When I recently read that activists — including hedge funds — are planning to target executive compensation, one word quickly jumped to mind: chutzpah.
Of all groups, hedge funds are going to question how corporate executives get paid and how much? Bad idea.
Granted, many corporate pay packages do not reflect the poor performance of the company or the lousy job the chief executive has done. And many of the severance packages of fired CEOs are insults to the intelligence of shareholders and employees they failed.
Meanwhile, hedge fund managers like to repeatedly remind people that their interests are directly aligned with their investors’. They stress how most of their net worth is tied up in their funds and how they make money when their investors make money, and so on and so forth.
Sounds great. Too bad it’s not totally true.
Rather, the dirty little secret is that many hedge fund managers — especially the ones running very large organizations — enjoy a heads-I-win-tails-you-lose arrangement.
Sure, they charge incentive fees, so they earn a portion of the profits.
However, they make money no matter whether they delivered the goods or greatly lagged the market. Very, very few have a hurdle above a certain benchmark before they get paid.
As we recently noted, in this year’s Rich List, 12 of the 25 highest-earning hedge fund managers in 2014 posted single-digit gains in their main fund or funds, underperforming the 13.7 return of the Standard & Poor’s 500.
None of them has a hurdle that triggers when a performance fee can start to be earned.
Bridgewater Associates’ Raymond Dalio ranked third on this year’s Rich List with $1.1 billion — double the previous year’s gains — after posting just 3.6 percent and 8.7 percent gains in his Pure Alpha Fund II and Pure Alpha Major Markets II funds, respectively.
This is because a big portion of Dalio’s earnings were generated by gains on his own capital. So, the wealthiest hedge fund managers don’t need to perform well to make ten figures a year.
Sure, when hedge fund managers lose money, most of them must return to break-even hurdles before they can resume earning performance fees. That means they don’t make money in down years.
However, hedge fund managers don’t have clawbacks of previous earnings when they lose money. I wonder what kind of risks they would take if they had that kind of provision.
Of course, the largest hedge fund managers don’t exactly go without some sort of compensation while they wait to return to that high-water mark.
First, their own money keeps growing even as they are telling their investors that they don’t get paid until their fund returns to breakeven.
Second, there is that little matter of the management fee.
In the earlier days of hedge funds — before the past decade — most funds charged 1 percent of assets, and firms were small enough that this fee mostly took care of overhead.
No longer.
Many now charge 1.5 percent or 2 percent and a fair number 3 percent of assets. Many firms run billions of dollars with these fees. The management fees at the largest firms wind up being a profit source that far exceeds the costs of running the firm.
So, in a down year firms — and their managers — can still make money on fees. And in years waiting to reach the high-water mark, firms and their managers still make money from fees.
These are the same managers who will tell you not to judge them on one year’s loss or mediocre performance. Hedge fund managers are very quick to tell reporters — and investors — that they should look at their funds’ long-term performance.
Yet these are the same folks who quickly pounce on a company with a temporary setback and bully them into spending their cash immediately on stock buybacks, large dividends and even special dividends to boost short-term stock performance. They even urge companies to take on debt and use the proceeds to buy back stock and dismiss notions that companies need the cash to invest over the long haul.
Don’t get me wrong. I think there are many companies that are underperforming and have benefited from an activist shaking up the status quo and entrenched management. Many of them need major regime changes, too.
However, hedge funds should not be making compensation a central issue. In many cases, the claim rings hollow.
