Hard Times Come To The Hedge Funds – Fortune Magazine, 1970 (Warren Buffett, AW Jones, Michael Steinhardt) by Hedge Fund Conversation

The arrival of the new year will mark not only the demise of certain other unsuccessful partnerships and the constriction of still others, but will also bring the liquidation of one of the country’s oldest, largest, and most successful investment partnerships, Buffett Partnership, Ltd, of Omaha. To call the Buffett operation a hedge fund is accurate only in the sense that Warren E. Buffett, thirty-nine, the general partner, shares in the profits of the limited partners. (Under his quite unusual arrangement, the limited partners annually keep all of the gains up to 6 percent; above that level, Buffett takes a one-quarter cut.) Otherwise, he is set apart from the regular hedge funds by the fact that he has invested almost exclusively in long-term “value” situations. Buffett’s record has been extraordinarily good. In his thirteen years of operation (all of them, including 1969 , profitable) he compounded his investors’ money at a 24 percent annual rate. Recently, the partnership’s assets stood just above $100 million, a figure putting Buffett ahead of Jones in size.

But now, to the immense regret of his limited partners, Buffett is quitting the game. His reasons for doing so are several, and include a strong feeling that his time and wealth (he is a millionaire many times over) should now be directed toward other goals than simply the making of more money. But he also suspects that some of the juice has gone out of the stock market and that sizable gains are in the future going to be very hard to come by. Consequently, he has suggested to his investors that they may want to take the “passive” way out, investing their partnership money not in the stock market but instead in municipal bonds.

Happiness at tax time

If Buffett is right in his appraisal of future market conditions, a lot of hedge-fund managers are going to be out looking for jobs that pay better than those they now have. Many could not at this moment survive another losing year, for as one general partner puts it, “20 percent of nothing is nothing.” Lately, a few new funds have been set up with pro- visions that, in effect, endow the general partners with salaries in those years in which profits are nonexistent or very small; ordinarily, these salaries are then considered to be advances against profits to which the general partners may become entitled in future years. This kind of arrangement, however, is not apt to sweep the hedge-fund business. Most investors seem likely to feel that, in handing over 20 percent of their profits in such years as these exist, they are already doing plenty for their general partners’ welfare.

In addition, many of these investors are sophisticated enough to know that when the general partners get around to paying their income taxes, there is something very wonderful about that 20 percent. It is not, in tax terminology, “compensation,” and it is not, therefore, automatically treated as straight income. Instead, the 20 percent is the general partners’ share of the fund’s profits, and these, if the market has been kind and the management wise, may be totally or largely in the form of long-term gains.

The results can be spectacular. Consider a fund of modest size-~say, $5 million. Assume that it makes a gain of 20 percent in a year (most funds did that well, or better, in 1967 and 1968) and that this $1 million is all in long-term gains. That leaves the general partners-there will probably be only two or three of them-with $200,000 in long-term profits to call their own. It is a heady scenario. There simply are not many other businesses in which the entrepreneur can hope to acquire, in fairly quick fashion, substantial long-term gains without necessarily putting up a cent of his own capital.

Hedge Funds, Warren Buffett, AW Jones, Michael Steinhardt

Hard Times Come To The Hedge Funds

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