Other People's Money

Managing OPM

If I asked you to summarize a financial service company’s business model in three letters, what would you say? Those of you working in commercial banking might say NIM (Net Interest Margin). Those of you working in fund management might say AUM (Assets Under Management). And those of you working in my old field, corporate finance investment banking might say WTF (Where’s the Financing?). These are all good answers, but a better response might be OPM (Other People’s Money). The financial services industry thrives on OPM; in fact I think its fair to say that without OPM there would be no FSI (Financial Services Industry).

Commercial banks fund themselves primarily with customer deposits. Investment banks finance themselves in the capital markets and with a bewildering array of transactional liabilities. Insurance companies fund themselves with policyholder premiums. And investment companies manage the money entrusted to them by their clients. All of these funding sources are examples of OPM, Other People’s Money.

OPM also plays a role outside of the financial services industry, of course. Think of the financial and trade liabilities employed in non-financial corporations. And on a personal level, think about your student loans, auto loans and home mortgages, not to mention all the money that your parents invested in your human capital along the way. All OPM.

OPM can be a liability, like deposits, borrowed money or policyholder reserves. Or it can be equity, as long as it comes from other people. Think about the cash proceeds raised in an IPO or the shareholders equity built up over many years in the form of retained earnings (earned income which has not been paid back to shareholders in the form of dividends or share buybacks). This is all OPM in some sense.

Using OPM entails legal and moral obligations to the providers of the capital. Depositors expect and are entitled to get their money back, either on demand or at maturity in the case of time deposits. Lenders expect their principal to be paid back at maturity with interest along the way, and they may insist on certain financial or non-financial covenants that the borrower must comply with during the term of the loan. Although common equity generally comes without these contractual obligations—it need never be paid back and shareholders are entitled to dividends only when, as and if declared by the board—shareholders do have various protections imposed by law, including the right to elect the board of directors. And directors in US companies by law owe shareholders various “fiduciary duties”, specifically the duty to govern the company in good faith and with due care. Using OPM to fuel your business has many advantages, but it does come with some costs, constraints and even big headaches from time to time.

Today I want to highlight the role of OPM in the investment management business, and note some of the tensions and conflicts that come with managing Other People’s Money. Investment management companies generally prosper when they grow AUM, since their revenue model is often based on taking a percent of AUM. Good investment performance attracts assets, increasing AUM and the management company’s revenues and earnings. Poor investment performance has the opposite effect and if sustained may put the investment management company out of business entirely. But even investment success and the increased AUM that goes with it has some downside, as the increased fund size may make it more difficult to replicate past investment success. It is one thing to generate a 50% annual return on $100mm of invested capital, but it is quite another to do so with $1bn, $10bn or $100bn invested. And of course it is hard to generate this sort of exceptional return year after year, regardless of how much money is under management.

Managing OPM is difficult even under the best of circumstances. Markets are fickle and investment management is a highly competitive business. Today’s rockstar portfolio manager often turns out to be tomorrow’s nobody. Clients sometimes have very short memories and a “what have you done for me lately” attitude. They are definitely not happy when they lose money, even in down markets. But they can also be upset when they make money, particularly if their investment manager underperforms some other hot manager or a passive index.

Investment managers act as fiduciaries for their clients and must act in their clients’ best interests, but this is no guarantee of good future performance. It also does not carry much in the way of compensation when an investment manager screws up, at least not when he/she does so in good faith and with due care. Investment managers who lose too much of their client’s money may be out of a job, of course, but their clients are usually just SOL.

It is not surprising then that some successful investment managers have tired of the business of managing OPM and have turned to managing money solely for themselves and sometimes their family and friends. We have seen many examples of this in recent years, for example Julian Robertson (Tiger Management) and Steven A Cohen (Point 72). Of course this strategy only really works if the investment manager has been successful and has made enough money personally to support the investment company infrastructure. How much money is enough to justify going off on your own? Hard to say generally, but I would note that it’s a lot easier to earn a billion dollar return if you start with $10bn invested than if you start with a much smaller pot of money. And who wants to get out of bed and go to work every day if you can’t reasonably expect to make at least a billion?

Of course not everyone who starts with $10bn is going to be successful on their own. Just ask our friend Bill Hwang, one of Julian Robertson’s Tiger Cubs, known to all of us from the spectacular implosion of his “family office” fund, Archegos Capital Management. Mr Hwang’s family office fund ultimately failed, but he made a lot of money along the way and almost took down Credit Suisse in the process. Not every one who starts their own fund can say that.

One of the reasons that successful hedge fund managers have moved away from the traditional fund management model is the ever-present threat of investor withdrawals, which tend to happen at exactly the wrong time from the fund manager’s perspective. There are many real world examples of this, which I have written about previously in my W&M blog. But for an even better dramatized example of how painful this can be, watch this scene from The Big Short:

One solution to the problem of investor withdrawals is to replace liquid funding sources with “permanent capital”. Think about the difference in investment time horizons and risk tolerance for a fund manager whose clients can pull their money out (1) at will (eg open-end mutual funds), (2) only at periodic intervals in limited amounts (traditional hedge fund), (3) only when investment proceeds are distributed over the defined life of the fund (traditional PE fund), or (4) never (closed-end funds or publicly traded investment companies, and the equity in financial and non-financial corporations).

Some insurance companies also operate with a large amount of more or less permanent capital in the form of shareholders equity and very long-dated policyholder liabilities referred to as “float” (discussed below). And as you might expect, a number of successful investment managers have discovered the benefits of funding their investment portfolios with the permanent capital generated by affiliated insurance companies. This includes a number of high profile hedge fund managers, private equity companies and even W&M’s own Todd Boehly.

Float is the lifeblood of many insurance companies’ investment operations. We can define float broadly as the cash received from policyholder premiums which can be invested during the (long) period before claims are paid. Float can be a fairly low cost and growing source of OPM if the insurance company manages to run its underwriting operations at a profit and write lots of new attractively priced policies. Underwriting profits and losses can be viewed as the “cost” of the float; underwriting losses are a positive cost and underwriting profits are a negative cost. Unlike most P&C insurers, Berkshire Hathaway has managed to run its insurance operations with an underwriting profit in most years, and so considers that its large amount of float has actually cost it less than zero over long periods of time.

The total profit earned by an insurance company comes from two sources—underwriting profits and investment profits—and it was a lot easier to earn investment profits (and subsidize underwriting losses) years ago when interest rates were in the high single digits. Today’s low interest rate environment has caused great pain for a number of insurance companies, particularly those who for regulatory or other reasons have to invest primarily in fixed income securities. So in some sense, the financial benefits of large amounts of low-cost float have never been less important than they are today, when even long-term corporate debt may only cost 2-3% (pre-tax). But long-dated policyholder float still looks good to many investment professionals, especially compared to other more liquid (temporary) sources of funding.

The world’s foremost expert on float is probably Warren Buffett from Berkshire Hathaway. You probably know Buffett as one of the world’s most successful investors, with a personal net worth of over $100bn. (That’s an accumulation of over $1bn per year, including his childhood years, as Mr. Buffett is now 90-years old.) But where did Mr. Buffet get the investment capital to generate these outsized investment returns? Initially he took the money from third party investors in a typical investment fund structure. But he gave that up after a decade or so (with good investment success) in favor of the insurance company permanent capital model, with BRK and numerous acquired insurance companies as his funding vehicle.

The float at BRK now totals over $138bn and Buffett gets to invest this money (plus a portion of the company’s $450bn of shareholders equity) on behalf of himself and the other BRK shareholders. (Buffett personally owns about 15% of BRK in economic terms, with a voting power about double that as a result of BRK’s dual share class structure.) Warren Buffett talks about float every year at the BRK annual meeting and in his annual letter to shareholders published in the BRK annual report. Here is what Buffett had to say about float in 2019 (see page 7).

And here is a much younger Warren Buffett talking to shareholders at the BRK annual meeting in 1995, when BRK’s float was only $3bn and mens’ fashion was going through a particularly bad period (at least in Omaha).

When we think about the various ways of managing OPM, we can learn a lot from the investment career of Warren Buffett and I encourage students to do so. The Buffett/Berkshire story is well told in many places, but it is summarized nicely in this short piece on OPM from Marc Rubinstein’s excellent newsletter, Net Interest, along with commentary on more recent trends in the investment management business. I encourage you all to read the Rubinstein article, and subscribe to Net Interest.

Of course Buffett and Berkshire Hathaway are not the only ones who have figured out how to operate a super-successful investment operation within an insurance company framework, but the list is not long. Students of mine, and those of you with VA roots, will already know of Markel Corp in Richmond and its star investment manager (now co-CEO) Tom Gaynor. And as noted in the Rubinstein piece, a number of high profile hedge fund managers and PE firms are also getting into the insurance business. So expect the competition to heat up, as it usually does when someone else appears to be making more money than you are.

In closing, I’d like to give a special shoutout to Banking and Beyond reader and former student Abe Haji, who put me onto Marc Rubinstein’s excellent Net Interest newsletter, which inspired and influenced today’s post. Thanks Abe (and Marc)!

Students and readers, keep your comments coming. I love hearing from you.