STRUCTURAL ALPHA (THE REAL SECRET TO BUFFETT’S SUCCESS)
I am a huge fan of Warren Buffett. This sentiment should always be kept in mind as this paper is being read. However, no one is perfect and there is room for improvement in everyone, including Buffett. If I had used a proportionate number of words in this paper to praise what I admire as I have used to critique him, far more than 95% would be words of praise. Praise for Buffett is well-trod ground and such a piece would bore most readers.
Thus, this paper is long on critique. But critique in the context of how one of the greatest performances in the history of business (if not the greatest) was achieved, how it might have been improved, and the application of those lessons to HFs, FoHFs, and family offices and their investors.
Buffett the Hedge Fund Manager
To the extent that a hedge fund is defined as a non-traditional investment strategy that actively buys and sells negotiable instruments (as opposed to private equity or real estate), seeks to generate alpha, absolute returns, and asymmetric returns, and primarily rewards its manager with a percentage of the profits, then it is arguable that the best known and most successful person to have ever run a hedge fund for more than 10 years is Warren Buffett.
Buffett started a series of private investment partnerships in 1956 (long before the term “hedge fund” was as ubiquitous as it is today) with $700 of his own money and less than $100,000 from friends and family. He worked from his bedroom in his parents’ house. Focusing on publicly traded securities, he always beat the benchmarks (alpha), never had a down year (absolute returns), and emphasized taking risks only when potential rewards more than justified them (asymmetric returns). He charged no management fee and a performance fee of 25% of profits in excess of 6%. God forbid, he even took short positions. The partnerships eventually merged into one called the Buffett Partnership.
13 years after starting, Buffett’s fund had produced returns of approximately 30% since inception (net of fees), was roughly $100 million in size, and Buffett’s share was $25 million. However, by 1969, roughly 50% of the fund consisted of a 70% stake in a publicly traded textile company - Berkshire Hathaway.
Had Buffett stumbled prior to 1969, he would have likely had redemptions, would have been unable to liquidate Berkshire in an orderly fashion, causing more losses and further redemptions, and might have suffered the same fate as Tiger 30 years later. Instead of becoming the “world’s greatest investor”, he might have become a charter candidate for Greg Newton’s Hall of Shame. If today’s hedge fund manager had 50% of his fund in an illiquid 70% stake in a publicly traded company, and the tidal wave of 2008 and 2009 redemptions washed over him, he would be marked for life.
By any standard, Buffett was a very, very, very successful hedge fund manager. Then he quit. Cold turkey. To go into insurance, reinsurance, and banking. From here on out, insurance and reinsurance will often be collectively referred to as (re)insurance.
To do this, he liquidated the Buffett Partnership and made a distribution in kind (which is tax free). Through horse trading and the liquidation of other positions, he increased his indirect stake in Berkshire from about 17.5% at the time the partnership was dissolved to a direct stake of 41%.
Prior to the dissolution of the Buffett Partnership, Berkshire had acquired insurance, reinsurance, and banking businesses. Because of the interests in the insurer, reinsurer, and bank and because his 41% stake (and the other 29% held by his former partners) gave Buffett control of Berkshire, he was able to
continue to invest in publicly traded securities without being deemed to be a closed end fund and running afoul of the Investment Company Act of 1940 (11 years later, regulators made him give up either (re)insurance or banking and he sold off Illinois National Bank).
At the time that he sold Illinois National Bank, banks in Illinois could not have branches (that is why First Chicago and Continental Illinois evolved into international powerhouses out of major high rises) and banks in general could not cross county lines in some cases and state lines in other cases. Furthermore, his personal stake would have put him at odds with the Bank Holding Company Act. As such, banking as a lone structure would have been too confining and keeping the (re)insurer was a no-brainer.
Today, banks can operate across state lines, even globally. However, if Buffett were given the choice today, I believe he would still choose (re)insurance. While its publicly traded portfolio represents roughly 60% of Berkshire’s net worth, Buffett has purchased more than 80 whole companies and could not have done so if Berkshire were a bank. As such, I am relatively confident that if he had to choose (re)insurance or banking today, he would still choose (re)insurance.
Why Did He Quit?
The official story is that his investors had come to expect a level of performance that he did not feel he could continue to match in the future. As such, he felt that he would be letting them down if he tried to continue as in the past and hated the pressure of having to meet their expectations and perform at a level that he no longer thought was achievable. Furthermore, as they grew in number and the fund grew in size, the investors increasingly impacted his time.
There is little doubt in our mind that performance pressure was a major factor in his decision and quite possibly the only factor. However, the decision had several other salutary benefits and it is difficult to imagine that a man as savvy as Buffett was unaware of any (or even all) of these other benefits.
The first benefit was that it removed him from having to deal with his investors as regularly as he had to do as the GP of an investment partnership. In fact, because Berkshire was a public company, he could no longer communicate for legal reasons as the partnership investors had come to expect in the past.
As I pointed out earlier, at the time of the transition, the Buffett Partnership had roughly 50% of its assets in one stock – Berkshire Hathaway. This position represented roughly 70% of Berkshire’s shares. As long as the fund kept growing through a combination of performance and new AuMs, this was a manageable situation.
But what if 1969 were 2008? Buffett suffered losses as did most everyone else in 2008 and if his performance in 1969 had also suffered in the same manner as it did in 2008, he would likely have had net redemptions as did most of the hedge fund industry. With 50% of assets owning a 70% position in a single stock, it could have been very ugly.
Thus, by morphing into the (re)insurance and banking businesses, Buffett solved his redemption risk and simultaneously achieved “permanent capital”. It is difficult to imagine that he was unaware of this outcome, but I have never seen it mentioned. Then again, drawing attention to this possibility might have triggered a sequence of events (redemptions) that he feared or should have feared.
On the surface, the transition from the hedge fund to Berkshire Hathaway was a transition from a partnership to a holding company. At the time, one of the seminal business theories was espoused by Bruce Henderson, the founder of the Boston Consulting Group. Essentially, Henderson’s concept was to milk the cash cow as it declined in order to fund new, ascendant business initiatives. Whether or not this influenced a voracious reader like Buffett is uncertain, but he redirected the cash flows of a declining textile business into other, unrelated lines of business, particularly (re)insurance and banking.
When one thinks of “growth”, (re)insurance and banking do not normally come to mind (although Buffett’s versions of (re)insurance and banking were truly ascendant). As such, there may have been other considerations at play in Buffett’s thinking. Thus, aside from the logical economic benefit of redeploying capital from a declining business to businesses that were ascendant, the selection of (re)insurance and/or banking had three additional significant, but very subtle, benefits.
First of all, reinsurers and banks are exempt from the Investment Company Act of 1940. If Berkshire were not primarily engaged in (re)insurance and/or banking, its own public status and its portfolio of publicly traded securities would likely have required it to be regulated as a mutual fund.
Had it been a mutual fund, Buffett would not have been able to intervene in GEICO or Salomon as he did, nor could Berkshire have acquired the more than 80 whole companies that it has over the last 40 years. Buffett also had several legal and regulatory problems early in the Berkshire saga (an anti-trust suit against Blue Chip Stamps, reorganization problems in consolidating his partnerships, and the acquisition of a savings and loan in California). It also appears to me that the acquisitions of GEICO and Gen Re may have insulated him from “inadvertently” becoming an investment company later on.
Again, I have never seen the exemption from the ’40 Act mentioned and while it is possible that Buffett was unaware of this benefit, if he were aware of it, it would not have served him to have this subtlety in the spotlight in view of the other legal and regulatory issues he had to deal with and a ’40 Act sword of Damocles would likely have hurt the market value of the company.
The second subtlety was the “float”, Buffett’s euphemism for leverage. Leverage is generally in disrepute at this time and Buffett has publicly eschewed the use of leverage over the years. However, there is leverage and then, there is leverage. As we will see later on, a form of specialized leverage without the drawbacks of traditional leverage is the major factor in the success of Berkshire Hathaway.
The real problem with traditional leverage (short-term borrowing) is the combination of its costs and availability. Asset values tend to move inversely with the risk free rate of return, which is the basis for the pricing of most leverage. Thus when costs of leverage go up, the asset values supporting it usually decline. This often has an effect on its availability in that loan to value ratios often require more equity when equity is unavailable, causing a liquidation of assets at a most inopportune time.
However, the availability of leverage is also tied to the inclination and ability of the leverage provider to continue to provide leverage. If the leverage provider is having difficulties on its own, it may have to withdraw its funding for reasons unrelated to the performance of the borrower. This has clearly been the case in the last two years and has tipped many performing borrowers into liquidation.
(Re)insurers and banks are leveraged by their very nature. However their costs of leverage are significantly lower than the costs of most loans (roughly 3% each and every year in (re)insurance, and variable in banking – currently less than 2%). Furthermore, the availability of their leverage is relatively independent of asset values (tied to insurable events in (re)insurance and depositor confidence – often backed by government guarantees - in the case of banking). Thus, reserves and deposits are less costly and far more stable than margin type loans.
The third subtlety is that (re)insurers and banks with believable balance sheets (a rarity these days) generally tend to trade at a premium to book value (1.25x to 3x). The implications of this, coupled with far higher ROEs due to leverage, cannot be overstated. Had the shareholders of Berkshire Hathaway sold all of their holdings in 1969 and reinvested the proceeds in the S&P 500, their $70 million would have compounded at 9.3% for 40 years and be worth $2.5 billion today.
But what of Warren Buffett, the “world’s greatest investor”? I have reverse engineered his investment record within Berkshire Hathaway. 12% per year. In investment parlance, his investment “alpha” is 2.7% per year. This is pretty good, but does it qualify him for the reputation he has as the “world’s greatest investor”? Had the same investors liquidated their holdings in Berkshire Hathaway and had Buffett the asset manager manage the proceeds in the Buffett Partnership, the $70 million would have grown to $4.4 billion in 40 years. This is a far cry from the $153 billion of market cap that BRK enjoys.
This Difference Between $153 Billion and $4.4 Billion is What I Call “Structural Alpha”.
In the (re)insurance businesses, the industry standard is that underwriting profits (or losses) equal premiums, minus claims, minus operating expenses. These generate an average underwriting loss of 3% per year (also known as the cost of insurance or “COI”) for each dollar of reserves. The industry generally invests these reserves in long only fixed income securities (“because that is how we have always done it”). Assume that the fixed income generates 5% per year. Thus, for every dollar of reserves in a traditional (re)insurer, returns are 2% per year (5% for investments minus 3% for COI).
In terms of ROEs, the key is the ratio of reserves to equity (leverage), which runs around 5x in the P&C industry. With its equity invested in the fixed income portfolio at 5% plus 5x of reserves earning 2% per increment of reserves, pre-tax ROEs tend to be 15% and after-tax ROEs are roughly 10%.
Consider the following excerpts from page 6 of Berkshire’s 2009 annual report:
“Our property-casualty (P/C) insurance business has been the engine behind Berkshire’s growth and will
continue to be. It has worked wonders for us. We carry our P/C companies on our books at $15.5 billion more than their net tangible assets, an amount lodged in our “Goodwill” account. These companies, however, are worth far more than their carrying value – and the following look at the economic model of the P/C industry will tell you why.
Insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from
certain workers’ compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums – money we call “float” – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit. Though individual policies and claims come and go, the amount of float we hold remains remarkably stable in relation to premium volume. Consequently, as our business grows, so does our float.
If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that
adds to the investment income produced from the float. This combination allows us to enjoy the use of free money – and, better yet, get paid for holding it. Alas, the hope of this happy result attracts intense competition, so vigorous in most years as to cause the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Usually this cost is fairly low, but in some catastrophe-ridden years the cost from underwriting losses more than eats up the income derived from use of float.
In my perhaps biased view, Berkshire has the best large insurance operation in the world. And I will
absolutely state that we have the best managers. Our float has grown from $16 million in 1967, when we entered the business, to $62 billion at the end of 2009. Moreover, we have now operated at an underwriting profit for seven consecutive years. I believe it likely that we will continue to underwrite profitably in most – though certainly not all – future years.
If we do so, our float will be cost-free, much as if someone deposited $62 billion with us that we could invest for our own benefit without the payment of interest. Let me emphasize again that cost-free float is not a result to be expected for the P/C industry as a whole: In most years, premiums have been inadequate to cover claims plus expenses. Consequently, the industry’s overall return on tangible equity has for many decades fallen far short of that achieved by the S&P 500. Outstanding economics exist at Berkshire only because we have some outstanding managers running some unusual businesses. Our insurance CEOs deserve your thanks, having added many billions of dollars to Berkshire’s value.”
Under Buffet’s leadership, Berkshire never had a cumulative underwriting profit until 2006 (after which time his cumulative cost of “float” or COI became less than 0.0%). Up until that time, Berkshire’s underwriting losses were still better than the industry norm (his COI was 1% to 2% p.a.). Furthermore, at 2x, his level of leverage was far less than the industry standard of 5x.
Nonetheless, while Buffett publicly eschews leverage, he puts lipstick on the pig and freely admits that the “float” (avoiding the term “leverage”) is the real driver of Berkshire’s success.
Investing the equity at 12% and adding 10% for each increment of reserves (investment returns of 12% minus the 2% COI), the total was a pre-tax 32% (12% + 2x10%). Taxes reduced it to an after-tax 20.3%. 20.3% compounding for 40 years turns $70 million into $120 billion. A price to book of 1.29x brings it to $153 billion. Thus the structure generated $149 billion of alpha ($114 billion in better ROEs and $35 billion in a premium to book value).
Stated another way, if Buffett had been run over by a truck 40 years ago but Berkshire had done all of the same things that it did in the meantime, except that it invested in the S&P 500, Berkshire would still be worth $26 billion (versus $2.5 billion in the S&P or $4.4 billion with a manager who could consistently generate returns of 12%). Substitute the HFRI index (a random selection of hedge funds) for the S&P 500 and the amount is $101 billion. While $153 billion seems like a lot more, Buffett’s share of the difference is far greater than any major hedge fund manager’s performance fees, save Steve Cohen.
However, had Berkshire invested in the S&P 500 and been in Bermuda, it would have been worth $323 billion or twice what it is today (the most valuable company in the world – without Buffett). Again, substitute the HFRI index, and Bermuda based Berkshire would top $1 trillion.
Berkshire with Buffett in Bermuda would have theoretically been worth the previously mentioned $6 trillion. If that were the case, it is arguable that Buffett’s decision to become the Sage of Omaha rather than the Sage of Bermuda has cost more than $5 trillion.
There are lies, damn lies, and statistics. The lie in the statistics? To borrow from Lord Acton, “Size kills and absolute size kills absolutely”. BRK with Buffett in Bermuda would hardly have become worth $6 trillion. Buffett has had serious difficulty deploying assets in liquid securities for more than a decade. Instead, he has bought whole companies for cash on cash returns that are not unattractive, but far short of his historical numbers. In more than 40 years, he has failed to beat the S&P 500 only seven times. Three of them were in the last 9 years when Berkshire has become too big to get out of its own way.
Is Buffett Still a Hedge Fund Manager?
If a hedge fund is defined as a non-traditional investment strategy that actively buys and sells negotiable instruments (as opposed to private equity or real estate), seeks to generate alpha, absolute returns, and asymmetric returns, and primarily rewards its manager with a percentage of the profits, it is arguable that there is still a lot of hedge fund manager in Warren Buffett.
Consider the following hedge fund–like attributes:
Currency trading? Sounds like global macro to me. See’s Candies, NetJets, Nebraska Furniture Mart? To borrow from Robert Duvall’s character in Apocalypse Now, “don’t you just love the smell of synergies in the morning”? Insurance and reinsurance risks? For the first 41 years, Berkshire had never had a cumulative underwriting profit. However, as Buffett has often pointed out, his “cost of float” was generally less than 1% to 2% per year and was not correlated to asset values as normal leverage is (meaning it cannot be pulled if asset values are down or if the provider has problems as margin loans often can).
A $70 billion portfolio with $50 billion of unrealized gains (he also enjoys the additional benefit of investing $20 billion of deferred taxes - BRK’s total net worth is roughly $120 billion). 2006 was one of the greatest underwriting years in the history of the insurance and reinsurance industries (no major disasters or shocks in the tort system) and Berkshire’s cumulative underwriting results turned profitable for the first time (finally giving him a negative cost of “float” over the history of the company). In the best underwriting year in history, Berkshire’s underwriting profits neared $7 billion, but the unrealized gains in the publicly traded stocks were $50 billion. So, what business is he in? No wonder he is called the “world’s greatest investor” rather than the world’s greatest insurance man.
The first page of Buffett’s annual letter shows each year’s performance against the S&P 500 (which he has beaten 32 out of 42 years) and the relative compounded values since inception (by which he has soundly trounced the index).
Buffett’s first rule of investment is to never lose money. His second rule is to never forget Rule #1. In fact, Berkshire Hathaway has only had two years where its book value per share decreased (when the dot.com bubble burst, it took everything down, even the old economy fuddy duddies like Buffett and Julian Robertson. The other was 2008’s annus horribilis).
Buffett says, “When Charlie (Munger) and I do not see anything we like, our default position is Treasuries. We hate taking risks and only do so when the rewards are compelling and relatively sure. Our idea of real risk is eating cottage cheese one day past its expiration date”.
41% is pretty good. He certainly never got rich on the $100,000 per year management fee.
As a pure hedge fund manager, Buffett was successful by any standard. However, because he quit the hedge fund business as we know it, he has been able to achieve a legendary level of success that is unlikely to be attained by any of today’s HF or FoHF managers who exclusively use the traditional hedge fund structure.
REPLICATING THE GOLDMAN AND BERKSHIRE MODELS
Goldman Sachs and Berkshire Hathaway have benefitted significantly by abandoning their partnership structures and becoming a bank in Goldman’s case and a (re)insurer and bank in Berkshire’s case.
In each case, their investors have been able to obtain returns that were superior to those they would have achieved as a partnership and do so without a proportionate increase in risk. This is largely due to their access to leverage that is far cheaper and far more stable than available to a partnership structure (or publicly traded broker dealer in the case of Goldman) and a premium to book value their stock prices command. As public companies, their investors also enjoy the legal right to resell their investments to the public that was unavailable when they operated as partnerships.
However, because they are based in the U.S., their earnings became subject to double taxation, whereas if either had started offshore, only their U.S. operations would be subject to double taxation. In addition, the new level of taxation is applied annually, which has major ramifications for compounding returns over long periods of time. As we will see, the benefits are compelling irrespective of tax, but mitigating tax cushions downside risk and permits more powerful compounding.
From their perspective as managers, Goldman and Berkshire are accessing assets they would otherwise be unable to access in a partnership structure, have permanent capital, and have been able to imbed the management in the structure, thus monetizing their management roles in a far superior manner than selling out to a larger institution or floating the management function on a standalone basis.
Any HF, FoHF, or family office manager that can consistently outperform long-only fixed income returns on a multi-year basis can replicate the best parts of either or both of Goldman’s or Berkshire’s successes. In doing so, their investors (including themselves as investors) should enjoy a combination of: (1) significantly better returns than offered by the partnership structure, without a proportionate increase in risk; (2) daily liquidity (if publicly traded); and (3) gentler taxation in the UK and U.S. As managers, they can: (1) greatly increase AuMs that would not otherwise be available; (2) obtain permanent capital; and (3) gain an additional option with respect to monetizing the manager’s business.
It is important to remember that Goldman’s net worth is $62 billion and Berkshire’s net worth is $120 billion. There should be no delusions that following their path will create a challenger to either of them. The idea is to follow their lead in creating a business that should benefit both investors and managers in ways that are far superior to the benefits of a fund structure.
HF managers, FoHF managers, or family offices do not need to take such a drastic step as quitting the HF, FoHF, or family office business cold turkey as Buffett did. Instead, he or she can simply start or acquire a (re)insurer or bank (whereby he or she would manage all of its investable assets) and treat the foray as he or she would treat the launch (or acquisition) of a new fund.
In order to do this, it is more than helpful (but not absolutely necessary) if the new business becomes publicly traded as soon as possible (even as a startup), because the HF manager’s, FoHF manager’s, or family office’s clients and (unaffiliated) Strategic Investors will be far more willing to make larger commitments if those commitments can be conditioned on the success of an IPO.
If the commitment from the manager, his clients, and his funds is only $10 million, the concept still makes sense (the significantly better returns and gentler tax treatment are more than justification), although as a private company (it would be too small to be publicly traded). In this case, operations will still produce $20 million to $100 million in AuMs for him, depending on the investment strategy.
However, the manager who cannot commit enough for an IPO or the manager who wishes to remain private will have difficulty in getting clients to come along unless he commits to use the earnings to fund a Dutch auction in order to return capital to investors that want liquidity at capital gains rates for taxable investors.
The greater the cumulative levels of commitment from the manager, his clients, and/or his funds, the more Strategic investors and the public are likely to invest and the greater the cumulative equity, and the larger the magnitude of reserves or deposits that might be deployed in the investment strategy.
If some combination of the manager, his investors, or his funds commits less than $50 million, it is unlikely that any Strategic Investor of note will join. However, at $50 million in personal, client, and fund commitments, it is possible that a strategic investor may join and it is likely that that investment banks can still raise a like amount in an IPO even if there are no strategic investors. This should still create a total of $250 million to $1.25 billion in new AuM, depending upon the investment strategy.
If the HF or FoHF manager and his investors are willing to commit $150 million or more, then Strategic Investors might invest $100 million or more. Because Strategic Investors validate the business strategy, the investment strategy, or both, investment banks may raise a far greater proportion of capital from the public (maybe as much as three times the committed capital, if the committed capital exceeds $250 million). This would generate another $2 billion to $10 billion of AuMs from (re)insurance or banking operations, depending upon his investment strategy.
It is not beyond the realm of possibility that a $50 million commitment by the HF or FoHF manager could result in $100 from his or her clients, $100 million from Strategic investors and $750 million from the public, resulting in $1 billion of equity capital. Even greater levels of commitment by some combination of the manager, his or her investors, and Strategic Investors, could magnify those amounts even more.
To place these greater amounts in perspective, a larger fund manager could arguably commit significantly more than $50 million, convince a larger number of its clients and Strategic Investors to commit billions, and a $5 billion, or even $10 billion IPO is not out of the question.
If an HF or FoHF manager could pull off a $10 billion IPO, the equity capital would be virtually equal to the 5th largest (re)insurer or 6th largest bank in the U.S. With $5 billion, the company would be equal to the 10th largest (re)insurer and 15th largest bank. With only $1 billion, it would be virtually equal in size to the 35th largest (re)insurer or 50th largest bank.
The best way for the HF or FoHF manager to convince investors of these benefits is to make the largest possible personal financial commitment to the new company (because the HF manager, FoHF manager, or family office believes it will achieve better returns than investing the same amount in its own funds).
Based on the HF or FoHF manager’s levels of personal commitment (could be conditioned on success of an IPO), many of the HF or FoHF manager’s clients will be more likely to commit, conditioned on a successful IPO, because they will get several significant benefits (relative to directly investing in the same HF or FoHF strategy): (1) higher returns, without a proportionate increase in risk; (2) daily liquidity (if publicly held) instead of lockups, periodic liquidity, notice periods, and gating; and (3) tax deferral on annual returns for U.S. taxable investors and capital gains rates for U.S. and UK taxable investors. The merits of these will be covered in the next Chapter “Significantly Improving the Investor Proposition”.
An IPO of a startup or early stage company runs counter to conventional wisdom, but in (re)insurance and banking, there are significant precedents. In the insurance and reinsurance business, I have had direct involvement with three companies that raised their startup capital in an IPO: (1) PartnerRe ($980 million in 1994); (2) Annuity and Life Re ($360 million in 1998); and (3) Scottish Annuity ($250 million in 1998). In 2005, Merrill Lynch raised $1 billion for Lancashire Holdings for a startup IPO in London.
Virtually every bank in the U.S. was initially financed through an IPO. In fact, U.S. banks are exempt from registration under the Securities Act of 1933, because public policy in the depression encouraged bank formations but was against concentrated power in banking. Government could diffuse power by making it easier for anyone to become a shareholder in any new bank (hence the exemption).
There are several reasons that a startup in insurance, reinsurance, and banking can finance itself through an IPO. Most new businesses only try to raise enough capital to get to cash flow breakeven, without diluting the founders more than is necessary. Because overheads in new insurers, reinsurers, and banks are relatively low as a percentage of equity capital, these businesses are usually cash flow positive at the very beginning due to investment returns.
Furthermore, founders of new insurers, reinsurers, or banks rarely get cheap stock (they usually participate in the upside through options and warrants, which have notional values proportionate to the size of the financing – that is an incentive for them to make the start up as large as possible), so dilution is rarely an issue for the founders.
Another reason that a startup insurer, reinsurer, or bank can raise its initial capital through an IPO (and allocate all of its investable assets to a HF or FoHF strategy) is that there are no diseconomies of scale. Most startups raise an amount of capital to target a specific return on that new capital. However, raising twice as much capital is unlikely to double the magnitude of the return, because the second increment of capital cannot be deployed as profitably as the original amount and the extra capital dilutes the founders.
If an insurer, reinsurer, or bank invests the IPO proceeds in a HF or FoHF strategy, then twice as much capital should generate at least twice the returns and four times should generate four times etc. Up to a point (passed by Berkshire long ago), size is also an advantage in insurance, reinsurance, and banking. First of all, size improves ratings so each entity can charge more for the same product or get the flight to quality nod when pricing is the same. Furthermore, size makes it easier to attract better talent. Lastly, after-market liquidity is better and more institutions will be able to own the stock.
If an investment bank likes the story enough, it can sell air conditioning in the Arctic and hangar heaters in the Amazon. Investment bankers are paid on the number of zeros separated by commas, so size matters for them. Since most startups limit the size of their initial financings due to diseconomies of scale and dilution issues, and because the investment has significant downside risk, they are not attractive enough to get the attention of major investment banks.
However, IPOs of startup insurers, reinsurers, or banks raising hundreds of millions (or billions) of dollars at book value, with significant commitments from the manager, his existing clients, and/or Strategic Investors has limited downside risk, is a story an investment bank can sell, and the payday is attractive.
Based upon the HF or FoHF manager’s demonstrated preference for investing in the startup (motivated by the prospect of significantly better returns than he would get in his funds not to mention the prospect of fees on permanent capital that could exceed 60 to 260 times his personal investment), he can craft a business plan and forecasts for the (re)insurer or bank and try to convince as many of his investors to follow him as is possible, but strictly subject to an IPO (no IPO, no obligation to invest).
Every investor who follows the manager converts his investment from something that can be redeemed to permanent capital. Based upon the HF or FoHF manager’s personal commitment and the commitments made by investors who know him or her well, he or she can recruit management and a board, and try to convince Strategic Investors with recognized expertise in alternative assets and/or insurance, reinsurance, or banking to invest as part of the IPO (again, no IPO, no obligation to invest).