6. Incentives, promoters, and the bikini balance sheet

Part 10 of 19 in The Patient Owner: Charlie Munger’s Ideas, as Rakesh Jhunjhunwala Might Have Taught Them to an Indian Investor← Part 9Part 11 →

This chapter explores the importance of understanding incentives in business and investing, using insights from Rakesh Jhunjhunwala and Charlie Munger. It highlights how incentives can influence business decisions and the transparency of financial statements.

Rakesh. Never, ever think about something else when you should be thinking about incentives. Charlie said that in cleaner English than I will. I say it like this. Show me how the man is paid, and I will tell you what the annual report is for.

Aniruddha. You used a line in public that I have never been able to improve on. A balance sheet is like a bikini. It shows more, but it hides what is vital.

A balance sheet is like a bikini. It shows more, but it hides what is vital. — Rakesh Jhunjhunwala, public interviews

Rakesh. The vital thing is usually not a ratio. It is a relationship. Who owes whom a favour? Whose son is the vendor? Whose pledge is at the financing company? Which customer is also a cousin? Indian accounting can be excellent. Indian structure can still be a family. The bikini is not a joke about disclosure standards. It is a joke about human nature. People reveal the flattering surface and forget, sincerely, the part that would change your mind.

Three Indian incentive machines

He did not want a theory. He wanted machines you could recognise on a Sunday.

The pledged promoter. A man who has borrowed against his own shares is no longer only an owner. He is a trader in his own stock, with a margin clerk for a partner. When the price falls he does not become more long-term. He becomes more desperate. Desperation is not in the vision statement. It is in the shareholding pattern, in the footnote most readers skip on the way to the earnings call.

The growth lender. A bank or an NBFC that celebrates disbursement is telling you what it pays for. Credit is a business of refusal. The years in which refusal is most valuable are the years in which the conference is most mocking about refusal. HDFC Bank’s long reputation was not a logo. It was a culture that treated a bad loan as a moral event, not as a percentage to be managed next quarter. Cultures like that can decay, and mergers can dilute them. The lesson survives the anecdote: underwriting is the product. The app is packaging.

The paid cheer. A rating agency paid by the issuer, a doctor paid by the procedure, a banker paid by the listing, an influencer paid by the order flow — same machine. CRISIL, which sat in his portfolio for years, was interesting to him not because a rating is magic, but because a reputation for being believed is a tollbooth, and a tollbooth with integrity has pricing power. The inversion is the agency, the channel, the doctor, who sells the tollbooth one smile at a time.

Aniruddha. I have sat on enough clinical decisions to know that a protocol does not save you if the incentive points the other way. We write the protocol and then we order the extra test. Investors write ‘governance’ on a checklist and then buy the charismatic promoter because the quarter was good.

Rakesh. Charisma is an incentive aimed at you. It is paid in the coin of your admiration. Charlie had a liking/loving tendency on his list. You overlook the faults of the man you have decided to love. Indian investing is a love market. We love a founder story the way we love a film. The cure is not cynicism. The cure is to ask, with a straight face, what this person gets if the public shareholder gets nothing. If the answer is ‘a lot, and soon’, you are not a partner. You are the exit.

Aniruddha. There is a kinder version. Some promoters are simply tired, or succeeding, and the structure was built in a harder decade. I don’t want to make a villain out of every related party.

Rakesh. Good. Inversion is not prosecution. A related party can be a factory that had to be built when no one else would build it. The question is whether the terms are terms you would accept from a stranger. If you would not, the bikini is doing its job, and so should you.

Evening question. For the business you most admire, write down how the top three people are paid, what is pledged, and who the related parties are. If you need the annual report and you do not have it open, admiration has outrun work.