In this article, we will take a look at Warren Buffett’s partnership letter covering the first half of 1961.
With this letter, dated July 22, 1961, Buffett diverged from his pattern of only writing an annual letter to his limited partners. From this letter forward, he started writing to his limited partners on a semi-annual basis. In Buffett’s own words:
In the past, partners have commented that a once-a-year letter was “a long time between drinks,” and that a semi-annual letter would be a good idea. It really shouldn’t be too difficult to find something to say twice a year; at least it isn’t this year. Hence, this letter which will be continued in future years.Next, Buffett went on to describe the Dow-Jones Industrial Average’s performance versus the partnership’s performance for the first half of the year:
During the first half of 1961, the overall gain of the Dow-Jones Industrial Average was about 13%, including dividends. Although this is the type of period when we should have the most difficulty in exceeding this standard, all partnerships that operated throughout the six months did moderately better than the Average. Partnerships formed during 1961 either equaled or exceeded results of the Average from the time of formation, depending primarily on how long they were in operation.However, at this point, Buffett makes two important points:
1. “…one year is far too short a period to form any kind of an opinion as to investment performance, and measurements based upon six months become even more unreliable.” Then, he states that one factor that made him hesitant to write a semi-annual letter was a fear that partners would start thinking in terms of short-term performance – which he says “can be most misleading.” Then he states: “My own thinking is much more geared to five year performance, preferably with tests of relative results in both strong and weak markets.”Next, Buffett indicates that the partnerships have “begun an open market acquisition of a potentially major commitment.” He states that this type of commitment “may be a deterrent to short term performance, but it gives strong promise of superior results over a several year period combined with substantial defensive characteristics.” So, again, Buffett’s focus here is long term performance.
2. Buffett states that the partnership may not be able to exceed or even keep up with the Dow Jones Industrial Average if it keeps advancing at the same pace as it did in the first half of 1961. Additionally, Buffett mentions that when general market levels rise, the partnership’s portfolio becomes even more conservative. Interestingly, he also states “At all times, I attempt to have a portion of our portfolio in securities at least partially insulated from the behavior of the market, and this portion should increase as the market rises.”
Combining All Partnerships
Buffett then talks about the progress that has been made toward combining all partnerships at the end of 1961. He states that he has spoken about the merger with partners that joined during the past year and with representative partners of all earlier partnerships.
He then goes on to address some of the different provisions associated with combining all partnerships.
A. The partnerships will be combined based on market value at yearend, with provision for appropriate allocation of future tax liability due to unrealized gains at yearend. Mr. Buffett states that the merger will be tax free, and that it will not result in “acceleration of realization of profits.”
B. Buffett then describes the division of profits between the general partner and the limited partners that will be in effect after the merger of the partnerships: “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.” He then goes on to state that “any deficiencies in earnings below the 6% would be carried forward against future earnings, but would not be carried back.”
Then he goes on to show three current profit arrangements that were optional to incoming partners. (Note: For comparison purposes, I have also included the profit arrangement that will be in effect after the merger of the partnerships.)
Below is a graph that shows limited partner returns based on the above profit arrangements. Please note this graph only considers annual positive partnership returns after expenses.
Excess to General Partner
Excess to Limited Partner
As Buffett notes in his letter, limited partners in profit arrangements 1 and 2 will be better off with the new profit arrangement (after merger) under all circumstances. He then states that the new profit arrangement is also superior to profit arrangement 3 up to 18% per year, however, above this rate, profit arrangement 3 is superior to the new profit arrangement.
Buffett then notes that “about 80% of total partnership assets have selected the first two arrangements, and I am hopeful, that should we average better than 18% yearly, partners presently under the third arrangement will not feel short-changed under the new agreement.”
C. In this provision, Buffet describes what happens in the event of losses. He states that if there are losses “there will be no carry-back against amounts previously credited to me as a general partner, although there will be a carry-forward against future expected earnings.” He then tries to convey to his limited partners that he will be in the same boat as them regarding losses. He states “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 or 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%.”
Interesting side note: Later in the letter, Buffett mentions that “estimated total assets of the partnership will be in the neighborhood of $4 million.” Thus, Buffett and his wife’s investment in the new partnership would be approximately equal to $667,000 (i.e. $4 million * 1/6 = approx. $667,000).
D. In this provision, Buffett discusses monthly payments that will be made to partners “at the rate of 6% yearly, based on beginning of the year capital valued at market.” He then notes that “partners not wishing to withdraw money currently can have this credited back to them automatically as an advance payment, drawing 6%, to purchase an additional equity interest in the partnership at yearend.”
E. The next provision that Buffett addresses is “the right to borrow during the year, up to 20% of the value of your partnership interest, at 6%, such loans to be liquidated at yearend or earlier.” This provision would add a degree of liquidity to each partner’s investment. However, Buffett expected that while this would probably be a “relatively unused provision,” it would be available to partners if something unexpected turned up and “a wait until yearend to liquidate part or all of a partner’s interest would cause hardship.”
F. This last provision is “an arrangement whereby any relatively small tax adjustment, made in later years on the partnership’s returns will be assessed” directly to Buffett. This way, all other partners wouldn’t need to update tax returns over some small future tax adjustment. Along these lines, Buffett states “any charge amounting to less than $1,000 of tax will be charged directly to me.”
Next, Buffett writes that the proposed merger agreement was submitted to Washington “for a ruling that the merger would be tax-free, and that the partnership would be treated as a partnership under the tax law.”
Buffett then addresses the minimum investment for new partners ($25,000), but he notes that this minimum amount doesn’t apply to present partners. Also, he states that the partnership’s method of operation “will enable the partners to add or withdraw amounts of any size (in round $100) at yearend.”
Finally, Buffett notes that due to the larger size of the partnership, the partnership is able to consider investments which it would have had to pass on a few years ago. (So, even though a larger asset base can be a drag on performance, it can also open up opportunities that were not previously available.)
Thanks for reading along. Next time, we’ll examine the partnership letter for all of 1961.
Links to other articles in the Buffett Partnership Series:
Previous article: Buffett Partnership Letter Series – 1960 (Part 3)
Introduction: Buffett Partnership Letter Series