High Water Mark & Hedge Fund Bonuses
The hedge fund format is a great business model. You collect a 1-2% fee on the money under management ostensibly to pay for office expenses. Although when you're running a billion dollars or more.....you can do the math. Then you collect 20% of the profits generated each year, your so-called performance fee or carried interest (in venture and private equity parlance). Most funds require that partners keep the bulk of their net worth in the fund at start-up (although, like anything else, exceptions are made) and a substantial amount of the annual performance fee is also required to be re-invested in the fund. This is to make sure partners have skin in the game and maintain it there. Believe me, when things go wrong it hurts. A neighbor of mine was partner of Amaranth and when their natural gas trading position took down the whole firm a couple of years ago, he lost the majority of his net worth. From what I know he had nothing to do with the energy team.
But there is a wrinkle that most hedge funds have in their charters that those who are not close to the business may not be aware of. It's called the high water mark. If a hedge fund loses money in any year, a fund that has a high water mark policy (and I would say that the majority do) must earn back the money they lost....or get back to their high water valuation mark....before they can start earning their performance fee. In the vast majority of cases this performance would be measured after the 1-2% management fee. Interestingly, the math is against the losing hedge fund manager. If you are running a $200 million fund and it falls 12.5%, your assets go down to $175 million, but to get back to your high water mark of $200 million you have to make 14.3%. Oh, and that's before adding back your 1 - 2% management fee....OUCH! In the past, many hedge funds that lost over 15% would close their doors, because the managers would potentially have to work sans performance fees for a couple of years to get back to the high water mark. I know the world's smallest violin is playing, but check out these statistics. Apparently it's a symphony.
According to the Wall Street Journal this morning, as of July 31, just 10% of hedge funds were receiving performance fees from their funds. Translated, this means the funds are under water and in fact according to the survey of 4,000 funds by Eurekahedge quoted in the article, 82% to 90% of funds were below their high water mark, depending on strategy. Frankly, with markets being insanely volatile and prior winning strategies like being long commodities and short financials being turned on their heads, it is unlikely that performance has gotten much better since.
The money that hedge fund workers take home as bonuses does matter to the New York City economy and frankly it's hard to say how many live within their generous salaries, or depend on bonus payments to pay for "essentials." Like anywhere else, people grow into their incomes, whether they are totally predictable or not. Hedge fund bonuses have undoubtedly had a big impact on the high-end New York City real estate market. That positive impact is sure to be on the wane until those high water marks are made back.
From the Blogosphere
Exposing the Hedge Fund Industry's Soft White Underbelly
Comments (12)
I expect we will also see a lot of funds close and reopen under other names. More the fool that gives $ again to those who do this but I am sure some still would.
Posted by AvnerUWS | September 22, 2008 12:47 PM
Great article! very interesting information :)
Posted by uwsider | September 22, 2008 1:18 PM
Avner,
You are correct that while frowned upon, in the past a few managers have closed down due to the challenges of a big high water mark and re-opened under a new name. Unbelieveable, people actually gave these knuckleheads money again. Not sure it will happen to any great degree though. A couple of big name funds have actually done the opposite and in several years, worked through significant high water marks and made back investors' money and more and were richly rewarded thereafter. (Some hedge funds do have class).
Posted by jeff | September 22, 2008 1:29 PM
I agree with the markets where they are its going to be hard for most managers to beat it. Here in Tucson AZ we are seeing the same thing that the high end real estate buyers are more scarce then previous years. Since most of those buyers have there net worth (at least a percentage of it) in the markets when there as unstable as the past 3 months, then it keeps home buyers on the sidelines.
Posted by Michael Oliver | September 22, 2008 1:37 PM
great piece Jeff! interesting comment by avner. Jeff, with regulation coming to cds market, it seems, how do you think this will affect hedge fund strategy, specifically for those funds that primarily trade cds? Do you see hedgies game being over too, or at least, downsized substantially leverage wise from previous years? or, will they innovate before wall street does?
Thoughts? Im curious to know the number of hedge funds based in nyc, and the aprox number of jobs that this unregulated industry has for our local economy. I always viewed hedge fun managers/traders as the riskier spenders of the wall street bunch.
Posted by Prague-Noah | September 23, 2008 4:14 AM
Noah,
Hope you are enjoying some R&R. I will try to get data on NYC hedge fund employment. As for the environment for hedging its go to be awful. Pension funds no longer lending out stock, fewer prime brokers with less capital, ever increasing prohibitions on hedging. meanwhile the cost of being unhedged has skyrocketed with unprecedented volatility in stocks, oil, gold, t-bills. Value at risk models don't include any history with conditions analagous to today, so you are somewhat flying blind relative to risk. Any hedge funds focused on CDS may have to tweak their models for sure. To make it all worse, I believe markets only act this crazy near a bottom....or maybe a total collapse.
Posted by jeff | September 23, 2008 8:09 AM
Agree that markets only act this crazy near a bottom. You can hold me to this (I may be wrong) but I do not believe we will see gold skyrocket to whatever crazy price (1200...). There may be a spike if there's a financial seize-up, but if there is it will be temporary. The short-term trading environment is one of bubbles and uniform hedge fund trading strategies, the current one being "short the dollar, long gold". This position, like any other, will be a short-term trading strategy and will unwind to a norm.
Posted by Anon | September 23, 2008 8:34 AM
Not to mention, if Cramer says "buy gold", well...
Posted by Anon | September 23, 2008 8:37 AM
This is totally off topic...I got here by Googling "selling real estate in New York City". Anyhow, I'm hoping somebody can help me with this question:
When a non-profit organization sells real estate in NYC, there is supposedly a form that must be filled out and submitted to the state. Anybody know what that form is?
Posted by Mark | September 23, 2008 3:30 PM
Mark,
I don't know, but I will try to find out.
Posted by jeff | September 23, 2008 7:55 PM
We'll soon be releasing the 2008 Hedge Fund Compensation Report based on our survey (taken over the summer) of over 200 industry players. The survey asked about expectations for salary/bonus in the coming year, as well as about comp already paid. Surprisingly, many were optimistic about increases. Numbers available soon.
Posted by Hedge Fund Search Digest | September 24, 2008 1:13 AM
On the topic of closing and re-opening a fund to reset the high watermark: although it may seem shady it's not that simple. Imagine you have a strategy that makes 100% per year for 5 years. Your $100 becomes $3200. In year 6 it loses 50% - you're back to $1600. Now you have to double the size of the fund to get back to earning an incentive fee. There is no way that fund can pay staff competitively in the coming years(s) if it makes no incentive and it's management fee has been cut in half. So are you going to walk away from a fund that made you 16 times your money in 6 years just because they had one bad year? Thats why investors agree to reopen and reset the watermark. It's the very same reason why companies reset the strikes on employee stock options. If they are too far out of them money nobody will hang around.
Posted by JC | September 24, 2008 9:33 AM