Recently, Third Point’s Daniel Loeb launched a scathing attack on the Oracle of Omaha and his hedge fund structure. “I love how he criticizes hedge funds, yet he really had the first hedge fund. He criticizes activist investors, yet he was the first activist,” says Loeb.
It was must be recalled that Warren Buffett ran one of the original uber-successful hedge funds in the industry. Today, hedge funds are dime a dozen in the US. A closer look at the original ‘hedge-fund’ partnership of Buffett reveals the following:
- The ‘Buffett Associates’ structure was a partnership. Not a limited liability partnership, just a plain partnership which meant that Warren was exposed to unlimited loses. His obligation to pay back was not limited to his capital. I think this was a very gutsy move. The confidence that Buffett shows on his own abilities is amazing. This does align his incentives with that of his partners.
- No management fee.
- To boot that, he also paid 4% interest on the capital. If the performance exceeded the 4% hurdle, Buffett got paid 25% of the profits. Now, consider this. If the partnership just broke even, Buffett had make good the difference to the tune of 4%. With liabilities not limited to his capital, on a base of $105K capital that Buffett raised, he had invested only $100. His potential losses would have been high. However, Buffett did have other money that he had accumulated. In a bad year, if the partnership was down 40% (say), Buffett would have to pay 4% and the partnership would lose 36%.
- in 1958, Buffett amended the partnership further in favour of his partners, where he agreed to take 25% of all downsides. Which mean, if the partnership was down 40%, Buffett would pay 4% interest and 10% of the losses from his own capital. Buffett’s hedge fund structure was onerously favouring the shareholders in bad years and limiting their downside while leaving them with a sizable upside as well.
Compared this to Third Point’s 2 and 20 structure is in stark contrast where Loeb’s stands to make money of 2% even if the partners lose money with very limited liability. It is a classic screw the clients in a bad year and scoop their profits in good years. I think the difference between the two structures are night and day, a far cry from the shareholder orientation that Warren Buffett had in his partnership.