Wednesday, May 18, 2011

If Buffett Were Paid Like a Hedge Fund Manager

It's well known that Warren Buffett is paid $ 100,000 per year (excluding security costs) to manage what is now a $ 150 billion portfolio and the operating company* for Berkshire Hathaway (BRKa) shareholders.

The operating company alone employs 260,000 people and earned $12.9 billion last year.

Now, consider that the sum of all salary received by Buffett over of the past 40 years or so is actually less than half what the highest earning hedge fund manager made in a day last year.

No kidding.

The increases to Buffett's wealth has come from gains in the value of the Berkshire shares he owned after ending his investing partnerships in 1969. His business skills and capital allocation talents driving the substantial increase in Berkshire's value since then. So, unlike a hedge fund manager, Buffett gets no fees nor other forms of compensation like bonuses, stock grants or options or from Berkshire Hathaway. Just what is, at least in this context, a token salary.

My focus here is not on that contrast in compensation. I think the contrast speaks for itself. I think what's far more interesting than that crazy gap in pay is the impact extremely high compensation has on potential shareholder returns. More importantly, the compensation systems most prevalent these days are likely expensive in a broader sense (beyond the walls of Berkshire or any hedge fund).

Some quick background and context:

Hedge Fund Pay
The 25 best paid hedge fund managers made a combined $22 billion last year which was actually down from the year before. The top person in pay was John Paulson at $ 4.9 billion ("yeah, that's right" as David Puddy from Seinfeld would say).

10. Paul Tudor Jones (Tudor Investment Corp): 440 million
9. George Soros (Soros Fund Management): 450 million
8. Bruce Kovner (Caxton Associates): 640 million
7. Carl Icahn (Icahn Management): 900 million
6. Eddie Lampert (ESL Investments): 1.1 billion
5. Steve Cohen (SAC Capital): 1.3 billion
4. David Tepper: 2.2 billion
3. Jim Simons (Renaissance Technologies): 2.5 billion
2. Ray Dalio (Bridgewater Associates): 3.1 billion
1. John Paulson (Paulson and Co): 4.9 billion

What I'd like to focus on here is not the gains that come from the money these managers have invested in their funds (especially if those invested funds DID NOT come from the accumulated fees charges in prior years) but, instead, on the money made from the hedge fund industry standard "2 and 20" compensation structure.
(This type of compensation structure includes a management fee that's 2% of assets under management. It also includes, when applicable, a performance fee for 20% of the profits -- sometimes above a certain threshold -- or some similar variation.)

A good chunk of the above earnings comes from fees though, of course, this varies greatly by fund.

To keep this simple but meaningful, let's consider a hedge fund with $ 20 billion in assets under management (excluding what the fund manager has kept invested in the fund). Many of the larger hedge funds have more than that much under management -- some much more -- so it's a reasonable scenario.

Now, in a year where a hedge fund generates, let's say, a 10% return -- what is, of course, a $ 2 billion increase -- that means the frictional costs for investors in would roughly be:

2% of $ 21 billion plus = $ 420 million
(The fund would have increased from $ 20 to $ 22 billion so I've used the midpoint.)

and

20% of the $ 2 billion profit = $ 400 million

= $ 820 million

These rather huge frictional costs couldn't contrast more greatly with the model that exists within the Berkshire.**

Now let's look at how the above compensation structure, if adopted, would have impacted Berkshire.

Berkshire Hathaway
Berkshire Hathaway has come a long way from the New England textile company Buffett bought in the 1960s.

Back then Berkshire was definitely no earnings powerhouse.

In fact, it was not a good business at all.

In contrast to the shaky Berkshire of the early 1960s, it is now a capital producing machine with a collection of mostly wide moat businesses, equities, and other investments.

Now, let's consider a kind of "Bizarro" Buffett scenario.

This version of Buffett is equally talented at capital allocation with a key difference.

Instead of accepting the $ 100,000 annual paycheck -- a salary he's, in fact, been paid for quite a long time -- this Buffett is paid via the "2 and 20" compensation structure. The kind of arrangement (or some variation) that generated a good chunk of the earnings for the above hedge fund managers. This Buffett does not reinvest those fees back into Berkshire Hathaway either.

Under these circumstances, how much would Berkshire Hathaway be worth today?

No where near its current market value of $ 195 billion.
(For simplicity, let's set aside the question whether the market value represents anything close to Berkshire's intrinsic value.)

In fact, it'd likely be worth more like roughly $ 20 billion.

One-tenth or so its current value.

So, a businesses worth ~$ 195 billion today that employs 260,000 people likely ends up something like 1/10th or so its current size due to the "2 and 20" frictional costs. (This is easy to calculate. Just subtract the "2 and 20"  fees from Berkshire's returns since it was purchased to come up with the approximate compounded effect. The exact number would depends at what level of profits the 20% kicks in. That seems like splitting hairs. The effective outcome ends up being still roughly the same...give or take, an order of magnitude difference in value.)

Not only does this version of Buffett not reinvest those fees back into Berkshire, he happens to also be a gold bug. All the capital he extracts in fees goes into the yellow metal.

The net effect is that Berkshire's long-term shareholders end up with ~ 1/10th the amount in wealth and, since Buffett buys only gold in his personal account, the benefits of his skills at capital and resource allocation do not extend beyond the walls of Berkshire.***

It's worth pointing out that, in this scenario, Buffett is clearly worse off as well. The returns from his gold, minus the frictional costs (incl. taxation), plus his ownership of the much smaller Berkshire almost certainly wouldn't come close to his current wealth (though, no doubt, some might argue under certain circumstances gold could perform exceptionally well). Even if, instead of buying gold, this Bizarro Buffett bought as much Berkshire stock as possible using the "2 and 20" fees from the new compensation arrangement, he would likely still be far worse off.

Why?

Because Berkshire itself is now worth so much less. An enterprise depleted of capital in the form of fees, grows its intrinsic value at a lower rate, and ends up a shadow of its potential self.****

An order of magnitude difference in earning power, capacity to invest, and ability to employ.

Buffett would own a much bigger percentage of the entity, but the entity would be worth intrinsically far less.
(Even at 100% ownership of the much smaller Berkshire's stock, it wouldn't equal his current partial ownership of the much bigger entity.)

So this would obviously be very costly to Buffett and Berkshire's other shareholders but I think the reality is the costs extend much further.

I'll get to that in a follow up post.

Adam

Long BRKb

Related post:
If Buffett Were Paid Like a Hedge Fund Manager - Part II (follow up)
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* The operating businesses that Berkshire owns outright include: GEICO, General Re, National Indemnity, MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of The Loom, Russel Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar Metalworking, among others. These businesses generated the bulk of those $ 12.9 billion in earnings. So it's not a hedge fund but obviously Berkshire owns and manages much more than even the largest among them.
** Buffett was paid $ 100,000 last year but did not get any stock grants, stock options, or bonuses. An apples-to-apples comparison to hedge fund frictional costs would also include the operating costs of Berkshire's corporate office (though much of those costs are presumably related to the operating businesses Berkshire owns outright) and related (that now also would include the costs related to Todd Combs, the new investment manager). Buffett does have personal and home security paid for by Berkshire. Consider how small these costs are in the context of Berkshire overall. The difference in frictional costs is still measured in orders of magnitude compared to a typical hedge fund. So let's not split hairs. The difference, I think, speaks for itself. Precision not required. Berkshire has been built to minimize frictional costs for investors like few other investment vehicles. Of course, during Buffett's partnership era, the fee structure was lucrative for him on the upside but also gave him exposure to losses on the downside. In fact, he could lose more money than he invested into the partnership by covering some of all losses from his partners. From Alice Schroeder's book, The Snowball: "I got half the upside above a four percent threshold, and I took a quarter of the downside myself. So if I broke even, I lost money. And my obligation to pay back losses was not limited to my capital. It was unlimited." (pp. 201-202)
*** It's not as if the money disappears but whoever Buffett buys gold from may or may not take Buffett's cash and allocate it wisely. Those dollars could end up invested in something useful and productive just as easily as it could end up in something like so-called AAA mortgage backed securities circa 2005, the IPO for pets.com, or maybe just plain old consumption. The point is it'd be hard to argue that, as far as capital allocation goes, the money will be in the hands of someone better at it. The world is not made up of equally wise capital allocators. Of course, the real Buffett would certainly not be buying a non-productive asset like gold. He'd most likely use those "2 and 20" fees to make big returns for himself -- and maybe others -- separate from Berkshire and its shareholders. It's true that eventually the money, as it flows through the economy, will likely end up invested intelligently at some point. There is, if nothing else, a delay. Well, since there's a time value of money, that alone is a real cost. So the delay is, in itself, expensive on a compounded basis over the longer haul. The specific cost may not be easy to measure but, ultimately, this dynamic seems likely to at least slow the rate of increase to living standards and wealth creation. It's just that these frictional costs, at the very least, diffuse and delay effective capital formation and allocation. Capital needs to get in the hands of capable allocators, with a longer investment time horizon (patient capital), meaningful scale, and in a timely manner.
**** Now, if the company consistently raised capital to offset the capital depleted by those "2 and 20" fees, then theoretically it could be the same size enterprise, but the Berkshire investors not named Warren Buffett would still be far worse on a per share basis due to the dilution.
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