Hedge fund CEOs who crow about aligning their interests with those of their investors now have an opportunity to prove it when it comes to paying out their performance fees. In June the Internal Revenue Service officially approved a form of deferred compensation for offshore hedge funds that provides what institutional investors have long sought: payment of performance bonuses at the end of a multiyear period instead of annually, as is typical now. Fund managers had been concerned that they might have to pay annual taxes on deferred bonuses. The IRS ruling assures them that as of 2015 they will pay deferred taxes.
But before a fund’s decision makers jump into deferred plans, they might consider the experience of Apollo Global Management. As a publicly traded company, the New York–based private equity firm already had the ability to replace annual bonuses with deferred ones. When it did, three top managers left.
Apollo offers a stark example of the tension between investors and top hedge fund talent. A number of large pension funds, including the California Public Employees’ Retirement System and Utah Retirement Systems, argue that deferred compensation is more in line with the way investors get paid: realizing gains only when they redeem, usually after several years. By contrast, if a hedge fund manager has a big gain in year one but losses in years two and three that exceed the gain, under the annual bonus system he gets a big bonus in year one. Though the manager gets no bonuses in years two and three, the investor who redeems at year three gets no gain at all for the entire period. Under a deferred program the fund manager would get the same thing as the investors: nothing.
“We want a two- or three-year carry,” says Bruce Cundick, CIO of Utah Retirement Systems. “If there is volatility, all of it gets netted out. That is what we get. The manager should participate in that too.”
As many as 95 percent of hedge funds take annual performance bonuses. Cundick contends this could be a costly mistake if other managers begin to adopt deferral programs and can use them as evidence that they win and lose alongside their investors.
“In theory, if a manager is great and earns money every single year, this doesn’t make any difference,” says Cundick. “If he shoots for the fences one year and loses big-time the next, then this probably does impact his compensation. But he has been doing that at the expense of his investors.”
