21: How Warren Buffett Rewards Berkshire's Managers For Using Less Capital
Here's my informed guess as to how it's done at Berkshire
Warren Buffett has provided lots of hints on Berkshire’s compensation arrangements with managers. At times, such as at the 1995 annual meeting (video below), he’s also discussed how a manager can be rewarded for releasing capital.
A question about the mechanics of that arrangement prompted a somewhat lengthy response in the comments section and the idea to bring this wonderful group of readers into the discussion.
How (I Think) It’s Done:
Berkshire has many different businesses. Some are capital intensive (like BNSF or BHE). Others use very little capital (think Business Wire). The focus here is on those that use capital.
Perhaps the best way to think about this is to look at it forward and then backward (i.e. invert). Let’s see how the arrangement works for a manager using additional capital. But first, a base case to set the stage.
Base case:
Let's say a BRK subsidiary uses $100m of capital. Buffett perhaps sets a base salary for the person and then incentivizes them by giving them 10% of any profits over a 15% return on capital.1 The business earns 20% or $20m and the manager gets a bonus of $500k ($20m minus $15m bogey = $5m x 10% = $500k).
Use of Additional Capital:
If that manager wants an additional $100m, say, they're going to want to be very sure they can earn at least 15% on that capital. If they can't then their bonus could be in jeopardy. If profits went from $20m to $30m but they employed $200m capital, then earnings would just meet the threshold and the manager wouldn't get a bonus. Still with me?
Returning Capital:
Now let's say that manager is working under the original scenario with $100m in capital but finds a way to do business with $90m. So they've sent $10m back to Omaha but still earn $20m. Well, that's just another way of saying return on capital increased from 20% to 22.2% ($20m / $90m). What does the manager earn for a bonus?
A 15% return would be $13.5m. So $20m - $13.5m = $6.5m. The bonus, at 10%, is $650k. So that manager has earned an additional $150k by figuring out how to earn the same amount of money with less capital. The manager gets $150k more and Berkshire gets $10m to allocate elsewhere.2
Simple, rational, and tied to the business.
To be clear, I have no proprietary access or insight into Berkshire's comp structures. But the scenario I've laid out above seems to make sense given what Buffett has said in the past.
Stay rational! -Adam
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I’m choosing this arbitrarily but with the rationale that Todd/Ted (Berkshire’s two investment managers) are incented with 10% of the amount over the S&P 500 performance. It seems like a figure Buffett would use.
And this scenario would remain year after year assuming no change in capital or earnings. Essentially Buffett would be willing to pay a royalty on the release of capital because he'd then be in a position to reallocate that capital. In this scenario, Berkshire would be “paying” 1.5% ($150k / $10m) to get its capital back. Not a bad deal.
Just out of curiosity, in Buffett's letters, he often states that small companies are unable to "move the needle" even if they are very profitable, implying that due to Berkshire Hathaway's (Brk) huge size, these companies won't make a difference in Brk's profitability. However, why doesn't he just buy larger quantities of such small but profitable companies? Is it because it is too much trouble to take over a new company and Buffett wants to minimise the number of companies he takes over?
Good one Adam...Can I disagree in the way the "returning capital" was interpreted? Two assumptions: (1) Capital can be returned mostly near to the end of the year, considering the same is of no further use; (2) There is no fixed income earned on idle capital available in the checking account. Now comparing apples to apples (if the total return earned on capital remains at 20%); Two outcomes: 1) If entire 100Mill allocated was used, it means a bonus of 500k...viz. 10% of (100*20%-100*15%); (2) If only 90Mil used and balance 10Mil returned...bonus should be 300k ! ....viz.. 10% of (90*20%-100*15%). While Buffett allocated 100 Mil assuming the same would earn minimum 15% return (benchmark), the manager used only 90 Mil and returned the balance 10Mil (Though the manager is rewarded for good performance on using 90Mil, he will be slightly penalized for excess budgeting and keeping 10Mil capital idle). In your calculation, you assumed 22.22% return on 90Mil to arrive at the same 20Mil return on capital and considered 15% benchmark return on 90Mil to arrive at 650k bonus! (While Buffett is expecting his entire money, 100Mil should work for him at 15%)