Wednesday, May 7, 2014

How Big-Time Hedge Fund Managers Make Their Money

How Big-Time Hedge Fund Managers Make Their Money

Institutional Investor’s Alpha Magazine released the annual list of hedge fund billionaires. Set out below is the list of the top ten managers.    Whether it’s David Tepper at $3.5 billion or Paul Tudor Jones at $600 million, 2013 was another great year for the biggest hedge fund managers.  In the last 24 hours there has been a big debate over where these earnings come from.[1]    Alexandria Stevens of Dealbook surmises that these hefty paydays are largely due to the 2% management and 20% incentive fee charged by the typical hedge fund manager.[2]  Matt Levine of Bloomberg thinks that the bulk of last year’s earnings were merely returns the managers earned on their own capital.[3]  In my estimation, they are both wrong.  Ms. Stevens is right that 2 and 20 can make a hedge fund manager very wealthy.  But Mr. Levine makes a valid argument that the top hedge fund managers have so much capital that the primary source of their earnings come from returns on their money.   What they are both missing is that most of these managers’ wealth comes from the long-term appreciation on the annual profits generated by their funds (fees and incentives, less expenses and taxes).

Mr. Tepper’s firm, Appaloosa, has been around since 1993, and Tudor Asset Management has existed since 1981.  In short, Mssrs. Tepper and Jones didn’t become billionaires overnight.  Their annual earnings are derived from three sources: (i) the appreciation on the original capital they put into the business; (ii) the appreciation on the after-tax profits of the business, much of which was probably invested in their funds; and (iii) the income earned from fees and incentives in 2013.  Over the years, marketing to institutions and high net worth families was the key to building this incredible level of annual earnings.

To illustrate how the economics work, I created a hypothetical hedge fund manager.  Let’s start with a manager with very modest ambitions.  Imagine an ex-Goldman trader who sets up a hedge fund with $50 million of his own money and $100 million from outside investors.  Let’s assume he generates annual gross returns of 25%, charges 2 and 20, spends 30% of fees on expenses, and pays 35% in taxes.  We’ll assume that he invests all the profits in the funds.  For a moment we’ll also posit that he never markets to any other investors.  The summary data is displayed in the table labeled “What Success Looks Like Without Marketing After Ten Years.” After ten years, he’d have $1.4 billion in assets under management, and 62% of those assets would be his own capital.  Of his $874 million in wealth, $466 million (53%) would simply be the growth of his original $100 million stake.  However, $408 million (47%) would be due to the appreciation on the after tax profits reinvested in the business.  By year ten, the business would look like Mr. Levine’s model; $133 million (86%) of the business’s earnings would be derived from the manager’s capital, although much of that capital was derived from reinvesting profits.

A quick note on performance:  as you can see in the table, the manager earned 25% on his invested capital since he doesn’t pay fees, while the investor only earns 18%.  The difference, of course, is due to fees and incentives, which are paid to the manager.  If you added those fees and incentives, net of expenses and taxes, to the manager’s return, his capital was compounding at just north of 30%.    What a great business model for the hedge fund manager.

What Success Looks Like Without Marketing After Ten Years
(all figures in millions)

Let’s move to the more likely business scenario.  With his uncanny ability to generate consistent 25% returns, our ex-Goldman traders decides to market his fund.  In year two, he attracts $2 billion in new client assets and in year five he generates $4 billion in new business.  I’ve also assumed his pre-tax expenses rise to 40% as a result of paying for marketing and client service.  The summary data is displayed in the table entitled, “What Success Looks Like With Marketing After Ten Years.” After ten years, he’d have $23.6 billion in assets, including $6.2 billion of his own capital.  Note that $5.7 billion (92%) of his wealth is derived from the appreciation on the fees and incentives generated by the business (after taxes and expenses) over the years.  In year 10, the Goldman trader would be #5 on Alpha Magazine’s list with $1.45 billion in earnings.  The 2 and 20 component would only generate  $355 million, and the remainder would be a return on the manager’s capital.

What Success Looks Like With Marketing After Ten Years
(all figures in millions)

I’m sure there are flaws in my model.  However, I believe it captures the key drivers that fuel the growing wealth of the world’s wealthiest hedge fund managers.  The model also shows that when a hedge fund manager decides to shed outside clients (e.g., George Soros) or is forced to give up clients (e.g., Steven A. Cohen), it doesn’t really matter.  The manager’s capital will continue to generate hundred of millions of annual earnings even though the management fees and incentives have disappeared. 

While financial markets can make investment professionals very wealthy, it is client money that takes a small fraction of these folks far beyond the richest 1%.


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