When it comes to hedge fund compensation, “social usefulness” is a red-herring

Fees 18 Jun 2008

After the release of Alpha Magazine’s rankings of the highest-paid hedge fund managers (e.g. John Paulson of Paulson & Co.), we questioned the uproar over the compensation of some managers.  Although astronomical, their compensation fell short of gains logged by entrepreneurs in other sectors (e.g. by Gates, Buffett, Bloomberg, and several lesser-known rich guys).

We proposed a number of hypotheses to explain this apparent double-standard.  One was that traditional entrepreneurs created a product or service of tangible value.  However, the value created by hedge fund managers (provision of liquidity etc.) is intangible at best.  As a result, hedge fund managers are often accused of simply “re-arranging the chairs”, not building them.

But a letter in last Thuraday’s New York Times by John Berlau of the Competitive Enterprise Institute reminded us how traditional entrepreneurs shouldn’t be given a free ride since they create something tangible.

Berlau was responding to a June 10 Times Op-Ed (IHT reprint here) that said:

“Bill Gates built a socially useful product to make his fortune. But what message do the compensation packages that hedge fund managers get send across the country?”

While Berlau returned to the familiar refrain that hedge fund managers actually do provide a “socially useful product”, we take an opposite tack – that Bill Gates is no angel either.

I just bought a new laptop and spent more on MS Office than I did on the machine to run it.  In fact, Microsoft software is the only software that is kept under lock and key at my local bog box electronics outlet.  The result?  Massive profits and a huge market cap.  And that’s okay.  If Gates can charge that much, then more power to him (within the bounds of anti-trust regulations).

Such profits are no better or worse that those made by hedge fund managers.  They only appear to be more socially redeeming because they are generated in concert with the delivery of a tangible product to a large number of buyers.  The delivery of an intangible product to a small number of purchasers (e.g. a hedge fund) is apparently afforded no such ethical protection.

The bottom line is that John Paulson and Bill Gates aren’t that dissimilar.  The only litmus test of “social usefulness” that we can all agree on in the end is the existence of pricing power and its resulting profit.  On that score, hedge fund entrepreneurs and traditional entrepreneurs both provide social value.

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