Tuesday, July 10, 2007

Hedge Fund Billionaires

Reports of outsized hedge fund manager remuneration have been making the rounds. It started with a tally in Alpha Magazine that has been bouncing through the media like a pinball, “This year's list of 25 top-earning hedge fund managers make, on average, an altogether astonishing $570 million”.

But don’t believe the numbers.

It is easy to do the math to estimate a hedge fund’s revenue: If a $10 billion fund with the typical 2-and-20 structure has a great year, generating gross returns of 25%, it will generate $700MM of revenue – $200MM from the management fee and $500MM from the incentive fee. But to get the profits you have to subtract out the costs, and people seem to be forgetting this part of the equation.

Costs have gone up markedly over the past ten years. In the “old days”, the 1990’s, the manager did the trading and had a relatively modest support staff. Now large hedge funds are run with substantial infrastructure and with a stable of portfolio managers who get a cut of the action.

For example, one hedge fund on the Alpha Magazine list has 800 employees and over 90 portfolio managers. Each of these managers gets half of the incentive fee their trading brings in. Add to these costs the partnership shares of all those in senior management, and the revenue gets whittled down further. And, of course, besides these big ticket expenses for talent and staff, there are the cost of office space, communications and data feeds. Once you make adjustments, you can see that the reported numbers, based on revenue, are way too high.

Truth is, you can’t actually adjust for costs even if you want to, because estimating the largest costs – the incentive fees to the portfolio managers – requires information that is not available to anyone outside the fund. The problem is netting: if some of the managers do well and pull in a total of $5 billion while the rest generate losses of $2.5 billion, the fund will have gross returns of $2.5 billion, but there will be nothing left over after the portfolio managers who are in the black take their fifty percent split. Because of netting, a fund can be up for the year and still be operating at a loss. But to get a handle on the netting you have to know the revenue and payout structure for each of the portfolio managers. And that’s top secret.

So even if you know the cost structure, you cannot take revenue and get any sense of the net income going to the guy whose name is on the door. The estimates are likely to be inflated, or just plain wrong.

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