Why So Much Cash?
One question we get quite a bit from investors when they see our track record for making cash distributions from our funds is why do you and your companies throw off so much cash? Because with the S&P 500 yielding less than 2% and many public companies paying no dividends at all, ours look high by comparison. There are a few reasons.
First, our businesses are typically structured as pass-through entities. What this means is that they don’t pay corporate income taxes, but rather “pass-through” both tax liability and the cash to pay that tax liability to their owners. In other words, the dividends paid by our companies and funds, unlike the dividends paid by C corps, are issued on a pre-tax basis, which will make them definitionally higher.
Second, when it comes to capital allocation, there are really three things a business can do with its money:
Pay dividends.
Buy back stock.
Reinvest in the business.
For C corps, they not only pay dividends after paying income taxes, but individuals receiving them then have to pay another 15% to 20% in dividend tax. Leaving aside the issue of whether this double-taxation is fair or not, what it means for C corps is that they get more bang for their buck on behalf of their owners by either buying back stock or reinvesting (because those activities are not taxed twice and reinvestment can be tax-advantaged through policies like accelerated depreciation), so if they are being rational about value creation they will do more of that and less paying of dividends.
Third, incentives. Because we like dividends (more on that below), the people who run our businesses are typically bonused based on the amount of cash they distribute out of the business. This stands in contrast to the compensation plans of many CEOs of public companies who are rewarded based on stock price appreciation. The thing about dividends is that when they are paid out, cash (a balance sheet asset) leaves the company, so the stock price goes down (not good if your bonus depends on the stock going up). Buying back stock and reinvesting, on the other hand, are both things that give a stock price a better than 0% chance to go up. “Show me the incentive and I’ll show you the outcome” indeed, as Charlie Munger used to say.
Fourth, there’s a relationship between the size of a business and its ability to tolerate reinvestment and growth, and our experience has been that the more aggressively one tries to reinvest in and grow a small business, the more risk one introduces into its operations. Because remember that anytime you create the opportunity to make gains, you are simultaneously creating the opportunity to take losses. So while our operating team works with our companies to maintain ranked lists of reinvestment opportunities, they are typically never executing on more than one or two of them at once. That’s in order to stay focused on making the reinvestment we’re making successful, but also so that, if it isn’t, we haven’t bet the company.
Fifth, cost of capital matters. When it comes to reinvestment, our businesses are typically reinvesting in scaling assets such as vehicles, machinery, or facility expansions. Because these assets are tangible and easy for a lender with a lower cost of capital such as a bank to underwrite, it’s typically cheaper to finance them that way than with retained earnings. And so we do.
Finally, the golden rule applies. As investors, since we are the ones who have to face the consequences of any losses incurred by our investment decisions, we think we should also be the ones who get to decide what to do next with any gains – and we think our investors deserve the same courtesy. This is why distributions paid by our companies to our funds are almost entirely paid forward to the fund investors as beer money rather than recycled by us into something else. We feel that if, after receiving their cash, our investors want to give them back to us to reinvest, they can do so by committing to a future fund, but that that should be their, and not our, decision.
-Tim
