And why the model was flawed from the start
SMITH BRAIN TRUST – For a long time, it has seemed like 3G Capital was the batter who couldn’t help but hit home runs. A model of good management, the private equity firm seemed to just keep hitting them out of the park.
But is it really?
The iconic Kraft Heinz, which is backed by 3G and Warren Buffett’s Berkshire Hathaway, last month announced a whopping $15 billion write-down, an SEC investigation into its accounting practices and a plan to slash its dividend amid a dismal outlook for the year. With the announcement, the market’s initial euphoria about the future of Kraft Heinz faded dramatically. The highly revered Buffett, who had partnered with 3G to combine Heinz and Kraft, admitted his own rare misstep, paying too much for the deal, and admitting a nearly $3 billion loss.
A similar story happened with 3G’s involvement in Anheuser-Busch InBev, says Maryland Smith’s Paulo Prochno. “And now,” he says, “the issues faced by both are calling into question the limits of 3G’s extreme cost-cutting approach.”
It’s a shift that’s not altogether surprising, says Prochno, a clinical professor of management and organization at the University of Maryland’s Robert H. Smith School of Business.
For years, 3G has followed a certain playbook, adding value by restructuring companies after acquisitions, imposing a model that’s based on extreme efficiency. Shareholders have praised it, cheering on the implementation of zero-based budgeting at Anheuser Busch InBev, Burger King, Tim Horton’s, and Kraft Heinz. “The story of restructuring, efficiency, cutting costs, et cetera, was seen as very positive until now,” says Prochno.
It’s no wonder. The strategy creates an almost-immediate, sizable impact on short-term profits, reducing staff, closing plants, finding synergies.
But, here’s the thing. The model is challenged from the start. In most acquisitions, Prochno notes, the buyer is paying a premium on the value of the company – typically from 20 to 30 percent above the asking price of the asset itself.
“How do you justify that premium? You have to extract some new type of value,” Prochno says. “And it’s often easier to extract new value by cost-cutting, rather than innovating, after a merger. It’s faster.”
Those cuts, he says, often come at the expense of long-term capabilities, such as creativity and innovation. That’s what’s happening to Kraft Heinz. And as research demonstrates, it’s what often happens when companies fall prey to the market short-termism and myopia.
“You can't cut costs forever,” Prochno says. "There is a limit. So now 3G is facing the limitations of the model. 3G will either have to keep finding acquisition targets – and there is a limit to that – or it needs to find a new value creation model. And that's extremely hard.”
In Prochno’s strategic management course, student analyze InBev’s takeover of Anheuser Busch, a deal led by 3G about a decade ago. Prochno halts the narrative as the acquisition offer is made, and asks the students how they would handle the post-merger integration. “And usually the students come up with a very different way to manage the company than what ended up happening,” he says.
The students typically proposed a “best of both companies” approach in its post-merger integrations, one that leverages InBev’s strength in efficiency and Anheuser-Busch’s strength in marketing and branding.
“That would be in theory the better choice, given the complentaries and skills that were there,” Prochno says. But that means mingling two corporate cultures. It’s a process that takes a long time and pays off slowly, Prochno says, though it’s likely more profitable as it creates a new culture and takes a longer-term view. Instead, Anheuser-Busch disappeared in InBev’s shadow. Of the senior executives that were left in place after the merger, one was from Anheuser-Busch and 11 from InBev. “And then the extreme cost-cutting began. We discuss that during class as well,” he says.
What they are discussing is the predictable trajectory: a string of positive results for the stock, then a string of gradually shrinking returns, then a thud, as the company’s austerity, its lack of investment in innovation and creativity, catches up with it.
Acquisitions are fraught with potential pitfalls. “A lot of mergers should not happen, in fact,” Prochno says. “And often that is because the price was too high and the company is never able to recover the premium it paid above the acquired company’s value.”
Kraft Heinz CEO Bernardo Hees, who is a partner at 3G, blamed his company’s recent miss on a shift in consumer tastes. New products, such as Heinz Mayochup, hadn’t caught on.
Prochno laughs. “Well, of course, consumers are changing,” he says. “They’re always changing. That happens in every industry.” It’s the job of management to stay on top of those changes.
“The question is why hasn’t the company responded to those customer changes? Why isn’t it prepared to deal with those changes? And in this case, it’s because the company has been focused on extreme cost-cutting and efficiencies, and not on creativity and innovation.”
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