The UK's Daily Telegraph recently reported on what were described as the "rip off" of hedge fund management charges. The article was based on underlying research by Terry Smith - a well known executive in the UK financial services industry - who claimed that an individual who invested $1,000 with Warren Buffett in 1965 would currently hold a nest egg of $4.3 million. However, if Berkshire Hathaway had been a hedge fund charging 2 and 20, that $4.3 million would have accrued $300k to the investor with a stunning $4m to the manager. Certainly sounds like a rip off to us.
However, one of Castle Hall's analysts reviewed Mr Smith's calculations (an underlying spreadsheet is available on the above link) and found that the analysis - while creating a great headline - does not reflect the full story.
At a micro level, there are a number of calculation problems:
1) Mr. Smith had assumed that the management fee is paid on year end assets. In fact, it is typically paid quarterly; an accurate calculation would therefore take 2% of the average of beginning and end of year capital.
2) Mr. Smith had assumed that the incentive fee is paid on gross end of year assets before the deduction of the management fee. In fact, the incentive fee is paid on net end of year assets, i.e. after the 2%.
3) Mr. Smith had not taken account of the high water mark feature embedded in virtually all 2 and 20 structures.
We agree that the mechanics of NAV calculation are not always the most exciting topic. However, it is nonetheless interesting to see how investors can easily misunderstand the process to calculate first the management fee, then take the incentive fee, and then take account of a HWM.
As a first observation, therefore, correcting for these calculation errors "gives" the investor $650k, more than doubling their return. However, it's still the case that the manager allocation, even with corrected data, comes in at $3.7m. Still firmly in the land of "rip off".
We need to turn to the bigger picture to understand what is happening. The key to this analysis is that Mr. Smith's calculation assumes that the hedge fund manager can reinvest his annual compensation (the sum of each year's management and incentive fees) back into Berkshire Hathaway stock; this will then compound based on Mr. Buffett's ongoing performance. It goes without saying that that performance is firstly very good, and that we moreover have a very long time period over which to consider compounding.
Based on our revised calculation, over the 45 years involved, the investor will pay total fees of $256,000; it is this number which has turned into $3.7 million, or a 15 times return. The investor, mind you, makes an initial investment of only $1,000 which increases to $650k - a 650 times return.
There is a further problem: the original analysis assumes that the hedge fund manager can reinvest his fee income without paying tax. Fine if you happen to run the fund from the Cayman Islands; not so fine if you live elsewhere. Applying a 30% tax rate reduces the manager's "take" to $2.5 million (we won't speculate as to whether the government could have taken their tax revenue each year and, in turn, reinvest that back into Berkshire Hathaway stock!) Carrying on to a final point, the original analysis also assumes that not only does the hedge fund manager pay no tax, but that he also does not need to use any of his fee income to pay his staff or cover the overhead of his business. In reality this would, of course, further reduce the amount which would be available for reinvestment.
What we have here, therefore, is an extreme example of the magic of compounding - which is, of course, a key element of Warren Buffett's phenomenal success. In the big picture, an investor in Berkshire Hathaway stock has received a compound IRR of approximately 20.5% over the 45 years involved. A hedge fund structure would take that gross return and deduct 2% for a management fee and then take 20% of what remains as an incentive allocation; this would leave the investor with a baseline IRR of 14.8%. Overall, therefore, 75% of the compound IRR goes to the investor, and 25% to the manager.
That certainly seems fair to us for a manager able to generate an IRR of 15% over the best part of half a century.
Hedge Fund Operational Due Diligence.
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