Pabrai/Buffett partnership fee structure

[JBird]

"The economics make no sense to those without connections or those with large AUM. You couldn't just get a few people today together and offer the same Buffett partnership scheme. If I'm reading this right, you can't get 5 people to pitch in $100k each and take a performance fee. I can see why innovation is in such short supply."

 

BUT 100,000 back then is equivalent to how many million now?

 

Buffett partnership started with $105,000 in 1956. That's equivalent to $856,459 today.

 

http://www.bls.gov/data/inflation_calculator.htm

 

[DoddDisciple]

I was just talking about $500k today, not in Buffett's time. I don't think you could setup a $500k investment partnership and charge performance fees unless everyone was qualified investors.

[slkiel]

I read this a few days ago and really identified with it: Some Thoughts on Becoming an Independent Fund Manager, http://www.rvcapital.ch/pdfs/Some_Thoughts_on_Becoming_an_Independent_Fund_Manager.pdf

 

I'd excerpt parts of it, but all of it is great. Highly recommend reading it if you have a small fund or if you're thinking of starting a fund.

[matjone]

I wasn't aware of the recent 2012 designation of accredited vs qualified investors, but overall it just seems to make it unlikely for anyone to want to start a fund from scratch, especially something more eclectic.

 

With accredited investors, unless they're supplying a huge amount of money to your fund, you can only charge a 2% management fee, regardless of results. So to make $70k, not factoring in all supplemental business and advisory costs, you'd have to raise $3.5M. There's not much reason to do anything beyond just sticking the money in something plain and marketing for more money after that, since you're not going to get any of the upside.

 

To actually get a performance fee, you have to have qualified investors with even higher net worth requirements, and the performance fee is limited to 20%. On the same $3.5M, let's say you do 20% and take 20% of the upside beyond 5%. You're only talking about $100k here, which is a great salary, but again, you have all these other fees and it's not guaranteed.

 

I can now see why success in the investment field is 99% based on the connections you have.

 

Connections and AUM.  When I see this math I wonder why someone's taking the risk of managing money?  Most people doing this can make the same amount doing the same thing for someone else with zero risk.  There is zero liability risk etc.

 

Unless you can raise a substantial amount of capital, or you're doing it on the side for some spare pocket change the economics are tough.

 

On the other hand I know someone who opened a RIA.  They are managing any and all capital.  If a retiree wants them to manage their 401k they have a strategy for it.  If someone wants a value strategy they have that as well.  They aren't AUM constrained, I like that approach a lot.

 

What's to stop you from starting something on the side and keeping your day job to feed the family?  You are already doing that now and doing alright.  The management of it will certainly take some time commitment but there is also a huge potential reward to yourself and others.

[Mephistopheles]

The state rules for performance fees vary. You don't necessarily need to have qualified or accredited investors to charge a performance fee. In NJ, for example, as long as you don't register with the state, you can charge performance fees to anyone. And you don't have to register with the state unless you manage 5 partnerships or more.

[Kiltacular]

I wasn't aware of the recent 2012 designation of accredited vs qualified investors, but overall it just seems to make it unlikely for anyone to want to start a fund from scratch, especially something more eclectic.

 

It seems like some of the rule changes reduce competition.  This seems to often happen, in many industries, when regulations are increased.  They are often increased after a crisis.  The large, entrenched players welcome the new regulations.  We saw what the Sarb./Oxley regs. did for smaller public companies, we saw what the new banking regulations did for the smaller banks.

 

This isn't to suggest things should go unregulated.  It is just something I've become aware of over the years.  The big players (who survive the crisis that is the impetus for the new regulations) often appear to have a much stronger position going forward.

[DoddDisciple]

I wasn't aware of the recent 2012 designation of accredited vs qualified investors, but overall it just seems to make it unlikely for anyone to want to start a fund from scratch, especially something more eclectic.

 

It seems like some of the rule changes reduce competition.  This seems to often happen, in many industries, when regulations are increased.  They are often increased after a crisis.  The large, entrenched players welcome the new regulations.  We saw what the Sarb./Oxley regs. did for smaller public companies, we saw what the new banking regulations did for the smaller banks.

 

This isn't to suggest things should go unregulated.  It is just something I've become aware of over the years.  The big players (who survive the crisis that is the impetus for the new regulations) often appear to have a much stronger position going forward.

 

Exactly. This is what really surprised me about this regulation. I may just be stupid, but I thought you could charge a performance fee to accredited investors and not just a management fee. Who can blame Sonkin for shutting down Hummingbird/Tarsier in this light; I'm sure his newly offered day job would have paid more!

 

Really, the finance industry seems to exist to just serve itself. I joking believe the master plan is to get most people stuck in index funds but charge 1% or more for the privilege. I've seen this in so many retirement accounts. You have the manager leeching 20% per year or so if you're lucky, and then you have the government sucking out the reduced amount when distributions are forced out.

[Tim Eriksen]

The state rules for performance fees vary. You don't necessarily need to have qualified or accredited investors to charge a performance fee. In NJ, for example, as long as you don't register with the state, you can charge performance fees to anyone. And you don't have to register with the state unless you manage 5 partnerships or more.

 

NJ would be quite unusual.  Most states mimic the SEC rules.  A few are more restrictive, like Washington.  I do know that the SEC established that performance fees may only be charged to qualified clients ($2 million net worth and above, up from $1.5 million previously).  As to earlier posts, there is no SEC rule limiting fees to 2% and performance fees to 20%.  It is possible to charge more, but you will have to include a lot of disclosure.       

[John Hjorth]

... The fee structure that Buffett had was that he got 50% of profits because he had a 50% interest in the partnership so legally (remember I could be wrong) he wasn't charging a performance fee rather he was entitled 50% of the profits because he owned 50% of the company. ...

 

This basic assumption for your post about the early partnership years is not correct, Cameron.

[racemize]

I am reading Benjamin Graham: The Father of Financial... while flying home today. In it, the authors describe a fee structure where he gets a small salary and then 20% of profits over 6% hurdle. So, at least for me, this solves the question of why Buffett used 6%. As to why Graham did, maybe it was the prevailing high grade bond rate at the time?  i will need to look it up when I get home.

[BRK7]

 

...for a regular hedge fund the general partner usually only owns 1% of the limited partnership.

 

Not true.  The GP can own anywhere between 0% and 100%, unless there is something in the limited partnership agreement that stipulates otherwise. 

 

Typically, outside investors will want the GP to have "skin in the game"  and it is not uncommon for the GP to be a large investor (as a % of total assets) in a given fund. 

[John Hjorth]

Cameron,

 

I apologize for a non-constructive reply to you here.

 

Mr. Buffet started from the start block with the first partnership with an initial capital of USD 105,000 from the limited partners [family members], and USD 100 of his own. With a 4 per cent watermark, taking 50 per cent of the total profit excess of 4 per cent.

 

When he was extremely good at what he was doing at that time under such an agreement with the limited partners, he got totally extreme returns on invested capital in the early phase of the whole thing.

 

One can actually say, that he was levered/amplified 1,050 times on the upside [105,000/100, and naturally still subject to the watermark], while at the same time participating in losses equally with his limited partners.

 

His returns on his own capital account in the early years must been in thousands of per cents, however I have never seen any attempt to do the calculations, most likely because his withdrawals and capital injections to his capital accounts in the partnerships are still today not disclosed.

 

Link. You have to to add the "X/42"'s in the agreement to understand the built-in profit sharing mechanism.

 

This was for the first partnership.

[Read the Footnotes]

 

This is why Buffett had to open new partnerships when new people tried to get him to invest for them because if they were to invest in the original partnership he would have to dilute his 50% in the original and would thus mean he was no longer entitled to the 50% of the profits because he didn't have a contract stating that he got 50% of profits.

 

Actually, additional partnerships were opened due to the regulatory limitations on the maximum number of partners allowable in each partnership at the time. It had nothing to do with his ownership interest in each partnership.

[Tim Eriksen]

I'm really trying to understand this, but does the fact that the partners get 21/42 not mean that they own 50% of the partnership? Or am I completely off base because under X it says: "A limited partner has no right to substitute an assignee as contributor in his place.", this doesn't constitute ownership?

 

It is not referring to ownership, but to share of gains.  Completely different. 

[John Hjorth]

Cameron,

 

I apologize for a non-constructive reply to you here.

 

Mr. Buffet started from the start block with the first partnership with an initial capital of USD 105,000 from the limited partners [family members], and USD 100 of his own. With a 4 per cent watermark, taking 50 per cent of the total profit excess of 4 per cent.

 

When he was extreme good at what he was doing at that time under such an agreement with the limited partners, he got totally extreme returns on invested capital in the early phase of the whole thing.

 

One can actually say, that he was levered 1,050 times on the upside [105,000/100, and naturally still subject to the watermark], while at the same time participating in losses equally with his limited partners.

 

His returns on his own capital account in the early years must been in thousands of per cents, however I have never seen any attempt to do the calculations, most likely because his withdrawals and capital injections to his capital accounts in the partnerships are still today not disclosed.

 

Link. You have add the "X/42"'s in the agreement to understand the built-in profit sharing mechanism.

 

This was for the first partnership.

 

I'm really trying to understand this, but does the fact that the partners get 21/42 not mean that they own 50% of the partnership? Or am I completely off base because under X it says: "A limited partner has no right to substitute an assignee as contributor in his place.", this doesn't constitute ownership?

 

Cameron,

 

No, you are confusing the profit sharing agrement with capital acccounts of the general partner and the limited partners. The capital accounts of the partners [general or limited] define the ideal share for each partners share of the whole partnerships net worth.

 

Hint: Fire up Excel, and try to do some calculations.

 

Edit:

 

Tim beat me to it! [ ; - ) ]

[Tim Eriksen]

The SEC says you cannot receive incentive compensation from anyone who is not a qualified investor.  I don't think there is any loophole around that.   

[ValuePadawan]

Hello COBF fund experts I'm looking for a little advice as it's difficult to find the pertinent information online I thought you would be the best resource.

 

First of all I wish to set up a fund or structure where I manage money using the 0/6/25 fee structure.

 

I'm in my 20's located in Ontario, Canada.

 

I have a family member who is independently wealthy and wants me to manage their money, I would of course put in all my investment capital.

 

I've heard a limited partnership is advantageous for tax purposes as the income flows through to the respective partners. Am I misinformed? Are other structures more advantageous.

 

I've also heard it can be difficult setting up a fund in Ontario without extensive employment experience in the sector which I lack.

 

If there are any pitfalls or mistakes that I may want to avoid?

 

In my current financial position I can wait years for management fees to start coming in I am not strapped for cash (no wife and kids).

 

Would I be better off with a more informal arrangement to avoid all the regulatory fees?

 

How much does it cost at bare minimum to keep up with regulatory costs in Ontario annually (ballpark)

 

Any other comments concerns or advice is greatly appreciated.

[Guest]

Hello COBF fund experts I'm looking for a little advice as it's difficult to find the pertinent information online I thought you would be the best resource.

 

First of all I wish to set up a fund or structure where I manage money using the 0/6/25 fee structure.

 

I'm in my 20's located in Ontario, Canada.

 

I have a family member who is independently wealthy and wants me to manage their money, I would of course put in all my investment capital.

 

I've heard a limited partnership is advantageous for tax purposes as the income flows through to the respective partners. Am I misinformed? Are other structures more advantageous.

 

I've also heard it can be difficult setting up a fund in Ontario without extensive employment experience in the sector which I lack.

 

If there are any pitfalls or mistakes that I may want to avoid?

 

In my current financial position I can wait years for management fees to start coming in I am not strapped for cash (no wife and kids).

 

Would I be better off with a more informal arrangement to avoid all the regulatory fees?

 

How much does it cost at bare minimum to keep up with regulatory costs in Ontario annually (ballpark)

 

Any other comments concerns or advice is greatly appreciated.

 

I can't speak about Canada but in the states you can run a fund for about $20,000 if you carry the load on some of the paperwork from my understanding.

 

Also, would you be managing a large part or all of the family member's assets? There will be points in time where you suck. How would that affect your relationship?

[scorpioncapital]

Hello COBF fund experts I'm looking for a little advice as it's difficult to find the pertinent information online I thought you would be the best resource.

 

First of all I wish to set up a fund or structure where I manage money using the 0/6/25 fee structure.

 

I'm in my 20's located in Ontario, Canada.

 

I have a family member who is independently wealthy and wants me to manage their money, I would of course put in all my investment capital.

 

I've heard a limited partnership is advantageous for tax purposes as the income flows through to the respective partners. Am I misinformed? Are other structures more advantageous.

 

I've also heard it can be difficult setting up a fund in Ontario without extensive employment experience in the sector which I lack.

 

If there are any pitfalls or mistakes that I may want to avoid?

 

In my current financial position I can wait years for management fees to start coming in I am not strapped for cash (no wife and kids).

 

Would I be better off with a more informal arrangement to avoid all the regulatory fees?

 

How much does it cost at bare minimum to keep up with regulatory costs in Ontario annually (ballpark)

 

Any other comments concerns or advice is greatly appreciated.

 

In the situation you mentioned there are virtually no regulatory costs except corporate tax return. The reason I say this is because for this situation I suggest a much simpler solution. Incorporate a company for $1000 with your relative and yourself as shareholders. Your only real running costs are annual tax returns which shouldn't run more than $2000. I can't imagine anything cheaper than this solution except...there is also an IB platform product called family office which allows you to trade on behalf of your relative's capital. You can segregate funds and even set a compensation fee percentage. This is probably even cheaper as it's just in your own name. Given the relationship I do not think there is any regulatory requirement.

[longlake95]

Be careful, I have been looking at this for sometime - in Ontario. There are significant regulatory barriers. You will trip the "advising and dealing" in securities rule, therefore you will need to be registered and be a portfolio manager (you can't just LP like you can in the U.S. - our regulators are anti business growth and cater to the big firms). PM me if you want more detail.

 

LL

[Cigarbutt]

Be careful, I have been looking at this for sometime - in Ontario. There are significant regulatory barriers. You will trip the "advising and dealing" in securities rule, therefore you will need to be registered and be a portfolio manager (you can't just LP like you can in the U.S. - our regulators are anti business growth and cater to the big firms). PM me if you want more detail.

 

LL

I am not as familiar with the Ontario-specifics but the regulations are pretty uniform on this side of the border for that aspect and I tend to agree with longlake in the sense that your efforts are unlikely to succeed if your goal is to go through a formal arrangement.

You have two hurdles:

1-Obtain an exemption, when you accept money from somebody else to "manage" it, in order to avoid the prospectus rules. This would essentially involve producing an offering memorandum showing that your 'investors' are rich, sophisticated, 'accredited' and are ready to (consent to) lose all their money because they think you are great.

2-Obtain an exemption in order to avoid the need to register yourself as some kind of an adviser. This requires time, potential frustration, fees and your job is then to somehow convince somebody that you have the capacity and ability to do this outside of official bounds.

https://www.getsmarteraboutmoney.ca/protect-your-money/investor-protection/regulation-in-canada/types-of-prospectus-exemptions/

https://www.osc.gov.on.ca/en/Dealers_asking-relief_index.htm

 

I hear what longlake is saying about investment managers being stifled but this area has always attracted individuals with poor credentials (and poor incentives) and it may be a price to pay for the collective blanket of security.

[longlake95]

I am familiar with Ontario and the National Instruments. I won't argue that some regulation is good - of course it is. However, the current rules stifle legitimate people starting new firms unless you fit a very narrow scope of rules ( no allowance for unusual but safe and legitimate situations). Even with the strict rules, we still have blow-ups and crooks in Canada. That likely won't stop. It would very good if we moved to the LP, accredited investor model that the U.S. uses.

[Cigarbutt]

I am familiar with Ontario and the National Instruments. I won't argue that some regulation is good - of course it is. However, the current rules stifle legitimate people starting new firms unless you fit a very narrow scope of rules ( no allowance for unusual but safe and legitimate situations). Even with the strict rules, we still have blow-ups and crooks in Canada. That likely won't stop. It would very good if we moved to the LP, accredited investor model that the U.S. uses.

Absolutely.

[returnonmycapital]

Being remunerated for managing other people's capital (advising, in regulatory parlance) has regulatory implications. The first being licensing. You must become licensed as a portfolio manager or investment fund manager. In order to be licensed, certain prerequisites are essential: experience and education. Education is typically earned through the CFA Institute exams and eventual charter. In order to get a CFA charter, a minimum of 3 years' worth of relevant investment analysis/management work is required. The regulators will expect some, if not all, of this to be realized prior to considering granting a license. Meaning, you may have to work for another registered firm prior to setting up on your own.

 

The operating expenses are only somewhat onerous and mainly comprise:

 

1) Setting up of a management company (licensing requires a legal entity) ($500 setup and then ongoing registration fees with the regulator of at least $1,100/yr - depending on entity revenues);

2) Production of a Policies and Procedures Manual (PPM) for the legal entity and any of its employees ($a lot);

3) Hiring of an auditor for the management company ($7-10,000/yr);

4) Setting up a trust or LP for the investment fund ($5,000);

5) Producing an Offering Memorandum ($15-25,000?); and

6) Hiring administrators, auditors, compliance consultants, and legal advisors to help with the ongoing admin/compliance of the investment fund (other than the administrators & auditors, which charge the fund directly, probably $10,000/yr).

 

If you get past all this and you want to charge an absolute hurdle (6%) performance fee, your investment fund will need to be a non-reporting issuer fund (Prospectus funds can only charge fixed fees (% of assets) or hurdle rates based on a reasonable benchmark (i.e. S&P500 TR Index)). This means that your fund will only be accessible to "accredited investors." Accredited investors have a minimum annual income requirement, or minimum liquid investment funds, or minimum asset size, etc., etc. The market for such investors is small and competitive.

 

As longlake95 suggests, it is daunting but not impossible and, if successful, worthwhile.

[ValuePadawan]

Being remunerated for managing other people's capital (advising, in regulatory parlance) has regulatory implications. The first being licensing. You must become licensed as a portfolio manager or investment fund manager. In order to be licensed, certain prerequisites are essential: experience and education. Education is typically earned through the CFA Institute exams and eventual charter. In order to get a CFA charter, a minimum of 3 years' worth of relevant investment analysis/management work is required. The regulators will expect some, if not all, of this to be realized prior to considering granting a license. Meaning, you may have to work for another registered firm prior to setting up on your own.

 

The operating expenses are only somewhat onerous and mainly comprise:

 

1) Setting up of a management company (licensing requires a legal entity) ($500 setup and then ongoing registration fees with the regulator of at least $1,100/yr - depending on entity revenues);

2) Production of a Policies and Procedures Manual (PPM) for the legal entity and any of its employees ($a lot);

3) Hiring of an auditor for the management company ($7-10,000/yr);

4) Setting up a trust or LP for the investment fund ($5,000);

5) Producing an Offering Memorandum ($15-25,000?); and

6) Hiring administrators, auditors, compliance consultants, and legal advisors to help with the ongoing admin/compliance of the investment fund (other than the administrators & auditors, which charge the fund directly, probably $10,000/yr).

 

If you get past all this and you want to charge an absolute hurdle (6%) performance fee, your investment fund will need to be a non-reporting issuer fund (Prospectus funds can only charge fixed fees (% of assets) or hurdle rates based on a reasonable benchmark (i.e. S&P500 TR Index)). This means that your fund will only be accessible to "accredited investors." Accredited investors have a minimum annual income requirement, or minimum liquid investment funds, or minimum asset size, etc., etc. The market for such investors is small and competitive.

 

As longlake95 suggests, it is daunting but not impossible and, if successful, worthwhile.

 

This seems like an awful lot to do just to manage a majority portion of one close family member's capital. Would a more informal arrangement of me managing their brokerage account and then calculating any fees once a year be a better alternative? Would them wiring me fees at the end of the year cause me tax issues?