Rob Small is a Managing Director at Berkshire Partners and Stockbridge, as well as a Director at TransDigm. Under Rob’s direction, Stockbridge has maintained a concentrated position in TransDigm and demonstrated remarkable conviction to add (and occasionally trim) at opportune times. In this discussion, we contrast TransDigm with traditional private equity portfolio companies, examine the company’s approach to capital allocation, and dissect Berkshire’s and Stockbridge’s position management over time.
Explore the materials we used to prepare this podcast episode, including our proprietary research, original investment memos, and more.
July 10, 2022
Internal case study on TransDigm’s value creation playbook, historical performance, approach to capital allocation, notable crises, and peer group.
Private Placement Memorandum
Memorandum prepared for TransDigm’s original acquisition of Imo Industries’ Aerospace Components Group in partnership with Kelso & Company.
Private Investor Presentation
Investor presentation prepared for Warburg Pincus following the 2003 auction process.
2003 Investment Memo
May 23, 2003
Berkshire Partners’ investment memorandum from their unsuccessful bid with Greenbriar Equity Group and Western Presidio to acquire TransDigm in 2003.
2003 Exit Valuation
May 23, 2003
Diligence on exit valuation expectations leveraging comparable companies, historical trading multiples, and relevant private transactions.
2008 Investment Memo
May 19, 2008
Berkshire Partners’ investment memorandum from their open-market acquisition of public shares in 2008 following Stockbridge’s investment in 2007.
2008 Investment Presentation
May 19, 2008
Research and data behind key investment considerations supporting Berkshire Partners’ 2008 investment memo.
Esterline Initial Assessment
Long Path Partners
Initial evaluation of TransDigm’s $4 billion acquisition of Esterline, leveraging public filings and management commentary.
Mental Model Framework for TDG
Long Path Partners
Overview of Long Path’s framework to assess a business’ value accretion, initially informed by TransDigm’s example.
Systems view of Constellation Software and TransDigm, investigating the game selection, strategies, and execution responsible for their success.
Could TransDigm be the Valeant of the Aerospace Industry?
January 20, 2017
Short report speculating on price gauging, an unstable capital structure, and other headwinds that preceded a spike in short interest.
Bull Thesis in Response to Short Report
Value Investors Club
March 21, 2017
Anonymous investment case for TransDigm in response to Citron’s short report, addressing pricing, acquisitions, and leverage.
Interview with Yen Liow, Aravt Global
Graham & Doddsville, Issue 36
Interview in which Yen Liow highlights Nick Howley and TransDigm as an excellent manager and business.
Interview with Alex Captain, Cat Rock
Graham & Doddsville, Issue 39
Interview in which Alex Captain shares his perspective on TransDigm following COVID-19’s influence on aerospace.
Capital Cities: Briefing
The Outsiders, John Gilligan
January 27, 2005
Investigation into Capital Cities’ superior performance from 1966 through 1995, detailing industry-leading operational execution and its unparalleled acquisition activity.
Capital Cities: Interviews
The Outsiders, John Gilligan
May 11, 2005
Interview highlights from key operators, including Tom Murphy and Dan Burke, and investors featuring Capital Cities’ decentralized structure and disciplined operating practices.
[00:07:13] Will: Lots of people talk about private equity in the public markets. However, you’ve actually lived that. In fact, as you said earlier, at this juncture, you’ve spent almost exactly 50% of your investing career in each camp. 15 years in private equity and 15 years in the public markets at Stockbridge, although I realize you’re still very involved in the PE side at Berkshire as an IC member these days. But I thought this bipolarity could be a useful framework to tick through a couple of interesting topics at TransDigm. I wanted to have you, if you were open to it, compare and contrast TransDigm and other companies you’ve been involved with over the years at Berkshire on a couple dimensions.
Why don’t we start with management team. What has been distinctive in your mind about the TransDigm team? How does it compare to other top teams you’ve been involved with over the years?
[00:08:12] Rob: Yeah, we’ve been very lucky as capital providers or investors, you either have the privilege or the problem of watching other people execute as they run a company. And we’ve been very lucky at both Berkshire and Stockbridge to partner with some great teams. There’s a lot of good management teams.
TransDigm’s the one that I’ve spent the longest time with and been closest to from my board position and they are exceptional. What they have done that I think a lot of companies could learn from… It’s hard to strategically pick a position in an industry that is so precisely and perfectly done as TransDigm has done. If every business had that type of opportunity, that would be great, but I don’t think there are many of those, but their ability to focus on what’s important, get the whole organization to focus on what’s important, which their mind creating value is done by focusing on their 3Ps, which is value pricing, productivity, and profitable new business.
And they focus the organization on that, and you could hear everyone in the organization down to a pretty far level will tell you that’s what their job is about. Having that type of discipline is very, very unusual and the simplification and focusing on that. It’s not about bureaucracy, it’s not about politics. It’s about letting people do their jobs, but then vigilantly watching and helping them do their jobs of focusing on those three things.
If you went and interviewed people across the organization, you would hear the phrase, “If you’re not working on the 3Ps, you might as well be playing golf,” over and over and over. That has sunk in there, and I don’t think they’re playing a lot of golf, so it’s very impressive.
Culture, Decentralization, & Compensation
[00:10:05] Will: So, that leads to maybe the broader topic of culture. Can you talk a little bit about the TransDigm culture, and again maybe compare it to others you’ve been involved with over the years?
[00:10:14] Rob: What’s fascinating because a company that’s built by acquisition, you would think would inherit lots of cultures and have lots of different types of cultures, but the TransDigm one overwhelms it. People are there to create value. They’re autonomous, but transparent. They need to talk about their problems, talk about their good things, talk about what they’re going on in the quarterly reviews with senior management, and focus on the 3Ps. If people do that, they succeed, they treat the business like owners, they’re compensated like owners.
Everything is reinforcing that culture, and that’s where I think a lot of places get it wrong, including investment firms, is you need all your systems to align. Your culture along with your compensation system, along with how you operate day to day need to align. And there, it’s about creating value for the business.
[00:11:11] Will: A bunch of interconnected topics around culture. One of them is the organizational structure at TransDigm is just so decentralized, and that’s such a key design principle. Have you been involved with other companies where that’s the case, and do you think that feeds into the uniqueness of the culture?
[00:11:28] Rob: It’s an important part of the culture, because everyone then has responsibility. I don’t know if that would work for every company because TransDigm sells a huge number of products to a huge number of customers and not very high volume of any of them. Engaging in the detail of each product and product line takes a lot of attention and a lot of focus, and managing that from the center would be very, very difficult. I think it works for them.
I think often the store manager of a retail operation is an extraordinarily important position, but they need a lot of directives to create consistency across the store experience from the center. We’re trying to create consistency in operating practice, but then apply it to a huge variety of different types of products and engineering issues and customer issues. The culture is actually highly centralized in the sense that there is a very consistent culture developed across units, but then how that is put into place is the recognition that there needs to be flexibility for each product type, or each customer situation, is what leads to the decentralization and makes that work.
There are lessons I think about empowering people with the right incentives, and then monitoring closely that they can handle and make good decisions, but I think that it’s uniquely good for TransDigm’s situation. I think that’s the biggest lesson in TransDigm in many ways is they’ve optimized their situation as well as I’ve seen anyone optimize a situation. And really thinking through what is going to work best in that particular situation, and they do that and continually try to figure it out and get better at it.
[00:13:17] Will: When you say situation Rob, you mean pretty holistically, right? Given their competitive position in an attractive market, how do you ring the most equity value out of that?
[00:13:26] Rob: They’re in an industry where you don’t create demand. Nothing they do is going to make more airplanes fly. They would like to have a greater share of the parts on an airplane and be able to produce every one of those parts more efficiently, and have it there on time for their customer with extremely high quality, and then sell it at a price that reflects that value. They’re trying to optimize that and, as we talked about, airplanes have a huge variety of parts. They need to be flexible in what types of parts they provide, but they know customer requirements, they know quality manufacturing, they know quality engineering, and they know how to price for that. They push all that together, and then spread it out, so that way, each product decision, almost each sale is highly thought through with that lens. And you can’t do that from a centralized way.
[00:14:17] Will: You’ve talked a little bit over the years about the GSD culture at TransDigm to get shit done culture. Any stories come to mind, or any more color around that?
[00:14:28] Rob: You hear constantly about people who like to talk well and just try and explain things. They don’t want to hear about explanations. They want to hear about what you did and why you did it. And they’re happy to help teach someone how to do it better. Someone who talks well isn’t going to do that well at TransDigm.
And I think where it shows up is there’s not a lot of lamenting of what’s happened in the past when something happens. When the pandemic happens, none of us like seeing what happens in the world. And when you sell parks to airplanes, it’s a lot easier to feel sorry for yourself. They don’t do that. They just sit down and say, “This has happened. What are our best steps forward? And let’s move the ball down the court. What do we do?” When there’s a short attack with, in my mind, basically unfounded information being used against them, they don’t complain that wow, we’re in a terrible world where people can do that. They say, “What’s the best path forward,” and they just keep moving forward. And it’s when you’re in a business that’s grown this well for this long, you need that type of attitude. You just keep moving the ball down the field.
[00:15:35] Will: Another important reinforcing element around culture is obviously compensation, and TransDigm’s approach to compensation is pretty unique in the public markets, but maybe you could start by comparing it to other Berkshire companies you’ve been involved with, and then talk a little bit about the evolution of that approach in the public era.
[00:15:56] Rob: One of the basic premises of private equity has been that if you align the management team, if they’re not just employees, but fellow stockholders, that aligning those incentives with the shareholders will result in better results. That people are human, humans react to incentives, so having aligned incentives with the people who ultimately own the business is a good thing. And I think that has proven itself to be quite correct over time. Public companies often have ownership requirements, and try to get that sense of alignment.
TransDigm has tried to carry more of a private equity compensation culture into the public markets where option grants are a significant part of someone’s compensation. Their salary and bonus are typically below medium for the industry, and that’s made up for with an equity opportunity that, if the company does well, people can make significant amounts of money.
In a public market, we’ve had the interesting issue of you have to publish certainly the top five people in the company and how much they make in your proxy. And you have say-on-pay votes. We’ve had to adjust the system to a degree to the public markets and, for some of the people, we have more annual grants, instead of multi-year grants because multi-year grants in the year they’re given look like a lot of pay. And then they have very little pay the next year, and that’s harder to explain to people voting on say-on-pay. We’ve done more single year grants to the senior people. And there’s been other little changes, but on the whole, we’ve kept the philosophy.
And we believe that the shareholders will do better if the management team has an opportunity to make a fortune helping shareholders make a fortune. And since almost all the pay is performance-based, I’d prefer as a board member to take the heat of “overpaying” our management because that means that they made the shareholders a tremendous amount of money. That’s the only way they get “overpaid.” We’d rather take the argument that that’s not overpaid when we’re sharing the upside with the people who created it.
[00:18:03] Will: Is it that heat that’s the reason more public companies don’t follow a similar compensation model?
[00:18:10] Rob: I think it’s partly that. I think it’s partly that many companies don’t have the formula for value addition down that this management team has. It only works over the long haul if people do get a chance to make a significant amount of money. It starts to unravel that if you pay people below median on a cash basis and then they never earn any money on their equity, then if zero equity plus below median cash equals below median pay, it’s a self-fulfilling prophecy if you don’t perform that it will fall apart. It does need to keep the performance up.
If at a time there’s less opportunity at TransDigm to do very well, we may have to change the pay structure to reflect that, and people would have less upside, but also probably get closer to median or above pay. But fortunately, I don’t see that time anytime soon.
Evaluating Nick Howley as CEO
[00:19:04] Will: Let’s turn to Nick quickly. How would you compare Nick to other CEOs you’ve been involved with? What makes Nick unique?
[00:19:13] Rob: If you know Nick, you understand very quickly why he’s unique.
I would say that Nick is someone who is very serious about his work, but isn’t very serious, which is a wonderful combination to work with. He sees humor in a lot of things. His quick mind is extremely valuable to the business, but is also very fun. And he takes what he does very seriously. I’ve never met anyone as responsive. If you email or call Nick, the odds if you call him is he’ll pick up. If he doesn’t, it means he’s on another call, and he’ll call you back very quickly. If you email him or text him, he will respond extremely quickly. He is very serious about what he does, and he is very focused on what he does. He’s disarming in his aphorisms and throws things out that I think puts people at ease, but also I think does it partly because it keeps him entertained. He’s a pleasure to work with.
He is not afraid to get opinions from others and change his point of view based on those opinions, but he won’t change his point of view because someone has another opinion. He will factor that into his decision making. He reaches out, he gets lots of opinions, and then he comes up with his own decision. He’s very good at that.
He’s very good at asking questions when he doesn’t understand something. Usually in my watching him, it means that someone didn’t explain it very well, but sometimes it could mean just not understanding it. And he will continue to ask until he understands with a goal to understand.
And he’s very good at understanding that he can’t control the past, and there are certain parts of the business that he can’t control. He can’t control OEM demand for airplanes. He focuses on what he can control, and he focuses on the next step to accomplish what he wants to on what he can control. And then he will consider things step by step. In strategy, you want to look 10 steps forward. On most operating things, you want to look one step forward and you want to do the next step. And he’s very good at doing that.
[00:21:14] Will: He’s setting a cultural model. Is he the genesis of the 3Ps? The streamlining and simplification that led to the power of those three value creation levers… Was that Nicks doing?
[00:21:25] Rob: He and Doug Peacock had that for as long as I’ve known of the company. Keeping it simple makes sense. I think complicating things rarely is a positive. The world’s complicated, and I think the more you can simplify it and have that be effective. That’s true in investing, and I think it’s been very true with TransDigm. He’s been a great leading by example, but I think he’s ingrained that personality into the firm now. I think it goes way beyond him. I think it is now in the fabric of TransDigm.
Rob’s Service on the Board of Directors
[00:21:57] Will: Okay. I want to shift to the board. It’s pretty unusual for a public owner who’s organized in the form of a fund or a partnership to take a public board seat because of the accompanying trading restrictions and regulatory scrutiny and so forth. It’s unusual that you’ve been on this board and on this board now for almost a dozen years. Maybe to set up the context, how many PE boards have you been on, Rob, over the years?
[00:22:24] Rob: Oh, I don’t know, maybe 10.
[00:22:24] Will: Just at a high level, how different is the public company board function from a typical private equity board?
[00:22:34] Rob: A well-functioning public company board and a well-functioning private equity board have lots of similarities. They should work in many of the same ways, and the main job probably being a steward for the shareholders, and hiring and evaluating the CEO and some of the direct reports potentially, and then providing advice and counsel to the company.
With most private equity situations, either one firm or a couple firms tend to control the company. Board meetings and regular meetings can often meld together a little bit, and there’s a huge sense of engagement and everyone playing together to try and help make the company together. On a public board, there’s some level of formality.
But in the true sense of how a board functions, a good board should be a good board, whether you’re public or private. It’s trying to do the same thing, which is provide governance and advice to a management team.
[00:23:37] Will: What do you think are the characteristics of a great board member in your experience?
[00:23:41] Rob: It’s like asking what makes a great basketball team. You need someone who can rebound. You need a point guard. You need someone who can shoot, and you need people who can play defense. There’s a lot of different roles on a board. That’s what you want is, I think, a collection of experts who each can pitch in and help at certain moments in time.
I think if I were Nick, my definition of a good board member would be someone who is there for advice when I need them, is there to hold me accountable and ask the tougher questions, but also someone who doesn’t get in the way. Recognize that the people carrying the water or the management team and they’re doing that day to day. And I think his phrase often is, “the first test is do no harm,” and I agree with that. I view my role on the board as someone who can ask a tough question when needed, push the management team to make sure they’ve thought of everything, who can take a tough stand occasionally when I’m representing the shareholders, then try to bring resources and value whenever I can.
[00:24:50] Will: Is there an example of a tough stance you’ve had to take over the last 10 years?
[00:24:55] Rob: Well, it was fascinating, I would say the toughest stance I ever took was the meeting before I was a board member when I was invited to make sure it was a good fit, which was an uncomfortable position. But at the time, there was a private equity firm who had made a proposal to take the company private. And, as a shareholder, I questioned what value a private equity transaction would do for shareholders.
There’d be a premium, but you would also lose the opportunity to be a long-term investor in the company. And, at that time, the company was relatively leveraged. In a private transaction, they might have put on one more turn of leverage. They weren’t going to run the company any differently. They weren’t going to have access to more acquisitions. If anything, they might have access to fewer acquisitions if our public stock was attractive to anyone. It seemed to me that going private was not the right move for the shareholders.
The management team arguably might have done better in a take-private, but that was the great thing about Nick. He had no problem with me expressing my opinion, even though he might have had a different incentive. I expressed my opinion. I actually had to leave the room since I wasn’t on the board when they decided what they were doing.
Fortunately, I think in probably my biggest act of creating value for public shareholders, although my guess is the company would’ve been public again in a few years, probably happened before I actually joined the board, if I had anything to do with the board deciding not to go private.
[00:26:29] Will: That’s a pretty good audition for public shareholders.
[00:26:32] Rob: A little bit uncomfortable.
[00:26:34] Will: TransDigm is a well-functioning public board. So, maybe take us into the boardroom for one of the recent crises, whether it was the Citron short seller initiative, or maybe COVID. What was it like in the boardroom during the heat of a crisis?
[00:26:55] Rob: The fascinating thing about TransDigm is I don’t think the board meeting felt any different during a crisis, or a non-crisis. There is a factual look at what’s happening and trying to bring everyone up to speed and understanding, and then a description of how management believes is the best way to handle it and what they’re doing, and an openness to any suggestions or thoughts on how to do it better. Usually, it mostly sounds right to me. That’s the fascinating thing about TransDigm is I don’t think you feel a different sense of urgency. There’s always a sense of urgency of handling what’s next. And when there’s a crisis, that’s what’s next. And that calmness I think permeates the organization and is part of the reason they’ve been so successful.
Approach to Capital Allocation
[00:27:47] Will: Let’s maybe talk a little bit about capital allocation and the company’s evolving approach to capital allocation. By the time you joined the board in 2010, there was a clear M&A playbook in place, the company had a philosophy around leverage, had begun to head down the path of special dividends as a way to return capital to shareholders, but can you talk a little bit about how that approach has evolved in the dozen years since?
[00:28:14] Rob: I would say that the capital allocation has been remarkably consistent. The first place is if you have high return opportunities within your businesses to invest capital, invest it. And there is basically an unlimited amount of capital available internally for high return projects. There’s not an allocation or a penny pinching or anything. It’s, if you have a high return and we all believe it’s high return, let’s do it.
Second is that we should do acquisitions as long as they meet our criteria. Company has an incredible hit rate on choosing which acquisitions to do, and then performing well with them. So, that’s the next best use of capital.
Following that, we have to decide whether our leverage levels are appropriate. The company can handle quite a bit of leverage. It’s shown that (a) that its revenues and profits are remarkably consistent, even through a pandemic, and that they’re able to handle quite a bit of leverage, although they’ve been very careful over time to manage down the rate and manage out the maturities. In some ways, that’s one of the things I’ve been most impressed with is they’ve consistently pushed out maturities carefully, which never seemed that important until there was a pandemic. But when there was a pandemic, we were very, very happy that we didn’t have any near term maturities. They’ve been very careful about that over time.
If they don’t have any more uses for excess capital beyond that, they want to return it to shareholders. And there’s two potential ways to return money to shareholders. One is through dividends. They’ve always chosen special dividends. So, that way, they choose when they have excess capital, instead of getting people on a regular dividend when one of the more important uses could have a claim on that dividend they wish they hadn’t given it back. Or, second, you can buy back shares. Here, the company has tended to lean towards dividends. I probably would have a little bit more of a predilection for buying back more stock. The argument over time has been the amount of money. It’s usually been at the time of the financing to create that liquidity, that we then use that for a dividend. If you did a large financing and had a lot of excess cash, at that point, to buy that much stock back could be very difficult. I like the opportunity to buy back stock and we’ve done some of that. One, because you get an opportunity to serve those that stay if you buy at attractive prices, and you don’t have to buy if you believe your stock’s expensive. That creates a responsibility to keep an idea of the value of your stock, which the company does quite well. And so they could do that. And two, it allows continuing shareholders to defer taxes. And one of the best things of our tax code for investors is that compounding returns don’t get taxed until you sell. When you get a dividend, you pay some taxes often. Although for many people, it’s a return of capital. For a lot of our stock, the basis is now zero, so it means a tax bill. As a shareholder, you often could prefer some stock buybacks as long as it’s done at attractive valuations.
Returning Capital to Shareholders
[00:31:29] Will: And is that a recurring topic at the board level, repurchases versus special dividends?
[00:31:34] Rob: We’ve talked about it and over time, they have bought some stock. The difficulty is the quantum. Their special dividends have been quite large. You start to add quite a bit of cost if you try to take the risk out of the price on buying back stock and hire a bank to do a deal. Ultimately, thought that on the whole, the dividend’s been the best path for shareholder return.
It’s interesting, we pay option holders on vested options their dividend as well, because they effectively, on vested stock, own the stock. If we’re treating them as shareholders, which they are, they should get their dividend, and that’s created some of our public controversy on the amount we pay people. Again, it’s been on dividends that people have gotten paid a lot, dividends on value that’s been created for shareholders, which they are. It’s been one of the negatives of being a public company.
[00:32:28] Will: On capital allocation, there’s an interesting period if you go back and look at the data 2013, 2014-ish where the company pays two very significant special dividends, mid-teens each as a percentage of market cap and, in doing so, takes its leverage up to a new level, the highest level, a step function change since IPO, into the zip code it’s been in ever since, six to seven times from five-ish times. Do you remember that period? It felt like there was a clear change in the approach, both on the balance sheet side and on the deployment side.
[00:33:08] Rob: I don’t remember the specifics perfectly. My impression is I think the market became more comfortable with lending money to TransDigm, not the other way around. In a sense that we could raise money at very attractive rates, at very attractive terms. We thought the risk of doing it was low and returning that to shareholders.
Remember, our management team is equity focused, and their options depend on rates of return of the equity. There’s incentives for them to make sure that the equity can compound at high rates of return. If you let the equity account grow too much, grow beyond what it needs to be, that job gets a lot harder.
Operating under Private vs. Public Ownership
[00:33:53] Will: Capital allocation wise, again compare contrast with a typical Berkshire company, any meaningful differences in terms of how TransDigm’s thought about capital allocation versus a PE company?
[00:34:05] Rob: TransDigm’s uniquely stable in its cash flows. We’re continuing to live through the worst possible situation for a company that services the aerospace industry, yet they remain cash flow positive.
A lot of private equity deals, you lever to the maximum point at the time of the transaction, and a lot of the goal of the management team is to de-lever in order, at least to a degree, to create a little more breathing room.
And at TransDigm, I think they’ve learned over time, they can exist at a more comfortably high leverage level than most companies, so that the re-levering dividend recaps at private equity companies, the consistency of remaining at a high leverage point, always leaving enough dry powder to do meaningful acquisitions is probably unusual. But I think that’s driven by its business situation as much as by a cultural norm.
[00:35:02] Will: It’s interesting, Rob, as you say that, it highlights an interesting difference between TransDigm and a private equity portfolio company, which is… TransDigm, being publicly traded without a control shareholder, is running the company for the very, very long term, whereas any private equity portfolio company has some exit event on either the near term or the intermediate term horizon. Does that, in any way, do you think influence decision making in a way that’s different for TransDigm versus a portfolio company at Berkshire or elsewhere?
[00:35:32] Rob: It’s fascinating, I rated our 2003 lawsuit buying TransDigm as the most painful loss in my private equity career. And the irony of it is our investors made more money over time, because we lost that deal and then bought it as a public company than if we had just bought it as a private company because we would’ve owned it for a successful period, taken it public, and then sold our stock and probably moved on because private equity investors, our investors want liquidity over time. And in a private company, the way to get liquidity is often to sell the company. The reinvestment opportunity isn’t there as much.
In the public markets, one of the benefits is you never have to sell your shares unless someone redeems from your fund you may have to, but you can hold the shares indefinitely and you’re always comparing it to your other alternatives. The opportunity to continually compound, in some ways, is easier in a public company, although there’s plenty of reasons in the public company that it’s hard to.
Sale Decisions for Private vs. Public Equity
[00:36:41] Will: I want to talk a little bit about selling, holding and selling, and the profile of those two pools of capital is different. Can you talk a little bit about how the private equity fund evaluates a sale decision versus how Stockbridge does, and maybe specifically as it relates to the TransDigm holding?
[00:37:00] Rob: We think of ourselves as one firm. We have two teams in one firm. I straddle more than most of us, but we really cooperate and we always have, on TransDigm, had one project team. Then, two different groups make the decisions on the purchases and sales. We coordinate if we’re buying or selling at the same time, but it’s one team presenting to two different decision making bodies, and I happen to serve on both. The private equity and public equity have two different general sell decisions.
We are always on the public side trying to trade off the future opportunity versus our other opportunities. We have an absolute standard, but assuming we’re above the absolute standard of what we think the forward returns are and the risk are, then we’re trading off on sizing with what else is out there.
Private equity uses the capital once and, usually with private companies, actually the management team is often desirous of liquidity at some point, so they often usually push the sale, or come up with now’s the time, or it’s a joint decision certainly, as that is the opportunity to turn promise into true dollars, which many management teams want to do over time. It is a great incentive, even if they sell to another firm or even recap with us to ring the bell and then move on. The funds are formed to handle that type of opportunity. They have use the capital once, they have a fixed life, and are designed to, since they’re such long term funds, that liquidity comes, you give it back to the limited partners. It’s set up more to create liquidity. And then on top of that, private equity investors typically don’t love when private equity firms invest in public stocks and charge basically higher than our management fees and carry on a public stock. That’s not what they think we’re in business to do. We think we’re in business to maximize returns. We try to do that as much as we can for the limited partners benefit, but that means that private equity has to find a time to create liquidity typically.
We’ve made those decisions differently over time. Private equity has tried, with the public stocks, to both buy and sell… certainly buy at moments of extreme, when there’s an extreme opportunity, and sell when it’s closer to a less interesting opportunity.
[00:39:25] Will: Does it feel to you as though holding periods on the private equity side are expanding at Berkshire? It feels to me like that’s a broader industry trend on the private equity side and you see it in these continuation funds, but just a general acknowledgement that longer holding periods can be beneficial to LPs, and some creativity around structures that are enabling that.
[00:39:43] Rob: You’re measured by your internal rate of return to investors, and the way to maximize internal rate of return, typically in a company, is to sell pretty early on your winners because, especially early in a fund, it makes a fund IRR math look good.
I personally think for my own investment, and probably for our limited partners, that it’s hard to find a good asset. And you should probably sell your less good investments earlier, and hold your better investments longer. Now, there may be different ways to do that through continuation funds and things like that, but that I think is the value maximizing thing, but there is a tension in the way funds are structured in the private equity markets that pushes liquidity earlier.
We’ve always had, I think, longer than industry hold periods. We like working with the companies, and we’ve always pushed a little bit for multiple of investment, and that’s been our main target over time.
Stockbridge’s Major Buy/Sell Decisions
[00:40:41] Will: I thought it might be interesting to dive into a couple of the larger decisions to add to the position and the two really trimming decisions. Focusing on Stockbridge, which has no fund life restrictions, as you said, it’s a different set of investors, different mandate. And what’s really interesting about this, Rob, is you’ve owned it personally for 15 years and Stockbridge has coming up on 12 years of ownership. Since Stockbridge was founded, it’s been your largest holding.
These additions need to meet two difficult tests. The first is they have to meet the difficult psychological test of buying something later at a higher price than you originally paid for it. Not an easy thing to do, human wiring wise. And then the second thing is it’s bold to be adding to your already largest position.
What’s interesting is if you look at the history of this, which we’ll put in the show notes, there are three occasions where you added to the position and the increment was at least 20% of the prior position. These are meaningful additions, and then they’re twice that you trimmed by 20%. This is in Stockbridge. The first two additions were pretty close to each other. One was in early 2013, February of 2013, which is shortly before the company stepped up its leverage levels pretty meaningfully and began to pay a series of larger special dividends. One was in early 13, and the other was in mid-14, right in the middle of that period. And just to frame it, the first of those occurred at about 3X Stockbridge’s original valuation and the third at about 4X, roughly. The stock had appreciated meaningfully in both cases.
[00:42:21] Rob: The reason TransDigm was our largest position was that we had the highest conviction level of any business we owned. We felt more comfortable that the company would perform well. Forget about valuation, that just the company would perform well over a long period of time. In many ways, that’s the easiest position to add to, in the company you’re most comfortable with. Then we were driven by relative return. When your favorite idea is compelling, it’s a lot easier to make that bigger, than take a chance on something you don’t know as well, that you haven’t lived with, that’s new, that you have a lot less conviction in.
There’s the argument of well then why isn’t it 100% of your portfolio? Our investors on the whole don’t really care, because they’re diversified way beyond us. It doesn’t matter to them, but it does create huge business risk for us when something unknown happens. And you never can be sure that something crazy isn’t going to happen and for us it did happen in TransDigm with the pandemic. We always had to think about our overall exposure. But within those rules and pretty aggressively in those rules, we were willing to make it bigger when we thought it was the most compelling opportunity.
[00:43:29] Will: Right in the middle of that is McKechnie—in between those two things. Those proof points you talked about earlier playing out in real time. And the third material addition was in the thick of COVID, May of ’20, that you grew the position by 22%. Obviously, at that juncture, you felt there’d been an overcorrection.
[00:43:51] Rob: Yeah. During COVID and during the nadir of the stock price… We trade only during open windows since I’m on the board and we’re obviously very conservative around those things. During the nadir, the window was shut, which was there’s positive and negatives of being on the board. That moment was a big negative.
[00:44:08] Will: Do those trading restrictions impact your investment process in any way?
[00:44:11] Rob: It’s fascinating. That discipline of only being able to buy in windows… It helps create some discipline that the public market allows your emotions to jump in and on things. We are forced to, and we try to carry this to other ideas, every idea we have, is only made very considered decisions to purchase or to sell the securities. While we lost the $200 share, I’m sure I forgot the times that I wanted to buy when waiting longer helped because you only remember the things that cost you.
[00:44:43] Will: Right, that’s interesting. Returning to your addition during COVID, how did that play out?
[00:44:49] Rob: In our view, we did this with our portfolio… First check was could COVID put the company out of business? We came to the conclusion pretty quickly that, one, their capital structure was pretty rock solid. They had no maturities for quite some time at that point. I think it was in ‘23 or ‘24 at that point before their first maturities were. And when you looked at the business, a lot of it was not commercial aerospace, which was really what was getting hammered the most. About half the business is between business and defense, grew up to be more when the commercial shrunk so much, but even during normal times, that our analysis was they were very unlikely to go cash flow negative during this period. Plus, they had done a financing to create cash on the balance sheet, a financing at what was high rates for them, think they were the first high yield financing during the crisis. It was an insurance policy. They created even more liquidity for the company.
It was priced as if it had a decent chance of going away, or going under. We didn’t think that was likely and, unfortunately, it had become quite a bit smaller in our portfolio during that period due to its price. I’m not sure we were buying our exposure up to the same level it was before, or just close to that level, but it was pretty easy decision. And private equity bought more at that time as well.
[00:46:03] Will: Was part of that watching how they managed the cost structure during the down tournament? As you look back on, it’s really remarkable to see how the stability in the EBITDA margin, even across the depths of COVID.
[00:46:13] Rob: Yes. I think they took a week or two to figure out what was going on, and I think felt apologetic a little bit to the board that it took a couple of weeks to decide. They took action very quickly. It’s no fun cutting people and TransDigm’s very proud of the people they employ and they employ a lot of people that are very hard working, but making sure the company is still there and can still do what it needs to for its customers is important as well. And they acted very quickly to right size to what would likely be lower volumes, and jumped on it very quickly.
[00:46:45] Will: Going back to that methodology you talked about before… You guys have that once a week where you run the 5-year model. Typical return for TransDigm were a mid-teens five-year IRR. During these three windows, is it safe to say those five-year returns might have cracked 20%? I mean is there some threshold level… Your whole methodology is very data driven.
[00:47:08] Rob: Yeah, it’s run every day. The model doesn’t change, so the price is just fed through it. We get a sheet each morning. Sometimes, you have it run multiple times a day if you want to make another decision, but it’s… Not that we’re that hair trigger traders. But yes, the model got well into the 20s. We’ve had a model on TransDigm that I would say during most points has run in between 15% and 20%. And the 15% has been the tightest, but it’s gone up into the mid-20s.
[00:47:35] Will: Let’s talk about the two sales, both of which were 20%. One was in early ’19, February of ’19 and the other was in summer of ’19, August.
[00:47:44] Rob: I was wondering how much we added when the short battle happened with Citron research.
[00:47:50] Will: The number’s there, about 17% in two purchases within three months of each other.
[00:47:54] Rob: Right. We had added there because we thought again… We redid all our work outside-in, helped the company redo their work inside-out over time. But very quickly, we believed that the accusations were false that they had made and that it was just wrong. Whether it was good work or bad work, it was wrong. We thought the stock got very oversold, so we purchased.
That brought our position… As the stock started to recover, it brought our position up. We thought it was prudent, at that point, only for risk management, not because we had less belief in the company, but just risk management, to take its size down. Part of that is so that way, you feel like you have the freedom if there’s another opportunity to buy. It’s when you’re at your max position size, it’s harder to manage. And we were pretty close to what we thought was our max position size, so we just sold in two chunks.
TransDigm’s Influence on Rob’s Investment Philosophy
[00:48:46] Will: I’m curious more broadly how the experience as a TransDigm investor and I guess a board member too has informed your investment philosophy, and specifically the criteria filter that you’re using. Focused a little bit more maybe on Stockbridge.
[00:49:03] Rob: Investing is humbling. We thought we had the perfect company and the perfect investment in TransDigm, and then the pandemic hit. You have your moments, and that’s always a reminder that investing’s about predicting the future. And by definition, predicting the future can’t be perfect. You have to always recognize that you can be wrong, and you can be wrong for both the right reasons and the wrong reasons. And you’ll never know really which one it was. Another thing that I find fascinating about investing is you never know if you’re really good, or whether you were really lucky. And if you did well, you probably were both and you never know what percentage breakdown is which, and you just keep trying to get better. And I do think you can know if you’re getting better over time, because you feel better about your judgments.
TransDigm was the perfect company for me early in my career, and that I hope it’s made me a better investor, in that, early in my career, I probably focused incredibly highly on business model. And the business model of going through the analysis of the competitive position, the secular growth in a market was the first on my list, and I cared about that deeply.
TransDigm has also added to me the power of execution. I think it’s still the hardest thing to judge, although it’s not hard to judge TransDigm’s execution because they’ve done it so consistently for so long. But when you’re evaluating new opportunity, trying to evaluate the execution is hard from the outside. You never know whether it’s the business model or the execution. But seeing the power of both in TransDigm, in that virtuous circle that the execution creates the cash flow, creates the ability to pay more for acquisitions, that gives the flexibility to do other things to take advantage of their industry position is amazing.
It’s also within the execution, you realize that one of the hardest things to do, and I look for it now, is the discipline to stick to your strategy, or change it when appropriate, but not take an easier way out is, “Oh my God, we need growth. We’ll let our acquisition criteria slip a little, or slide a little.” Always be open to new ideas and creative about it, but don’t give up the discipline. So, looking for those things.
We used to joke at Berkshire that every investment memo would have a TransDigm reference because they would hope that this is TransDigm-like as a way to help get approval for another investment opportunity. And, in some ways, TransDigm has been a huge help to my investment, but it’s also set a standard, both of my comfort with understanding the investment and the quality of the investment. I’ve always joked that if I find another one that I feel like I have as much conviction in and as good a business, I’m either going to make or lose a lot of money for the firm, depending on whether it turns out to be right, but I’ll have more courage to bet on more early.
TransDigm also taught me that, what we were talking about a little bit earlier, that concentration in your best ideas. Adding that extra dollar to TransDigm was a lot easier than buying something that was unknown. The truth is, if you have a couple of investment ideas over your career that you’re really confident and you do well on those, that’s more important than finding the 99th and hundredth frankly is really taking advantage, I think, of the ones that really click for you.
[00:52:32] Will: Coming back on execution, it’s inextricably tied to the culture. In TransDigm’s case, to the organizational form, decentralization, and those are inherently hard things to assess from the outside. You’ve had a ringside seat as a board member.
[00:52:46] Rob: The decentralization is very appropriate for TransDigm, and probably very appropriate for a lot of companies, but not every company. So, I think it fits.
The thing I like about TransDigm that I wish they would emulate is, if you ask Nick Howley or Kevin Stein what drives value at TransDigm, they give you an answer. If you ask the EVPs, if you ask the division Presidents, if you ask each of the 60 some divisions, if you ask all their direct reports, what is important and drives value at TransDigm, they’d all give you the same answer, the 3Ps. And that is incredible. That’s how they manage the business, the whole time I’ve known the business. And that consistency, that focus… It’s about creating value using the 3Ps, it has been incredible. That drives the culture more than anything.
Examining Stockbridge’s Approach to Selling
[00:53:39] Will: I want to come back on the general topic of selling. Your approach to selling, how has it evolved over time over the last decade or so at Stockbridge? I mean we talked a little bit about private equity, that’s a different animal.
[00:53:51] Rob: At Stockbridge, we’re very process driven. We strongly believe that investing through a process will create consistency, will make you less likely to fall prey to the emotional traps that come with investing, and is just a great way to build an organization and hopefully create repeatability.
Our process was probably too tied to our IRR models early. Trading off was a good idea if we could take a percent of the portfolio and move it from something that we thought had a 14% five-year forward IRR to something that had a 17% IRR, wouldn’t that weight up that average return of the portfolio?
We realized over time a couple of things. One is our models from the beginning are wrong. We always knew that, but the theory was they’re wrong, but they’re the best you got, so you got to go with the best you got. And two, we realized that the companies that we understood the best and had the highest conviction in their long term performance tended to outperform the models more often. And I think that is probably driven by the execution of the management teams, or their just incredible positions in their industry. But opportunities came their way, or they just did better than you were willing to put in your model. And that’s developed over time to where I now believe, sometimes on our best companies, the models have a tough time keeping up.
We now, on selling, are very careful to sell something only because of price. We are hesitant to sell only based on price. There’s obviously a price where something’s overvalued. You can never forget that. But if you have a long duration business that you have not changed your outlook on its prospects, you have to be very careful to walk away from it. And frankly, when I look back at our biggest mistakes… We’ve had mistakes on diligence and bought companies that have done poorly and we’ve been wrong about their quality, or things have happened that have made us wrong about their quality. But our most costly mistakes have been selling some of our best companies too early, partly because they got valued very highly and partly because of a failure of our imagination to see how well they could do. And I’d rather wait on our best companies and be a little quicker on the trigger on the ones that we think we may be actually wrong on their operating prospects.
[00:56:19] Will: I mean you had mentioned the example with TransDigm about how, for any company where acquisitions are a significant component of the value creation story, it’s just hard to model the pacing of those. And the tendency is to model them overly conservatively.
[00:56:33] Rob: Yes. I mean that’s definitely been the case. I think of both ourselves and, probably even more so, the people who own it. So, that’s actually I think been one of the things that has kept the valuation down. In other companies, our models have gotten to parts where we say we just have to sell this on valuation.
[00:56:50] Will: Can you give an example of a case where it, looking back, you wish you’d held?
[00:56:54] Rob: Classic one is a company called Tyler Technologies, which is business that sells IT systems to municipalities and court systems, and has slowly taken share from legacy systems and slowly done acquisitions to broaden their offering. But it has traded at very high valuations for a very long time now, and consistently grown earnings. We bought somewhere around 2008, 2009, 2010 at $17 a share, and we sold it and we bought it again, and we sold it over time. We don’t own it today and now it trades in the mid four hundreds.
[00:57:31] Will: Where was your last sale?
[00:57:33] Rob: We bought some at the beginning of COVID, I believe, when it traded down a bit, but then it traded up a lot and we thought there were better opportunities elsewhere. Again, it’s a wonderful business, really nice capital allocation, both on the acquisition side and on buying back their stock over time.
There’s an argument, since they sell to cities and towns, that cities and towns would pay the bill to Tyler on their maintenance before they would pay interest on their municipal debt because they can’t collect their taxes if they don’t have their system and they can’t collect all their fees. If their municipal debt has a 3% interest rate or whatever it has, what’s the cost to capital for Tyler? And cities and towns don’t go out of business.
[00:58:14] Will: Turning to the future, sitting here today early ’22, 12 years into the Berkshire ownership, 15 years into your ownership, how do you think about prospects going forward for the company? What’s the model showing today? Can you see this as something you’d be holding a decade from now?
[00:58:32] Rob: We have as high conviction in TransDigm as we have had at any point. The only thing that’s different, and this turned out to be a wrong assumption, but it was easy for many, many years to believe the secular tailwind of air travel was impregnable, and that it was just growing 5% to 7% for a very long time and it was likely to maybe continue to slide down a little bit, but was going to continue to grow very long time, and it was so steady, and you never had to worry about that. Turned out to be wrong. For the first time, we have a demand, an ultimate industry demand question. And my two biggest concerns aren’t about COVID. COVID I think will pass. We’ll figure out a way to live with it or deal with it.
[00:59:18] Will: Does Chris share that view? Rob’s wife is an excellent doctor.
[00:59:21] Rob: Yeah, she’s getting there. She thinks we’ll live with it.
The question is, to me, is a little bit the climate, and will there be costs and regulation. Although when you look at the total climate, things in the world, air travel is not that high on the list. The second is international and China, whether there’s a little bit of a decoupling of east versus west in international relations. I think both of those are going to work out. People want to fly, and planes will get more efficient over time. And they’ll figure out how to do that. And China wants growth and they need growth, and decoupling won’t create growth. Those are the questions that we wrestle with long-term.
But on the whole, the company’s position, the way they serve their customers, their positions on the planes that are being built are all very attractive. Obviously, as they continue to grow, it’s harder to have acquisitions make as much of a difference. But in our modeling, acquisitions have been the gravy and right now we have COVID recovery we think creates quite a potential for a lot of earnings growth. And then it goes back to the normal model which is pretty solid earnings growth.
[01:00:30] Will: Well Rob, thank you very much. This has been great fun.
[01:00:33] Rob: It has been a lot of fun. Thank you.