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Misalignment of Incentives

Product DetailsIn the hedge fund world, the phrase "2 + 20" remains at least a critical point in discussion of fees, even though there has been a lot of erosion over the years, and it isn't clear how much of the industry still gets away with actually charging 2 + 20.

The idea is that the management takes 2% of the assets it has under management [AUM] regardless of performance, and separately takes 20% of the profit it makes for its investors. The 20% incentive fee never goes below zero. That is, managers don't have to make up for the fund's losses, they simply get a chunk of gains when there are gains/

The 20% is the big money (at least in good times), while the 2% management fee keeps the lights on and the staff busily employed even in bad times.

The 20% also means that, in the hedge fund world, there is a lot of talk about getting back to a "high water mark," but I'll ignore that today.

The structure has come under pressure for a number of reasons. As long ago as 2001, in one of the early attempts to explain hedge funds to a broad public in a book-length format, Peter Temple said that the structure "loads the hedge fund dice in favour of risk taking, even if a manager ... has a substantial investment in the fund."

Lets run through (a slightly modified working of) Temple's hypothetical numbers. We'll think of an individual manager, rather than a management firm, for the moment. Our manager has a 5% investment in a $100 million fund, that is, he has invested $5 million. This sort of investment is sometimes described as a willingness to "eat your own cooking."

Now, the fund places its entire portfolio on a single bet, one that has  .50 chance of making a profit of 20% and an equal chance of making a loss of the same amount.

If the investment turns out badly, the fund loses that 20%, and is down to $80 million. The manager's own share in the AUM falls to $1 million.

The 20% here is meaningless. There has been no profit, and the incentive fee never goes below zero, so here it is at zero.

The 2% of AUM, though, is still in place and still lucrative. The manager here is set to receive $2 million, simply because that is 2% of $100 million, and until the bet went sour that is how much the manager was making.

Ah, but the manager has been eating his own cooking! He has lost along with his investors! Well, he lost 20% of his own $5 million investment, or $1 million. Certainly the $2 million he gets from the charge against AUM will ease that pain.

Of course if the bet did pay off, he'd have gotten the 20% gain on that $5 million, plus the charge on AUM, plus the 20% of the fund's gain.

The point, as Temple concludes, is that the profit opportunities if a bet goes right are disproportionately larger than the hit the manager takes if things go wrong. The objection is that the fee structure encourages recklessness.
  
There is a great deal more that might be said, and I expect to say some of it here in the near future. Some of it will take into account developments subsequent to Temple's 13-year-old publication.

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