This post is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please refer to the initial post in this series for more details. During 1961, Buffett started to write semi-annual letters because his clients told him the annual letter was “a long time between drinks.” The summary below is derived from the first of two letters written about the results of 1961.
Separate Accounts, Fee Structure
The business underwent conversion from multiple separately managed accounts to a pooled partnership vehicle. Buffett grappled with housekeeping issues such as proper allocation of “future tax liability due to unrealized gains” during the transition process since all the different partnerships would contribute different tax liabilities to the new pooled vehicle.
More interesting is the fee structure of the Buffett Partnerships. The new pool vehicle would charge 0% management fees, 25% incentive fee above a 6% hurdle, and “any deficiencies in earnings below the 6% would be carried forward against future earnings, but would not be carried back.”
Previously, the multiple partnerships had a number of different fee structures including:
- 6% Hurdle, 33.33% incentive fee
- 4% Hurdle, 25.00% incentive fee
- 0% Hurdle, 16.67% incentive fee
Additionally, Buffett provides his clients with a unique liquidity mechanism to supplement the annual redemption window:
“The right to borrow during the year, up to 20% of the value of your partnership interest, at 6%, such loans to be liquidated at yearend or earlier. This will add a degree of liquidity to an investment which can now only be disposed of at yearend…I expect this to be a relatively unused provision, which is available when something unexpected turns up and a wait until yearend to liquidate part or all of a partner’s interest would cause hardship.”
“Estimated total assets of the partnership will be in the neighborhood of $4 million, which enables us to consider investments such as the one mentioned earlier in this letter, which we would have had to pass several years ago.”
Buffett was cognizant of the relationship between AUM and his fund’s investment strategy. I suspect the investment “mentioned earlier in this letter” was an activist situation which required him owning an influential or controlling stake in the company – therefore requiring a minimum amount of capital commitment, now made possible by the higher total partnership assets of $4 million.
Portfolio managers are not the own ones who should monitor the AUM figure. The relevance of the relationship between AUM and a fund’s investment strategy has wider implications. For example, investors who allocate capital to funds should also be monitoring AUM and asking whether the changes in AUM impact a fund’s ability to generate returns due to sizing, strategy shift / drift, changing opportunity sets, etc.
Expected Return, Catalyst, Risk
“We have also begun open market acquisitions of a potentially major commitment which I, of course, hope does nothing marketwise for at least a year. Such a commitment may be a deterrent to short range performance but it gives strong promise of superior results over a several year period combined with substantial defensive characteristics.
The above quote highlights two important portfolio management topics.
First: the concept of “yield to catalyst.” Similar in concept to yield to call or maturity for bonds, it’s the annualized return between today to until the catalyst or price target occurrence – a sort of expected annualized return figure. In this situation, the price target was high enough that even if the security “does nothing for at least a year,” the “superior results over a several year period” was enough to make the investment worthwhile. For his basket of “work-outs” (see our 1957 Part 1 post for more details on this), the price target was usually lower, but the catalyst was usually not far away, therefore the yield to catalyst was still adequately high to justify an investment.
Second: the concept of risk-adjusted return. This one is slightly more difficult to estimate since “risk” is a squishy term and difficult to quantify. In the quote above, Buffett references the “substantial defensive characteristics” of the investment. This indicates that he is measuring the return against the risk profile. Unfortunately, he does not give any details as to how he defines risk, or does that math.