Saturday, January 10, 2015

Why did Warren Buffett close his investment partnership in 1969?


Warren Buffett started his entrepreneurial career as a hedge fund manager. In 1966 he stopped taking outside money and in 1969, he returned money to his customers and closed the partnership. 

Currently his investment platform Berkshire Hathaway is a public traded holding company rather than a hedge fund or PE firm.

In a typical hedge fund, limited partners can withdraw capital quarterly (or even monthly). It's not a problem if a fund makes short-term investments or trades with the similar horizon (i.e, quant funds, arbitrage funds, etc). However, it's a big problem for the funds pursuing long-term investment strategies. Buffett wants to move capital across businesses while not having noisy partners (customers) annoy him all the time when returns don't look as outsized as past performance.
Private Equity and Venture capital funds solve this problem by creating funds with specific life-time, and locking investors up for the duration of the funds. They raise a fund for n years, and lock-in investors for these n years. This structure allows them to avoid liquidity mismatch between their assets and capital.   

Though, Berkshire Hathaway resembles a private equity firm to the extent that it is also using leverage (not debt, but float) to boost its returns. Like private equity firms, Berkshire sits on a pool of billions of dollars in unspent cash searching for deals. It owns a portfolio of businesses. But that's about it! 

Most importantly, PE firms have an exit strategy (say in 5-7 years) while investing in any companies. Warren Buffet's strategy is to buy and hold. When he buys stake, he holds it forever. 

Buffett on PE firms:
You can sell it to Berkshire, and we'll put it in the Metropolitan Museum; it'll have a wing all by itself; it'll be there forever, or you can sell it to some porn shop operator, and he'll take the painting and he'll make the boobs a little bigger and he'll stick it up in the window, and some other guy will come along in a raincoat, and he'll buy it.
Warren Buffett solved this problem by using C-corp structure. It effectively locks-in capital indefinitely (investors can't withdraw capital at all). Such setup gives Buffett strategic advantage: he has the most "patient" capital pool on the market, and can afford to make the longest-term investments. It also gives him strong tactical advantage during panics and various liquidity crises, when the stocks are the cheapest. When other hedge funds are forced to sell their positions at bargain prices to meet withdrawals, Buffet picks them up. 

Also Warren Buffet likes to talk about his company. Under US securities laws, Buffet is not only allowed to talk about the prospects for his company and his investment philosophy, he is legally required to do so in his annual report. By contrast, if he were a hedge fund or PE firm, he would be legally barred from talking about his company as this would be considered advertising and illegal under US law.