Value Hedge Fund Manager Starts Revolutionary Pay Structure

I agree with the notion that traditional mutual funds encourage mediocrity. There are exceptions, but the financial incentive is to have as many assets under management as possible and simply collect the management fee. Too many mutual fund companies are marketing operations. They grow their assets by attracting new fund accounts and not by growing the portfolio value organically.

That's why I've always preferred what this New York Times article calls the "2 and 20" compensation arrangement of most hedge funds. I'll add "investment partnerships" because a lot of partnerships are often referred to as hedge funds.

The difference? Well, I may be wrong, but I've always been under the impression that hedge funds often engage in short selling. While investment partnerships often don't. Walter Schloss didn't. I think "hedge fund" has become a hot term with journalists.

The "2 and 20" structure is that the manager receives 2% of the assets they manage as a management fee and keep 20% of the profits as incentive pay. I like this because the portfolio manager's interests are aligned with investors. The manager only makes money if investors make money.

Of course, the pressure to make some money annually can prove a temptation for some managers, which can hurt investors' potential gains.

So the linked Times article reports on one value manager who has a different approach:

Lisa Rapuano, a longtime value investor, grappled with these issues and came up with a compensation structure based on the radical notion of delayed gratification. In January, she will start a value-oriented hedge fund that pays her a hefty incentive fee, but only every three years.

Lane Five Capital Management charges a 1.5 percent management fee and takes 40 percent of any profits that exceed her hurdle rate (the Standard & Poor’s 1,500 index) every three years. If the fund has negative returns, she gets nothing — a fact her husband finds very perplexing, according to Ms. Rapuano’s presentation at the Value Investing Congress in New York last week.

Her reasoning, which she outlined at the conference, was straightforward. She likes the hedge fund model of compensation because it is incentive-based. It is better than the traditional asset management model, which encourages mediocrity. Traditional managers are paid based on the amount of money they manage, not their performance.

But she called the 12-month time horizon of hedge fund compensation “less than ideal” because it can cause people to “gun for performance and take undue risks at the end of the year,” she said.

I'm intrigued by Rapuano's idea, though not quite ready to say I'd go her route if I ran a private fund. On a side note, I wonder why her hurdle is the S&P 1,500 index and not the S&P 500.

It will be interesting to see if her compensation approach catches on.

Comments

[Doug]

The S&P 1500 Index is closer to a "total market" index, which is probably more appropriate for a manager who will invest in a variety of stocks.

There are some insurance companies who pay their underwriters in similar fashion - the bonus is put in escrow and paid out over 3-5 years, depending on the "tail" of the business. That way, the underwriter won't want to underprice the business, only to have it develop against him over time and eat into his escrow account.

Philip Fisher may have had a traditional compensation plan, but was known to have told clients to stick with him for a minimum of three years, in order to get past the short term noise of the markets.

[John]

Doug: I can see why the S&P 1500 may be a better benchmark. I just thought that most managers measure themselves against the S&P500 (the exception being global funds).

And that's interesting about insurance companies. I didn't know that.

Thanks for reading and a great comment.

[Trent]

What "most managers measure themselves against" should be irrelevant. The benchmark decision should be based on the manager's style and the client's needs.

At any rate, 85% of the 1,500 market cap consists of the 500, so the two should track relatively closely.

[John]

Trent: I would think most managers measure their performance against the S&P500 for just that reason -- it's the best benchmark for them and their clients.

I also think a fixed benchmark, such as the rate of inflation plus 10%, may be the best measuring stick of all.

[Amit Chokshi]

Lisa worked for Bill Miller and Matador as well. Her idea makes sense and I expect more value oriented fund managers to adopt that view. Returns are all IRR driven, that's what really matters. So if I'm investing in some company that I believe is trading at half it's intrinsic value, if it doubles inside of 3-5 years I generate an IRR of 15-22% of so, not including any potential dividends. Those figures right off the bat beat the market. If you're focusing on mid cap to small cap companies, that's very possible, it's just about having the mental strength to ride out any adverse volatility. Check out ECOL or ASFI as great small caps that show some pretty heavy volatility at times but if you just focus on the fundamentals and of course valuation, you'll see that you're very well rewarded.

[John]

Amit: I'll check ECOL and ASFI out, thanks.

[Amit Chokshi]

ECOL has moved quite a bit up, it's a double over the past year, and has a great niche in hazardous waste handling. It's one of the few industries in my view that has good pricing power protection built in for the next few years. I never invested it back when it was at $10 or so but still like it here, it's just that I'm trying to block out the media/voices that say now's the time to go into megacaps. There are some great opportunities in the micro/small cap space where you can get an excellent balance sheet, great fundamentals, pricing power, insider ownership/aligned interests, and with ECOL even a dividend that make it extremely attractive. I didn't buy at $10 because of valuation, I hadn't done enough industry research and felt the 10x EV/EBITDA and high teens P/E ratios were too rich. ECOL can still pullback so once I get an idea of what I think it's really worth I'll decide if it's still a good buy.

ASFI has been on fire and may be due for a significant pullback based on short sellers. ASFI is a trading stock for many, not for me as I'm a buy and hold 3-5+ years person. ASFI's top guys, Gary and his father Arthur Stern, have a ton of stock in their name and in friends/family names/trusts that they have been liquidating for estate reasons. Arthur is 85 so it makes perfect sense, so they've engaged in the 10b5-1 programs and the stock has been range bound from $33-$36. A lot of short interest due to the fact that ASFI sells off their debt as well as outsources to collect on it. Sold debt is not viewed in the same light as collected debt and shorts point to the cash collections vs accounting figures. Accounting for any paper collectors is something investors need to be ok with and understand, but in ASFI's case some analysts (one who works for a market maker for PRAA, a competitor of ASFI and good company, but likes to publish hedge fund-ish pieces like long/short ideas) likes to beat up on ASFI. Since $20 these guys have generally been proven wrong on their assumptions.