Day 3 as a guest blogger - I promised on Monday to comment on why I am so enthused about hedge funds. In fact, my interest is in a broader category of business structures that includes all private investment funds, including venture capital and LBO funds, among others. My real interest lies in the way that these entities have managed to address internal agency costs by aligning the interests of fund managers and investors. I've written two articles on the subject, the first was published in the American University Law Review last December and can be downloaded here. The second is still in draft form but will be published in volume 60 of the Alabama Law Review this coming fall. Here is a link to my most recent draft. In addition, below is the abstract for the second article:
Progressive legal scholars argue that institutional investors should play a greater role in disciplining corporate managers. These reformers seek to harness the talent and resources of mutual funds and public pension funds to increase managerial accountability to shareholder interests. Conservative scholars respond that empowering institutional investors would do little more than relocate the underlying agency costs. Although shirking by corporate managers might indeed by reduced, institutional investors suffer from their own set of agency problems and so would need their own monitor. Ultimately, someone must watch the watchers.
In this Article, Professor Illig argues that neither corporate managers nor institutional investors are properly incentivized to serve shareholder interests. Therefore, neither is appropriately positioned to serve as the ultimate decision-maker. A better model of governance is the incentive fee structure employed by hedge funds and other private equity funds. If institutional fund managers were permitted to adopt a similar compensation scheme, their interests and the interests of their investors would merge. As a result, they would be transformed into ideal servants of shareholder interests, capable of bringing much-needed discipline to corporate America.
For the uninitiated, what makes private investment funds so unique is the manner in which they compensate their managers. This scheme has three parts and has developed in a regulatory vaccuum making it purely the result of market forces:
- First, profits are split 80% for the investors, 20% for the fund managers, such that the managers are only paid if they produce actual (and recurring) gains. Moreover, the incentive to pursue shareholder interests never dissipates, as each extra dollar of profit always means another 20 cents for the managers.
- Second, managers must invest a significant portion of their personal wealth in the fund. As a result, they feel the pain of any losses in equal proportion to the investors.
- Third, many of the best-run funds also include a hurdle rate. This means that the managers are not entitled to their 20% fee unless and until profits exceed some negotiated hurdle. As a result, these managers must produce above-market returns or receive nothing.
From a shareholder value standpoint, I believe this scheme creates an alignment of interests that far surpasses both the easily manipulated incentive compensation programs that are common among public corporations and the flat-fee non-incentive compensation earned by mutual fund and other public fund managers.
Thus, when I read in the April 2008 issue of Alpha that five fund managers each earned more that $1 billion in fees last year (yes that was a "b"), it doesn't give me the kind of heartburn that you might imagine. Certainly, these numbers are ridiculously high and the US suffers from significant disparity-of-wealth problems. However, at least these managers earned their fees by producing profits. For a manager earning a 20% carried interest to receive $1 billion in compensation, he (yes they are all men) must have produced much more in profits for his investors. Not bad for a day's (or year's) work. And remember that the investors who pay the fees - and who keep coming back - are extremely knowledgeable and sophisticated and believe they are getting a good deal. Most importantly of all, however, these billion-dollar payouts are actually far more equitable than the comparatively messily sum of $210 million that Robert Nardelli received when he left Home Depot after producing a cumulative 8% loss. Certainly, we need to reign in the raw size of executive compensation awards, but on a relative basis, compared to what many underperforming corporate managers earn, hedge fund compensation seems like a real bargain.
I should acknowledge, however, that there is a significant (but I believe temporary or at least not inherent) flaw in the system: currently, most funds charge a flat management fee in the range of around 2% of net assets. These fees were originally intended to cover expenses and thus to have a neutral effect on managerial incentives. However, as funds have grown in size (due to high investor demand for this low-agency cost model), management fees have remained steady at around 2%. Because a fund with twice as many dollars under management probably doesn't have twice the expenses, this doubling of the management fee means that a significant portion of the fee constitutes pure profit and a real drag on the incentive for managers to perform. Still, the answer to this demand-driven problem (funds can only continue to charge 2% because of increased bargaining power vis-a-vis investors) may be to increase supply...
Finally, I should note why I referred to private investment funds in my Monday post as "progressivism in conservative sheep's clothes." As I hope my comments make clear, hedge funds and other private investment funds have done a superb job at reigning in managerial discretion and creating real accountability to investor interests - goals that, while probably shared by all, tend to be favored by those on the left. Meanwhile, the primary vehicle for this increased accountability - hedge funds - is something that only those on the right (as well as their mothers, of course), could really love. To read more, check out my two articles.
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1. Posted by Vic on August 21, 2008 @ 7:34 | Permalink
Rob, this is very interesting work.
Regarding the management fee, it may play an important role in mitigating the risk-seeking behavior of fund managers. In the absence of a management fee, the asymmetric payoff of fund managers leads to risk seeking behavior: 20% of the upside, no downside. The promise of future management fees, however, produces risk aversion, as a bankrupt fund pays no fees. The two may largely offset each other.
There are some finance papers that try to model this; as I recall, precise modeling is difficult, but the basic intuition is easy enough to follow.
In any event, I tend to agree with you that the greater problem in public companies is a poor fit between pay and performance, and solutions like cost of capital indexed options should become more common.
2. Posted by Rob Illig on August 21, 2008 @ 10:08 | Permalink
Vic - thanks for the comment. I think you're right about the risk that the carried interest provides no downside for hedge managers. Thus, when a fund is headed south, why not bet the farm? For a manager who is only paid a percentage of the profits, a big loss is the same as a small one. And who knows, you might get lucky.
My sense, however, is that the real protection against such overly risky behavior is the market-driven notion that fund managers must invest a substantial portion of their personal wealth in the funds they manage. For example, of the $12 billion or so that ESL manages, Eddie Lambert, its principal, appears to have contributed about half. Thus, if ESL loses a quarter of its value because he decides to roll the dice, he's going to personally lose about $1.5 billion.