Defining a "good year" in hedge fund land

The list of the Top 10 hedge fund earners is out, and the fellow on the bottom of the list raked in US$350 million in 2009.

Risk / Reward, that’s the nature of the hedge fund industry, and the one thing to remember about hedge fund paydays is that they are also associated with massive gains for the limited partners who backed the fund manager. Seems fair enough, except for the lack of compensation “clawbacks” that most hedge funds have should things go sour the year thereafter.

What I found worth reflecting on was the track record of one particular high profile fund: Citadel Investment Group. In 2008, their fund was down 55%, and it rebounded 62% in 2009. According to Absolute Return (via the New York Times), Citadel’s CEO Kenneth Griffin would have earned US$900 million last year as a result — in part through management payouts on the fund, and the balance via his own personal investment in Citadel.

Imagine you were a pension fund that put $100 million into Citadel in late 2007, ignoring our advice that the asset class is tilted against the investor simply due to the industry’s unique payout structure (see prior post “No one is surprised, but whose to blame?” Sept 21-06). At the end of 2008, that $100 million was worth $45 million. The following year, Citadel was up 62%, which means your $45 million is now worth $72.9 million.

Hooray, except for the fact that you are still down at least 27.1% if you invested in late 2007.

The challenge with the industry is that under some hedge fund structures, a performance fee may well have been paid in 2009 in light of the great performance. Despite the fact that you were down 27.1%, a manager might have claim to 20% of that 62% gain in 2009. In this investors’ case, they gained $27.9 million on paper, but may have to share 20% of that with the manager; even though they’re still underwater on their original investment.

Is that the definition of a good year or a bad year in hedge fund land? Depends upon where you sit apparently.

The managers of private equity, venture capital and debt funds all generally operate under one set of rules, where upside is only shared when the “preferred return” is met over the life of the fund. With “clawbacks” against any payouts that were premature.

For some reason, large institutions sources aren’t able to get their hedge fund bosses to operate under the same rules as their other alternative asset class fund managers. Isn’t that just as newsworthy as the fact that someone on Wall Street made $1 billion last year?

MRM