Here is a follow up to this recent post:
If Buffett Were Paid Like a Hedge Fund Manager
That previous post explored the implications of Buffett being paid like a hedge fund manager (over the past 40 plus years) instead of $ 100,000 per year (and actually less in the early years) that he's been paid.*
The bottom line was that the frictional costs of that additional pay over that time frame results in Berkshire ending up something like 1/10th its current value.
Seems a bit crazy but that is roughly what happens when frictional costs of that magnitude is compounded over many years. So Berkshire would, in fact, be a shadow of its current self under that arrangement.
The first scenario was a look in the rear-view mirror.
Here's a forward look.
In this hypothetical scenario, the Berkshire Hathaway (BRKa) as we know it exists (260,000 employees, $ 150 billion portfolio, $ 12 billion plus in earning power) with one difference. The difference? Buffett decides that, starting this year, he will finally get in on the action and be compensated like a typical hedge fund manager. The hedge fund industry standard "2 and 20" (2% of assets and 20% of profits above a certain level) compensation structure will be used.
This compensation arrangement will apply only to the investment portfolio (the $ 150 billion portfolio of stocks, bonds, and cash that Berkshire owns).
Now, we know that Buffett's actual job goes beyond deciding whether to buy or sell shares in things like Wells Fargo (WFC) or Johnson & Johnson (JNJ). In addition to managing the $ 150 billion portfolio, Buffett, as CEO also oversees Berkshire's operating businesses (the businesses that employ those ~260,000 people and earn the bulk of that $ 12 billion or so per year). Under this new hypothetical arrangement he continues to have those responsibilities.
If Buffett Were Paid Like a Hedge Fund Manager
That previous post explored the implications of Buffett being paid like a hedge fund manager (over the past 40 plus years) instead of $ 100,000 per year (and actually less in the early years) that he's been paid.*
The bottom line was that the frictional costs of that additional pay over that time frame results in Berkshire ending up something like 1/10th its current value.
Seems a bit crazy but that is roughly what happens when frictional costs of that magnitude is compounded over many years. So Berkshire would, in fact, be a shadow of its current self under that arrangement.
The first scenario was a look in the rear-view mirror.
Here's a forward look.
In this hypothetical scenario, the Berkshire Hathaway (BRKa) as we know it exists (260,000 employees, $ 150 billion portfolio, $ 12 billion plus in earning power) with one difference. The difference? Buffett decides that, starting this year, he will finally get in on the action and be compensated like a typical hedge fund manager. The hedge fund industry standard "2 and 20" (2% of assets and 20% of profits above a certain level) compensation structure will be used.
This compensation arrangement will apply only to the investment portfolio (the $ 150 billion portfolio of stocks, bonds, and cash that Berkshire owns).
Now, we know that Buffett's actual job goes beyond deciding whether to buy or sell shares in things like Wells Fargo (WFC) or Johnson & Johnson (JNJ). In addition to managing the $ 150 billion portfolio, Buffett, as CEO also oversees Berkshire's operating businesses (the businesses that employ those ~260,000 people and earn the bulk of that $ 12 billion or so per year). Under this new hypothetical arrangement he continues to have those responsibilities.
So we start with the Berkshire Hathaway we know of today but what's interesting is, as a result of Buffett's new pay structure, a likely very different future.
Here's why.
Here's why.
Assume that $ 150 billion portfolio that Buffett manages increases in value by 14% this year.
Under a typical "2 and 20" pay structure Buffett would earn $ 6 billion in pay.**
The first implication of this is that the intrinsic value of Berkshire drops substantially since that $ 6 billion in pay cuts into nearly half of Berkshire's earning power.
That's not the worst part since $ 6 billion just happens to be the amount that Berkshire Hathaway's operating companies combined invest in capital expenditures (capex) per year. From the 2010 Berkshire Hathaway Shareholder Letter:
"Last year – in the face of widespread pessimism about our economy – we demonstrated our enthusiasm for capital investment at Berkshire by spending $6 billion on property and equipment. Of this amount, $5.4 billion – or 90% of the total – was spent in the United States. Certainly our businesses will expand abroad in the future, but an overwhelming part of their future investments will be at home. In 2011, we will set a new record for capital spending – $8 billion – and spend all of the $2 billion increase in the United States."
That's not the worst part since $ 6 billion just happens to be the amount that Berkshire Hathaway's operating companies combined invest in capital expenditures (capex) per year. From the 2010 Berkshire Hathaway Shareholder Letter:
"Last year – in the face of widespread pessimism about our economy – we demonstrated our enthusiasm for capital investment at Berkshire by spending $6 billion on property and equipment. Of this amount, $5.4 billion – or 90% of the total – was spent in the United States. Certainly our businesses will expand abroad in the future, but an overwhelming part of their future investments will be at home. In 2011, we will set a new record for capital spending – $8 billion – and spend all of the $2 billion increase in the United States."
These days, much of that capex is for investments that enhance and expand the capabilities of the gas pipelines (Berkshire's pipelines transport 8% of U.S. natural gas), railroads, and other utility infrastructure that Berkshire owns.
Kind of useful stuff.
These investments certainly should produce nice returns but the benefits clearly go beyond what it earns for the shareholders. Think of the accumulated benefits of those investments over 20 years? We are talking about easily $ 150 billion (actually considering likely growth...much more) of improvements to and the expansion of very useful and productive capital intensive assets over that time horizon.
The type of investments that have meaningful long-term economic benefits and maybe even improvements to living standards.
The point of all this being that it is certain those investments would have to be reduced substantially to accommodate Buffett's new hedge fund like pay structure. The company obviously simply cannot afford as much investment in the form of capex (or otherwise) if roughly half the earning power of a company is going to the top guy in the form of compensation.
As I noted above, the current intrinsic value will be reduced by the explicit cost of the higher pay but the real big hit is to the future growth in intrinsic value. That growth in value is throttled by an expensive compensation system draining capital away from potentially useful and value-creating investments.
(There might just be a few benefits to society as a whole in the form of improvement and expansion of infrastructure and the jobs that they create but that is beyond the scope of this post.)
Kind of useful stuff.
These investments certainly should produce nice returns but the benefits clearly go beyond what it earns for the shareholders. Think of the accumulated benefits of those investments over 20 years? We are talking about easily $ 150 billion (actually considering likely growth...much more) of improvements to and the expansion of very useful and productive capital intensive assets over that time horizon.
The type of investments that have meaningful long-term economic benefits and maybe even improvements to living standards.
The point of all this being that it is certain those investments would have to be reduced substantially to accommodate Buffett's new hedge fund like pay structure. The company obviously simply cannot afford as much investment in the form of capex (or otherwise) if roughly half the earning power of a company is going to the top guy in the form of compensation.
As I noted above, the current intrinsic value will be reduced by the explicit cost of the higher pay but the real big hit is to the future growth in intrinsic value. That growth in value is throttled by an expensive compensation system draining capital away from potentially useful and value-creating investments.
(There might just be a few benefits to society as a whole in the form of improvement and expansion of infrastructure and the jobs that they create but that is beyond the scope of this post.)
I'm using this example to illustrate the problem. Some may believe that the large amounts of capital currently invested in hedge funds is somehow different than the situation at Berkshire Hathaway because they do not have an operating business. It's not. The money drained away in the form of compensation subtracts from the capital in the system as a whole along with the potential for that capital to help those with bright ideas create and build important things.
(By definition, even though individual hedge funds may perform just fine, substantial capital is drained from the system in the form of compensation. Naturally, some of it may be reinvested.)
Back in early 2010, Jeremy Grantham made the point that these frictional costs actually "raid the balance sheet" of investors.
In his example, Grantham talks about how raising fees from .5 percent to 1 percent is a raid of the balance sheet of investors. Well, the hedge fund industry's current typical fees are much higher than that. They make the .5 percent to 1 percent seem like, by comparison, a quaint amount.
The thinking that the prevailing compensation systems used in asset management somehow doesn't directly or indirectly cut into the amount of investing dollars available to build, improve, and expand productive assets it would seem is some form of denial or delusion.***
There is clearly a real cost.
To put this in perspective, it's worth keeping the following comments by Buffett in mind (also from the most recent shareholder letter):
"The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective." - Warren Buffett
Fortunately, we have an incredibly effective overall system that works despite some of the current weaknesses (the above hedge fund compensation example represents one of the flaws...it's certainly not the whole problem) that have emerged in how we go about capital formation and allocation.
That doesn't mean we won't unleash somewhat less of the potential Buffett refers to if we don't put in place some kind of an intelligent overhaul. It's just not smart for us to ignore the real weaknesses that have emerged in our modern iteration of the financial system.
In the U.S., a system that effectively forms and allocates capital has historically been a source of economic strength.
It just happens to have, for a number of reasons, become less effective in recent decades.
It also happens to be fixable.
From the letter, Overcoming Short-termism signed by Buffett, Bogle and 25 others back in 2009:
"...market incentives to encourage patient capital...is likely to be the most effective mechanism to encourage long-term focus by investors. Capitalism is a powerful economic and societal force which, if properly directed, can have a hugely beneficial impact on society at all levels."
Capital Misallocation
Among other things, the letter recommends changes to the tax-code to reward long-term holders over short-term holders and reforms to compensation systems to focus on long-term value creation.
That letter did not have much impact but I can't say that's surprising. In the real world meaningful improvements will be pretty tough to come by considering the interests (and the amount of money) involved. So I don't expect much to happen anytime soon. It's possible future financial challenges could eventually create the pressure that will be needed to force improvements upon the system.
In a perfect world we would not wait for that.
"Somebody ought to spend a little time thinking, and this gets back to the classics, about the role of business in society. It should add value. But the financial business does not add value. By definition the financial business subtracts value. In round numbers, it takes something like $600 billion out of the pockets of investors every year. That's $6 trillion dollars in 10 years." - John Bogle
Bogle: History and the Classics
I just don't think there is much doubt that a few well thought out changes could go a long way toward the objectives of reducing frictional costs and encouraging real investment over casino capitalism.
(By definition, even though individual hedge funds may perform just fine, substantial capital is drained from the system in the form of compensation. Naturally, some of it may be reinvested.)
Back in early 2010, Jeremy Grantham made the point that these frictional costs actually "raid the balance sheet" of investors.
In his example, Grantham talks about how raising fees from .5 percent to 1 percent is a raid of the balance sheet of investors. Well, the hedge fund industry's current typical fees are much higher than that. They make the .5 percent to 1 percent seem like, by comparison, a quaint amount.
The thinking that the prevailing compensation systems used in asset management somehow doesn't directly or indirectly cut into the amount of investing dollars available to build, improve, and expand productive assets it would seem is some form of denial or delusion.***
There is clearly a real cost.
To put this in perspective, it's worth keeping the following comments by Buffett in mind (also from the most recent shareholder letter):
"The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective." - Warren Buffett
Fortunately, we have an incredibly effective overall system that works despite some of the current weaknesses (the above hedge fund compensation example represents one of the flaws...it's certainly not the whole problem) that have emerged in how we go about capital formation and allocation.
That doesn't mean we won't unleash somewhat less of the potential Buffett refers to if we don't put in place some kind of an intelligent overhaul. It's just not smart for us to ignore the real weaknesses that have emerged in our modern iteration of the financial system.
In the U.S., a system that effectively forms and allocates capital has historically been a source of economic strength.
It just happens to have, for a number of reasons, become less effective in recent decades.
It also happens to be fixable.
From the letter, Overcoming Short-termism signed by Buffett, Bogle and 25 others back in 2009:
"...market incentives to encourage patient capital...is likely to be the most effective mechanism to encourage long-term focus by investors. Capitalism is a powerful economic and societal force which, if properly directed, can have a hugely beneficial impact on society at all levels."
Capital Misallocation
Among other things, the letter recommends changes to the tax-code to reward long-term holders over short-term holders and reforms to compensation systems to focus on long-term value creation.
That letter did not have much impact but I can't say that's surprising. In the real world meaningful improvements will be pretty tough to come by considering the interests (and the amount of money) involved. So I don't expect much to happen anytime soon. It's possible future financial challenges could eventually create the pressure that will be needed to force improvements upon the system.
In a perfect world we would not wait for that.
"Somebody ought to spend a little time thinking, and this gets back to the classics, about the role of business in society. It should add value. But the financial business does not add value. By definition the financial business subtracts value. In round numbers, it takes something like $600 billion out of the pockets of investors every year. That's $6 trillion dollars in 10 years." - John Bogle
Bogle: History and the Classics
I just don't think there is much doubt that a few well thought out changes could go a long way toward the objectives of reducing frictional costs and encouraging real investment over casino capitalism.
Adam
* 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 should also include all 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's assets 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. This difference, I think, speaks for itself. Precision not required. Berkshire is 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 a quarter 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)
** The first part of the "2 and 20" calculation would go something like this: 2% of $ 150 billion equals $ 3 billion in pay. The second part: assume that the performance benchmark is something like 4%. Subtract that 4% from the 14% return achieved and multiply by the $ 150 billion equals $ 15 billion in profit above the benchmark. That $ 15 billion in profit is multiplied by 20% for another $ 3 billion in pay. Total pay would = $ 6 billion (a bit more than the $ 4.9 billion hedge fund manager John Paulson made last year).
*** I realize Buffett is likely to take his fees and invest it wisely elsewhere. So, in his case, the money will almost certainly still get put to use as patient capital. Still, another money manager could just as easily pull a Citizen Kane so to speak and use the money to purchase expensive works of art or some kind of trophy property. (There is certainly nothing wrong with that by the way. The freedom to buy or sell whatever one wants is crucial. My point here is systemic not individual.) The person who sells the art will then, of course, buy something else and eventually the dollars may even someday end up back in the hands of another talented capital allocator (who puts those dollars to the kind of use Berkshire in its current size and form is capable of doing). So the money, of course, does not disappear but it may take some tangential journeys before it again ends up in the hands of a smart allocator with some scale. My point is that some of the most impactful long-term investments need patient capital to be allocated with big scale to succeed. We are better off with a system designed to encourage funds to stay inside the Berkshire's of the world (i.e. places that intelligently allocate capital at some scale and with low frictional costs) while obviously maintaining the freedom for individual wealth to be spent whatever way one wants. In the current system's form, an awful lot of capital ends up as diffuse consumption or trophy-oriented spending/investment. Excessive frictional costs in finance, as Grantham points out, literally does "raid the balance sheet" of the country.
* 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 should also include all 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's assets 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. This difference, I think, speaks for itself. Precision not required. Berkshire is 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 a quarter 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)
** The first part of the "2 and 20" calculation would go something like this: 2% of $ 150 billion equals $ 3 billion in pay. The second part: assume that the performance benchmark is something like 4%. Subtract that 4% from the 14% return achieved and multiply by the $ 150 billion equals $ 15 billion in profit above the benchmark. That $ 15 billion in profit is multiplied by 20% for another $ 3 billion in pay. Total pay would = $ 6 billion (a bit more than the $ 4.9 billion hedge fund manager John Paulson made last year).
*** I realize Buffett is likely to take his fees and invest it wisely elsewhere. So, in his case, the money will almost certainly still get put to use as patient capital. Still, another money manager could just as easily pull a Citizen Kane so to speak and use the money to purchase expensive works of art or some kind of trophy property. (There is certainly nothing wrong with that by the way. The freedom to buy or sell whatever one wants is crucial. My point here is systemic not individual.) The person who sells the art will then, of course, buy something else and eventually the dollars may even someday end up back in the hands of another talented capital allocator (who puts those dollars to the kind of use Berkshire in its current size and form is capable of doing). So the money, of course, does not disappear but it may take some tangential journeys before it again ends up in the hands of a smart allocator with some scale. My point is that some of the most impactful long-term investments need patient capital to be allocated with big scale to succeed. We are better off with a system designed to encourage funds to stay inside the Berkshire's of the world (i.e. places that intelligently allocate capital at some scale and with low frictional costs) while obviously maintaining the freedom for individual wealth to be spent whatever way one wants. In the current system's form, an awful lot of capital ends up as diffuse consumption or trophy-oriented spending/investment. Excessive frictional costs in finance, as Grantham points out, literally does "raid the balance sheet" of the country.
If Buffett Were Paid Like a Hedge Fund Manager - Part II
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Published :
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