2005: Is competition from hedge funds lowering investment returns?

AUDIENCE MEMBER: Greetings from Bonn, Germany. I’m (inaudible). Thank you for another great year added to your track record of investing. And thank you again for allowing us to be partners at these favorable terms.

This year, I want to ask you another question about how you see Berkshire positioned versus others.

Last year, I asked you how you see the increased competition for buying companies through the rise of the private equity industry and how that affects Berkshire’s ability to buy great businesses at fair prices, and you basically said that there are still enough business owners who would rather sell to Berkshire versus a private equity fund.

This year, I would like to hear your views on the hedge fund industry.

We see hedge funds going into all investment strategies. We know that you have spoken about the fees of the hedge fund industries, but I would like to hear from you how you see Berkshire positioned.

Are returns in strategies like merger arbitrage, like convertible bonds — are returns going down because of the increased competition? And are there other factors where Berkshire can be unique versus the hedge funds?

WARREN BUFFETT: Well, that’s a great question. It’s the $64 question.

There’s no doubt about it that there is far more money looking at deals now than five years ago, and they’re willing to pay out more for the good, but mundane, businesses that we’ve been successful at buying in the past.

And you mentioned the private equity firms and they’re bigger than ever.

The hedge funds have gotten into the game, to some degree. And if someone is auctioning off a business today — this has changed just very slightly in the last four or five weeks because of some change in the junk bond market, but not in any significant degree — there were people lined up to bid on almost anything.

In fact, you have private equity firms selling their businesses to other private equity firms.

And there are a lot of companies that are being sold, that are being sold to someone who’s buying them to resell in a fairly short period of time.

We can’t compete in that field and that’s, you know, that’s a source of distress to us. But that’s the way it is.

We will — it won’t go on forever, in our view. We still occasionally, as this deal I mentioned to you, the party on the other side and we just — we made a deal that did not go through an auction process. And we see that occasionally, but we don’t see it anything like we saw it four or five years ago.

So, in terms of the near-term outlook for Berkshire, in terms of doing what it’s important that we do, do successfully, which is buy businesses and keep adding to this collection, we are not positioned favorably at all for that.

And we do find it extraordinary, both Charlie and I have over the decades, just how fast things can change.

There have been at least three times, maybe more, where it’s looked to me in my own career, where it looked like there was so much money sloshing around that it would be impossible to do intelligent things with money.

And I actually terminated a partnership back at the end of 1969 because I felt that that the money was coming out, you know, of the woodwork. There were all kinds of people that wanted to use it and compete, and I just didn’t feel we could do intelligent things.

Within four years, I saw the greatest opportunities that I’ve ever seen in my lifetime. And we’ve had several experiences like that.

You know, in 1998, when Long-Term Capital Management got in trouble in the fall of 1998 and other things were happening, you had incredible opportunities available in the investment world.

Now, people were just as smart then. They had all these people with 150 IQs running around, and they actually had money. But the world became paralyzed for a short period.

And you literally had so-called “on- the-run” Governments, which were the most recent issue, and “off-the-run” Governments, which were issued by the same government, the United States government, payable in dollars. You had a 30-basis point differential between the 30-year and the 29-and-a-half year.

Both bonds issued by the U.S. government, you know, one a half-year shorter. Both quite liquid, but the “on-the-run” being more liquid. And a 30-basis point differential in yield means about a three-point difference in price.

Well, you wouldn’t believe that could happen in the United States of America in 1998, but it did happen.

And I think I have a slide here. Mark, if it — if we can put that up — that shows what high-yield bonds —the situation in those, just really less than three years ago.

In the fall of — yeah, there it is —I n the fall of 19 — in the fall of 2002, you had all these high IQ people in the financial world. You had lots of money.

And I don’t know how easy it is to read those figures, but you’ll see that a bunch of high-yield bonds — this actually is a table that involves a friend of mine, but we were doing pretty much the same thing.

And you can see that he was buying bonds at anywhere from a 25 percent to 60 or 70 percent yield basis, and within 12 or 14 months had sold these same bonds on a 6 percent yield basis.

You don’t need to do that very many times in a lifetime.

But that was two-and-a-half years ago after all these people had graduated with MBAs, and studied modern finance theory, and had money coming out of their ears, and all had a desire to make money, and yet conditions like that could exist.

We bought about seven billion of junk bonds during that period, because it was a fairly short period.

But things do happen that change the landscape dramatically, I mean really dramatically, in financial markets from time to time.

But right now, we are positioned very badly in terms of buying businesses, and it’s a big negative.

And your Berkshire stock will not do as well under these conditions as it would do if the conditions of five years ago or 20 years ago existed.

And I don’t have any magic solution for that except just to tell you what the facts are.

Charlie?

CHARLIE MUNGER: Yeah. A lot of the buying by private equity funds in both real estate and stocks, and for companies, is fee-motivated.

In other words, the investment manager will rationalize any price paid because he likes the extra fees for managing the extra assets.

I have a friend that tried to buy warehouses with a lot of family money and he just stopped. Whatever he bid was always topped by some professional manager, managing other people’s money on a fee basis.

So this is a very peculiar era where all these asset classes have been driven to very high valuations, by all historical standards.

Some investment operations are very ethical in this (inaubible).

I think Howard Marks is here today. He sent a lot of money back, and stopped soliciting money from his clients in certain activities where the opportunities went away.

That’s the right way to behave, but it’s not normal.

WARREN BUFFETT: Yeah, I don’t think he’ll mind — I didn’t know Howard was here today — but those actually are Howard’s figures for one of his funds.

And like I say, we were doing similar things. We didn’t know it at the time but we found out we had some similar positions later on.

About five or six years ago, when the terms of these deals were somewhat different, I actually had a fellow call me, whose name most of you would recognize, and he started asking me questions about the reinsurance business because he was in — he said he was thinking about buying a given company, which got sold, and he didn’t really know much about the business, but that unless he spent these x dollars, he was going to have to give it back to his investors in a few months because the term of the initial sign up period expired at that point, and any unexpended funds were to be returned.

And he was going to get 2 percent a year on those funds regardless of how they did. So he was looking at businesses that he didn’t understand with the hope that he can place the money.

Charlie and I are at a disadvantage in buying businesses because we have almost all of our net worth in the downside as well as the upside.

You know, if we had a 2 percent fee and 20 percent of the profits and a goodbye kiss for the losses, you know, that’s a different equation than exists at Berkshire.

We run it as if it’s 100 percent our money, which it is close to 100 percent of our net worth.

And we will own the downside. And we don’t get paid for spending the money, we get paid for making money.

And it’s tough — competing right now is tough and likely to be relatively futile, although we have one or two things that could happen that could involve the expenditure of real money.

CHARLIE MUNGER: I don’t think any of the businesses that have sold to us over the years, which are run by the kind of people we like being associated with, would have wanted to sell to a hedge fund.

So there exists a class of assets out there that doesn’t want to deal with hedge funds or private equity funds.

Thank God. (Laughter)

WARREN BUFFETT: Yeah, we’ve seen no deal anybody else has made the last year that we wish we had made.

Now that was not the case 15 or 20 years ago when there used to be plenty of deals made with other people that we would have liked to have made if they’d come to us .

But I have seen nothing that — I’ve seen nothing that if it sold for 10 percent less than the advertised price that we would have had any interest in buying. So we are in a different world right now.