Pay for Performance

As the hedge fund industry flourishes, the question of fair compensation packages for hedge fund managers is yet to be addressed
September 2002 BY TOM KELLERHALS

With the growing interest surrounding hedge funds, at least one intriguing human resource question has yet to be addressed. Even though the size of the hedge fund industry has tripled over the past 10 years, no standards seem to exist for issues relating to compensation. This became evident to our executive recruiting firm, The Westminster Group, when sponsoring the first comprehensive hedge fund hiring and compensation survey in 2001. Lois Peltz at Infovest21 conducted the survey and the results were published in early 2002.

Portfolio managers and their chief associates and analysts are among the highest Compensated employees in the asset management industry. However, when the firms were asked specifically to give compensation ranges, they were inconsistent. This wide variation in remuneration has worked so far, and the packages offered may be well deserved. However, as the hedge fund industry grows and matures, it will be necessary to have an understanding of competitive compensation ranges in order to attract and to retain “top talent”, as well as insuring reasonable operational costs for running a profitable business.

So why has so little attention been given to finding out “who gets paid for doing what” when it is such a critical first step toward creating guidelines for the industry?

RELIABLE DATA IS HARD TO OBTAIN

To date, surveys have uncovered no single formula that would let hedge fund operators simply plug in numbers to come up with an industry-standard compensation package. There are two possible reasons for this.

The small number of hedge fund companies may be part of the problem. The Association for Investment Management and Research (AIMR), a global non-profit organization of more than 36,000 investment professionals from 70 countries worldwide, conducts one of the most wide-ranging compensation surveys every two years. Its studies examine pay levels of portfolio managers, securities analysts, pension officers, marketing executives, client services professionals and other senior management in a wide variety of investment management firms.

However, it has not measured remuneration of hedge fund managers. “If we decided to pursue it, we would most likely incorporate it into our existing compensation survey,” explains Rich Wyler, vice-president of public communications at AIMR. “However, I am not sure what kind of a sample we would get, as few members are hedge fund managers.”

Another issue contributing to the problem of establishing criteria for compensation within the hedge fund industry is that the usual organizational chart of responsibilities of an asset management company does not apply.

Pat Lunkes, a Chicago-based human resources consultant who has spent over a decade studying compensation levels of investment professionals in financial futures and options, suggests compensation trends in the futures industry may apply to hedge funds.

Lunkes recently compiled a survey that uncovered wide variations in compensation among areas of specialization within the profession, types of financial organizations and individuals based on professional certification and other criteria.

He says: “The key thing to remember is that fund managers in some organizations may spend 100% of their time managing money, while their counterparts in other firms may be responsible for investing assets, conducting research, carrying out marketing and performing client service functions. When it comes to defining skill sets of portfolio managers, no one description applies, so direct and indirect compensation will vary.” This can be said of all members of a hedge fund team.

SERVICES STANDARDS TO INCREASE

As hedge funds continue to grow, the entrepreneurial hedge fund manager continues to struggle with decisions regarding compensation, responsibility and other structural issues.

Often, hedge fund operators have a very successful background in trading. However, this very background leads to an inherent weakness, little or no experience in human resources management, marketing, accounting and law, all of which are crucial to the long-term success of the venture. As the hedge fund market matures, it is important for hedge fund operators to get reliable information on compensation issues as they have wide-ranging implications for the industry and its customers. Furthermore, as hedge funds become increasingly involved in the institutional market, the infrastructure needs of the hedge fund manager become more important, as well as expensive. Institutional investors are by nature long-term investors.

As institutions continue to allocate more assets to hedge funds, the industry will have to provide the same type of services that institutional investors have customarily received from traditional asset managers, and these services are expensive.

COMPENSATION ISSUES IMPACT TRADITIONAL FIRMS AS WELL

Questions of compensation within the hedge fund industry also plague traditional asset management companies which have existing policies and procedures in place for other business units as they form hedge funds.

David Bauer, co-author of the 2001 Casey Quirk and Acito Study on hedge funds, Fund Of Funds – Rethinking Resource Requirements, says: “Every long-only investment manager we know has explored, if not started, a hedge fund over the past two years to retain top talent or to catch the current wave and hopefully add profits to the bottom line. Often companies cannot get over the hurdle of how to compensate hedge fund managers in a way that does not compromise pay scale policies and ultimately disrupt the culture of the overall firm. One approach is to create separate economics for the hedge fund managers and the rest of the firm.”

Bauer continues: “An example would be to set up separate companies for each hedge fund in which the manager and the firm share the profits. If the manager believes the company delivers a lot of value, then another option could be to share part of the hedge fund’s incentive fee with the broader firm.

“No matter how a company resolves this issue, it comes down to compensating investment professionals based on performance or risk losing their best people.”

SIMILARITIES IN THE US AND THE UK

A hedge fund can be set up so the manager receives whatever percentages are specified and this may be an answer to structuring compensation.

One commonality in compensation for hedge funds is the “one and 20” fee structure that is often standard in the US and the UK. It states that hedge fund managers get 20% of the profits as a performance fee and a 1% management fee. “The structure of this scheme amplifies the positive selection process,” explains one longtime fund manager. “Unlike mutual funds, most hedge funds have limited capacity to invest assets and must generate profits consistently – this scheme accomplishes that.”

It is also aided by the fact that most managers invest their personal capital in the funds they manage and require key employees to invest as well. This concept of percentages may be the model that has to be used for the hedge fund industry.

Unlike their US counterparts, however, those who run money in the UK are frequently part of a staff of a mid- to large-size asset management firm, bank or mutual fund company, or are a partner in the firm with a few associates.

Those who are on staff earn base salaries from £150,000 to £350,000, with total compensation reaching seven figures based on performance. Deferred compensation is designated frequently to keep portfolio management talent within the company.

WHY FAIR PLAY IS KEY

In a recent article on manager compensation in the June 2002 issue of Institutional Investor, seven of the 30 top hedge fund managers were graduates of the now defunct Tiger Management Corp. Though it is not mentioned in the article, industry insiders say the firm went under in large part because of pay issues. When hedge fund managers in Tiger Management Corp Fund were not adequately compensated, it produced a lot of “Tiger cubs” – fund managers who struck out on their own rather than be part of a firm where pay for performance was part of the talk and not the walk.

“We pay a reasonable salary and give them a considerable slice of the incentive fee – they also take home 50% of profits when pre-hurdles are overcome,” according to a London-based hedge fund manager. “We also require them to be active participants in road show presentations to major institutions and to do a reasonable amount of client service,” he adds.

Industry changes will surely impact current policies on compensation. As any of us who watched the formation and maturation of boutique institutional investment management firms know, the same maturation process is at work in the alternative investment business here and now. Different time, different venue, same process.

Key Points Tom Kellerhals is a senior partner of The Westminster Group, an executive search and recruiting firm specializing in the asset management industry.

Even though the size of the hedge fund industry has tripled over the past 10 years, no standards seem to exist for issues relating to compensation.

When the firms were asked specifically to give compensation ranges, they were inconsistent. As the hedge fund industry grows and matures, it will be necessary to have an understanding of competitive compensation ranges in order to attract and to retain top talent.

Reprinted with the permission of Hedge Funds Review | Hedge Funds Review | September 2002 www.HedgeFundsReview.com