Is high hedge fund compensation really that new?

17 April 2008

Many countries around the world take a somewhat skeptical view of wealth.  While many people in those countries aspire to be wealthy, those who have achieved wealth are usually expected not to flaunt it.  As a result, foreigners are often struck by the respect and admiration engendered by wealth in the United States.   In the US, wealth isn’t just tolerated, it is celebrated. 

But even this staid reverence has its limits.  Yesterday’s release of Alpha Magazine’s top-earning hedge fund managers has – at least for this week – reignited the debate over what is fair and equitable in US society.  The result has been a sort of mixture of two familiar issues: CEO compensation and the get rich quick phenomenon of the (pre-implosion) tech bubble 

John Paulson was #1 on Alpha’s list with 2007 earnings of $3.7 billion.  Nine other hedge fund managers made over $500 million.  Not surprisingly, the media is now replete with stories about how “crumbling home prices and $100 oil helped Wall Street’s Highest Earners pull in $19 billion last year”, and there is growing outrage over the quantum of these numbers.

Paulson’s net worth rose by $3.7 billion last year.  Yet he wouldn’t have even have made the top 10 on Forbes annual list of the largest year-over-year increases in wealth.  According to the most recent Forbes 400 list (October 2007), Bill Gates and Warren Buffet each made $6 billion while Michael Bloomberg made $6.2 billion.  Relative no-names like David Koch and Sheldon Adelson made $5 billion and $7.5 billion respectively.

   
So why the uproar over Paulson et al?  For starters, the confluence of two events has laid the groundwork for a public backlash: A) People are learning about his fortune on the same pages that contain stories about job losses and financial stress and B) He actually made his fortune betting that others would experience such financial hardship.  This provides new meaning to the word Schadenfreude and, at the very least, it creates a perfect storm of bad PR.

But let’s rewind a few years to when everyone was making good money.  The popular reaction to these numbers was still quite similar.  “How could such egregious compensation be justified?” people would ask.  

Without passing judgment on the legitimacy of hedge fund compensation, here is our attempt to explain why hedge fund earnings are interpreted very differently than, say, Michael Bloomberg’s earnings.

1. Appreciation vs. Compensation: The obvious difference is that the Forbes richest Americans made money on their investments.  In other words, their earnings were from appreciation, not compensation.  Somewhat ironically, citizens in capitalist societies are often more sanguine about earnings from appreciation than they are about earnings billed as “compensation” for services they personally provided - which implies that the earner is somehow that much more valuable than the average worker. (Having said this, Alpha Magazine included both sources of income in their earnings calculations.  For example, two thirds of George Soros’ 2008 earnings were from returns on his own holdings in his funds.  One hundred percent of Julian Robertson’s 2007 earnings were from his own investment - “appreciation”.  As a result, he didn’t even make the list.)
   
2. Paper vs. Cash: Hedge fund manager earnings are liquid (i.e. cash).  While many on the Forbes list could probably sell an amount of stock equal to their investment appreciation last year, there is a sense that their feet are being held to the fire via relatively illiquid stock.  In fact, cash earnings are objectively worth more than less-liquid stock earnings of the same magnitude.
    
   One oft-cited way to correct for this would be to require hedge fund managers to stay invested in their funds for a certain amount of time – say, 3 years.   But many hedge fund managers already do this and it doesn’t seem to have bought them any additional sympathy.          

   In fact, even if they were required to reinvest their earnings back into the fund, they would still be effectively de-risking.  Due to simple mathematics, hedge funds themselves are far less volatile than their stream of performance bonuses.  Reinvesting a performance bonus into a fund would be like the founders of Google moving their wealth into IBM the day after their IPO.  

3. Income vs. Options: Hedge fund manager earnings reported this year actually occurred in previous years.  The money earned by John Paulson (from other investors) was actually a just the result of a fair bet that happened to pay off in 2007.  Paulson was effectivley compensated during previous years when he was granted options (a.k.a. “performance fee potential”) by his investors.
    
   This, of course, was one of the big issues in the executive stock option fiasco.  Companies were eventually forced to recognize the true value of the options granted to senior executives – even if they were underwater at the moment they were granted.  After all, they could yield significant returns.  And that had a non-zero value.          

   No such objective valuation is required in the granting of the performance fee option to hedge fund managers.  Every time an investor puts $10 million into a hedge fund, they are simultaneously granting an option with a significant fair market value (for free).  If the manager could turn around and sell the option, they just as well might.  But their hands are tied.  So instead of a lot of managers crystallizing the value in these options after they are granted, a small number of managers experience a windfall when they expire.

4. “Creating” vs. “Speculating”: Of course, there are powerful social aspects to the hedge fund compensation debate.  Bill Gates and Michael Bloomberg “created” something of value while hedge fund managers just “speculated”.  But what about Warren Buffett?  Is he speculating or creating?  How about David Koch, the aforementioned oil & gas tycoon?  At the end of the day, this is a matter of perception, not objective fact.    

We propose that two factors have to combine to create the kind of water-cooler talk that results from hedge fund compensation rankings: the number has to be large and the money must have been earned as “compensation”.  The absence of either factor would raise nary and eyebrow.  In the chart to the right, red indicates popular villains, green represents popular heroes and orange is something in between. 

Aside from great gossip, the debate over which rich guy should have more or less of other rich guys’ money may be immaterial.  At the end of the day, professor Xavier Gabaix of NYU might have had it right in an interview with the AP yesterday.  Reported AP:

“Xavier Gabaix, a finance professor at New York University, said it is not clear whether such gaping inequality is necessarily bad.

“Because hedge fund managers make their money by charging fees on investments from rich people, these fees represent the redistribution of wealth from the rich to the very rich, he said.

“By contrast, the income inequality plaguing many developing countries represents rich people profiting at the expense of the poor, he said.”

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2 Responses to “Is high hedge fund compensation really that new?”

1. Friday links: SPAC spree « Abnormal Returns Says:
   April 18th, 2008 at 11:29 am

   […] Redistributing wealth from the rich to the very rich. (All About Alpha) […]

2. The Big Picture Says:
   April 20th, 2008 at 7:09 am

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