Why did Buffett use a 6% hurdle rate?

[fwallstreet]

I've always wondered how he arrived at 6% for being the hurdle rate to use after consolidating the early partnerships. But I can't remember reading anything that outlined his thinking. If someone knows or, preferably, could point me to a primary source detailing his reasoning, I'd appreciate the info.

 

Is it based on historical gov't bond yields up to or from the late 50s? Or equity market returns? Thanks in advance

[stahleyp]

I believe it was the yield on the 10 year treasury.

[Andy Dufresne]

From what I was told by a mentor who worked directly for WEB and CM in the 80s due to them coming into the Salomon Board, the hurdle rate WEB used/uses is 9% - 3% inflation and 6% real return; in any case, IMHO WEB doesn't really attribute much value to the discount rate - if he can find a business that has pricing power, he knows he can pass on most if not all of the inflation ... so all that is left is to find a business where you can earn a decent RoE. WEB's disadvantage compared to individual investors is size, but with the CFO from dozens of strong businesses he can easily optimize the capital structure of any subsidiary easily (i.e. optimize the debt/equity ratio), and while individuals can leverage, they will tend to pay higher interest and they have fewer uncorrelated sources of CF. Hope this helps!

[fwallstreet]

Thanks for both of your thoughts. My first guess was also the 10 yr, but based on the historical data that I've looked at in the mid to late 50s, seems like 10 yr yield was in the 3.5% to 5% range.

 

I also thought I read something along the lines of it being related to avg equity market returns, but again based on historical data that I looked at, that didn't seem to fit either - closer to 9-10%. Andy, your info on the inflation factor might be the missing link and makes the math seem to work.

 

Also agree with your other thoughts - preaching to the choir! - but I guess what triggered this question was what Buffett, Pabrai, Sanjeev or any other fund manager that uses this relatively unique fee structure would say to an investor that asks, "So why a 6% hurdle? Why not 4% or 8%?" Maybe this isn't a common question bc I imagine after comparing it to other fund fee structures - esp. those without hurdle rates - this one understandably comes off as being extremely fair and a perfect alignment of incentives.

 

Would still be interested to hear what others here think if different from the above two - thanks again to you both!

[JAllen]

He talks about it in partnership letters or somewhere.  It was definitely the risk-free rate back in the 50s, but I don't recall if it was treasuries or long-terms.  He was like 'I only get a share above the amount you could safely earn elsewhere', or something to that effect.

[Hielko]

I think the 6% threshold is simply saying "if I deliver crap results I'm not going to get paid". Considering that average equity returns are around 10% he would get a somewhat reasonable fee for average performance, and only a great fee if he really manages to outperform. Pretty effective while keeping things simple if you ask me.

[Tim Eriksen]

It was based on his estimate of long term rate of return for the Dow.  In the 1961 letter (written in Jan 1962) he said:

 

"Over any long period of years, I think it likely that the Dow will probably produce something like 5% to 7% per

year compounded from a combination of dividends and market value gain. Despite the experience of recent

years, anyone expecting substantially better than that from the general market probably faces disappointment."

 

 

[fwallstreet]

Thank you Eric! I skimmed through the letters awhile back trying to remember why I kept thinking the 6% was related to some equity market return after realizing the govt yields didn't fit. Obviously I totalled missed it, thanks for digging that up - much appreciated.

 

http://finance.zacks.com/average-return-dow-jones-during-its-lifetime-3314.html

 

This article seems to show that he was certainly in the right range if looking across its history all the way to 1890s! I'd be interested in knowing others thoughts on what hurdle rate would be appropriate if launching a fund using the Buffett fee structure like many on this board have done now or in recent past (obviously small list but Pabrai, Sanjeev, etc). Since the Dow obviously has many flaws as a price weighted index, demonstrated by standard benchmark being market cap-weighted S&P nowadays, would you guys feel that someone who wanted to stay true to Buffett's thinking should raise the hurdle higher to maybe 9%? Just thinking out loud.

 

IMHO seems like that would be too high of a hurdle and is one of the reasons why my first attempt to rationalize the 6% was similar to stahleyp's - using the 10 yr yield. Also the rationale behind that seems to make a lot of sense too as others here have pointed out - fund manager is only paid based on outperformance over the easily accessible, risk-free return of govt bonds rather than "riskier" equity market. Plus I'm sure it certainly helps (justifiably) these fund managers when they can say they're using the same fee structure as Buffett did!  :)

[Andy Dufresne]

Good discussion. I guess the answer is an amalgamation of what everyone has said - it's a simple fee structure where "true' outperformance is rewarded. I also think that the 6-7% is the long term natural growth rate we've had over the past 100-150 years, with 2-3% coming from inflation and the balance coming from growth in the labor pool + growth in labor hours/effectiveness, with the latter two parts making up the real portion of growth (I'm no economist so I hope this makes sense ).

 

To re-emphasize what I said in earlier post, since WEB grasped the power of compounding early, I think that as long as he found a business that could give him a good chance to beat the LT general rate, he knew that holding is over 20+ he'd do well with his investments ...

 

[BG2008]

Interestingly the 6% rate was also the rate that Buffet will pay LPs if they wish to send money prior to a scheduled opening.  It is a form of financing for the fund.  Regarding a fee structure for a fund, I spent a ton of time trying to devise a clever fee structure that would align my interest with my LPs.  I thought about setting the 10 year treasury as the hurdle and let it float each year.  You start running into issue with the fund admins with a floating rate fee structure.  I know some individuals who use 0,6,25 and actually ran into trouble with fund raising because of the 0.  From prospective LPs' perspectives, some of them want to pay the GP during lean years.  Great fund managers with great moral compass tend to be easier to pick in hindsight.  Most fund managers who are down 40-50% would often just close down the fund and start a new fund.  Hence, the prospective LPs understand that a 0,6,25 fee structure can lead to a GP not having any cashflow for 2-3 years.  Hence, having a 1,6,25 fee structure will motive the GP to work his/her way out of the hole. 

 

If I were an LP, a 0,9, 25 would make me uncomfortable (my 2 cents).  The GP can't cover expenses unless there is substantial out performance. 

[Happy]

I think Buffett started out with 0,4,25% and 0,6,33.3% , and 0,0,16.7% as his fee structures. He only switched to 0,6,25 because he wanted to combine them all into the same structure and wanted to be superfair and not leave anyone thinking that his old fee structure could possibly have been better.

So if one starts today with only one fee structure, shouldn't one actually use one of the terms he started out with rather than with his "concession" to existing partners? Historically very low interest rates and the high market valuation would also lead me conclude that 0,4,25% might be fairer than 0,6,25% when starting a new fund today.

[peter1234]

I think Buffett started out with 0,4,25% and 0,6,33.3% , and 0,0,16.7% as his fee structures. He only switched to 0,6,25 because he wanted to combine them all into the same structure and wanted to be superfair and not leave anyone thinking that his old fee structure could possibly have been better.

So if one starts today with only one fee structure, shouldn't one actually use one of the terms he started out with rather than with his "concession" to existing partners? Historically very low interest rates and the high market valuation would also lead me conclude that 0,4,25% might be fairer than 0,6,25% when starting a new fund today.

 

Fair depends which side you are on.  ;D

 

If you think you can do 10% pre fees, the difference is quite big at 50%: 1.5% vs 1.0%

;)

[fwallstreet]

Interestingly the 6% rate was also the rate that Buffet will pay LPs if they wish to send money prior to a scheduled opening.  It is a form of financing for the fund.  Regarding a fee structure for a fund, I spent a ton of time trying to devise a clever fee structure that would align my interest with my LPs.  I thought about setting the 10 year treasury as the hurdle and let it float each year.  You start running into issue with the fund admins with a floating rate fee structure.  I know some individuals who use 0,6,25 and actually ran into trouble with fund raising because of the 0.  From prospective LPs' perspectives, some of them want to pay the GP during lean years.  Great fund managers with great moral compass tend to be easier to pick in hindsight.  Most fund managers who are down 40-50% would often just close down the fund and start a new fund.  Hence, the prospective LPs understand that a 0,6,25 fee structure can lead to a GP not having any cashflow for 2-3 years.  Hence, having a 1,6,25 fee structure will motive the GP to work his/her way out of the hole. 

 

If I were an LP, a 0,9, 25 would make me uncomfortable (my 2 cents).  The GP can't cover expenses unless there is substantial out performance.

 

Great points, I think your reasoning makes a lot of sense when you think about the fee structure from a practical view - which is clearly what's important - vs a theoretical/what would Buffett do now perspective. If you don't mind sharing, what fee structure did you ultimately end up settling on?

 

To everyone else, thanks for the great discussion.

[nodnub]

Interestingly the 6% rate was also the rate that Buffet will pay LPs if they wish to send money prior to a scheduled opening.  It is a form of financing for the fund.  Regarding a fee structure for a fund, I spent a ton of time trying to devise a clever fee structure that would align my interest with my LPs.  I thought about setting the 10 year treasury as the hurdle and let it float each year.  You start running into issue with the fund admins with a floating rate fee structure.  I know some individuals who use 0,6,25 and actually ran into trouble with fund raising because of the 0.  From prospective LPs' perspectives, some of them want to pay the GP during lean years.  Great fund managers with great moral compass tend to be easier to pick in hindsight.  Most fund managers who are down 40-50% would often just close down the fund and start a new fund.  Hence, the prospective LPs understand that a 0,6,25 fee structure can lead to a GP not having any cashflow for 2-3 years.  Hence, having a 1,6,25 fee structure will motive the GP to work his/her way out of the hole. 

 

If I were an LP, a 0,9, 25 would make me uncomfortable (my 2 cents).  The GP can't cover expenses unless there is substantial out performance.

 

I was just reading the Of Permanent Value by Andy Kilpatrick (1998 edition).  It  referred to 6% hurdle being based on the rate available on savings at the bank. Does that seem right for that era?    The book also mentioned paying 6% interest on early deposits sent by LPs before an opening.

[ukvalueinvestment]

Why would you feel uncomfortable about the GP not being able to cover expenses unless there is substantial outperformance?

 

Buffett fee structure:  Didn't he guarantee to make good any losses as well?

[peter1234]

Why would you feel uncomfortable about the GP not being able to cover expenses unless there is substantial outperformance?

 

Buffett fee structure:  Didn't he guarantee to make good any losses as well?

Because you cannot cover your expenses and pay all your staff. So they might leave.

 

I think early on he guaranteed any losses. Remember, he ran a few different funds.

 

;)

[ukvalueinvestment]

But you shouldn't be in business unless you believe you can deliver substantial outperformance, should you...?

 

And any good business plan should enable you to survive through periods of underperformance (cash buffer).

 

To my mind, if you are confident in your abilities you should have zero management fee and high performance fee.  Why should you get paid anything for under or equal performance?

[ASTA]

Regarding the management fee the only time I think its worth more then 0,6,25% is Distress debt think Oaktree. Other then that why would anyone pay more then 0,6,25% when investing in equities take's maybe 10H a week or 100% index.   

[peter1234]

But you shouldn't be in business unless you believe you can deliver substantial outperformance, should you...?

 

And any good business plan should enable you to survive through periods of underperformance (cash buffer).

 

To my mind, if you are confident in your abilities you should have zero management fee and high performance fee.  Why should you get paid anything for under or equal performance?

 

In theory, I absolutely agree with you.

 

In practice, however you might underperform for a few years in a row. So you might fold just before outperforming again and then the LP will not participate.

 

For example, Pabrai uses a similar structure. When he was underperforming, I think most others would/could not keep going.

;)

[TREVNI]

This is perhaps simplistic, but at a 6% annual rate the early investors who withdrew monthly would get 0.50% of their last year's ending principal balance per month.  Not all of the early investors 'let it ride' so-to-speak.  Some were giving him their retirement savings and needed regular cash.

 

I'd imagine that the long-term rate of return and government alternatives would have played into the decision too.  On the other hand keeping the math simple for his investors (such as his aunt) and for himself (paper-based records) could have been the reason. 

[Travis Wiedower]

Regarding a fee structure for a fund, I spent a ton of time trying to devise a clever fee structure that would align my interest with my LPs. 

 

Fee structure is something I think about a lot as well. The best idea I've seen (and I may try to use it in the future) in terms of alignment of interests is 40% of the difference between my returns and my benchmark. For example, I only invest in small caps so the Russell 2000 could be a reasonable benchmark for now. If that loses 5% this year but I gain 5%, I'd get 40% of the difference so +5% - (-5%) = 10% * 40% = 4% of AUM. Problem is many investors wouldn't like having to pay in a year that, for example, the benchmark loses 20% and I breakeven because then they end up paying me 8% of AUM and now they're down money on the year. I think it's very fair for all parties and is the best way to align interests though.