Potential Implications of Rapuano’s Break with the Pack

Fees 20 Nov 2006

The hedge fund community is in a tizzy about value investor Lisa Rapuano’s break from the pack regarding hedge fund fee structures.  As the New York Times details, she is launching a new fund with a 40% performance fee that is calculated triennially instead of once a year.

While “40%” and “triennial” make great headlines, it’s important to peel back the layers of the onion to understand what this may portend for the industry.  Succinctly stated, we believe that Lisa Rapuano has opened a Pandora’s Box of issues for the hedge fund industry.

A Return to Symmetrical Compensation

First of all, Rapuano is essentially tackling a common criticism of the hedge fund industry: that manager compensation is asymmetrical.  There are no “negative performance fees”.  That is, managers never “give-back” performance fees when a fund is down in subsequent years.

However, it’s worth noting that hedge funds already have de facto “intra-year” negative performance fees.  In other words, performance fees are accrued and “un-accrued” monthly until they are paid out at year end.  So extending the finish line to 3 years from one year, means more of these “negative performance fees” can be charged back to the manager.  This makes manager compensation more normally distributed and less option-like in the short run.

Less Swinging for the Fences?

The main argument provided by Rapuano for the three-year performance fee horizon is simple: that a 12 month horizon causes managers to gun for performance and take undue risks at the end of the year”.  We don’t disagree.  However, what will happen when a manager is down 2.5 years into a 3-year performance fee period?  Faced with an impending (and very infrequent) opportunity to make it all worthwhile, will a manager have an even larger incentive to point to left field and take a swing for the ages?

But even though the incentives to take risks in the home stretch might actually be larger in the triennial model, one thing’s for sure: this “window of asymmetry” would occur less frequently.  And that’s probably a good thing.

Performance Fee for Returns or for Alpha?

As a value investor, Rapuano has the luxury of a ready-made benchmark against which to measure alpha.  She uses a hurdle of the S&P500 to calculate performance fees.  This amounts to a crude way to charge for alpha, not just absolute returns.  A hurdle rate of 0% (common in the hedge fund industry) allows the manager to surreptitiously ride a beta (or betas) toward a performance fee payday.  A more appropriate hurdle may actually be fairer for investors even if the performance fee rate above that hurdle is higher than the usual 20% (witness MLIM charging “a quarter to one third of the alpha generated” on a recent Australian portable alpha mandate).

More Complex Accounting

As any hedge fund operations head will tell you, performance fee allocation is already one of the most complex parts of shareholder accounting.  This is because an annual performance fee is calculated on an entire fund (or a series of the fund), not on each investor’s account.  As a result, investors who entered the fund on, say, November 1st, will get dinged with a performance fee even if the fund was down in November and December (as long as the fund ended up on the year).  Conversely, an investor who jumps into a losing fund on November 1st and rides it up in November and December will end up paying no performance fee even though her holding appreciated (as long as the fund ended the year in the red).

(note: private equity funds, inventors of the “20% carry”, don’t have this problem since they accept subscriptions/commitments only once – at the launch of the fund)

So a hedge fund has three choices when it comes to assigning performance fees to each investor:  it can launch a new series of the fund every month, it can “equalize” everyone’s performance fee annually to compensate for the date at which each one entered the fund, or it can do nothing.

Unless subscriptions were also triennial, triennial performance fees would compound these problems.  Either there would need to be 36 separate “series” of a fund (one for each month) or the performance fees would have to be extensively “equalized”.  Doing nothing would benefit late investors in underwater funds and hurt late investors in funds that lose money down the home stretch.

Performance Fee “Calculated” or “Paid”?

It’s not clear whether Rapuano will actually be paid a performance fee a) triennially or b) annually with a requirement to re-invest it in fund for three years.  While we assume the fee will only be paid and calculated triennially, the New York Times notes that “She will pay taxes every year on money that she gets only every three years.”  We’re not CPAs, but paying tax on hoped for earnings seems a little wonky.  What if the fund is down in years two and three?  Will the IRS credit her back the taxes she paid on the interim valuation after year one?

In any event, this raises interesting questions since the triennial performance period would transcend taxation periods.  To what extent is the (expected) performance fee after year one guaranteed?  If fully guaranteed, then taxation seems appropriate.  If not guaranteed, then taxation seems premature.  Is there a hybrid model? (e.g. a realization of half the performance fee with a requirement to lock-into the fund plus an unrealized half that spills over into years two and three for a triennial realization).

One other alternative might be a rolling three year window.  But is this just a slippery slope toward the complex “series accounting” described above?

Performance Fee Compensation: Options Expense Redux?

While Rapuano is right when she says performance fees better align the interests of managers and investors, an even better way to align interests is for managers to participate in both gains and losses by investing a significant portion of their net worth in their own fund.  This is common practice in the hedge fund industry where most funds began life as privately managed accounts anyway.

This sort of reminds us of the balancing act often performed by under-funded start-ups.  Should you provide executives with loans to fund stock purchases or should you award options?  (or a compromise: should you sell in-the-money options to executives?).

At the end of the day, the treatment of hedge fund performance fees smells a lot like the treatment of executive stock options.  It is now generally recognized (especially by the IRS) that options are not free and therefore should be expensed.  So perhaps the best way to compensate a hedge fund manager is to value the performance fee as a call option sold by the investors to the manager.  This would explicitly recognize the extensive (hidden) value received by hedge fund managers.  Rapuano’s option would simply have a longer expiration date.

Cynics charge that a hedge fund is simply an investment vehicle with a unique (read: lucrative) compensation scheme.  If this is true, then Lisa Rapuano’s throwing down of the gauntlet may challenge the industry’s very foundation.

– Alpha Male

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