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Warren Buffett’s Investment in Goldman a future model for WallStreet?

There is a good read up this morning on Warren Buffett’s investment in Goldman Sachs.

Specifically, Buffett invested in preferred shares and the reasoning is that he has to gain from aligning not short term interest of Goldman Sachs through debt. These preferrred shares behaves like corporate debt and its high yielding debt since it pays 10%. In a sense, it creates a hurdle that the management will need to clear in order for them to be profitable long term:

Buffett didn’t buy Goldman common stock. Instead, he privately negotiated a very special preferred stock deal that made the capital very expensive for Goldman. He took taking $5 billion worth of perpetual preferred stock that promised him a 10% dividend and warrants to buy $5 billion of common stock with a strike price of 115 a share.

In many ways, Goldman operates for Buffett the way a profitable hedge fund does for its limited partners. The general partner of a hedge fund usually makes very little unless the firm’s earnings cross a specified hurdle. Similarly, Buffett’s 10% dividend means he gets the first cut of Goldman’s revenues, before the Goldman partnership itself.  If they don’t earn enough to pay Buffett, there’s nothing left to pay the partnership.

Perhaps surprisingly, the perpetual preferred shares mean that Buffett’s interests are very closely aligned with those of the Goldman partnership. He has a concentrated interest in Goldman and little interest in having the firm pursue short term gains. Similarly, the Goldman partners have their fortunes tied to the profits of a single firm, both through their interests in the firm continuing to pay them and their large holdings of its stock.  Both have an interest in the firm being cautiously “long-term greedy.”

Compare that to an ordinary investor in Goldman’s common stock. Those folks are happy if just 20 percent of the firm’s revenue go to equity. They stand behind Goldman’s partners, employees and overhead when it come to seeing a cut of the revenues. Their capital is in a far riskier position. What’s more, ordinary shareholders tend to hold Goldman as part of a diversified portfolio and don’t much care about the fate of a single firm. They want more risk than Goldman’s partners want.

The structure of Buffett’s investment also resolves some of the dangers of Goldman’s partners becoming too cautious if they are forced to lower their leverage. Ordinarily, a combination of debt load and stock options helps encourage the management of corporations to overcome the excessive risk aversion that comes from their undiversified interest in their company. Their interests become aligned with their shareholders since they need to achieve enough returns to be profitable after the fixed costs of debt payments. In short, the guys in charge need to make sure the firm makes enough money that they can get paid after the lenders get paid.

As firms lower their debt, the barrier between revenue and the bosses paycheck lowers. This lowers the appetite for risk. But Buffett’s guaranteed 10% puts that barrier back in place, re-creating the role of debt to incentivize risk taking.

As firms and regulators attempt to reduce leverage and risk in the financial sector, we wouldn’t be surprised if the capital structure of many Wall Street firms began to shift in this direction. The problem of excessive risk is solved by a fixed return, and the problem of excessive risk aversion is addressed by forcing managers to make distributions.

[Read the rest of this article at ClusterStock >>]

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