Closing the Pension Funding Gap - A Tweak to Hedge Fund Incentive Compensation Achieves True Alignment and Enhances Returns without any Alpha Improvement

April 6th, 2010
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Contributed by: Rick Ehrhart, JD, Optcapital
Pension systems worldwide are in crisis. U.S. public and private pensions alone are facing a shortfall of more than $1 trillion. To catch up, pensions are increasingly turning to hedge funds. For the decade ending in 2009, the S&P 500 Index was down 1% while the Credit Suisse/Tremont Hedge Fund Index was up 6.6%. Many pensions have recently announced plans to increase their exposure to hedge funds.

Although good news for the hedge fund industry, it doesn’t mean “business as usual.” Pensions along with other large institutional investors are calling for change. In addition to better transparency and independent oversight, they are demanding that incentive compensation align investment managers with investors’ long-term interests.

This article demonstrates that by changing the incentive compensation model from annual banking to options or stock appreciation rights (SARs), pensions can achieve true alignment and expect to increase their hedge fund returns by about 6% over a 5-year period, without any improvement in alpha. For every $1 billion of hedge fund investment, pensions would be about $12 million a year better off on average. Moreover, options/SARs can dramatically reduce downside volatility. In a down year, the manager’s share of the cumulative profits transfers to the pension investor to mitigate the loss. To receive these extra returns and cushion against losses, pensions need only to ask managers to take their incentive compensation in the form of options/SARs.

The Current Model
Almost universally, hedge funds pay their investment managers incentive compensation consisting of a percentage of the profits, e.g., 20%. Regardless of the duration of an investment, however, the manager “banks” its incentive compensation at least annually. When the investment extends beyond the initial “banking” period, the investor’s share of the cumulative profit is less than 80%, while the manager’s share is more than 20%. For example, consider the division of cumulative profits from a $100 million investment from 2004 through 2008 in a fund that performed at the same rate as the Credit Suisse/Tremont Long/Short Equity Index and that paid the manager 20% of the annual profits.

The fund generated a cumulative profit of about 78% after 4 years, and 43% after the -18% return of 2008. Because of annual banking of the 20% incentive fee, however, an investor received only 64% of such cumulative profit after 5 years (rather than 80%), while the manager received 36%. This misalignment clearly added to the pension underfunding gap in 2008, which frustrated many pension systems. CalPERS summed it up this way:

"The present model provides the possibility of a hedge fund manager realizing a 20 percent performance fee at the end of a bonanza year. If the fund suffers a significant decline the next year, the manager could still have a large net gain at the end of the two years, but the investor may break even or even lose money."

Astute pensions note, too, that managers receive more than their 20% when performance is good. At the end of 2007, after 4 consecutive positive years, the manager received 24% of such 4-year cumulative profit, while the investor received only 76%. Because 20% of the new growth is banked each year, the manager receives not only 20% of the profits attributable to the original investment, but 20% of the profits attributable to the annual “reinvestment” of the investor’s share of the profits. The awards on the deemed reinvestments of profits gives managers an increasing share of the cumulative profit over time.

Simple Tweak
Under the current model, managers typically require that investors commit for one year. This commitment is commonly called a “lock-up.” The fund rewards the manager with a specified percentage of the profits. Most funds crystallize and pay the manager’s incentive compensation annually, although some do it quarterly.

Instead of 1-year lock-ups and periodic banking of incentive compensation during the life of an investment, funds can use an incentive compensation technique that creates a true co-investment partnership. By providing U.S. investment managers with fair market value (FMV) compensatory options or stock appreciation rights (SARs), managers and investors co-invest their whole profits over the life of the investment, share proportionate risk, and receive exactly their pro rata shares of the cumulative profits at the end of the investment, whether 2 years, 5 years or 20 years. Consider the results of the example above if the fund had paid its incentive compensation in the form of 20% options/SARs.

Better Returns
A fund that pays incentive compensation in the form of options/SARs will always deliver greater returns to multi-year investors than funds paying incentive compensation in the form of annual fees or profit allocations. Options/SARs redefine the “profit pie” as cumulative profit over the life of the investment. As a result, the manager always receives exactly 20% (or other specified percentage) of such terminal profit, and the investor always receives 80% (or other specified percentage).

Over any 5-year performance period (i.e., investment cycle), an investor can expect to gain an average of 5.73% more return, or $5.73 million on a $100 million investment. Average increase in profits is 9.09%. Table 1 is based on the Hennessee Hedge Fund Index annual returns.

As compared to annual banking, an option/SAR fund provides investors with two distinct economic benefits. First, it increases upside performance by avoiding the periodic awards on deemed reinvestment of interim profits. Under the current model, the manager receives not only a share of the profits attributable to the original investment, but a share of the profits attributable to the reinvestment of the investor’s profits. The option/SAR fund, on the other hand, works like the traditional private equity model. During the life of an investment there are no periodic awards on deemed reinvestments of interim profits.

Second, the option/SAR fund reduces downside risk by ensuring that all previously accrued manager compensation remains at risk to absorb its proportionate share of subsequent losses. The longer the investment commitment (and thus the period of accumulation of manager compensation), the insurance against losses grows. As Chart 3 illustrates, an investment in 2004 would have produced 6% more in cumulative return at the end of 2008. This “claw back” benefit is of particular importance to pensions because it mitigates funding gaps when needed most. Exactly when a pension suffers a widening of the unfunded gap due to asset declines, the option/SAR fund claws back capital for the pension thereby lessening the gap.

Consider the effect of the claw back on returns in a down market. Chart 4 below uses the example above and shows the returns for 2008 under each type of fund.

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Related Entities: California Public Employees' Retirement System; CalPERS Equities; CalPERS Investments
Related Article Tags: Multi-Strategy, Long Short, Equity, Debt and Global Macro Hedge Fund News; Hedge Fund Resources and Featured Partner News

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