Pabrai/Buffett partnership fee structure

[skanjete]

I understand that Pabrai copied the fee structure in his partnership from the Buffett partnerships : 25% on the profit above 6%.

I was wondering what happens after a down year. In a down year, there is no profit participation of course, but what happens thereafter? If I remember correctly, in the Buffett partnerships, there was no profit participation until all losses were made good.
But does this also count for the 6%? One never had the chance to check this for Buffett, because his partnerships never had a down year.

For example :
year 0 : start with 1000$
year 1 : - 20% : result 800$
year 2 : +50% : result 1200$

As I understood the fee structure from the Buffett partnership, (and I suppose thus now from Pabrai), the managing partner gets 0.25 x  (1200 - 1000 x 1.06 x 1.06) = 19.1$ after the second year.

Does anyone know if this is correct?

[Mephistopheles]

That would make sense, although I'm not sure what the exact terms were either.

Didn't Buffett also have a fee structure where he took some of the losses? I think he got 50% of profits above 6% and took 25% of losses or something. Or rather he guaranteed a certain %.

[Redskin212]

Skanjete,

Your calculation and understanding is correct.

[skanjete]

In that case, the partners indeed do get a fair deal!

And is profit participation calculated for the partnership in its entirety or for each partner individually?
I'm asking this because, depending on extra investments or liquidations along the way, the result can be different for each partner individually.

If one partner invests extra money after year 1 (a down year), his losses will be recouped faster than the partner who doesn' t invest extra money,  and thus profit participation should kick in quicker for the extra investing partner.

[JBird]

(B) A division of profits between the limited partners and general partner, with the first 6% per year to partners based upon beginning capital at market, and any excess divided one-fourth to the general partner and three-fourths to all partners proportional to their capital. Any deficiencies in earnings below the 6% would be carried forward against future earnings, but would not be carried back. Presently, there are three profit arrangements which have been optional to incoming partners:

Interest Provision. Excess to Gen. Partner. Excess to Ltd. Partners
(1) 6% 1/3 2/3
(2) 4% 1/4 3/4
(3) None 1/6 5/6

In the event of profits, the new division will obviously have to be better for limited partners than the first two arrangements. Regarding the third, the new arrangement will be superior up to 18% per year; but above this rate the limited partners would do better under the present agreement. About 80% of total partnership assets have selected the first two arrangements, and I am hopeful, should we average better than 18% yearly, partners presently under the third arrangement will not feel short-changed under the new agreement;

(C) In the event of losses, there will be no carry back against amounts previously credited to me as general partner. Although there will be a carry-forward against future excess earnings. However, my wife and I will have the largest single investment in the new partnership, probably about one-sixth of total partnership assets, and thereby a greater dollar stake in losses than any other partner of family group, I am inserting a provision in the partnership agreement which will prohibit the purchase by me or my family of any marketable securities. In other words, the new partnership will represent my entire investment operation in marketable securities, so that my results will have to be directly proportional to yours, subject to the advantage I obtain if we do better than 6.

[skanjete]

JBird,

I suppose that's Buffett vintage. I think I read it in one of his partnership letters at the moment when he consolidated his separate partnerships into 1 partnership.
 
So since his partners had the choice between 1,2 or 3, I suppose the profit sharing is calculated per partner individually.

[racemize]

JBird,

I suppose that's Buffett vintage. I think I read it in one of his partnership letters at the moment when he consolidated his separate partnerships into 1 partnership.
 
So since his partners had the choice between 1,2 or 3, I suppose the profit sharing is calculated per partner individually.

I believe that section indicates that the previous structures were 1, 2, or 3, and that he was consolidating into the 6%/25% structure.

[skanjete]

JBird,

I suppose that's Buffett vintage. I think I read it in one of his partnership letters at the moment when he consolidated his separate partnerships into 1 partnership.
 
So since his partners had the choice between 1,2 or 3, I suppose the profit sharing is calculated per partner individually.

I believe that section indicates that the previous structures were 1, 2, or 3, and that he was consolidating into the 6%/25% structure.

Yes, I think you're correct. I was to fast with my conclusion.

But is profit participation then calculated individually or not? Because differences between partners can be quite substantial after years as 2008, 2009, depending on their follow up investments.

[Parsad]

JBird,

I suppose that's Buffett vintage. I think I read it in one of his partnership letters at the moment when he consolidated his separate partnerships into 1 partnership.
 
So since his partners had the choice between 1,2 or 3, I suppose the profit sharing is calculated per partner individually.

I believe that section indicates that the previous structures were 1, 2, or 3, and that he was consolidating into the 6%/25% structure.

Yes, I think you're correct. I was to fast with my conclusion.

But is profit participation then calculated individually or not? Because differences between partners can be quite substantial after years as 2008, 2009, depending on their follow up investments.

Yes, profit participation is calculated individually, as income, dividends, gains, losses have to allocated every time capital comes in or out.  So if you are accepting capital monthly, then you have to allocate income/losses monthly and set the new high watermark. 

It is definitely the most equitable way to pay a manager and also incentivize them.   You lose money for partners, it takes longer and longer to get paid.  You make money, you get paid.  You make a lot of money for partners, you get paid very well!

But, I believe that level of compensation works best in a system where capital can be taken away from the manager, not one where they have permanent access to it.  The more permanent the capital, the lower the incentive fee should be, as the amount of risk to the manager reduces over time.  Just my opinion!  Cheers!

[skanjete]

JBird,

I suppose that's Buffett vintage. I think I read it in one of his partnership letters at the moment when he consolidated his separate partnerships into 1 partnership.
 
So since his partners had the choice between 1,2 or 3, I suppose the profit sharing is calculated per partner individually.

I believe that section indicates that the previous structures were 1, 2, or 3, and that he was consolidating into the 6%/25% structure.

Yes, I think you're correct. I was to fast with my conclusion.

But is profit participation then calculated individually or not? Because differences between partners can be quite substantial after years as 2008, 2009, depending on their follow up investments.

Yes, profit participation is calculated individually, as income, dividends, gains, losses have to allocated every time capital comes in or out.  So if you are accepting capital monthly, then you have to allocate income/losses monthly and set the new high watermark. 

It is definitely the most equitable way to pay a manager and also incentivize them.   You lose money for partners, it takes longer and longer to get paid.  You make money, you get paid.  You make a lot of money for partners, you get paid very well!

But, I believe that level of compensation works best in a system where capital can be taken away from the manager, not one where they have permanent access to it.  The more permanent the capital, the lower the incentive fee should be, as the amount of risk to the manager reduces over time.  Just my opinion!  Cheers!

Parsad,

Thank you for your clarification.

We work very similarly, the only difference being that the treshold is 0% (instead of 6%) and 15% instead of 25%. I guess I was less confident when we started than Buffett or Pabrai, rightfully so, I might add.
Actually, I hadn't read the Buffett partnership letters yet when we got started, but the arrangement just seemed to be a correct way of working. I had a day job back then managing construction projects, and my experience in that job too was that 15% was a cut that most people considered fair and correct. More than 15% didn't last because some people got frustrated, jealous or feeled like being taken advantage of.

Later on, I read the 6%-25% arrangement of Buffett (and Graham before him I think), and I proposed this way of working to some partners because I think it's even fairer for the partners, but most of them preferred our 0%-15% arrangement (this was before 2008  ), so it stayed that way.