp division got a $40mm capital investment approved in a few minutes over the phone, where at the old Georgia-Pacific it would have taken weeks mired in bureaucracy, and most likely would not have been approved. It paid to have financial flexibility and a long-term mindset.
By the time the US economy turned over in 2008-2009, Koch Industries was sitting in a position of strength. It owned a wide array of cash-generating businesses that were important to the underlying fabric of the US economy. It also financed these businesses conservatively, so while earnings roughly halved during the recession, the future of Koch Industries was never in doubt. At this point, Koch Industries actually contained a large trading division, which would lead to disaster at many other firms, but Charles Koch placed strict risk controls on the traders, which averted huge losses and even led to some very large gains on a contango trade during this period.
After another period of strong growth after the great financial crisis, by 2018 Koch Industries owned a large, diversified group of cash generating businesses. From 1991 to 2018, Koch’s fortune was estimated to increase from $2.35bb to $53.5bb, good for a 12.3% CAGR (and more if you include distributed cash). The growth rate for the 25 years leading up to 1991 was likely even better growth than that, resulting in an astounding business record over a 50 year period. Currently, supported by those diverse cash flows and conservative, non-recourse financing, the future of the company is as secure as it could possibly be.
Conclusion
From a business standpoint, Koch Industries is a fascinating case study. Charles Koch has been a masterful capital allocator over the past 50 years by using all the tools that most excellent allocators use - a focus on cash-generative assets, long-term thinking, non-recourse financing, the ability to improve operations, and sticking largely to what you know. In the one period where they struggled with capital allocation, the decision makers were clearly focused on paychecks and not on long-term returns. That should be a warning to us all.
Operationally, you can repeatedly see the benefits of a lean, entrepreneurial structure and a focus on long-term profits - managers were able to quickly make decisions on important capital projects with excellent economics, they were free from worrying about budgets or annual profit targets, and they could focus on running their business as efficiently as possible.
Even with these areas of strength, the clearest lesson from Koch Industries is that management must always invest in controls and compliance. If you incentivize your business unit managers to maximize ROI and you don’t put any controls in place, you’re going to cause misbehavior. If your end markets are physically dangerous like energy and heavy manufacturing, you’re going to kill people. 10,000% compliance is the right attitude. It should have been enforced from day one.
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