The hedge fund industry didn’t invent the performance fee. Clearly, performance-based pay has been around a long time. Large organizations have been dealing with the asymmetry, risk mis-alignment, and cultural resistance that come with performance-based compensation for years. So we thought it would be interesting to explore existing examples of performance fees to see what lessons might be gleaned.
In its February 5th issue, Pensions & Investments ran an editorial called “Performance Incentives” in which it argued for an increase in performance-based incentives for the heads of public pension funds. Interestingly, many of its arguments can be easily applied to the hedge fund world.
P&I argues that “exceptional pay is good for the fund…because it makes the pension promise more secure by raising funding levels”. The magazine even says the lack of performance-based compensation can lead to “inexperienced or untalented investment personnel (that) can actually raise a fund’s costs by producing poor investment returns.”
Performance-based pay also has its own effective hurdle rate. According to P&I, that hurdle should be implicitly set at “excess returns”:
“A performance-based compensation structure is sensible for all stakeholders. After all, the incentive pay is taken out of excess, or above average, returns and therefore costs beneficiaries and tax-payers nothing, while the fund gets the bulk of any excess return.”
But what are “excess returns”? Returns in excess of a benchmark? Or returns in excess of liabilities? Or both? Sounds like they mean beyond what the plan needs – in other words: beyond a liability benchmark. (If you’re having an options-expense-fiasco deja vu, you’re not alone. “…Costs beneficiaries nothing” does sound familiar, doesn’t it?).
But regardless of the specific bogey established, the discussion of an appropriate benchmark can lead to a more enlightened management of pension fund, says P&I:
“Performance-based pay forces the board to think more deeply about performance benchmarks and attribution.”
As in the hedge fund industry, asymmetric performance-based compensation can also lead to moral hazards for pension heads. For example, funds that are under their benchmark in November might swing for the fences knowing they won’t lose, and can only gain. So P&I recommends “experienced compensation consultants to ensure the pay structure encourages only prudent risk-taking.”
It strikes us that the investment duties of a pension fund manager are not dissimilar to those of a fund of funds manager. So we wonder if pressure to lower fund of funds performance fees might wane as more pension heads receive performance-based compensation themselves…