How to become the richest person in the world
I read a very interesting article on Arohan’s Investing Life this week. He compared Stephen Schwarzman and Warren Buffett in order to make the argument that the hedge fund model, while very lucrative for hedge fund managers, doesn’t necessarily yield the best return for great investors. It’s based mostly on an article published in the Financial times which illustrates how much Buffett would have made if he ran his business as the Buffet Investment Partnership rather than as the CEO and major equity holder in Berkshire Hathaway.
I have to say that I don’t necessarily agree with this analysis. Comparing simply running a hedge fund to earning a business is like comparing owning a diamond to owning a diamond mine. The key to understanding this is understanding the difference between equity and compensation. Equity is the ownership you have in a business. You are rewarded when the business does well and improves its valuation. Compensation is how well you are paid for doing your job it comes regardless of improving the value of your business. For some CEOs, it comes even when they destroy value in their business. On a compensation only basis, I don’t think Warren Buffett is really all that well compensated for his work given that he is the most successful CEO in America. Yes, he delegates much of the operational and strategic responsibility away from his position, but he manages cash flow and capital allocation better than any CEO in the world (or human history for that matter). His annual compensation for this is rumored to only be in the $100,000 range. Buffett’s enormous wealth has come from his ability to generate growth in value of his business, Berkshire Hathaway, a business he has majority equity in.
Now, you may argue that the articles linked above was more about wealth generation than some argument over the semantics of equity and compensation. For great investors like Buffett and certain hedge fund managers, their ability to generate wealth has as much to do with their ability to improve the equity stake of their business as it does with their ability to generate huge compensation for their services. Even if we were to take this route in interpreting the “spirit” of the argument, I don’t believe that the Warren Buffett/Berkshire Hathaway model represents the only route towards extreme, wealthiest man in the world level wealth. In fact, I believe that the Schwarzmann example is actually kind of a counterfactual to the argument that a hedge fund manager can’t become rich to the same level that Warren Buffett is rich. Schwarzman actually did turn his “hedge fund” – more an all purpose money creation business given that Blackstone is probably more known for its investment banking, real estate investment, and private equity than strictly for hedge funds – into a viable business for which, this year, his equity was valued at $4.77 billion. While it may seem like he was compensated in stock and cash for his work as CEO, he did start this business and was always entitled to that equity stake. The stock payment was simply an artifact of his company going public. In 10 or 20 years, who’s to say that Blackstone will not be wildly successful with their business and reach Goldman Sachs level market caps. At that point, if Schwarzman is still alive and hasn’t sold his ownership of the business, he too will be worth tens of billions similar to Warren Buffett (maybe even hundreds of billions as the economy will grow over that period).
In the end, “2 and 20″ is the only the year-to-year compensation for running a hedge fund and does not represent everything that you can make as a hedge fund manager. Obviously, looking at compensation alone does not represent a complete picture of your ability to generate wealth. If you also own the hedge fund you run and manage the business such that it is impressive enough at what it doesand turns into a viable investment management business, then you too could one day sell your equity for billions but this is not a compensation as much as it is a reflection of the value you’ve created in your business. In the case of Warren Buffett, he saw more opportunity to create a very viable conglomerate with his investing skills – taking over and running great businesses to get cash flow that allowed him to take over and run more great businesses. Schwarzman used his skills to put together an elite investment management and advisory business.
Ignoring the Blackstone example because it is not necessarily a pure hedge fund, a good hedge fund manager might be able to put together a business who’s sole purpose is the management of investment funds and also cash out with tens of billions. Take Fortress Investment Group for example. The company’s only job is to manage billions of dollars in various hedge funds and private equity funds. In a great year as the manager of one of these funds, you could probably make billions in management fees for yourself. And, if you owned all or part the company, your equity would probably increase billions as well. In actuality, running this kind of a business may be more lucrative on a year-to-year compensation basis than running Berkshire Hathaway. This is because you will be paid billions for your work and your equity stake will continue to increase with the success and growth of your business.
All-in-all, we can learn from this analysis that it is not enough to simply get paid well for your work. (Depending on perspective. I’d be fine getting hedge fund manager salaries even without equity.) For someone looking to become the richest man in the world, it’s just as important to seek equity value for what they do. This doesn’t mean it has to be in the form of a holding company. In fact, it could be as simple as striving for equity value in a manager’s own fund. Obviously, it’s possible you believe that no investment advisory business can possibly grow to the size of Berkshire Hathaway and thus could never provide the kind of wealth that running your own holding company can provide. But, that’s an argument for another day. Or, for the comments section of this post.
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