Monday, March 10, 2014

Buffett on "Asset Gathering" vs "Asset Managing"

During this CNBC interview, Warren Buffett and Becky Quick discussed the compensation of his two investment managers, Todd Combs and Ted Weschler:

BECKY: "Both of them were managing their own hedge funds before, and the compensation structure in Berkshire is very different than the two and 20 you would get if you were a hedge fund manager."

BUFFETT: "That's right. If they-- last year they started with about five billion each. If they'd put it under the mattress under the standard hedge fund arrangement they each would've made about $100 million. I mean, that shows you how nutty the arrangement is.

But they would have literally made $100 million by sticking it under the mattress. If they put it in an index fund, and gotten the two and 20, they each would've made over $300 million. All they had to do was buy the vanguard index. And they each would've made over $300 million. They also would've gotten more favorable tax treatment on it then they got by getting a salary from Berkshire.

So imagine I mean, you can retire forever on $300 million. So one year you go, you put the money in an index fund so it just shows that the-- it shows you amounts you get by asset gathering rather than asset managing. I mean even though a great many hedge funds in recent years have not delivered high performance, they've delivered high fees.

But our arrangement is that they get a salary and then they get which to most hedge fund guys would look like nothing, and then they get paid on the excess. They get ten percent of the excess over the S&P performance. But it's done over a three year staggered period. So they can't have just one up year and then another down year, or something of the sort."

Buffett then added...

"So, only if they do better than I can do by sticking the money in an S&P fund do they get paid a dime of performance. And it seems to me that's quite logical, but it's not something that the hedge fund community is out there pushing harder for."
(The above is from page 29-30 of the transcript.)

Berkshire has over $ 200 billion of stocks, bonds, and cash equivalents.

If two and twenty was the compensation structure used by Berkshire, the 2 percent alone would cost the company -- and, of course, the owners -- $ 4 billion per year.

Also, let's say, in a year there is a 10% portfolio return (a $ 20 billion gain). Well, using the traditional hedge fund arrangement, 20% of that gain would become compensation and cost the company an addition $ 4 billion. So that'd be $ 8 billion of additional compensation cost for Berkshire.
(Again, that's per year and, of course, quite a bit more if the portfolio were to perform exceptionally well in a particular year.)

So, those with this arrangement, by gathering enough assets, do more than just fine even with just subpar performance (they still get the 2% of assets under management) and really well in any year they generate some decent or better gains (20% of profits).*

If Berkshire had such an arrangement, this cost would hit the company year after year, dramatically lowering intrinsic value.

But, in my view, that's not all that's of significance here.

Consider the entire amount that Berkshire is spending these days on plant and equipment:

"Our subsidiaries spent a record $11 billion on plant and equipment during 2013, roughly twice our depreciation charge. About 89% of that money was spent in the United States. Though we invest abroad as well, the mother lode of opportunity resides in America." - From Buffett's latest Berkshire Hathaway (BRKa) Shareholder Letter (page 5)

So in a year that the portfolio produces a 10% return -- even if it simply equals the S&P 500 -- those typical hedge fund fees would consume $ 8 billion of the $ 11 billion (there are some accounting and tax considerations but no need to split hairs) of what is mostly rather useful infrastructure (railroads, utilities, and pipelines among other things) that, not only serves shareholders, likely improves the productive capacity of society more generally. That's a big hit to important capital investments year after year. Berkshire's capital expenditures cut across lots of different businesses, but a significant portion comes down to the following (from page 11-12 of the letter):

 - BNSF Railway which "carries about 15%...of all inter-city freight, whether it is transported by truck, rail, water, air, or pipeline" in the United States.

"Indeed, we move more ton-miles of goods than anyone else, a fact establishing BNSF as the most important artery in our economy’s circulatory system."

- MidAmerican is made up of utilities that "serve regulated retail customers in eleven states" and includes a large amount of pipeline infrastructure.**

"...we are the leader in renewables: From a standing start nine years ago, MidAmerican now accounts for 7% of the country’s wind generation capacity, with more on the way. Our share in solar – most of which is still in construction – is even larger."

Buffett notes that, once completed, they'll have spent $ 15 billion on their renewables portfolio alone.

"We relish making such commitments as long as they promise reasonable returns."

The reinforcement and expansion of all this infrastructure would, instead, be undermined by the need to pay those hedge fund like fees.

"...society will forever need massive investments in both transportation and energy. It is in the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects. It is meanwhile in our self-interest to conduct our operations in a way that earns the approval of our regulators and the people they represent."

Well, if such fees can so materially reduce Berkshire's ability to make important investments -- and I think an $ 8 billion haircut out of $ 11 billion (73%) qualifies as a material hit -- it's not a stretch to suggest that this prevailing compensation system subtracts from the effectiveness of capital formation and allocation in a more general sense.

I mean, is the world really better off with so much capital being quietly siphoned in this way?

I've used this quote by Jeremy Grantham before, but it remains relevant:

"If we [the investment industry] raise our fees from 0.5 percent to 1 percent, we actually raid the balance sheet. We take 0.5 per cent from what would have been savings and investment and turn it into income and GDP. In other words, you're taking money that would have become capital and chewing it up as bankers' bonuses." - Jeremy Grantham

Jeremy Grantham: 'We Add Nothing But Costs'

Anyone who thinks the current system is serving the world anywhere near optimally is kidding themselves or, just maybe, suffers from some kind of self-serving bias.***

The negative compounded effect over time isn't small. Consider that these extreme fees do not only cut into today's capacity for capital expenditures; they also inhibit future increases to capex.

So that would mean Berkshire's capacity to make incremental purchases of plant and equipment -- let's say 10-20 years from now -- ends up a shadow of its potential.

According to this article, the hedge fund industry assets under management stands at $ 2 trillion.

This indicates it's a bit more.

Either way, it has increased substantially over the years. So the overall impact is certainly not getting smaller. The two and twenty arrangement (and similar) against a $ 2 trillion plus asset base doesn't exactly amount to spare change.

Some will argue that eventually at least a portion of all those fees will end up being put to work as capital in some form again. While that's true it is, to me, a terribly inefficient way to go about allocating funds to their most productive uses.

Frictional costs matter.

In the letter, Buffett mentions the "crumbling infrastructure" of the U.S. (though, as he points out, it doesn't apply to railroads). Well, maybe it'd be crumbling just a bit less if the Berkshire model was more the norm instead of the exception.

Berkshire's business prospects would necessarily be a lot different in twenty years if, as in the example above, 70-75% of its capital expenditures were diverted to fees instead of investing in useful and economically sound infrastructure enhancements.

I'm not suggesting the impact, on a compounded basis, is limited to infrastructure; these fees also impact investment more generally.

I'm also not suggesting these frictional costs could be eliminated entirely. There's a vital role to be played by effective investment management and related activities.

There'll always a certain necessary amount of frictional costs, yet I don't think it is hard to argue we are well beyond that amount.

I'm just suggesting, in it's current form and with current norms, these aren't just harmless defects and that obvious room for improvement exists (and it's not just the hedge funds); that a directional shift would be a very good thing should be obvious to all but those who are currently served well by the existing system.

This isn't to say that there are not some very capable hedge fund managers. There certainly are some very talented managers capable of delivering terrific long run results. It's just that the prevailing compensation system is too often a heads-I-win-tails-I-win-more system (for the investment managers, not the investors). Now, it seems pretty tough to blame anyone -- including those who might be somewhat (or even a whole lot) less talented than the very best -- for simply going where the money is. That's a perfectly legitimate and reasonable thing to do even if I happen to think, in its current form, the system doesn't serve its greater purpose nearly as well as it could.

Meaningful changes to behavior don't usually come about without real changes to the system itself.

Considering how lucrative the system is for those who benefit directly, don't expect the change to come from within or, as Buffett said during the interview, change is "not something that the hedge fund community is out there pushing harder for."

It's a fundamental overhaul that, among other things, would alter incentives (and ultimately even culture) but I won't even begin to suggest that there's an easy solution.

That a change is needed seems pretty clear. How to make it come about considering the forces at work is not at all obvious to me.

Still, it remains a big opportunity for someone wise and capable enough to fix some of the defects.

That's not going to happen soon. In the meantime, investors have no shortage of ways to avoid these costs and, well, just might want to act accordingly.

Adam

Long position in BRKb established at much lower than recent market prices

* Some will surely argue that you don't gather lots of assets unless the performance warrants it. While this no doubt is true in some cases, at times a somewhat different dynamic is at work. Brilliant performance over several years can attract lots of assets. Several years may seem a long time but, with investing, it's just generally not long enough. It's necessarily difficult to know what previous short and even intermediate performance tells you about future outcomes. Was it sound process or good fortune? Figuring out what previous returns reveal, if anything, to the investor about future outcomes is difficult enough, but judging how much risk was involved is even more so. That's just the nature of risk. Returns are relatively easy to measure; risks often not so much. A fund may seem to perform very well for years until the inherent weakness of an approach is revealed. It's sometimes not obvious that the apparent investment genius was merely a beneficiary of things like but certainly not limited to: random chance, a period that happened to be compatible with a particular approach, lots of leverage, and/or some other form excessive risk-taking that wasn't clear to investors before things went very badly south. Since, at these compensation levels one good year can make someone very rich indeed, the idea that this type of compensation system encourages, on a widespread basis, sound long-term capital allocation, with attractive returns, and smart risk management seems unlikely. Exceptions will always exist, but a well-designed system shouldn't be built around the exceptions. Even if it was broadly contributing to wise capital allocation, the huge frictional costs added to the system as a whole with little to no net benefit seems undeniable. The system will never be perfect; it could be much better.
** From the 2010 letter: "Our pipelines transport 8% of the country's natural gas. Obviously, many millions of Americans depend on us every day."
*** According to these notes, Charlie Munger said the following at USC Law School commencement back in 2007: Thinking that what's good for you is good for the wider civilization and rationalizing all these ridiculous conclusions based on this subconscious tendency to serve one's self is a terribly inaccurate way to think. Of course you want to drive that out of yourself because you want to be wise, not foolish. You also have to allow for the self-serving bias of everybody else because most people are not going to remove it all that successfully, the human condition being what it is. If you don't allow for self-serving bias in your conduct, again you're a fool.
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