Lessons Learned from Brookfield Asset Management’s CEO, Bruce Flatt

Lessons Learned from Brookfield Asset Management’s CEO, Bruce Flatt

We work hard to institutionalize the lessons we learn in our business in order to prevent the repetition of mistakes as we grow. This has become a core part of our culture, and experience has shown that doing this enables us to continue to become better at what we do.

Over time, we have found that the five most important principles to successful real asset investing are to: stick to what we know; ensure that we are diversified; buy at a discount to replacement cost; focus on quality assets and businesses; and finance with asset specific non-recourse debt.

We have also found that the single greatest way to dig ourselves out of mistakes is to be patient with investments and, in most cases, double down. This is the best way to recover losses, although it requires conviction as well as availability of the necessary capital. This is particularly important when we have acquired a good business, but our timing was poor. Doubling down in this case is virtually always the answer. However, one has to be careful because if the business is just a bad business, it only serves to compound the pain. But, generally we have found that in the absence of technological change in the extreme, doubling down and being patient is the most proven way to turn around an investment.

In addition to these principles, we have tried to institutionalize the lessons learned from our mistakes. Our five most important lessons are:

1) A bad business is usually just a bad business. We have found that some businesses, no matter how deep the discount to replacement cost, are just bad businesses. In these circumstances, there is essentially no price that can be paid to make up the cost of turning it into a viable business. These risks are most often found and magnified when technological change is affecting a business. The skill to be able to determine if a business is one or the other is the difference between a great value investment and a loser investment. In these situations, we must always be vigilant to ensure that our historical knowledge bias to just do what we have always done, along with our tendency to double down, does not keep us in a business that is destined to decline.

2) Development and approval risks in new businesses are often underestimated. When we develop assets ourselves, the process of acquiring approvals is methodically secured over time, often involving significant relationship management. In the alternative, when a business that has significant development and approval risks is acquired, the approvals can sometimes disappear with the departure of management or the mere change in circumstances as local officials revisit their perspective. This has affected us in real estate and infrastructure developments. As a result, we are very careful when acquiring companies with development projects, ensuring that we only allocate nominal value to these projects.

3) Currencies really matter. As a global investor that benchmarks return in U.S. dollars, the local return in a currency is relevant, but not what really matters to us. Earning a 20% compound return in a local currency and losing all of it with a currency loss still results in a zero return. To ensure we manage these risks, with many low-cost currencies in developed markets (Euro, Pound, Aussie, Kiwi, Loonie) we often hedge back to the U.S. dollar, provided the financial hedge risks are not too large. With high-cost currencies (Rupee, Real) it is difficult to justify hedging on longer-term assets. As a result, we invest capital when markets are stressed and foreign direct investment is low. This usually means that the currency is low, or at least has a greater chance of being more fairly valued. On the flip side, in these markets it is important to be more transactional in nature; therefore we often sell all or portions of assets as values increase. We rarely leave the countries entirely, but protecting our capital helps mitigate risk.

4) Structured financial deals often hide asset imperfections. The financial markets are filled with schemes to enhance returns where the returns do not otherwise exist at the levels promised. This is particularly acute when values are high, or interest rates are low. Often this takes the form of imprudent leverage, camouflaged by structured products or mismatched risks (the most recent example – the numerous VIX Volatility products sold to investors). In these circumstances, seldom do the long-term returns work out as structured, as changing the long-term characteristics of assets with financial engineering is impossible. Some, such as traders, may profit from these, but it is usually from on-selling the product at a higher price prior to its collapse. This is not how we invest. We therefore avoid participating in structured products, or investing in anything in which small annual returns can be offset with an improbable (but possible) outsized capital loss. Rarely have we made this mistake, and hopefully never again.

5) The nature of debt and maturity profile is critical. With the exception of modest amounts of corporate debt used for largely “flex” or “bridging” purposes, we limit recourse of debt to specific assets and virtually never guarantee debt across the company. This compartmentalization is the difference between problems with debt and easily moving through tougher periods in the capital markets. This includes not cross-collateralizing assets and avoiding parent or any affiliate guarantees to ensure that risk is compartmentalized. Furthermore, we keep loan-to-value appraisal covenants which require capital top-ups to a minimum, and avoid maintenance covenants if at all possible. Bottom line, we will never risk the company, any fund, or any investment with a financing strategy.

Excerpt from Bruce Flatt’s letter to shareholders, 4^th quarter 2017