Thursday, January 19, 2006

Hedge Funds and Executive Pay Excesses

by Tom Bozzo

Bryan Smith sends a link to the Jesse Eisinger W$J article (works for non-subscriber me; YMMV) on executive compensation excesses previously referenced here. An additional angle it pursues, in addition to highlighting Lucian Bebchuk's recent research on the startling magnitude of top executives' compensation, is suggesting that hedge fund managers could and should do something about it,
but given how much they pay themselves, they don't make great poster children for the outrageous compensation issue. And many think there isn't enough value being destroyed by top-executive compensation to really make a difference.
My snarky take, which I suspect would withstand some actual analysis, is that hedge fund managers' fees are such that they're dependent on a class of investors with so much money that they don't miss 20% of their returns (*). There may be a degree of co-dependency, even, as managers working some hedge fund styles have incentives to throw money at executives to get deals done, and the "all the executives are above average" ratchet mechanisms take over.

Interested folks might also take a gander at an article in Legal Affairs by David Skeel, Behind the Hedge, describing some of the history of the hedge fund business and remarking on some fund activities that might be good for their investors but not obviously for the 'markets,' let alone society at large.

Skeel notes that the standard 20% incentive fee for hedge fund managers — i.e., they receive 20% of the funds' net positive returns (**) — is a byproduct of the fee structure for the original hedge fund, founded in 1949. Insofar as there is nearly no variation in incentive fee structure, that may be a more enduring feature than the original hedging strategy itself. Indeed, the lack of variation in hedge fund fee terms despite mammoth entry seems to bode ill for anyone (see: SEC Chairman Cox) who thinks that competition alone will rectify excessive compensation problems.

(*) In addition to management fees that are high by the standards of smarter mutual fund choices.

(**) If funds earn negative returns, managers typically don't receive further incentive pay until the fund reaches the previous high-water mark. The general lack of disincentive pay for negative returns, combined with managers' ability (which some use) liquidate their funds and start over rather than earn their way back to distant high-water marks, makes for a less than ideal set of incentives.
This shows you why I disagree in reality but not conceptually with the John Maudlins of the world who declare that hedge funds should be available to all. Taking more risk for less reward isn't a good general strategy, though Glassman et al. may disagree.

Any measure of executive compensation that doesn't include those "rest of life" benefits--look, to take the obvious extreme, at Jack Welch's current comp from GE--severely understates the value of the contract, and those who suggest that "median" CEO pay is too low are working from a market that overpays on the high end specifically because it isn't "free." Of course the long, high tail makes the median appear low.

The follow-up to the ASQ article should be a study that measures company performance with three metrics: CEO pay, lowest pay in home country, and lowest pay (equivalent) in outsourced company.

Finally, thank you for the link, which allows us all to start using "irrefragable" in general discourse.
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