November 14, 2005
Hedge Funds: A Compensation Scheme Masquerading as an Asset Class
Posted by Victor Fleischer

After a long weekend trying to figure out exactly what I want to say in my hedge fund paper (apologies to those who muddled through Friday's long post) ... I've decided to move the project to the back burner to let it simmer while I finish a few other things. 

One reason I'm setting it aside is that I think there's a bigger story here than just another lap around the track on whether regulation is helpful or hurtful.

Several times in my research I came across the saying, "Hedge funds are a compensation scheme masquerading as an asset class."  People who say this usually just mean that hedge fund managers are greedy.  But what if it's true?  What if the defining characteristic of hedge funds is the compensation scheme, not the underlying portfolio?  What are the normative implications?

Perhaps a magic formula isn't the reason hedge funds are thriving.  Maybe they are thriving because they have legal and institutional advantanges over other forms of managing financial capital. 

Many hedge funds are like the proprietary trading desks of investment banks, only wrapped in a limited partnership shell.  Others are like buyout funds (but move more quickly), which are also like the holding company of a conglomerate (but in a very different organizational form).  Still others are like mutual funds, but with a different clientele.  What all hedge funds have in common is the compensation scheme.  Hedge funds are an efficient way for the most talented managers to extract out as much rent as they deserve (and maybe more).  And because the human capital talent here is mobile (not tied to physical capital or even firm-specific capital), stars are free agents, able to move around or start a new fund, extracting nearly all the surplus they create from the investors who put up the financial capital. 

More on the normative implications when I get a chance.  Think of it as the exact opposite of team production -- more like A Terrell Owens Theory of the Firm. 

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Comments (10)

1. Posted by Kate Litvak on November 14, 2005 @ 15:30 | Permalink

I've never seen a study on compensation schemes in hedge funds. Could you point me to such study? Gracias.


2. Posted by Vic Fleischer on November 14, 2005 @ 16:30 | Permalink

It's mostly models so far. See the literature discussed in this paper on funds of funds: http://www2.gsb.columbia.edu/faculty/aang/papers/FoF.pdf

I've accumulated bits and pieces of data from various practitioner sources. But I'm not aware of a systematic study of the sort that you probably have in mind. I suspect that some hedge fund consultants have pretty good data but aren't anxious to share, at least with me.


3. Posted by Robert Schwartz on November 14, 2005 @ 20:17 | Permalink

Vic: I think you basically have it right. The asset classes change when markets change. There are so many funds now that when a class (convertible debentures, for example) becomes faddish, the profits are milked out of it, sort of like a plague of grasshoppers.


Kate: I am sure such studies are done, because this is a basic metric in evaluating funds. OTOH, the 20% carry, and 2% fee is kind of bog standard.


4. Posted by Kate Litvak on November 14, 2005 @ 20:53 | Permalink

Vic: I don’t quite understand what it means that “the defining characteristic of hedge funds is the compensation scheme” when we have no data on what that compensation scheme is – or even on whether there is more than one popular scheme. I actually looked and found nothing; that’s why I asked.

I am also not sure how you can discuss “normative implications” of something for which we have no data. Likewise, I am not sure how, in the absence of data, we can tell that “hedge funds are an efficient way for the most talented managers to extract out as much rent as they deserve (and maybe more).” I don’t understand how we can determine the amount of rent that anyone “deserves.” Also, I don’t quite understand what the word “rent” means in this context. Market rate of compensation?

It may all make sense, I am just not following.

Robert: no studies that I’ve heard of; please let me know if you see something. If the 20% carry and 2% fee defines "hedge fund," then, a whole lot of private equity vehicles (including venture and LBO funds) are "hedge funds" too. That can’t be right.


5. Posted by Vic Fleischer on November 14, 2005 @ 22:17 | Permalink

Hi Kate. We have some data, just not terribly reliable data. To draw any useful conclusions, I'd have to make some assumptions about what's going on in the world. If my assumptions seem faulty, practitioners are pretty well positioned to tell me. For example, someone today told me that he thought hedge fund managers are putting in substantially more capital than I had assumed. I recognize that drawing conclusions based on unreliable data is risky. On the other hand, the SEC is making policy now.

All I was getting at with the rent extraction sentence was the following: compared to public companies, the organization of hedge funds may allow the most talented financial managers to get paid what the market will pay them without a whole lot of camouflage or belly-aching.

It's also possible that they get paid more than they deserve because investors may overvalue their services.


6. Posted by Kate Litvak on November 14, 2005 @ 23:11 | Permalink

Vic: anecdotes are not data. If compensation were a tiny part of your story, I wouldn’t care. But this seems to be a centerpiece, and it has no legs. Moreover, assuming anecdotes represent reality accurately: which exactly pieces of a hedge fund managers’ compensation are similar across all forms of hedge funds (to serve as a unifying theme), but not similar to the compensation of other private equity managers (to distinguish hedge funds from other funds)?

Also, and you are free to ignore it, but I would abstain from commenting about who “deserves” what compensation. In the market economy, the only price that one “deserves” is the price that someone is willing to pay. I can’t think of intrinsic ways of determining who deserves what, much less to compare someone’s intrinsic worth at several hypothetical alternative employments (e.g., public company and hedge funds).


7. Posted by Vic Fleischer on November 14, 2005 @ 23:47 | Permalink

Hi Kate -- Good comments, thanks. I'm not sure that I *want* to distinguish between hedge funds and other investment funds for purposes of this piece. I'm trying to make a point about the mobility of talent, and a comparative advantage that investment funds offer but public companies cannot (or at least seem to be having trouble doing). Distinguishing among asset classes misses the point. What's new about my approach is that it starts the analysis by looking at compensation scheme first (as a response to regulation and institutional forces) rather than thinking of the compensation scheme as the inevitable result of transaction costs associated with the underlying asset class.

I certainly take your point that the details are important and should be backed up. At this point I'm still brainstorming, so you might show a little patience. When the paper is finished and where the arguments are backed up only by anecdote or conventional wisdom, well, that's where you can bring in your nifty data sets and try to prove me wrong. In the meantime, it's more useful for me if you'd just point out where I'm getting the conventional wisdom wrong.

Thanks for your point about what a manager "deserves." Whether the market for fund managers functions well or not isn't something I'm ready to commit to one way or the other. There is certainly something fishy going on; whether it's cause for concern or just the odd result of a good market isn't clear to me quite yet.


8. Posted by Kate Litvak on November 14, 2005 @ 23:50 | Permalink

Is there more mobility among fund managers than among top corporate managers?


9. Posted by Michael Guttentag on November 15, 2005 @ 19:28 | Permalink

Vic,

I think you and Kate are discussing an important point as to whether the distinctions between hedge funds and private equity funds are significant for your purposes (and what are the differences, by the way).

To the extent that there are similarities between the two, I think the recently published paper by Steve Kaplan and Antoinette Schoar, Private Equity Performance: Returns, Persistence, and Capital Flows . Journal of Finance, Volume 60, Number 4 (August 2005), pp. 1791-1823, is intriguing. They seem to find the returns from private equity funds are roughly comparable to the S&P 500 after fees (which are quite substantial) are paid. One could interpret this as an outcome where the private equity managers have fully captured as compensation the excess returns they are able to provide. I think it would fit with your idea that private equity firms are defined more by their compensation structure than by their investment strategy.


10. Posted by Robert Schwartz on November 15, 2005 @ 23:18 | Permalink

"Robert: no studies that I’ve heard of; please let me know if you see something. If the 20% carry and 2% fee defines "hedge fund," then, a whole lot of private equity vehicles (including venture and LBO funds) are "hedge funds" too. That can’t be right."

Well, why not. The labels such as venture fund or LBO fund are asset class labels. The vehicles are pretty much the same. (although venture funds won't let you have your money back any-time soon, thus the SEC's year benchmark). Generally speaking, a hedge fund is a trading vehicle run by traders and the other types are more long term and run by banker types. but that is not a real typology.

As for studies, they will not be on SSRN. It is safe to assume that somebody at Goldman Sachs knows. But they are not talking, not without money and an NDA.

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