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Warren Buffett: Activist Investors Can Sometimes Be Useful

Activist investors have a mixed reputation. Often they are considered to be nothing more than a white-washed version of the corporate raiders of the 1980s. Warren Buffett (Trades, Portfolio), however, believes they can sometimes serve a useful purpose. In an interview with Fortune in October 2015, the Oracle of Omaha took some time to espouse his views on activist investing, and how different investment vehicles go through varying periods of popularity.

A good battering ram

"If every company were managed well, there wouldn't be any need for activists. There might still be a few, but there wouldn't be any reason for them. But the truth is that at some companies, the managers forget who they are really working for and it becomes their own playpen. And at others the managers are sometimes incompetent. It's the job of a board to do something about it if that occurs, and sometimes they don't. So there's a reason why activism makes sense in certain cases. I don't think the bulk of activism is like that. The bulk of activism just wants a quick hit, they want the stock to go up next week."

So although Buffett believes most activist investors are motivated by short-term gain that isn't necessarily in the long-term interests of the company or its shareholders, they can be a useful battering ram in cases where management is truly bad. Then he went out of his way to contrast this approach with his own, saying Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) is run for the shareholders who are going to stay with the business, not those who are trying to sell their stock.

He then moved on to a more general point concerning the extremely generous fee structure paid out to the partners at activist hedge funds. Traditionally, active managers in the hedge fund industry are paid on a "two and twenty basis," that is, they receive 2% of all assets under management and 20% of the return. Ostensibly, this structure is supposed to incentivize managers to maximize returns. In practice, however, this means that if you can attract enough money, the 2% begins to eclipse the 20% in importance. Buffett pointed out that if you have $20 billion in assets under management, that equates to a 2% fee of $400 million - before performance.

"I had a friend who describe Wall Street in the way that it operates as having 'the innovators, the imitators and the swarming incompetents.' And essentially, that's the way money attraction is."

Buffett explained that different types of investment vehicles go through periods of varying popularity. At the time of the interview, he believed activism was having its turn in the sun, and that many prospective fund managers would be using this publicity to attract capital.

The skewed incentive fee structure means the most successful managers are often the ones who are best at raising capital, rather than putting it to use. This becomes a problem when prospective clients equate the amount of money that a particular fund has at its disposal with the abilities of its partners. To be sure, eventually an incompetent fund manager will lose all of their clients. But by then, they may have enriched themselves to to the point where it scarcely matters whether they or their great-grandchildren ever work a day in their lives again.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.