The formulas, tricks and trade secrets of Private Equity

Warren Buffet Carried Interest

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An interesting tidbit: when Warren Buffett started his Buffett and Associated, Ltd. Partnership in the late 50s, he quoted his limited partners a 25% carry (although, I’m sure he didn’t use the term “carry”). By the time the partnership began investing though, it became a 50% carry above a 4% hurdle and a negative 25% carry on the downside.

This meant if the partnership made a 20% return, Buffett would keep 50% of the 16% over 4%, which would be 8% of the overall return. However, Buffett didn’t take this payment; he reinvested it back into the partnership to compound upon itself. If the partnership made 4% for the year, there would be no performance fee. The surprising bit is if the fund lost 10%, Buffett would personally cover 25% of the loss below the 4% hurdle. So in this example, he’d pay back 25% of 14%, or approximately 3.5%.

This downside protection for the partners (or as I referred to earlier, a negative carry) was unlimited until all capital was lost. Can you imagine a private equity firm today structuring a fund like that? Buffett’s response to this risk was that he knew he wouldn’t lose money over the long term. Somehow, I suspect he wholeheartedly believed this and didn’t just spout it for the sake of fundraising.

Another interesting fact about his partnership is that while he convinced his friends and family to part with almost $100k, he only contributed $100 to the fund. A private equity fund would rarely get off the ground with this lack of skin in the game, but after all, he probably had more than enough skin in the game by guaranteeing 25% of the downside.

As an aside, understanding the ventures that Buffett thought up and supported, I would say he’s more of a private equiteer than maybe even he would like to admit.

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