Marginal Utility

by Tom Bozzo

The headline to Joseph Nocera's column yesterday in the NYT business section, "Punishing Success at Harvard" (here, though the business columnists including the estimable Gretchen Morgenson and Floyd Norris are also behind the "Times Select" pay/print subscriber wall), had me wondering how that wacky Larry Summers could be driving the place into the ground this week. Turns out the crimes are possibly insufficient fealty to the university's departed star money manager — who left to open a hedge fund — and trying to restrain the astronomical compensation of the Harvard Management Company's top earners.

The top six earners at Harvard Management (and, by extension, Harvard) collectively made $107.5 million in the 2003 fiscal year, and $78.4 million in 2004, the latter enough to pay the 2005-06 tuition, room and board of 1,881 Harvard undergraduates (or 28.7% of the undergraduate enrollment). The top individuals made $35.1 million in 2003, and $25.4 million in 2004. Astonishingly, there's a group of alumni publicly complaining that such sums are excessive. Even Ben Stein expresses misgivings in today's column. According to Nocera, the Summers "punishment" would cap the payouts at around $20-$25 million.

Shocking, I know. I just don't know how I would handle that sort of punishment. But in the business, it's considered a threat to Harvard's ability to hire first-rate money managers. Nocera writes:

Just about everybody in hedge fund land takes exactly the opposite view and thinks that the criticism is the height of foolishness. They point out, for starters, that Mr. Meyer saves the university money. After all, outside hedge fund managers who turn in investment performances like that of Mr. Mittleman and Mr. Samuels make far more than $35 million.

Likewise, Stephanie Strom had reported in the Times last November:

Harvard says that it would cost more to farm out all its assets to external managers and that it is inappropriate to compare compensation paid to its top money managers with compensation in the nonprofit sector at large. It contends their compensation should be compared with that paid to private hedge fund managers.

As Stein notes, hedge fund managers can make far more than the investment bank partner money offered by the elite universities' big endowments, let alone mere institutional money manager pay. The analogy with hedge fund managers at least is not as malapropos as the analogy between university presidents and corporate CEOs, though that's not for want of trying by some of them and their requisite supine boards.

The real conundrum here is how the comparison group of hedge fund managers avoids seeing a good chunk of the incentive fee-based compensation competed away. There's been lots of entry of both managers, as an array of finance stars (and otherwise) seek to cash in, and capital as an increasingly broad array of institutions and individuals seek to hop on the bandwagon. There is, according to this UMass report for Lehman Brothers (PDF), (older) research suggesting that there is little evidence that extraordinary returns derive from extraordinary individual manager skill, given a fund's investment style. (That is, the driver of differences in returns between "good" and "bad" performers owes to the consistently poor performance of the screw-ups.) Nor is there an obvious shortage of finance whizzes who might take excellent if not obscene pay to demonstrate their eligibility for free agency. You'd have to consider the 'fooled by randomness' possibility if the departed star managers are systematically relying on gut instincts versus reproducible quantitative analyses — and it's tough to rule it out even if they aren't.

So what gives? I'm inclined to view hedge fund managers as being in a position akin to real estate agents: Their compensation is driven by convention as competitive forces. The rich individuals and institutions seem to view themselves as price takers (ludicrously, in the case of Harvard, where the alternative of paying full incentive fees to outside managers is threatened even as it negotiates fee-reducing deals with its former managers gone free agent) rather than sophisticated actors who can negotiate with the managers. It also could be that they just don't miss the money.