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Ongoing Moral Hazards in Money Management October 28, 2006

Posted by David Bookstaber in Finance.

There is a moral hazard for investment managers to take big unjustified risks:  They are gambling with other people’s money.  In general, managers share proportionally in the rewards when they succeed, but do not share proportionally in the losses when they fail.

For example, mutual fund managers are generally benchmarked to an index and they “succeed” to the degree that they outperform their index.  Success brings in more investors, which brings in more fees that the manager takes home.  Failure to beat the index may result in attrition of assets.  But in the worst case the manager doesn’t lose money they way his investors lose theirs.  He just has to start a new fund without the bad track record, or take another job.  Thus, the incentives for a new manager who wants to make a fortune, but who doesn’t have any special ability to beat the market, is to take a gamble with a portfolio that is riskier (higher beta) than his index.  Any such portfolio could outperform or underperform the index.

Suppose the manager has “won” his gamble and as a result has captured more investments.  Eventually, he may become content with his elevated position, at which point he will stop gambling, which means the investors who bought in expecting him to beat the index will now just be owning the index — but will still be paying extra management fees to their exceptional manager, who in fact is just a lucky gambler.

Hedge funds exacerbate this hazard, because the risks can be essentially unlimited, and the payoffs to managers from big wins are nearly immediate.  One would hope that after a hedge fund manager blows up with an unjustified gamble that would be the end of his career in the industry.  Today’s WSJ reveals that such a hope may be in vain:

Brian Hunter, the natural-gas trader behind last month’s massive losses at hedge fund Amaranth Advisors, is exploring whether to get back in the game, people familiar with his plans say.

He approached Wall Street contacts to gauge investor interest in backing him, these people say, and may decide whether to resume energy trading in a few months. …

Amaranth, based in Greenwich, Conn., is liquidating, after Mr. Hunter’s bad bets triggered roughly $6.4 billion in losses, or 70% of its assets.

An executive recruiter in contact with Mr. Hunter says he has offered to help introduce the once-highflying trader to investors. The recruiter sees opportunities for Mr. Hunter to make a fresh start with high-net-worth investors, possibly in Russia and the Middle East.

Mr. Hunter was estimated to have made at least $75 million in 2005.

So here’s a manager who took home something like $75MM in incentive fees for making enormous gambles with other people’s money.  He banked his fees, and the next year not only lost more than half his investors’ money but also destroyed his employer.  Not only does he not lose any of his own money, but apparently there are still people out there who want him to gamble their money.

Betting on fallen hedge-fund stars isn’t all that uncommon. John Meriwether, who led Long-Term Capital Management until its 1998 implosion, now runs another hedge fund.


1. federalist - February 25, 2007

Breakingviews.com notes some funds that are addressing this problem:

Orbis Investment Management, a Bermuda money manager, has found a way around this asymmetric payoff. It pays back past performance fees during lean years. Here is how it works. Orbis, which manages about $17 billion, collects 25% of any gains above a benchmark. In the case of its Orbis Global Equity Fund, that is the FTSE World Index. This bonus, however, doesn’t go directly to Orbis, but into a reserve fund. If the firm underperforms in future years, Orbis pays a refund out of this bucket to its clients.

Orbis isn’t alone. A newly established London investment firm, Sleep, Zakaria & Co., has a similar approach, with a slight twist. It will charge a 20% performance fee only on gains above a 6% annual hurdle. If this hurdle isn’t cleared in future years, the firm will pay a refund.

Performance fees that can be clawed back have several advantages. For a start, they align the interest of clients and money managers. They also serve to smooth returns in bad years. Refunds may make clients more loyal. Because the money managers don’t earn bonuses on profits that are later reversed, they may be encouraged to take a longer-term view.

2. federalist - June 29, 2007

BreakingViews.com today illuminates the most egregious moral hazard yet:

Private-equity firms are trying out a new form of exit: selling assets to themselves. Two big European transactions this week involved leveraged-buyout firms selling businesses to other portfolio companies they have stakes in. This is a twist on a normal “secondary” buyout where one LBO house sells an asset to a totally different one.

Where is the exit if one is just selling an asset to oneself? All the big private-equity funds have many “pockets” — investment funds of different vintages or with different mandates. Provided the money to buy the asset comes out of a different pocket from the one that’s getting the proceeds of a sale, there’s an exit. And, if there’s a big enough upside, the private-equity firm’s partners can cash in their 20% or so slice of the profits.

If the asset subsequently loses value then the partners keep their fee and the other investors eat the loss.

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