Warren Buffett set up his partnerships using a very interesting structure. He didn’t take an annual management fee from his partners. Unlike almost every other investment fund at the time (and indeed today) this was unique because it meant that in down years, Warren Buffett wouldn’t be paid.
In fact, rather than receiving money from investors no matter what, Buffett was actually on the hook for funds if he didn’t produce a positive performance for investors.
Buffett’s partnership structure
According to various sources, the initial investors in Buffett Associates, LTD were paid interest of 4%, which would be, “charged as expenses of the partnership business.”
Each limited partner would “be paid interest at the rate of 4%” on their capital account at the end of the prior year. If he did outperform, Buffett was entitled to a performance fee of 50% of net profits.
Under this complex structure, Buffett had to return 4% a year or fund the 4% annual interest fee to partners out of his own pocket. If he achieved a return of more than 4%, he was allowed to keep 50% of the profits over this hurdle.
So, for example, if the fund produced a return of 10%, 4% would go to partners, and the remaining 6% would be split between Buffett and his partners. If the partnerships lost money, say 10%, Buffett would still have to pay up his 4% interest, reducing investor losses down to 6%.
These initial figures (they were later revised so that Buffett would take 25% of the downside of any losses) helped the young investor stand out. He couldn’t just sit around and collect a management fee, he had to generate a positive performance of at least 4% a year or risk having to spend his hard-earned savings making partners whole.
Low risk, high reward
Buffett wasn’t planning for that scenario. He was convinced that his strategy of buying deeply discounted equities would produce fantastic results.
And he was right. In 1957, the partnerships returned 10.4%. In 1958, they returned 40.9%. In 1959, they returned 25.9% and in 1960, Buffett Associates returned 22.8%. Between 1957 and 1967, Buffett produced a total cumulative return for partners of 2610.6%, compared to just 185.7% for the Dow Jones Industrial Average.
On a compound basis, the partnerships returned 31.6% per annum, compared to 9.1% for the Dow Jones between 1957 and 1968.
Buffett smashed the market by buying deeply undervalued securities and then holding on until the rest of the market realised the value. In a 1993 talk to Columbia University students, Warren Buffett described three early Buffett Partnership investments:
“I found a little company called Genesee Valley Gas near Rochester. It had 22,000 shares out. It was a public utility that was earning about $5 per share, and the nice thing about it was you could buy it at $5 per share.”
“I found Western Insurance in Fort Scott, Kansas. The price range in Moody’s financial manual…was $12-$20. Earnings were $16 a share. I ran an ad in the Fort Scott paper to buy that stock.”
“I found the Union Street Railway, in New Bedford, a bus company. At that time it was selling at about $45 and, as I remember, had $120 a share in cash and no liabilities.”
It was really that simple.
Disclosure: The author owns no share mentioned.