Why Warren Buffett is richer than the Hedge Fund managers - a tale of two business models
March 12, 2008
By: 
Arohan
Category: Buffett, Hedge Funds, Investing, Personal Finance, Private Assets
Two interesting articles/stories caught my eye today
The first one talks about the mind boggling 2007 total compensation (earnings + stock) to Blackstone Group’s co-founder Stephen Schwarzman. According to this AP story, his compensation in 2007 was $350.7 million and along with stock grants valued at $4.77 B during Blackstone’s IPO, his total takeaway was $5.13 Billion in 2007 alone
With earnings like this, it is no surprise that many hedge fund managers are now counted among the Forbes Global Richest list.
This brings us to the second article that examines what would have happened if Warren Buffett had followed the hedge fund model of compensation instead of just staying with his equity position in Berkshire Hathaway and let the investment compound. To quote from the FT article,
At “2 and 20″, the split is $57bn for Buffett Investment Management and $5bn to the Buffett Foundation. The effect of compounding at 14 per cent, rather than at 20 per cent, is to reduce the accumulated pot by over 90 per cent.
It is basically saying that if Buffett had followed the Hedge Fund model of compensation, his accumulated wealth would have been just 10% of what it is today
The difference is in the business models. A hedge fund manager primarily derives his income from fees. The assets of the hedge fund are owned by investors in the fund and only a part of the growth in the value of this asset works towards increasing the net worth of the hedge fund manager. For Mr Buffett, and indeed many entrepreneurs, net worth is primarily determined by the equity stake in the business that they own. Equity ownership lets the business income continue to compound in the business. As the business grows, the net worth of the owner grows correspondingly (the story would have had a different ending if Buffett had kept diluting his stake in Berkshire Hathaway by continually bringing in new investors like a hedge fund does)
Also to note (and a point unaddressed by the FT article) is the effect of taxation. While a hedge fund manager pays taxes each year (capital gains or income, a matter of controversy for sure but not relevant to this analysis), Mr Buffett will only pay taxes if he sells his equity (again, the fact that his charitable actions have helped him avoid taxes altogether is besides the point)
If you are a superlative investor (like Mr Buffett or like many of the better hedge fund managers), business ownership model of Berkshire Hathaway will generate greater wealth over a long period of time. Sure, running a hedge fund will get you to great riches quickly (adding lot of investors quickly, in the years where the fund does very well, etc), but it is not a superior wealth creation machine over long term
Maybe that is why Warren Buffett long ago discarded the investment partnership model. Or maybe another reason why Blackstone, Fortress et al. are now choosing to go public bestowing large equity stakes on their founders
Related posts:
- Can Hedge funds really beat the market over a long term?
- Stock investors, who is the next Warren Buffett - Part 1
- Obama has a plan to slow down the economic growth engine of US
March 13th, 2008 at 2:37 am
Dan has posted a counter to this analysis on his website which is an expanded version of the comment he posted here. Please go and visit his site to read his response to this article at The Curious Investor
A trackback link to his response is also available in one of the comments below (Comment #4)
—-Arohan
March 14th, 2008 at 6:00 am
[…] admin wrote an interesting post today onHere’s a quick excerptThis brings us to the second article that examines what would have happened if Warren Buffet had followed the hedge fund model of compensation instead of just staying with his equity position in Berkshire Hathaway and let the investment … […]
March 15th, 2008 at 2:48 am
Arohan I pick your post for my post of the day at ________ matters.
Nick’s last blog post..Is Buffett’s Business Model More Lucrative than a Hedge Fund?
March 15th, 2008 at 4:04 am
[…] read a very interesting article on Arohan’s Investing Life this week. He compared Stephen Schwarzman and Warren Buffett in order to make the argument that the […]
March 15th, 2008 at 5:53 am
Interesting perspective. It’s interesting because most people say buyside guys make way more than the sellside because of leverage and the ability to invest rather than just earn fees, but this shows that even on the buyside, building equity rather than just taking the cash leads to more long-term wealth.
Inquisitor’s last blog post..Weekly Reader Q&A: Nonprofit To Private Equity, The Role Of Accounting Firms And Startup vs. Marketing Internship
March 15th, 2008 at 9:40 am
@Nick thanks for the honor!
@Dan, thanks for the trackback on your response to my article. I will be posting a response to your response soon
@Inquisitor, I think this is the reason why someone like Edward Lampert would find it attractive to buy a long term stake in Sears/K-mart or why a Fortress or a Blackstone goes public. Otherwise in a hedge fund model, there is no equity building, just cash outs.
March 16th, 2008 at 7:29 am
I thought hedgies can do the same thing by putting their fees into the fund as ‘Carried Interest’. Isn’t that what the politicians are trying to tax now?
Options Strategery’s last blog post..Short Idea: True Religion Apparel (TRLG)
March 23rd, 2008 at 8:00 pm
If I’m not mistaken, isn’t he the richest man on Earth?
Melo’s last blog post..EntreFrame: A Second Look At Entrecard Widgetsurf
March 24th, 2008 at 12:22 am
@Options Strategery: Yes ‘carried interest’ is basically a hedgies equity in the fund. Politician would like to tax the fees as income (which I agree with) but the hedgies argue that it is actually capital gains (which it is for the fund; not for the hedgies though) and should be taxed at the lower 15% rate. Regardless of the rate, the every year the fees are taxed unlike in a situation where you are holding equity and let it grow where the taxes do not come into play until the time you cash out
@Melo: No, you are not mistaken
March 25th, 2008 at 7:53 pm
Hey Arohan, I’ve been stopping by your page fairly often lately, thought I’d leave a comment. Was wondering if you’d like to do a blogroll exchange with me…
I think you know my website: http://hedgeagainstspeculation.com
Also, if you get a chance, you should enter into the contest I have on my website, best of luck to you.
Richard’s last blog post..BULLS vs. BEARS, MY PREDICTION