Top hedge fund manager made $3.7B last year. Does this give anyone pause?

Great Debates
21

Just a quick addition: the managers earning these outsized fees are managers who have earned their investors huge amounts of money. They aren’t earning only 1.4% over mutual funds. You won’t hear about those managers. Mr. Paulson, who earned $3.7 billion, had a one year return of 590% and 353% in the two funds he manages. However, incentive fees are a “what have you done for me lately” type salary. If Mr. Paulson’s $28 billion dollar fund loses 50% next year (down to $14 billion) there will earn $0 incentive fee, plus he will not earn an incentive fee again until he doubles his $14 billion back up to $28 billion (known as the “high water mark”).

[It’s a little more complicated than this. For those interested:
Each individual investor will have a high water mark, not the total fund, so if Mr. Paulson loses 50% of his investors due to withdrawal (down to $7 billion), the high water mark would then be $14 billion. But say that Mr. Paulson looses half his fund from withdrawals (-$7 billion), but gets $3 billion in new investments - the investors who have stayed with Mr. Paulson have a high water mark where they will pay no incentive fees until they recoup the highest level of their investment, while the new guys have no established high water mark, and will be eligible to pay incentive fees right off the bat.

To address Martin Hyde: Smart pension plans use hedge funds as a point of diversification, just as they use real estate, international investments, bonds, etc. Actuarial tables base predictions on a constant growth rate; down years wreak havoc on meeting actuarial predicitions, much more than simply underperforming, and may force a company to increase pension funding (which they are loathe to do). Pension plans look for investment options that are uncorrelated to each other. If the pension plan does its job correctly, it will look for hedge funds are the least correlated to their other investments.

22

Nope. The investor must seek out the hedge fund. Often, there are arranged “capital introduction sessions”, where a third party will introduce qualified or accredited investors to a number of hedge fund managers. Once an investor shows interest and is cleared (in the case above, the third party does the job of clearing the investor), then the hedge fund can distinguish itself as the best choice for the investor.

23

D_Odds, thanks for your enlightened information on this topic. I’m confused about this, though:

If it’s a type of salary, why isn’t it taxed as income?

ETA: Or rather, why do you think it shouldn’t be taxed as income? I don’t want 30%+ of my salary going to the feds, either, but I don’t have a loophole that keeps me from paying the structured income tax on my salary.

24

I agree with this, but I don’t understand why you think those locked in said pensions shouldn’t be able to pull the WTF card?

25

(1) I did not say how it is taxed. I said that if the incentive fee is treated as a transfer of fund assets and then withdrawn, it may be treated as a withdrawal rather than as income. I’m not a tax consultant, so I don’t know for sure how the incentive fees are taxed. Mr. Paulson’s personal gains in the funds (as he is likely also an investor in addition to a manager) is treated as gains for any other investor.

For example, you and Mr. Paulson are the only investors in a $100 fund, each 50%. The fund is up 100% for the year. You, as a limited partner, pay 1% of total assets as a management fee and 20% of profits as a performance fee, calculated at the end of the period. Mr. Paulson, as general partner, is exempt from the fees. (Simple, but common set-up for smaller funds)

At year end, before fees, you each have $200. You pay the Management Company (set up to handle administration of the fund) $2. This is income to the management company (which Mr. Paulson is probably CEO), and will be matched against expenses such as marketing (sending you your statements), accounting (figuring out how much you owe), office supplies (all those fancy computers), etc. Hedge funds tend to make very little, if any, off of management fees, after expenses. You are now down to $198 (and the fund is down to $398). You now pay 20% on your profits (I will round to the nearest dollar) directly to the general partner. You have a profit of $98, so you pay $20 to Mr. Paulson through a transfer. So now, Mr. Paulson’s balance is $220, and yours is $178, and the fund is still at $398. I would have to ask a tax accountant how that $20 is handled. Lastly, the partnership agreement may limit Mr. Paulson to owning only 50% of the portfolio (another common contract term, though usually much much lower than 50%), so he has to withdraw money from the fund. He will have to withdraw $42. This will be made up of a mix of short-term capital gains (netted against short-term capital losses), long-term capital gains (netted against long-term capital losses), and ordinary income from interest and dividends (netted against dividend and interest expenses). Only l-t gains get preferential tax treatment.

A little more on the taxing of the funds. First, the fund itself is not taxed, it is treated as a pass through vehicle to the investors. Second, investors are only taxed on realized gains (netted against realized losses). At the end of every year, a tax form must be sent to each investor (including the general partner) and filed with the IRS stating the what portion of the short and long term realized gain/loss and ordinary income of the fund belong to each investor, who must then declare that income or loss on their tax return.

26

Sorry, hit post instead of preview:

Lastly, a little definition - realized gains come from closing out a security position. If Mr. Paulson’s only holding was Apple (AAPL), he would not realize any gain or loss until he sold it, and thus would not have to pay taxes until that time. Profit is measured period-by-period not just on realized gains, but also on unrealized gain or loss. So if Mr. Paulson bought AAPL at $10 on Jan 3, and on Dec 31 it was $20, but he never sold it, he can claim 100% profit (ignoring transaction fees for the purpose of illustration) and, very importantly get paid an incentive fee for the unrealized appreciation. If on the following Jan 3, Steve Jobs breaks his neck skiing in Aspen and AAPL drops to $5, Mr. Paulson is still due his incentive fee for the previous year! This is a risk an investor chooses to take when investing in a hedge fund, and I have seen January blow-outs that wipe out previous year gains. As an investor, you’ve paid for appreciation that has disappeared and you will never realize.

27

One more little hiccup - often the 20% is carry is 20% above and beyond the returns the investors would have received if they had placed the money in something safer (treasury bills, for example).

Phrased another way - the manager gets 20% of the increase in value of the fund above what it would be if it earned a flat 6%.

Venture Capitalists used to work under a similar model at one time (and they might still do).

28

I have seen that, Algher, mostly in equity-only market neutral funds. I don’t get to review many contracts anymore (thank Og), so I don’t know if that is becoming more widespread.

29

I used to design comp plans for execs and we would put stuff that in - why pay an exec for just keeping up with his peers? It made us pretty popular with the comp committee, and as long as we goosed the plan for really good performance, the execs liked us too.

I got out of it years ago though - my knowledge is a good 10 years old I admit.

30

Whew, that was a mouthful, D_Odds. Thanks for taking the time to explain it Barney style to me.

31

It gives me pause and I’m pretty much as capitalist as they come. :eek:
Granted there are only like a thousand billionares in the world, but lets consider people who make hundreds of millions as well. I’m all in favor of people getting rich, however after a certain point, one does question the “fairness” of a system where one can “earn” ten thousand times the average MBA’s mere six figure salary.

I guess the first question is do these people - hedge fund managers, investment bankers, CEOs, athletes and entertainers - actually earn that kind of compensation? In some cases (ie Tiger Woods), the person possesses a unique skill. Or like Bill Gates, they created a multi billion dollar company out of nothing.

In the case of many CEOs and financial services personal, one does wonder whether this compensation is actually earned. Did John Paulson actually do something to warrant that $3.6 B or did he just happen to be one of a thousand monkeys throwing darts at a list of stocks and his happened to hit big?

32

Mr. Paulson took a contrarian view on the mortgage market. This is risky, because if you do not time it correctly, you can get burned by margin calls before you can cash in on the crash. An educated guess says that Mr. Paulson was highly leveraged, which magnifies the gains (and losses).

Another bad thing about hedge funds, as compared to mutual funds, is that it can be difficult to get out of them. They only pay out periodically, you usually have to give long notice (90 days is not uncommon) before a withdrawal, and there are lock-up periods where new investors may not withdraw at all (no withdrawal for 1 or 2 years). When things go bad (which is currently happening to lots of hedge funds who were taking advantage of the upside on sub-primes), hedge funds tend to adhere strictly to these rules. Still, lest you think hedge funds are being sneaky or slimy in these contract provisions, understand again that investors must at least be qualified, and these agreements usually are viewed by lawyers, and the terms are clearly spelled out in the agreements.

33

Sure, it’s my business. I am a citizen of this society, just like Mr. $3.7B. I have a vested interest in how resources are used in this society, like everyone else who lives here. And when we’re talking about giving a single individual $3.7B we’re talking about QUITE a transfer of resources. It’s quite reasonable to ask, what’s this guy doing that makes him worth $3.7B, much less $3.7B in one year? Frankly, I can’t imagine anyone being worth so much as $1B overall in our society, save maybe a doctor who comes up with a cure for old age, or an inventor who comes up with a cheap, ecologically sound substitute for oil.

This guy sounds like a standard economic drudge, nowhere near as valuable as the people I mentioned. From what I can tell, he’s advising people on investing their money. Sounds like a valuable skill. Probably well worth compensating if he’s good at it. I’d say though that he’s probably not worth more than $1-3M a year to our society as a whole. He’s probably replaceable for that much or less, by people about as skilled as him.

$1-3M a year is still a shitload of money.

He sounds like he’s ridiculously overcompensated to me, orders of magnitude beyond his value to society as a whole. The people who are paying him so well are, in my opinion, fools. There are a lot of people like that nowadays. If I were President, I’d look at establishing wealth ceilings to keep people’s compensation at reasonable levels, somewhere in line with thier value to society as a whole. We’ve got a lot of ridiculously over-compensated people in our society.

Thanks for asking, Renob!