It is not hard to agree that one of the primary causes of the global economy's rollercoaster ride from excess to catastrophe has been compensation. We have commented before on the many inconsistencies of hedge fund compensation and the fundamental weaknesses of the "2 and 20" structure. Indeed, Castle Hall's White Paper, "Hedge Fund Investing in a New World", discussed these issues in October 2008.
Another compensation issue is, of course, the pay structure in the world of Wall Street's investment banks. According to Bloomberg today, "Wall Street bonuses may go the way of the dodo" and, yesterday, President Obama was widely reported as saying that the $18 billion bonus pool Wall Street paid itself at the end of 2008 was "shameful".
And yes, Wall Street's bonuses are shameful. Particularly, they are asymmetric: you get paid on the way up but have no obligation to pay anything back on the way down. It's like a balloon blowing contest where the person who blows the biggest balloon gets paid the most, but doesn't have to repay anything if it bursts a moment later.
What is really shameful - and what really is the root problem here - is the finance industry's sense of entitlement. Progressively, it would seem that those working at the top of the finance "system", including many investment bankers and hedge fund managers, have developed their own value system, and their own, ever more inflated baseline for "normal" compensation. Never has the gap between the psychology of Wall Street and Main Street been so wide.
Hedge fund investment professionals, just like investment bankers, need to remember that $500,000 a year - let alone $5 million - is not a threshold level of "acceptable" compensation. It is also the case that the compensation you make in your best year is not your baseline minimum for what you expect to get next time - a bonus may well be a highly generous recognition of being fortuitously in the right place at the right time.
In the hedge fund industry, one of the areas of fallout from this psychology is the call for hedge funds to amend their fee structures. It is, many now claim, impossible to retain "talent" if a fund cannot charge an incentive fee. With many hedge funds down 20% or more, it will be a long time before many firms regain their high water marks ("HWM").
Unfortunately, it is absolutely correct that firms who are below their HWM will find it difficult to retain "talent". There is apparently a broad swathe of hedge fund traders who will be happy to leave the mess they have left in one sandbox and go and play in the clean sand next door. There doesn't seem to be too much incentive to stick around and help clean up.
As a result, investors may very well have to accept different fee regimes if "talent" is to be retained, accepting the least worst alternative. This is, of course, as those same investors face 20, 30 or 50% losses in their portfolio, with some of those losses coming from what were previously thought to be "best of the best" hedge funds. Oh, and they can't even get their money out - but that's another story.
The other point, which again goes to the sense of entitlement, is to remind ourselves of the fact - so rarely acknowledged - that 2 and 20 is an astonishingly generous compensation scheme for asset management services. Let's say that again - 2 and 20 is a phenomenally good deal. Such a fee structure can only be justified in any way, shape or form if hedge funds do what they always promised - generate absolute returns. Now that hedge funds have failed to do that, wanting to change the fee structure is absolutely akin to changing the rules of the game half way through. It's fine to play with a set of rules when you're winning, but you now want to change those rules - more players, smaller pitch - now that you are 25 points behind?
We want to make one final point to give perspective to the finance industry's compensation debacle. It was widely reported that, in 2007, Goldman Sachs paid its employees an average bonus of $600,000.
We thought that we would compare that to another job which draws on the intellectual elite of society - heart surgeons. According to this interesting link (second tab) the average salary, base plus bonus, of US heart surgeons is approximately $500,000, with the 75th percentile earning $612,087.
We doubt that we would find many observers who would agree that investment bankers are that much more clever, more hard working or more highly trained than a heart surgeon. And yet so many investment bankers can't live on a heart surgeon's salary?
Hedge Fund Operational Due Diligence
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