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The new Koch

December 19, 2013, 5:20 PM UTC
Illustration: Hello Vo

The headquarters of Koch Industries isn’t exactly the first place you’d expect to find an information technology evangelist. It’s about 1,600 miles away from Silicon Valley and even more distant culturally and politically. Located on the northeast fringe of Wichita, where the city streets give way to open expanses of prairie grass, the campus of one of America’s largest private companies has grown over the years to support an expanding oil and gas empire.

But when Koch CFO Steve Feilmeier was asked recently about the future of the U.S. economy, he launched into a spirited monologue about the bright prospects for the nation’s high-tech industry. “It’s the little things, like these BlackBerrys that didn’t exist eight or 10 years ago,” said Feilmeier, holding up his distinctly last-century smartphone and growing animated in his modest office along executive row. “These technologies have improved the quality of our lives tremendously. That’s going to continue, very rapidly.”

In early December, Koch Industries put some serious money behind that belief when it closed on its $7.2 billion acquisition of Molex, a global electronic components manufacturer headquartered in Lisle, Ill. Molex makes parts for a wide variety of gadgets, including iPhones, and was traded on Nasdaq before the buyout. Koch sees huge potential for Molex to benefit from the so-called Internet of Things revolution that’s on the horizon. (See “Everything Is Connected.”) “Think about sensors and connectors and how [they’re] proliferating right now,” says Feilmeier, a stout 52-year-old who has the rah-rah intensity of a high school football coach. “As technology becomes more user-friendly and machines become wired to be more proactive — whether that be industrial robotics and automation, or you have automobiles doing more for you and telling you more and keeping you out of accidents — we think Molex is really well positioned to capture that growth.”

Feilmeier envisions Molex growing from today’s $3.6 billion in revenue to $10 billion within a decade and says there are hundreds of smaller tech companies that could be acquisition targets. “They just weren’t out acquiring those companies or those technologies to enter new markets, and we’ll really be able to help them with that,” he says.

To the degree that most people have heard of Koch (pronounced “coke”), it is likely because of the political activities of the company’s primary shareholders — the brothers Charles and David Koch. Thanks to the tremendous growth of the family company founded by their father, Fred, more than 70 years ago, the Kochs are among the very wealthiest people in the world today. Each brother has a net worth estimated at $36 billion or more, and as their fortunes have grown, they have been aggressive about using their money to influence the political conversation in the U.S. The Kochs are staunch libertarians — David ran for Vice President on the Libertarian Party ticket back in 1980 — with a distaste for big government and, some would argue, regulation that might infringe on the profitability of their businesses. Money from the Koch brothers helped fund groups that spawned the Tea Party movement. One of the prime vehicles for their efforts is the Koch-sponsored political advocacy group Americans for Prosperity, which has taken on an array of political fights — from repealing Obamacare to fighting the power of public sector unions in Wisconsin. According to a recent study by the Center for Public Integrity, AFP spent $122 million in 2012 alone. But that is hardly the extent of the Kochs’ political spending. They have given tens of millions to help support a network of other conservative organizations. As a result, the brothers have become outsize figures in America’s partisan political narrative — all-purpose bogeymen to those on the left.

All the attention on the Koch brothers’ politics, however, obscures the story of how their sprawling conglomerate has become one of the most important companies in America. If Koch Industries were eligible, its $115 billion in revenues would be enough for it to rank No. 17 on the Fortune 500, with sales larger than those of Google, Goldman Sachs, and Kraft Foods combined. It has doubled in size in the past decade. But Koch isn’t important just because it’s big. As Koch grows, it is reaching into new areas of business and becoming more closely entwined with more consumers. Koch owns well-known brands such as Stainmaster carpet and, thanks to its $22 billion purchase of Georgia-Pacific in 2005, Quilted Northern toilet paper, Brawny paper towels, and Dixie cups.

While it began as an oil company, Koch today operates more like a giant private equity fund. It is essentially a massive pool of cash that is looking to invest wherever it sees the potential for long-term profits. When the company moves into a new industry, it does so strategically and patiently. Just 10 years ago, for example, Koch was a minor player in the fertilizer business. Then it made a series of quiet investments that turned it into the third-largest maker and distributor of fertilizer products in the U.S. Now Koch occupies a crucial role in the world’s food system — a position that the company is using as a beachhead for further investments in agribusiness.

To better understand Koch’s strategy and its methodology, Fortune spent months interviewing current and former executives of the company, poring over available documents on the private company, and talking to competitors. What emerged was a picture of a highly disciplined organization that plans to play a critical and growing role in delivering electricity, food, technology, and, one day, maybe even tap water.

It all revolves around the mind of one man: Charles Koch. People tend to refer to the Koch brothers as a single entity, but David, 73, the younger of the two, is clearly the junior partner inside the company. David retains the title of executive vice president, but he has long lived in New York City and spends much of his time involved in public-facing roles like philanthropic giving. In 2008 he pledged $100 million to Lincoln Center and got a theater named after him. Charles, 78, lives in Wichita and has held the titles of CEO and chairman since his father, Fred Koch, died in 1967. Charles and David Koch declined to be interviewed for this article.

Based on Koch’s growth, there is a strong case to be made for Charles as one of the elite business executives of the past half-century. When he took the reins of the company nearly 50 years ago, Koch had around $200 million in revenues (vs. $115 billion today). He has steadily built on the foundation left by his father. Fred Koch, the son of a Dutch immigrant, studied engineering at MIT and invented a new method of converting oil to gasoline in the late 1920s. He worked in the Soviet Union under Joseph Stalin for a time before returning to the U.S. to found his own refining company in 1940. One of the original members of the John Birch Society, Fred imparted his conservative values to his four sons. Yes, four. David’s twin, Bill, is a businessman and sailor who won the America’s Cup back in 1992 and more recently made news by leading the fight against wind turbines off the coast of Cape Cod. The eldest Koch brother, Frederick, 80, is a collector and philanthropist. In 1983, Charles and David bought out Bill’s and Frederick’s shares in the company for just over $1 billion — spurring a long-running family feud that in the 1990s led to a contentious lawsuit by Bill and Frederick claiming that they had been underpaid and ended in 2001 with an undisclosed settlement.

The structure of Koch Industries today would probably be unrecognizable to Fred. There is a central group, officially called Koch Equity Development, which reports directly to Charles and other senior executives and which operates like a high-level think tank, evaluating potential deals, sometimes on a 10- to 15-year horizon. The company also has smaller development groups in its different divisions, such as Koch Fertilizer and Koch Minerals. These groups constantly scan the landscape of their respective industries for potential deals, feeding information back to the central group. Koch spends roughly $100 million a year to fund the research in its development groups, according to Feilmeier.

The company also leverages other means of intelligence gathering — for instance, its massive commodities trading operation. Koch is the world’s fourth-largest commodities trader, according to a 2011 ranking by Reuters, with trading floors in Houston, New York, Geneva, Singapore, and Wichita. Koch’s traders buy and sell contracts on a wide range of commodities, from oil to silver to orange juice. In addition to generating profits, Koch’s traders act as scouts in the marketplace, according to current and former senior employees in the trading division. This helps Koch as it looks for new deals and new companies to buy. For example, Koch’s trading unit began buying and selling petrochemicals called olefins in the late 1990s because the market was undertraded and attractive, according to a former senior trader. In 2007, Koch bought a group of olefin plants from Huntsman Corp. as part of a $770 million transaction. The deal relied, at least somewhat, on analysis of the olefin market developed by the traders.

Each of Koch’s major divisions reports to Charles Koch and other top executives at least every quarter with an update on their business. These meetings are not perfunctory. Every business unit of Koch is potentially up for sale all the time, and executives know it. They don’t dare fudge numbers or gloss over shortcomings when they stand in front of Charles Koch. He is known to pierce weak arguments with a single question.

“It is intense,” said Jeremy Jones, who from 2007 until 2009 was vice president of Koch’s internal venture capital fund, which worked closely with Koch’s central development group. Jones learned the hard way when he pitched an investment in biofuels to Charles. After Jones made his case, Charles began grilling him in his no-nonsense style. Had Jones considered the fact that ethanol delivers only 66.7% of the energy of gasoline? Did his forecasts incorporate the fact that there was a government mandate for ethanol use, which could change? “My analysis was built on faulty assumptions,” Jones recalls. “He was really quick to figure that out. If you don’t know something, you’d better say you don’t know. Do not try to dance.”

Once Koch commits to an investment, the company employs a rigorous approach to running the business that Charles has refined over decades. He has codified this approach into a philosophy that he calls Market-Based Management®. (Yes, he uses the registered symbol when writing about it.) In 2007, Charles published a book called The Science of Success, explaining how the system works at Koch. MBM, as Koch employees call it, lies at the heart of how Koch operates every day. There isn’t a lot of art on the walls in Koch’s headquarters, but everywhere you turn there is a copy of MBM’s 10 guiding principles hanging from the wall. When employees get a free cup of Starbucks coffee in the break room, the principles are printed on the disposable cup.

The influence MBM has on Koch employees cannot be overstated. “It’s your life, man,” says one former senior Koch executive who worked closely with Charles Koch for many years. This executive said that the importance of MBM doesn’t lie just in its concrete advice. MBM is critical because it unites Koch’s employees, giving them a common language and a common goal.

It can be maddening to try to understand MBM from the outside. The belief system can seem like little more than a grab bag of management consulting clichés. For example, the 10 guiding principles of MBM include malleable terms such as value creation, integrity, change, and principled entrepreneurship. But there is something very real at the heart of MBM, and in turn at the heart of Koch Industries’ corporate culture. And the only way to understand how Koch really works is to delve into specifics. There is no better case study for this than Koch’s fertilizer business.

In 2002 a company named Farmland Industries, which owned a network of nitrogen fertilizer plants, was forced to declare bankruptcy and began selling off its divisions. The following year Farmland held an auction for its fertilizer plants in a conference room at its headquarters in Kansas City, Mo. The room was lined with glossy posterboard photos of the plants, designed to entice a bidding war. But only two companies showed up: the fertilizer giant Agrium and Koch Industries.

Koch’s presence was puzzling to outsiders. Why was an oil company interested in buying fertilizer factories, at the very moment when those factories were least profitable? What outsiders didn’t know at the time was that Koch had been studying Farmland for years, in just the same way that Koch is studying other industries and companies today. This kind of analysis happens inside Koch’s central development group. When evaluating a deal, Koch executives focus on three key criteria:

1. The business in question must be in trouble. When a company is humming along, there’s not a lot of upside. If it has some sort of huge problem, there’s a better chance that Koch can reap profits from its recovery.

2. The deal must be a long-term play. Most public companies need to show good results on a quarterly basis. Even private equity funds need to show their senior investors that investments are paying off in at least a few years. Koch doesn’t. Being privately held means the company can think in terms of decades.

3. Koch needs to have key skills (or “core capabilities” in MBM lingo) that will benefit the company. Koch doesn’t just bring money to the table. It brings knowledge. And if Koch doesn’t already know something important about running the business in question, it will pass on the investment.

Koch’s development group pores over the details of any possible deal and conducts a series of futures studies, gaming out what might happen in any given industry over the next 10 to 15 years, according to current and former Koch executives, including Brad Hall, who ran the group in the late 1990s. The development group then charts out the possible outcomes into a kind of bell curve, with highly likely scenarios in the middle and unlikely, “black swan” scenarios on the edges. If a deal is profitable under enough of the likely outcomes, Koch will make a move.

In the early 2000s Koch’s small fertilizer business was doing just this kind of analysis. Steve Packebush, a young employee in the unit, was on the team that started analyzing global supply and demand trends for fertilizer. At the time Koch owned only a small plant and some pipelines that transported fertilizer ingredients. Then, in 2002, natural-gas prices shot up, dramatically increasing the manufacturing costs for nitrogen fertilizer makers and putting companies like Farmland under duress. Nitrogen fertilizer may sound like an agricultural commodity, but it’s actually an energy product because the main input in the manufacturing of nitrogen fertilizer is natural gas.

Packebush’s group saw an opportunity in the price spike and recommended that Koch take advantage of the market turmoil and buy more fertilizer factories. At the time the U.S. fertilizer industry was in a deep hole, and about 40% of U.S. production had been knocked out of business. That meant the surviving factories were the most efficient and would benefit when the industry rebounded, Packebush said. Farmland’s fertilizer plants were particularly attractive because they were located in the U.S. Cornbelt, stretching from Oklahoma to Iowa. That gave the plants a slight price advantage over imported fertilizer, which had to be shipped in from the Gulf Coast.

Charles Koch and the board gave their approval for the fertilizer business to invest when the right opportunity appeared. So in 2003, Packebush went to the auction at Farmland’s headquarters and outbid Agrium. Koch walked away with the fertilizer plants for pennies on the dollar in a deal valued at $293 million. Koch soon began applying its “core capabilities” to the business by investing about $500 million over a decade to upgrade the fertilizer plants and other infrastructure, running the operation with the same eye for efficiency Koch uses at its oil refineries.

Then Koch Fertilizer was given a big boost by a scenario that almost no one saw coming. Beginning around 2008, hydraulic fracturing, or “fracking,” technology opened up enormous reserves of natural gas in the U.S. Supplies jumped and prices plummeted. Koch was suddenly buying its primary feedstock at about half the cost that Farmland paid when it went bankrupt. But retail fertilizer prices remained high, because record-high corn prices incentivized farmers to buy as much fertilizer as they could use. The spread between cheap natural gas and expensive fertilizer translated into pure profit for Koch.

The mix of luck and skill has made Koch Fertilizer one of the company’s largest divisions, and one of its most important. Koch CFO Feilmeier said agribusiness is one of the top areas where Koch will be looking to expand in coming years, and many of the deals could be made through the fertilizer unit. “The fertilizer business is right in the center of agriculture,” Feilmeier says. “Here’s the problem the world has: We’re at [a population of] 7 billion people today, 9 billion by the year 2030, okay? How are we going to feed them?”

Koch is not particularly bullish about the economy right now. Feilmeier says the company is expecting sluggish growth in the near future. But there will be bright spots. Constant innovation in electronic devices will boost demand for high-tech manufacturing. The Molex deal, of course, is a means of capitalizing on that trend.

Another long-term trend that Koch has identified is the need for utility companies to reinvest in the electricity grid. One surprising way Koch plans to benefit from this is by entering the steel business. It recently invested in a $1.1 billion mill being built in Osceola, Ark., by Big River Steel. Koch won’t say how much money it invested, but steelmaker Nucor estimates that Koch is getting a 40% equity stake in the plant by putting in a mere $125 million. The investment is relatively small for Koch, but that’s how the company often enters a market — making small deals at first, the kind of low-stakes experiments that allow it to learn and fail on the cheap. For example, Koch got into the forest products business cautiously in 2004 when it bought pulp mills and other holdings for $610 million from the timber company Georgia-Pacific. After briefly operating those mills, Koch suddenly bought all of Georgia-Pacific the following year.

Feilmeier said Koch was attracted to the Big River Steel deal because the mill will be the only large-scale producer in the U.S. of electrical-grade steel used to make transformers, power lines, and other equipment used in the specialty grids of tomorrow. “What we see is an opportunity to help the U.S. retool itself on the electrical grid, and this plant is being positioned to do that,” says Feilmeier. “So we learn a lot. We bring a lot. And it potentially puts us into new markets 10 and 20 years from now that we’re not in today.” Does that mean that Koch could eventually make a multibillion-dollar bid to take a steelmaker like Nucor private, as it did with Georgia-Pacific? “Maybe so, if they have a problem that we can help them solve!” says Feilmeier.

Koch’s investments in steel and electronics are plainly visible. But the company is also making quieter deals in the background. One of the most intriguing of these investments has to do with the most precious natural resource on the planet — water. Koch is among a handful of companies that are building the foundation of a privatized water industry. The investment thesis is simple: Fresh, clean water is increasingly scarce, and demand is growing. Booming populations in the developing world are outstripping freshwater supplies, creating strong demand for machines that can desalinize seawater or purify polluted streams. The market to desalinate water is expected to grow 9.5% year over year between 2012 and 2016, according to the market research firm TechNavio. “I think it could be a great business,” says Jones, the former vice president at Koch’s venture capital fund. He says he pushed water investments during his time there. “Fresh water, pure water, usable water: It’s not an asset that’s growing right now.”

Koch is making a quiet push into the water business through a unit called Koch Membrane Systems, based in Wilmington, Mass. The division was originally founded to sell equipment that purified wastewater at industrial sites like Koch’s oil refineries. Scientists at Koch Membrane Systems became experts at making high-tech water plants that could fit in a small amount of space. In the 1990s the group started buying technology that opened the door to purifying water supplies for consumers rather than oil refineries, says Steven Iannelli, who worked for Koch Membrane Systems from 1991 until 2000 and left as vice president of the division’s development group.

Today Koch offers a range of water products and services. It is selling its water-purifying systems to U.S. cities like Franklin, Mass., and pushing to expand overseas. Koch has sold desalination systems to a power plant in China and a mine in Chile. It has also supplied, to U.S. Department of Defense contractors, technology for portable water plants that can make drinking water out of saltwater or other sources that are polluted by chemicals and even nuclear waste. Then there is Koch’s Puron Plus system, a prefabricated water plant that can be made to order for cities or factories to install. Koch makes Puron “packaged plants” that can be quickly built to order, with the filtration systems set up in different floor plans designed to fit into small spaces. Products like this could help overcrowded cities that need new wastewater-treatment plants but don’t have a lot of space to house them.

Koch’s water business is still tiny compared with the company’s oil refineries and fertilizer plants. But the company sees potentially huge profits down the road. Feilmeier says that Koch has been offered “many hundreds of millions of dollars” for the group of patents it has developed around water technology. “We’re not willing to do it, because we think we can take that technology and get it commercialized in the markets,” he says.

One aspect of Koch’s long game that remains unclear is who will run the company after Charles Koch. The energetic 78-year-old doesn’t seem ready for retirement anytime soon, but succession plans are important for a company that invests with 20-year horizons. Nobody interviewed for this story suggested that David Koch would take over the company. Speculation tends to focus on the small coterie of lieutenants who work closely with Charles, including CFO Feilmeier and the company president, 51-year-old David Robertson. But there is one young up-and-comer at Koch who generates more speculation than anybody: Charles Chase Koch.

Charles Koch’s son, known as Chase, inherited his father’s sense of fierce competition, say those who know him, and was a nationally ranked tennis player by the time he was 12. Now 36, Chase studied business at Texas A&M and joined Koch Industries in his mid-twenties. It appears that he is being groomed for leadership. Chase has shadowed senior executives and other employees in different divisions of Koch since being hired. He is now a vice president of Koch’s agronomics division, and in early 2014 he will be promoted to president of Koch Fertilizer, helping to guide the company’s expansion efforts. The company declined to make Chase available for an interview for this story.

Whoever becomes the next CEO of Koch Industries must prove that the company is more than just the product of Charles Koch’s business acumen — in some ways similar to the challenge handed to Apple CEO Tim Cook and his executive team after Steve Jobs’ death. And the next leader of the company will be working with a transformed portfolio of businesses. As Feilmeier puts it, “When we buy something, it’s with an intention of holding it forever.” Someday, maybe people will talk about Koch Industries as a tech company.

This story is from the January 13, 2014 issue of Fortune.

Update 12/20/13 — Response from Charles Koch:

Your story “The New Koch” (Jan. 13) was overall an accurate and honest portrayal of our company but one aspect of it fell far short of being accurate — that is your characterization of my brother David Koch’s role in Koch Industries, Inc.

David has played and continues to play an active and significant role in governing and leading Koch Industries. He is an equal shareholder in Koch Industries with me. He serves as an executive vice president of the company and has been a member of its board of directors since 1967.

David also serves as chairman and CEO of Koch Chemical Technology Group. Since joining KCTG in 1970, he has led and built that company to record levels, far beyond what was ever imagined. Steve Feilmeier’s quote in the story that we have been offered “many hundreds of millions of dollars” for Koch Membrane’s valuable water technology patents is just one piece of evidence of how significant David’s leadership has been.

Charles G. Koch
Chairman of the Board & CEO
Koch Industries, Inc.