Pabrai/Buffett partnership fee structure

[skanjete]

I understand that Pabrai copied the fee structure in his partnership from the Buffett partnerships : 25% on the profit above 6%.

 

I was wondering what happens after a down year. In a down year, there is no profit participation of course, but what happens thereafter? If I remember correctly, in the Buffett partnerships, there was no profit participation until all losses were made good.

But does this also count for the 6%? One never had the chance to check this for Buffett, because his partnerships never had a down year.

 

For example :

year 0 : start with 1000$

year 1 : - 20% : result 800$

year 2 : +50% : result 1200$

 

As I understood the fee structure from the Buffett partnership, (and I suppose thus now from Pabrai), the managing partner gets 0.25 x  (1200 - 1000 x 1.06 x 1.06) = 19.1$ after the second year.

 

Does anyone know if this is correct?

[Mephistopheles]

That would make sense, although I'm not sure what the exact terms were either.

 

Didn't Buffett also have a fee structure where he took some of the losses? I think he got 50% of profits above 6% and took 25% of losses or something. Or rather he guaranteed a certain %.

[Redskin212]

Skanjete,

 

Your calculation and understanding is correct.

[skanjete]

In that case, the partners indeed do get a fair deal!

 

And is profit participation calculated for the partnership in its entirety or for each partner individually?

I'm asking this because, depending on extra investments or liquidations along the way, the result can be different for each partner individually.

 

If one partner invests extra money after year 1 (a down year), his losses will be recouped faster than the partner who doesn' t invest extra money,  and thus profit participation should kick in quicker for the extra investing partner.

 

[JBird]

(B) A division of profits between the limited partners and general partner, with the first 6% per year to partners based upon beginning capital at market, and any excess divided one-fourth to the general partner and three-fourths to all partners proportional to their capital. Any deficiencies in earnings below the 6% would be carried forward against future earnings, but would not be carried back. Presently, there are three profit arrangements which have been optional to incoming partners:

 

Interest Provision. Excess to Gen. Partner. Excess to Ltd. Partners

(1) 6% 1/3 2/3

(2) 4% 1/4 3/4

(3) None 1/6 5/6

 

In the event of profits, the new division will obviously have to be better for limited partners than the first two arrangements. Regarding the third, the new arrangement will be superior up to 18% per year; but above this rate the limited partners would do better under the present agreement. About 80% of total partnership assets have selected the first two arrangements, and I am hopeful, should we average better than 18% yearly, partners presently under the third arrangement will not feel short-changed under the new agreement;

 

© In the event of losses, there will be no carry back against amounts previously credited to me as general partner. Although there will be a carry-forward against future excess earnings. However, my wife and I will have the largest single investment in the new partnership, probably about one-sixth of total partnership assets, and thereby a greater dollar stake in losses than any other partner of family group, I am inserting a provision in the partnership agreement which will prohibit the purchase by me or my family of any marketable securities. In other words, the new partnership will represent my entire investment operation in marketable securities, so that my results will have to be directly proportional to yours, subject to the advantage I obtain if we do better than 6.

[skanjete]

JBird,

 

I suppose that's Buffett vintage. I think I read it in one of his partnership letters at the moment when he consolidated his separate partnerships into 1 partnership.

 

So since his partners had the choice between 1,2 or 3, I suppose the profit sharing is calculated per partner individually.

 

[racemize]

JBird,

 

I suppose that's Buffett vintage. I think I read it in one of his partnership letters at the moment when he consolidated his separate partnerships into 1 partnership.

 

So since his partners had the choice between 1,2 or 3, I suppose the profit sharing is calculated per partner individually.

 

I believe that section indicates that the previous structures were 1, 2, or 3, and that he was consolidating into the 6%/25% structure.

[skanjete]

JBird,

 

I suppose that's Buffett vintage. I think I read it in one of his partnership letters at the moment when he consolidated his separate partnerships into 1 partnership.

 

So since his partners had the choice between 1,2 or 3, I suppose the profit sharing is calculated per partner individually.

 

I believe that section indicates that the previous structures were 1, 2, or 3, and that he was consolidating into the 6%/25% structure.

 

Yes, I think you're correct. I was to fast with my conclusion.

 

But is profit participation then calculated individually or not? Because differences between partners can be quite substantial after years as 2008, 2009, depending on their follow up investments.

[Parsad]

JBird,

 

I suppose that's Buffett vintage. I think I read it in one of his partnership letters at the moment when he consolidated his separate partnerships into 1 partnership.

 

So since his partners had the choice between 1,2 or 3, I suppose the profit sharing is calculated per partner individually.

 

I believe that section indicates that the previous structures were 1, 2, or 3, and that he was consolidating into the 6%/25% structure.

 

Yes, I think you're correct. I was to fast with my conclusion.

 

But is profit participation then calculated individually or not? Because differences between partners can be quite substantial after years as 2008, 2009, depending on their follow up investments.

 

Yes, profit participation is calculated individually, as income, dividends, gains, losses have to allocated every time capital comes in or out.  So if you are accepting capital monthly, then you have to allocate income/losses monthly and set the new high watermark. 

 

It is definitely the most equitable way to pay a manager and also incentivize them.  You lose money for partners, it takes longer and longer to get paid.  You make money, you get paid.  You make a lot of money for partners, you get paid very well!

 

But, I believe that level of compensation works best in a system where capital can be taken away from the manager, not one where they have permanent access to it.  The more permanent the capital, the lower the incentive fee should be, as the amount of risk to the manager reduces over time.  Just my opinion!  Cheers!

[skanjete]

JBird,

 

I suppose that's Buffett vintage. I think I read it in one of his partnership letters at the moment when he consolidated his separate partnerships into 1 partnership.

 

So since his partners had the choice between 1,2 or 3, I suppose the profit sharing is calculated per partner individually.

 

I believe that section indicates that the previous structures were 1, 2, or 3, and that he was consolidating into the 6%/25% structure.

 

Yes, I think you're correct. I was to fast with my conclusion.

 

But is profit participation then calculated individually or not? Because differences between partners can be quite substantial after years as 2008, 2009, depending on their follow up investments.

 

Yes, profit participation is calculated individually, as income, dividends, gains, losses have to allocated every time capital comes in or out.  So if you are accepting capital monthly, then you have to allocate income/losses monthly and set the new high watermark. 

 

It is definitely the most equitable way to pay a manager and also incentivize them.  You lose money for partners, it takes longer and longer to get paid.  You make money, you get paid.  You make a lot of money for partners, you get paid very well!

 

But, I believe that level of compensation works best in a system where capital can be taken away from the manager, not one where they have permanent access to it.  The more permanent the capital, the lower the incentive fee should be, as the amount of risk to the manager reduces over time.  Just my opinion!  Cheers!

 

Parsad,

 

Thank you for your clarification.

 

We work very similarly, the only difference being that the treshold is 0% (instead of 6%) and 15% instead of 25%. I guess I was less confident when we started than Buffett or Pabrai, rightfully so, I might add. ;)

Actually, I hadn't read the Buffett partnership letters yet when we got started, but the arrangement just seemed to be a correct way of working. I had a day job back then managing construction projects, and my experience in that job too was that 15% was a cut that most people considered fair and correct. More than 15% didn't last because some people got frustrated, jealous or feeled like being taken advantage of.

 

Later on, I read the 6%-25% arrangement of Buffett (and Graham before him I think), and I proposed this way of working to some partners because I think it's even fairer for the partners, but most of them preferred our 0%-15% arrangement (this was before 2008  ;)), so it stayed that way.

[oddballstocks]

The structure is fair, but has a hole in my view.  If you can't earn an incentive fee in the first year or two, or you start in a bad market there is no reason to stick around and try to earn out of that hole.

 

Maybe this works if you're independently wealthy, but if I'm running a fund, and I need a fee to pay for food/mortgage/kids I can't be waiting around forever hoping to eventually earn a fee.  I guess maybe this could become an advantage, if I do end up waiting for years I might not have to pay child support or alimony after my wife divorces me because I"ll have no income.

 

A sizable drop and a quick rebound, like what we just experienced isn't much of a problem, the fee might be lost for a year.  What kills this structure is multiple years of declines, or a flat market.

 

Not everyone can be Buffett, I applaud anyone who's done well with this structure, although there's an element of survivorship bias in it.  Where are the stories of managers who tried it, didn't make any money and shutdown their fund and started a new one?

 

I like a structure where the manager is paid something, enough that they're not worried about getting another job or taking crazy risks, yet they are incentivized if they do well.

[Kraven]

The structure is fair, but has a hole in my view.  If you can't earn an incentive fee in the first year or two, or you start in a bad market there is no reason to stick around and try to earn out of that hole.

 

Maybe this works if you're independently wealthy, but if I'm running a fund, and I need a fee to pay for food/mortgage/kids I can't be waiting around forever hoping to eventually earn a fee.  I guess maybe this could become an advantage, if I do end up waiting for years I might not have to pay child support or alimony after my wife divorces me because I"ll have no income.

 

A sizable drop and a quick rebound, like what we just experienced isn't much of a problem, the fee might be lost for a year.  What kills this structure is multiple years of declines, or a flat market.

 

Not everyone can be Buffett, I applaud anyone who's done well with this structure, although there's an element of survivorship bias in it.  Where are the stories of managers who tried it, didn't make any money and shutdown their fund and started a new one?

 

I like a structure where the manager is paid something, enough that they're not worried about getting another job or taking crazy risks, yet they are incentivized if they do well.

 

These are good points. I've never understood high water marks except as a matter of marketing and asset gathering. From the standpoint of managing money though why should someone have to make an investor whole before they get paid?  They did the work and oftentimes a loss is due at least in part to just overall market performance. My feeling is that unless lookups are unreasonable if someone isn't happy with performance take your money out and fire the guy.

[Parsad]

The structure is fair, but has a hole in my view.  If you can't earn an incentive fee in the first year or two, or you start in a bad market there is no reason to stick around and try to earn out of that hole.

 

Maybe this works if you're independently wealthy, but if I'm running a fund, and I need a fee to pay for food/mortgage/kids I can't be waiting around forever hoping to eventually earn a fee.  I guess maybe this could become an advantage, if I do end up waiting for years I might not have to pay child support or alimony after my wife divorces me because I"ll have no income.

 

A sizable drop and a quick rebound, like what we just experienced isn't much of a problem, the fee might be lost for a year.  What kills this structure is multiple years of declines, or a flat market.

 

Not everyone can be Buffett, I applaud anyone who's done well with this structure, although there's an element of survivorship bias in it.  Where are the stories of managers who tried it, didn't make any money and shutdown their fund and started a new one?

 

I like a structure where the manager is paid something, enough that they're not worried about getting another job or taking crazy risks, yet they are incentivized if they do well.

 

In our Canadian Fund, we did not receive an incentive fee for the first five years.  Not many managers could survive that long without some form of payment.  But I think that type of survivorship is good for the industry.  There are way too many, in fact the vast majority of investment managers, making a paycheck while adding zero value for their investors that could not be achieved through passive ETF's. 

 

These are good points. I've never understood high water marks except as a matter of marketing and asset gathering. From the standpoint of managing money though why should someone have to make an investor whole before they get paid?  They did the work and oftentimes a loss is due at least in part to just overall market performance. My feeling is that unless lookups are unreasonable if someone isn't happy with performance take your money out and fire the guy.

 

If an investment manager does a good job, at some point in time they would receive incentive fees, and generally the better the job, the greater the compensation.  So the high watermark is irrelevant in terms of the manager getting paid.  The truth is, that most managers want to manage money, but not take the risk and costs associated with an incentive fee structure without any fixed management expense ratio.  It's nice if you have $50M under management and get "1 & 15", because you are guaranteed $500K a year...whether you do well or not.  Even if you manage $10M, that's a decent $100K a year...which manager is going to sweat making $100K a year for doing nothing?

 

And that is where the high watermark becomes incredibly important for incentivizing the manager.  You lose money, and it may be years before you get paid again.  Thus, you better be making good decisions short-term and long-term regardless of where the market goes!  Cheers!

[skanjete]

And that is where the high watermark becomes incredibly important for incentivizing the manager.  You lose money, and it may be years before you get paid again.  Thus, you better be making good decisions short-term and long-term regardless of where the market goes!  Cheers!

 

That's essential. As a partner or client you want you manager to be focused on the most important thing, which  (in my view) is risk.

 

In the example of Buffett/Pabrai, if they lose the first year 20%, they have to make make more than 40% (i.e. 1.06 x 1.06 / 0.8) the second year just to start earning something. If it takes them 2 years to make up, they have to make 22% annualised for 2 years before earning something (i.e. sqrt(1.06 x 1.06 x 1.06 / 0.8)) .

So losing big percentages is a disaster. and the only way to do well for the manager is to deliver consistent and substantial overperformance.

 

The manager has a fantastic advantage since he is asymetrically leveraged, just like Berkshire Hathaway with it's float. So I think it's only fair to have some downside as well in that an underperforming manager could have to wait a very long time to earn something. If you don't add the downside, the thing gets to positively skewed for the manager, and he'll be tempted to focus too much on the rewards, and not enough on the risks of the investment process.

[skanjete]

The structure is fair, but has a hole in my view.  If you can't earn an incentive fee in the first year or two, or you start in a bad market there is no reason to stick around and try to earn out of that hole.

 

Maybe this works if you're independently wealthy, but if I'm running a fund, and I need a fee to pay for food/mortgage/kids I can't be waiting around forever hoping to eventually earn a fee.  I guess maybe this could become an advantage, if I do end up waiting for years I might not have to pay child support or alimony after my wife divorces me because I"ll have no income.

 

A sizable drop and a quick rebound, like what we just experienced isn't much of a problem, the fee might be lost for a year.  What kills this structure is multiple years of declines, or a flat market.

 

Not everyone can be Buffett, I applaud anyone who's done well with this structure, although there's an element of survivorship bias in it.  Where are the stories of managers who tried it, didn't make any money and shutdown their fund and started a new one?

 

I like a structure where the manager is paid something, enough that they're not worried about getting another job or taking crazy risks, yet they are incentivized if they do well.

 

 

I like the idea of a manager who is already financially independent.

Because if he has a track record that is worthwile, he'll be already a long way towards financial independance.

Secondly, as a partner, you don't want your manager to be pressured to take unnecessary risks because he needs the fee money to survive.

For an investor, patience is no luxury, it is a neccessity, and if your manager is being pressured by debt or by income problems, the first thing to go is the patience, and with it the rationality and prudence.

[Kraven]

These are good points. I've never understood high water marks except as a matter of marketing and asset gathering. From the standpoint of managing money though why should someone have to make an investor whole before they get paid?  They did the work and oftentimes a loss is due at least in part to just overall market performance. My feeling is that unless lookups are unreasonable if someone isn't happy with performance take your money out and fire the guy.

 

If an investment manager does a good job, at some point in time they would receive incentive fees, and generally the better the job, the greater the compensation.  So the high watermark is irrelevant in terms of the manager getting paid.  The truth is, that most managers want to manage money, but not take the risk and costs associated with an incentive fee structure without any fixed management expense ratio.  It's nice if you have $50M under management and get "1 & 15", because you are guaranteed $500K a year...whether you do well or not.  Even if you manage $10M, that's a decent $100K a year...which manager is going to sweat making $100K a year for doing nothing?

 

And that is where the high watermark becomes incredibly important for incentivizing the manager.  You lose money, and it may be years before you get paid again.  Thus, you better be making good decisions short-term and long-term regardless of where the market goes!  Cheers!

 

I was making a different point.  I don't disagree with the incentives, but if I am a manager and I lose money in 2008 it's not necessarily because I didn't make good decisions.  In fact, I was probably sweating it out and ruining my life for my clients.  And what do I get in return?  I have to work for free (other than my base fee) for years.  Why is that the proper way to incentivize someone?  Why not just say "if you're unhappy with me, take your money out".  If you go to a doctor and he treats you, but you still die, the bill is still outstanding.  He doesn't waive the fee.  To me, the incentives aren't necessarily aligned with highwater marks.  If I lose too much money, I'll just walk away and open a new fund.  Now maybe I'll have trouble raising money, but maybe not.  Either way, why should I kill myself when it might take years for incentives to kick back in and frankly, even if I do well clients have short term memories and the second things get better they probably still pull their money and give it to someone else. 

[Ham Hockers]

but if I am a manager and I lose money in 2008 it's not necessarily because I didn't make good decisions.  In fact, I was probably sweating it out and ruining my life for my clients.  And what do I get in return?  I have to work for free (other than my base fee) for years.  Why is that the proper way to incentivize someone? 

 

So do you turn down your fees when you benefit from a hot market?

[Kraven]

but if I am a manager and I lose money in 2008 it's not necessarily because I didn't make good decisions.  In fact, I was probably sweating it out and ruining my life for my clients.  And what do I get in return?  I have to work for free (other than my base fee) for years.  Why is that the proper way to incentivize someone? 

 

So do you turn down your fees when you benefit from a hot market?

 

No.  You missed the point.

[Ham Hockers]

No.  You missed the point.

 

I got your point.

 

Your point, that a HWM may misalign interests, partly hinges on your belief that a manager should not be punished for having poor performance which is undeserved (2008). So I asked if you would return your fees in a hot market. i.e. why should you be paid on gains that are not deserved?

[Kraven]

No.  You missed the point.

 

I got your point.

 

Your point, that a HWM may misalign interests, partly hinges on your belief that a manager should not be punished for having poor performance which is undeserved (2008). So I asked if you would return your fees in a hot market. i.e. why should you be paid on gains that are not deserved?

 

When you get the point, I will respond.

[Ham Hockers]

To me, the incentives aren't necessarily aligned with highwater marks.  If I lose too much money, I'll just walk away and open a new fund.

 

Whoever wrote this quote is clearly missing your point.

[oddballstocks]

The structure is fair, but has a hole in my view.  If you can't earn an incentive fee in the first year or two, or you start in a bad market there is no reason to stick around and try to earn out of that hole.

 

Maybe this works if you're independently wealthy, but if I'm running a fund, and I need a fee to pay for food/mortgage/kids I can't be waiting around forever hoping to eventually earn a fee.  I guess maybe this could become an advantage, if I do end up waiting for years I might not have to pay child support or alimony after my wife divorces me because I"ll have no income.

 

A sizable drop and a quick rebound, like what we just experienced isn't much of a problem, the fee might be lost for a year.  What kills this structure is multiple years of declines, or a flat market.

 

Not everyone can be Buffett, I applaud anyone who's done well with this structure, although there's an element of survivorship bias in it.  Where are the stories of managers who tried it, didn't make any money and shutdown their fund and started a new one?

 

I like a structure where the manager is paid something, enough that they're not worried about getting another job or taking crazy risks, yet they are incentivized if they do well.

 

 

I like the idea of a manager who is already financially independent.

Because if he has a track record that is worthwile, he'll be already a long way towards financial independance.

Secondly, as a partner, you don't want your manager to be pressured to take unnecessary risks because he needs the fee money to survive.

For an investor, patience is no luxury, it is a neccessity, and if your manager is being pressured by debt or by income problems, the first thing to go is the patience, and with it the rationality and prudence.

 

This is the current reality, the only people who can get into investment management either are young and have no expenses, or those who are older and already made enough money that day to day expenses aren't an issue.  This eliminates anyone who decides they'd like to have a family, which is probably why working all of the time is lauded for investment managers, they're either young or beyond kids.

 

Why would someone who's financially independent take on someone else's money to manage?  Managing money for someone else is not the same as managing your own money, it's much more stressful, with more responsibility.  If you are well off why add that to your life.  If I were financially independent I would not be managing outside money as something fun, I would probably manage my own money and spend time on things I wanted to do like skiing, biking etc.

 

The way for someone to manage money who has a family on their own appears to be as a RIA who builds a considerable book of business and earnings a straight fee, or for someone who's wealthy parents/relatives bankroll their living expenses while they build up AUM.  The second route is all about connections, if you come from a wealthy family I'd imagine it would be easy to collect assets which means you wouldn't need to live on your parents money for long.

[Edward]

The structure is fair, but has a hole in my view.  If you can't earn an incentive fee in the first year or two, or you start in a bad market there is no reason to stick around and try to earn out of that hole.

We have a fee structure of 0.5% - 10% in our company. I absolutely agree with the sentiment voiced by oddballstocks and this is the reason we chose this structure.

 

If you take only a performance based fee and bear the expenses, it is a very risky proposition. You might be unlucky for a few years and if your cost structure isn't very low you're going to be under massive pressure, not to say anything about trivial stuff such as food and shelter while you're at it.

 

 

 

[Parsad]

The structure is fair, but has a hole in my view.  If you can't earn an incentive fee in the first year or two, or you start in a bad market there is no reason to stick around and try to earn out of that hole.

We have a fee structure of 0.5% - 10% in our company. I absolutely agree with the sentiment voiced by oddballstocks and this is the reason we chose this structure.

 

If you take only a performance based fee and bear the expenses, it is a very risky proposition. You might be unlucky for a few years and if your cost structure isn't very low you're going to be under massive pressure, not to say anything about trivial stuff such as food and shelter while you're at it.

 

True, but like any real entrepreneurial endeavour, risk and sacrifice play a very significant part.  We run our business very lean, because if we didn't, we would have been out of business by now.  I think those habits are learned very quickly when everything is at risk. 

 

A fixed expense ratio of any sort to cover the manager's office and living expenses somehow strikes me as a less efficient way to learn that experience.  And if you somehow manage to get through the first few years, especially when they came during the worst crisis in 70 years, you know you can probably get through anything going forward.  There's some definite value in that.  Cheers! 

[oddballstocks]

The structure is fair, but has a hole in my view.  If you can't earn an incentive fee in the first year or two, or you start in a bad market there is no reason to stick around and try to earn out of that hole.

We have a fee structure of 0.5% - 10% in our company. I absolutely agree with the sentiment voiced by oddballstocks and this is the reason we chose this structure.

 

If you take only a performance based fee and bear the expenses, it is a very risky proposition. You might be unlucky for a few years and if your cost structure isn't very low you're going to be under massive pressure, not to say anything about trivial stuff such as food and shelter while you're at it.

 

I like your structure, also enjoyed reading the letters on your site.  Great job on Renault, I looked at that one and passed, not exactly a brilliant decision..