Performance-based compensation: Does size really matter?

Fees 11 Apr 2011

John Paulson, the now-famous hedge fund manager who rightly bet that the U.S. housing market and all related securities loans and mortgages surrounding it would bust, made news again recently for making another incredible boatload of money: $4.9 billion to be exact.

The earnings bested the $3.7 billion he made in 2007 when he rocketed to hedge fund fame with his enormously successful wager on the housing market’s collapse, according to Alpha+Absolute Return Magazine.

To put that in context, the new 2nd Avenue subway line in New York is estimated to cost around $17.9 billion, meaning Paulson made enough money last year and the year before to own stops from 125th Street to at least 23rd Street, and maybe even Houston or Grand.

As most in the business well know, his personal fortune comes on the back of the compensation structure that his and most other hedge funds are based: a management fee that covers the basic administration and functions of running the business and the performance fee that goes right into the manager’s pocket.

A recent paper by Bing Liang and Christopher Schwartz (click here to download from SSRN) takes a closer look at performance fees and how they correlate not only with performance of a hedge fund itself but also with the amount of assets under management a particular fund takes in and holds. They also examined whether or not the fund’s manager closes to additional assets when it reaches a certain size.

The conclusions are interesting, to say the least. For starters, the paper’s results show that hedge fund managers have a profit maximization function consistent with hoarding assets. Even though incentive fees are based on performance, they apparently still have a strong linkage to the size of the hedge fund.

Indeed, unless the delta change in performance is larger than the delta change in assets, hedge fund managers (according to the paper) will be incentivized to increase the size of their funds at the expense of outperformance. This relation holds even before accounting for fixed fees.

“Thus, our findings suggest that in most circumstances pay for performance alone is not sufficient to align agent and principal interests in the hedge fund industry,” the paper concludes. (See table below showing returns of all funds versus capacity-constrained funds.)

We wonder what Paulson’s investors might think of that.

One of the longest-running disagreement in the hedge fund industry has been whether fees actually matter. They certainly seem egregious to many outside the industry, in particular our friends in the ETF world, who find it appalling that an entire industry should feel entitled to earning at least 20% a year on profits. (See our post about the fee debate.) Still, the go-to argument has consistently been that if the profits are rolling in, who cares?

Those on side say what’s being paid for is active management, mainly skill, risk and hopefully alpha generation. And that’s only if returns surpass a high water mark. In this respect, everyone wins.

Detractors argue that performance fees actually encourage managers to take on undue risk that puts their investors’ capital in jeopardy. What’s more, the fees they do take off the top when after beating expectations is money that could be kept in the fund and put to better use for the benefit of the rest of the investors – not just the manager.

What the paper ultimately focuses on is whether managers like Paulson and others base their decisions to limit investment to prevent diseconomies of scale, i.e. whether they close their funds to new investment when assets reach a certain level to ensure their strategy (and in turn their fees) isn’t negatively affected.

“Specifically, by examining the decisions of a subset of managers who are cognizant of the negative impact of asset size on their strategies, we are able to observe directly whether the large pay–performance deltas of hedge fund managers sufficiently motivate them to avoid empire building.”

For Paulson, it’s a bit too late to say he hasn’t already built an empire. The man has enough money not only to build the 2nd Avenue subway but also buy a good chunk of the real estate alongside it.

Our bet is that performance fees are peripheral to the health and best interests of the fund and in turn its investors. At least we hope so…

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