This issue of Net Interest is dedicated to the memory of my business school classmate, Abhinav Deepankar, who lost his battle to COVID-19 in India last week. Happy memories, my friend.
Other People’s Money
In the 1950s and 1960s, Warren Buffett ran a hugely successful investment partnership. Aged just 25, he clawed together $105,000 from six investors and began managing it out of a small study in his rented home, accessible only via the bedroom. His agreement with these early investors was novel: they were guaranteed a return of 4% on their funds; anything above that he would split 50/50 with them, but he would also cover a quarter of any losses out of his own pocket. “My obligation to pay back losses was not limited to my capital. It was unlimited.” 1
Fortunately for Buffett, that loss clause was never triggered – he never had a single down year. In his first few months of operation, he beat the market by 4% and over the next 12 years he would go on to compound at a rate of 31.6% per year before fees. By the end of 1968, he was managing $105 million on behalf of over 300 investors. His reputation had grown and he had become rich.
And then he wound it all up.
Buffett wrote to his investors in May 1969 to explain. He offered four reasons: opportunities for his style of investing were drying up; his fund had grown too large for small cap investments to have a real impact; the market had become more speculative as a result of a swelling demand for returns; and finally, “the only way to slow down is to stop”. More than anything else, Warren Buffett wanted to slow down.
Over the next few months, Buffett liquidated his funds, returning to investors a mix of cash and stock in two illiquid holdings over which he had control – Diversified Retail Company Inc and Berkshire Hathaway Inc. He recommended clients reinvest their proceeds in his friend Bill Ruane’s fund or in tax-free bonds. And that was that.
“Some of you are going to ask, ‘What do you plan to do?’ I don’t have an answer to that question. I do know that when I am 60, I should be attempting to achieve different personal goals than those which had priority at age 20.”
We know now of course that Buffett didn’t really slow down. Fifty two years later he’s still at it. Last Saturday he took questions at the Berkshire AGM and on Monday, after years of speculation, he finally announced his successor.
So what prompted Buffett to change course all those years ago, to pivot from his role as a fiduciary into something else? And given how much success he’s had since winding up his fund, why haven’t more fund managers copied him?
A Revolving Door of Interested Parties
Buffett was neither the first nor would he be the last investment manager to wind up their fund. In March 2000, Julian Robertson announced that he was shutting Tiger after 20 years in the markets over which he had annualised 25% per year. In 2014, Nick Sleep and Qais Zakaria closed the Nomad Investment Partnership (20.8% per year, over twelve years). And in 2015, Bluecrest, once one of the world’s largest hedge funds, returned money to outside investors. The reasons for these fund closures are all different, but they have one feature in common: their managers didn’t stop actively investing after returning client money – they carried on, under a different structure.
The most glaring among this group is Bluecrest. At peak, the firm managed around $37 billion of assets, on which it earned 2-and-20 (2% management fee plus a 20% performance fee). Explaining its closure, the firm cited, “among other things, downward pressure on fee levels.” This gets to a key issue many managers face – if you’re really good at making money, what’s the right way to apportion the returns? Paying away 80% of the upside to outside investors may have been just about OK for Bluecrest; any more and it gets too expensive. When George Soros closed his own fund to outside investors in 2011, he approached Bluecrest to manage $1 billion of his money for 0.5% and a 10% performance fee; Bluecrest refused – giving away 90% of the upside was simply too much.
The issue becomes more urgent when the fund comes up against a size constraint. Diminishing returns to scale in fund management is something we’ve discussed here before (Zuckerman’s Curse and the Economics of Fund Management). It’s also a question Warren Buffett touches on often in his early investor letters. As long ago as 1962, when he was just 31 and managing $7.2 million, he wrote, “Aside from the question as to what happens upon my death… I am probably asked most often: ‘What affect [sic] is the rapid growth of partnership funds going to have upon performance?’”
If there is a limit to how much money can be profitably deployed, a manager may choose to put their own money – where they get to keep 100% of the upside – at the front of the line rather than client money. After returning outside capital to clients, Bluecrest continued as a private investment partnership and went on to shoot the lights out, returning 50%, 54%, 25%, 50% and 95% in the five years since it closed. 2
There are other reasons, too, of course, for closing a fund down. Julian Robertson was having a bad run in markets that didn’t suit his style of investing. “I’m not going to quit investing,” he told the New York Times. “But it will be nice to get out of the public eye. I don’t mind people calling me an old-economy investor, but it doesn’t go over well with the clients.” Similarly, Nick Sleep and Qais Zakaria “wanted to feel that we did not have to justify actions, and inactions, on an ongoing basis to a revolving door of interested parties.” [source]
Managing external expectations can be tough, particularly if they inform volatile fund flows. That’s not a problem Nomad had, but Tiger lost over a third of its client assets between the summer of 1998 and the end of March 2000. Buffett even saw $1.6 million of redemptions in January 1968 after he lowered his return targets in a preview of his fund’s eventual closure. (“Partners with attractive alternative investment opportunities may logically decide that their funds can be better employed elsewhere…”)
Managing your own money allows you to capture 100% of the upside; it also eliminates external scrutiny and redemption risk. But there is an alternative – permanent capital.
The Allure of Permanent Capital
When Warren Buffett liquidated his fund, he distributed to investors their pro rata share in a company he’d taken control of in 1965, Berkshire Hathaway. As we now know, this would go on to become his primary investment vehicle. The advantage is that, as a corporate entity, its capital was permanent – it couldn’t be redeemed. It also released Buffett of some of his fiduciary duties:
“I want to stress that I will not be in a managerial or partnership status with you regarding your future holdings of such securities. You will be free to do what you wish with your stock in the future and so, of course, will I. I think that there is a very high probability that I will maintain my investment in…B-H for a very long period, but I want no implied moral commitment to do so nor do so [sic] nor do I wish to advise others over an indefinite future period regarding their holdings.”
By the end of 1970, many of his former investors had cashed out, but Buffett bought more stock. His ownership of Berkshire increased from 18% to almost 36%.
Berkshire was useful as a pool of capital that Buffett could allocate freely. But its utility ballooned when combined with insurance assets. Two years before announcing his fund’s closure (and eight months before previewing it in the investor letter where he drops his targets) Warren Buffett bought an insurance company.
He’d followed the insurance industry for years, reportedly travelling from Columbia University, where he was a grad student, to Washington DC to visit the offices of GEICO in 1951. It was a Saturday and the doors were locked but a janitor let him in and he ended up spending four hours talking to Lorimer ‘Davy’ Davidson, a future CEO of the company; he later wrote up his recommendation of the stock in a note entitled ‘The Security I Like Best’ (here).
By 1967, Buffett’s eye had been turned by National Indemnity, headquartered a few blocks away from his office in Omaha. After a fifteen minute meeting with its founder, he agreed to buy the whole company for $8.6 million, a $1.9 million premium over its net worth. Rather than buy it directly in the fund, he bought it out of Berkshire Hathaway.3 The acquisition handed Buffett a new investment portfolio to manage. Its portfolio had previously been managed by its founder who, according to Alice Schroeder in her book, Snowball, “carried around hundreds of stock certificates in an old gym bag.” In 1967, the portfolio was sitting on $174,000 gains; by the end of 1968 – Buffett’s first full year of ownership – it was sitting on $1.76 million.
Thus began Warren Buffett’s love affair with ‘float’. According to Schroeder, “To someone like Buffett, having other people’s money to invest, on which he kept the profit, was catnip.” Unlike his fund structure, he could keep a much higher share of the investment profits. And nor were the funds going anywhere.
Float arises because most insurance policies require that premiums be prepaid and because it usually takes time for an insurer to hear about and resolve loss claims. While premiums flow in and claims flow out daily, the aggregate balance of float has a very long duration. In his 1995 shareholder letter, Buffett likened float to equity on the basis that it has no explicit repayment terms and its cost – at least in his case – was kept very low. The cost of float is equivalent to the underwriting loss incurred in the insurance business. If that cost can be contained below the cost of borrowing, float can provide a very cheap source of funds; if the insurance business actually turns a profit, the cost of float is negative and that’s great news.
Over the years, Buffett added to his insurance operations and to his float. In 1976, he acquired a 33% stake in GEICO for $46 million – 25 years after tipping it the security he likes best. In 1985 that stake was worth $596 million and accounted for 50% of Buffett’s portfolio – his highest ever concentration (Apple comes close at 43% as at end 2020). In 1995, he took full control of GEICO, paying $2.3 billion for the 49% he didn’t own (his ownership stake had increased over the years as a result of stock buybacks). On tangible book value, the price represented a multiple of 2.5x but the deal came with $3 billion of float – adding that in and the price was only 1.0x.
A couple of years later, Buffett made another major insurance acquisition, General Re, which came with $14 billion of float. Unfortunately, this deal turned out not to be so good, at least initially. General Re “did not reserve correctly…and therefore severely miscalculated the cost of the product it was selling. Not knowing your costs will cause problems in any business. In long-tail reinsurance, where years of unawareness will promote and prolong severe underpricing, ignorance of true costs is dynamite.” [source] A similarly unfavourable loss development had occurred within Berkshire back in 1984. The cost of float that year had ballooned to nearly 19%; in 2001 it was close to 13%.
These outlier years aside, Berkshire’s cost of float is normally very low. In 35 out of the 54 years in which Berkshire has been active in the insurance market, the cost of float has been negative; since that bad result in 2001, it has been negative every year bar two. Meanwhile, the scale of the float has increased. In 1967, it amounted to $20 million; by the end of 2020, it stood at $138 billion.
A few years ago, researchers at AQR Capital Management attempted to reverse engineer Buffett’s investment performance. They concluded that his public securities holdings outperform his private company holdings and wondered therefore why he bothers with the private companies at all. Tax aside, their hypothesis was that the insurance holdings provide a steady source of financing that allows him to leverage his stock portfolio. They estimate that the structure allows him to apply leverage at 1.7-to-1.
Which brings us to our final question: Given the benefits of operating such a structure, why have others not copied it?
By itself, the permanent capital vehicle is actually a very old idea. Investment trusts were established as closed-end investment vehicles in the UK in the nineteenth century (the first was the Foreign & Colonial Investment Trust, started in 1868 “to give the investor of moderate means the same advantages as the large capitalists in diminishing the risk by spreading the investment over a number of stocks” – they don’t do copy like that anymore!)
More recently, hedge funds and private equity firms have issued them. Dan Loeb of Third Point has one, listed in London. Bill Ackman of Pershing Square issued one on the Amsterdam Stock Exchange in 2014. In his latest shareholder letter, Ackman compares the structure of his Pershing Square Holdings Ltd to a conglomerate like Berkshire but with tax advantages.
The problem with these structures is that they frequently trade at a discount. Pershing Square currently trades at a 26% discount and Third Point at a 15% discount. They also can’t apply much leverage. 4
The insurance model has been gaining traction, though. Previously, only a handful of firms deployed it. The Markel Corporation, based in Richmond, Virginia, was relatively early. Founded in 1930 as a specialty insurance company (originally to insure jitney buses), it went public in 1986 with a market value of $40 million. The founding family hired Tom Gayner, a former analyst, specifically to help them replicate Berkshire Hathaway’s business model. William Green describes Gayner’s investment approach in his book, Richer Wiser, Happier. He has an impressive track record. Under his management, total assets of the firm have grown from $57 million in 1987 to $41.7 billion at end 2020. (As a side note, Berkshire is one of his largest holdings.)
Some hedge funds came at it from the other direction and founded insurance companies of their own (although they may have equally been motivated by tax benefits). David Einhorn of Greenlight has one (Greenlight Re) and so does Dan Loeb (SiriusPoint). In the past three years, Greenlight Re has had to pay for its float (through underwriting losses) although this stems from exposure to catastrophe loss; excluding the impact of catastrophes and the cost of float – like Berkshire’s – has been negative. The float is invested in David Einhorn’s funds.
Now, private equity firms are joining in, too. Apollo Global seeded an insurance business, Athene, in 2009 which grew via acquisition, came to the market in 2016 and is now being merged in with Apollo in a $30 billion deal. On his call announcing the deal, CEO Marc Rowan said, “Yes, there are elements of Berkshire Hathaway.”
The move is part of an overall strategy to increase the amount of permanent capital that Apollo has on hand to invest. Including other permanent capital vehicles, around 60% of Apollo’s assets under management are largely irredeemable. This lends the management company more value and peers have taken note. Three years ago, Blackstone President and COO, Jon Gray, gave Apollo credit for identifying the insurance market as an area of opportunity. Since then, Blackstone has done some of its own insurance deals and recently announced it would buy Allstate Corp’s life insurance business for $2.8 billion (taking the share of permanent capital in its assets under management above 31%). KKR similarly bought Global Atlantic Financial Group for $4.7 billion (taking its share to 43%).
The irony of course is that in a low interest rate environment, the value of float has never been lower. In its first fifty years of insurance activities, Berkshire had an average 4.7% per year cost of funds advantage over 10 year risk-free money. Buffett had a major head start on these new structures. But the irredeemable feature of float is as strong as ever. And for investment managers that “don’t want to be totally occupied with out-pacing an investment rabbit” (Buffett’s words, May 1969), permanent capital has many merits.
Adam Mead’s newly published book, The Complete Financial History of Berkshire Hathaway was a great help in researching this piece. Its combination of financial analysis, narrative and historical perspective make it a hugely valuable addition to the Buffett canon.
More Net Interest
Front Month has a review of the first quarter earnings from the exchange and financial data companies, highlighting S&P Global and Moody’s among others. Both businesses performed well last year as debt issuance ramped up globally and they have continued to do well this year with demand for their ratings continuing to be strong. We discussed the companies here a few months ago (The Business of Benchmarking). They capture enormous value as the uncontested authority not just of credit ratings but other units of financial standardisation like indices.
As S&P’s head of investor relations said last year, “Yes, we think of ourselves as a benchmark company. I mean, data is in vogue now, and people are really kind of a bit obsessed with data, data companies… I think data is nice, it’s interesting. But if you could turn something to a benchmark, it really transcends data.”
ESG was a big topic of discussion on both S&P Global and Moody’s earnings calls. S&P revealed it has 500 people working on ESG initiatives. Last year it recorded ESG revenue of $65 million and it has generated $21 million already in the first quarter. The prize for turning ESG data into an ESG benchmark is very high.
As a recipient of payment for order flow, Virtu has been in the spotlight a lot over the past few months. And because, unlike Citadel, the company is public, its CEO has become one of the practice’s principle defenders. When Andrew Ross Sorkin said something bad about payment for order flow on CNBC, Virtu’s CEO hit back via Twitter:
It seems he doesn’t hold back with analysts, either. On the company’s quarterly earnings call this week, the UBS analyst asked a question about April trends. Doug’s response?
“If you think April is important to that story, then write the note that you’re going to write… I’ve given you where we’re going to be in 2026. Where we’re going to be in 2026 is a lot more important to me than what you think about April.”
And when the UBS analyst wouldn’t let it lie.
“We've recreated an Execution Services business that candidly, your firm would love to have, okay? And so if all of those things don’t attract new investors, then I don't know what else we can do. Whether or not we should harp on monthly results on a stock that is a five year story, to me, is not the right way to approach your stock. You’re going to write your note. I know exactly what the headline is going to see, record quarter, but softening in the future… So write your note, and let’s have the next question.”
Ross Sorkin on CNBC and analysts in broker notes are incentivised to create noise and garner attention. Their agenda is very different from a CEO’s and sometimes the two clash.
We discussed Square in depth here just before Christmas and then Packy and I collaborated on a piece, Jack of Two Trades, looking at why Jack Dorsey runs Twitter differently from Square. This week, both companies reported and while Twitter earnings were disappointing, Square’s were very strong.
Gross profit at Square was up 79% versus the same period last year, but noteworthy is that it was driven by both the merchant (Seller) and the consumer (Cash App) sides of the business. Currently they are run as distinct ecosystems and they both had strong quarters. Seller benefitted from reopenings, international expansion and a shift towards upmarket merchants. Cash App benefited from higher consumer engagement and strong inflows. Revenue per user at Cash App is now running at around $56, up from $30 in 2019.
The potential at Square will be fully realised when both ecosystems converge into a closed network and some early signs of that became evident in the first quarter, with Square Loyalty being integrated into Cash App. After customers complete a purchase from a merchant using Square Loyalty, they receive a link to open or download Cash App, allowing them to view rewards centrally.
According to Dorsey, “These sorts of integrations are only possible because we have scaled ecosystems for both sellers and individuals, and we’re excited about the opportunity for future connections… There's a lot of connections that you probably don't hear of, which are all internal. So everything that we build on the seller side, we can utilize internally on the Cash App side and vice versa. And that’s allowed us to move much faster with both ecosystems because fundamentally, we have shared infrastructure.” When the convergence begins, it can happen very quickly.
On 1 January 1962, Warren Buffett dissolved all of his various investment partnerships into a single entity, Buffett Partnership Ltd (BPL) with a new fee structure comprising a 6% hurdle rate of return, over which he would take 25% of the profits.
In December 2020, Bluecrest agreed to a $170 million settlement with the SEC, having been charged with diverting top traders to its internal fund back in 2011 and replacing them on the client side with an inferior algorithm.
Many years later, in his 2014 shareholder letter, Buffett would cite this deal structure as the most costly mistake of his career. By buying National Indemnity via Berkshire, he shared the upside with the 39% legacy shareholders that retained a minority interest in Berkshire. “Despite these facts staring me in the face, I opted to marry 100% of an excellent business (NICO) to a 61%-owned terrible business (Berkshire Hathaway), a decision that eventually diverted $100 billion or so from BPL partners to a collection of strangers.”
Pershing Square Holding Ltd has issued some bonds, taking its equity/asset ratio down to 72% at end 2020, but “our credit remains misunderstood likely because we are a one-of-a-kind company, and it will therefore take time for fixed income investors and analysts to fully appreciate our story.”