FreeRolls--Why Hedge Funds and Stock Options are Not a Good Deal for Investors

FREEROLLING WITH OTHER PEOPLE'S MONEY

The compensation terms for hedge fund managers and for many corporate executives ostensibly are designed to benefit investors by rewarding performance by the fund or corporation's top managers. In practice however, these arrangements do not incentivize performance benefiting investors. In practice these compensation arrangements incentivize managers to take risks with investors' money in the hope of reaping rich rewards for themselves. In other words, as in the world of poker they are taking a "free roll" with somebody else's money.

Typically, hedge fund managers operate with 2 and 20 percent compensation arrangements. In other words, regardless of the outcome of the investments, hedge fund managers charge 2 percent of the funds invested as a management fee plus 20 percent of any gains, in most cases, without any exposure to losses. In theory, the managers get rich only if their clients do.

But, In actual practice as James Surowwiecki points out in this week's New Yorker, "things don't always work that way. Fund managers get bonuses at the end of each year, and they keep those performance fees even if the fund eventually goes south. So if a billion dollar hedge fund rises twenty percent in the first year and falls twenty percent in its second, its investors will have lost money, while the fund's manager might earn forty million dollars in performance fees. Hedge funds do have a rule that's meant to deal with this problem: when a fund loses money, it yields no performance bonus until investors get back to even. The catch is that nothing prevents a hedge-fund manager from simply shutting down after a bad yer and walking away with the fees he's already accrued. Sometimes this happens out of necessity: the two subprime funds at Bear Stearns whose closure precipitated this summer's market mayhem had seen theri assets annihilated. But SOMETIMES IT HAPPENS BECAUSE A MANAGER HAS NO INCENTIVE TO KEEP MANAGING A FUND THAT WON'T GENERATE A DECENT PERFORMANCE FEE. In either case, the managers keep what they've earned and INVESTORS ARE LEFT HOLDING THE BAG."

The 20 percent performance fee makes high risk taking much more in the interest of the hedge fund managers than is in the interest of the hedge fund investors. The increased risk frequently results from investments heavily leveraged with borrowed money. One of the Bear Stearns funds, for example, borrowed ten times its capital which means that small gains can be turned into big profits or small losses can be turned into enormous ones.

Surowiecki goes on to point out that stock option compensation of corporate officers also tends to incentivize risk taking on the part of managers in order to maximize the value of their options. As recent history has abundantly shown stock options have also incentivized some CEOs to cook the books and backdate their options to improve their payout. And under water options often are re-priced, again, in theory, to provide an incentive for performance on behalf of the stockholders.

Surowiecki concludes,

"One lesson of the current market chaos, then is that IT'S HARD TO GET INCENTIVES RIGHT. Investors, after all, want fund managers and corporate executives to take reasonable risks--that's the only way to make money--and many of them do just that. But, in trying to reward reasonable risks, we've encouraged unreasonable ones as well. And when you amke it rational for people to bet the house, you may end up without a roof over your head."

Aside from the downside of hedge fund 2/20 arrangements and corporate stock options, it's worth noting that human motivation is complex phenomenon which involves much more than financial rewards. Profit sharing plans, annual bonuses and stock options are over-relied on as motivators in corporations. They are costly to administer. Performance is hard to measure. Often they encourage decisions which help the bottome line in the short term but hurt the company, long-term. Individual incentive plans tend to undermine rather than encourage cooperation among employees whose efforts are critical to success of the company or a particular project. Behavioral science tells us that a variety of factors other than money are powerful influences on employee motivation in work groups.

See: "The Human Group" by George Homans

"Money and Motivation" by William Foote Whyte

"Management and the Worker" by Roethlisberger and Dickson

"Hawthorne Revisited" by Henry Landsberger

Hedge Fund Founder Gets 20 Years in the Slammer 4-15-08

 

A federal district judge sentenced Samuel Isreal III, co-founder of a hedge fund, Bayou Group, now defunct, to 20 years in prison for his role in a cheme that cheated investors of more than $400 million.

http://www.nytimes.com/2008/04/15/business/15bayou.html?_r=1&ref=business&oref=slogin

Some recent illustrations of the problems with incentive compensation

Two articles in today's NYTimes illustrate some of the issues involved in so-called incentive compensation.

The first one reports that Charles Prince, ousted CEO of Citigroup who bears the responsibility for Citigroup's current problems, will collect a bonus of $12.5 million as he goes out the door. This is in addition to other items adding up to $68 million, including his salary and accumulated stock holdings; a $1.7 million pension; an office, car and driver for up to five years--all in addition to the bonus.

Prince's plunder is a pittance compared to the loot his predecessor Sandy Weill walked away with--$874 million in stock and options, a $350,000 pension and lifetime use of the bank's corporate jet (since ractcheted back by the Board to 10 years).

Prince is also getting less than Stan O'Neal's $165 million for screwing up Merrill Lynch.

Prince's package, according to compensation specialist, Brian Foley, looks like it was done on the back of a napkin. It strikes me as very odd looking. It will look even worse if it turns out the losses are worse."

http://www.nytimes.com/2007/11/12/business/12bank.html

GOOGLE OPTIONS MAKE MASSEUSE A MULTIMILLIONAIRE

The other article on stock options tells a much happier story, of Bonnie Brown, who joined Google when it had only 40 employes and has become a multimillionaire as a result of the options she received in addition to her $450 a week salary as an in-house masseuse. Ms. Brown has written a book, yet to be published, entitled "Giigle: How I Got Lucky Massaging Google."

At Google's current price employees and former employees hold an estimated $6.2 billion in Google options and stock. An estimated 1,000 Google employes hold more than $5 million in Google shares from stock grants and stock options.

http://www.nytimes.com/2007/11/12/technology/12google.html

Seth Tobias, High Rolling FreeRoller

Hedge Fund FreeRoller Cashes in His Chips in Jupiter, Florida, Swimming Pool

The New York Times Dec 4 provides a fascinating peek into the short and lurid life of a CNBC financial commentator, hedge fund operator, high liver, drug user, Seth Tobias, who was found by his wife floating face down in the swimming pool at his Jupiter, Florida, mansion, September 4. Now Tobias's wife and his four brothers are involved in an ugly battle over his $26 million estate. His will left his estate to his brothers and failed to mention his wife. Mrs. Tobias is contesting the validity of the will because it was signed before they were married a year before his death. Tobias's brothers claim Mrs. Tobias drugged him and lured him into the pool where he drowned. Bill Ash, a shady character in his own right and a former assistant to Tobias, claims Mrs. Tobias confessed to him that she had "cajoled her husband into the water while he was on a cocaine binge with a promise of sex with a male go-go dancer known as Tiger." Here's a link to the fascinating NYT account of the short and unhappy life of Seth Thomas by Andrew Ross Sorkin:

http://www.nytimes.com/2007/12/04/business/04tobias.html?ref=business

[This story won't increase your confidence in hedge funds as an investment option for you retirement money!]

Ben Stein on Private Equity Investing

Speaking of which, your humble servant expressed doubt about private equity and how it could keep making super returns by basically picking up a penny on the sidewalk, shining it up and selling it for a nickel, and then the next guy does the same and sells it for a dime. My doubts weren't strong enough. It sure looks as if it was all a hot-potato game fueled by easy money. I got caught in it a bit with a few investments. It's sort of terrifying that even I, a longtime investor, could be caught in that game. It was a small amount, but even that is too much.

Here's a link to Ben Stein's column in the NYT 12-9-07

http://www.nytimes.com/2007/12/09/business/09every.html?_r=1&ref=business&oref=slogin

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Comments 6 comments

JazLive profile image

JazLive 9 years ago from Decatur

Great HUB! Investors beware!


Ralph Deeds profile image

Ralph Deeds 9 years ago Author

Last summer I met a former hedge fund owner/manager who named his 45-foot boat "FreeRoll." He folded a big hedge fund a couple of years ago and apparently walked away with a bundle.


William F. Torpey profile image

William F. Torpey 9 years ago from South Valley Stream, N.Y.

Very informative hub, Ralph. I've always held the theory that anywhere there's lots of money, there's always somebody trying to get their hands on it. It's no different in this case.


thecounterpunch profile image

thecounterpunch 9 years ago

There are true hedge funds for the knowledgeable and the super riches ... and there are the fake ones created for the mass public which have been upset by former classical funds after the 2000 bubble and who thought that it suffices to put the money in a hedge fund to get rich whereas it was just new packaging/marketing from their crook banksters. As usual their ignorance of how the system really works has everything to do with how they are doomed.

It's general people complain about this or about that, they don't believe in the warnings, they believe it's just conspiracy theory, until they get trapped and then they faint to have been fooled innocently. Frankly I feel I have no pity for the people who just want the easy money: they're not so innocent.


worldwidesekar 8 years ago

Nice information. Like http://www.opaleseque.com


Ralph Deeds profile image

Ralph Deeds 5 years ago Author

http://dealbook.nytimes.com/2011/06/21/jpmorgan-pa...

JPMorganChase Pays $153 Million to Settle SEC Fraud Charge.

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