The good news for hedge fund firms is that 2009 has been, so far, a significant improvement over 2008. Most hedge fund managers are up on the year. The bad news, however, is that many remain well below their high-water mark.
A high-water mark ensures a fund manager doesn’t get paid for poor performance. He or she must get the fund back above the high water-mark in order to be compensated. And with no management fee to give out, paying the executives, portfolio managers and analysts that produced the returns is no easy task. At many hedge funds the coffers are empty.
Every year, as bonus season draws near, I receive countless calls from hedge fund analysts and portfolio managers asking me what they are worth in salary. How do I compare to others at my experience level? How much of a bonus should I expect this year? I hear from numerous hedge funds’ COOs and CEOs asking me how much other funds are paying their people and what compensation formula or methods are they using. This year, the anxiety is starting even earlier than usual.
No standard exists in hedge fund compensation. Managers, typically, however, follow one of two overreaching methods when compensating investment team members who are not partners: the formula based incentive scheme, where staff are paid according to a previously agreed formula, or the discretionary incentive seem, where bonuses are paid out at the sole discretion of the senior or managing partners.
Many investment professionals I work with prefer the formula model. It helps to know during the year roughly what to expect, rather than having it come as a complete surprise. One complaint among hedge fund employees is “why should I worry and wait until one day in January to get paid what my boss feels is appropriate, when I can go to a competitor who uses the formulaic method?” In recent years more firms have shifted to the formula model, but for many firms the discretionary approach still makes a lot of sense.
One of the most admirable hedge funds I know, due to stellar performance and enormous asset growth, since 2002 has nearly zero staff turn-over. Year in and year out, they seem to have a house full of happy people, all of whom are receiving discretionary bonuses. They simply take care of their people.
In either case, after the 2008 free fall, something had to be done for hedge fund managers that did not have the funds to pay employees. The problem is complicated further by funds that are doing well in 2009, but remain under water. The solution I am seeing more and more of these cash-strapped funds adopt is ghost shares.
A ghost share works like an equity option. Typically ghost shares vest a year to two years after issuance. It is basically an I.O.U. A large hedge fund that I consider more creative than most, which had a rough 2008, awarded each of its employee’s points, or ghost shares, according to their ranking. Their ranking comes from their performance track record, years with the company, and level of experience and responsibility. The ghost shares serve as value towards claiming future profits from fund performance above its high water mark. While it was under water last year, this client has already exceeded its high water mark in 2009.
If a fund exceeds its high-water mark, and returns profit, by the time the ghost shares vest, everyone shares the wealth according to their assigned number of ghost shares. Although presumably they will earn less as they may be paying people back from previous years, which poses another challenge.
But, if the fund fails to perform, their ghost shares – will be worth nothing. Is it a gamble? Sure. But for those who believe in the fund they work for, or the fund they are considering moving too, can turn things around it is often a gamble worth taking. Moreover, hedge fund professionals have to work somewhere. And with so many funds fighting the same deluge, a deal like this can seem like an attractive option.
There is, of course, a more attractive alternative to ghost shares available to funds that have no or little management fee to spread around: true equity. Most investment professionals want to be a partner, or run their own show. They didn’t pull all nighters at Wharton studying to be second best. These people are the elite of the elite, the best of the best. And they want to own a piece of the business.
But partners are often hugely reluctant to give up an equity stake – after all, ownership is where the true money is made, and one day we may get back into an environment where a hedge fund can go public or be sold for a heady sum. So they tread cautiously.
For a managing partner, there is a balancing act between diluting partnership and watching talented investment professionals walk out the door if they feel they are not properly compensated with ownership.
So where does this leave us? Many professionals I talk to are hoping that ghost shares will be a temporary haunting. But for now, the question many hedge fund professionals will be asking themselves come January is – do you believe in ghosts?
John Pierson is the founder of 10X Partners a hedge fund recruiting firm based in New York. For more information, visit the company Web site at www.10xcap.com.
