It’s common for people to describe Wall Street banks as “giant hedge funds,” as a shorthand way of saying that they took a lot of risky bets.
That’s a fine descriptor in a limited sense, though it ignores the reality that hedge funds (as a class) have done much better than just about anyone else at weathering the financial crisis.
Sure, some have blown up — as they are prone to do in any environment — but they haven’t been a source of systemic risk, nor have they lost their investors boatloads of money, by and large.
Riffing on the controversy over Citigroup’s (C) Phibro unit, and its $100 million star trader, Roger Ehrenberg notes that real hedge funds tend to be more sophisticated than normal banks when it comes to comp:
Like them or hate them, the hedge fund compensation structure has many positive attributes that can be instructive for Wall Street (especially when the lion’s share of the trader’s net worth is tied up in the fund):
- Diluted agency impacts. While hedge funds generally involve running large amounts of OPM, when much of a trader’s net worth is invested in the fund their risk-taking directly impacts their financial wellness. This is not the case on Wall Street, where traders don’t get to actively participate in their strategy on an ongoing basis.
- Compounding capital. As Wall Street traders get paid out on current year results, there is no concept of compounding gains from current year returns applied to prior years’ capital balances. This is a huge disincentive for prudent risk taking and an emphasis on making profits in all market environments. It encourages a “swing for the fences” mind-set on Wall Street since each year stands on its own. Hedge funds, conversely, permit capital balances to accrete upward and benefit from lower levels of volatility in their IRRs.
- Long-term perspective. Since hedge fund traders are generally only able to withdraw a small amount of their capital each year, they have strong alignment of motives with their investors. Sure, while it can be argued that a hedge fund trader can take on huge risk, try and kill it and simply close down and start again if it fails, the fact that significant partner capital is wiped out with poor peformance makes this a less-than-likely outcome.
Personal investment in one’s strategy. Compounding capital. Long-term perspective. This sounds like a much better model for Wall Street, and can also serve as a vehicle for substantially increasing transparency and more accurately measuring performance.
Ehrenberg’s whole argument is compelling, and he arrives at a very similar conclusion to that of law professor Larry Ribstein, who recently discussed Michael Lewis’ Vanity Fair piece on AIG:
What I find more convincing is this little excerpt from Lewis’s article:
The typical hedge fund or private-equity fund has to schlep around and raise money all the time, and post collateral with big Wall Street firms for all the trades they do. The traders at A.I.G. F.P. had essentially unlimited capital on tap from the parent company, along with the AAA rating, rent-free.
Hedge funds have to “schlep around and raise money all the time” because their investors, unlike corporate shareholders, do not give them permanent capital. While corporate shareholders can sell their shares to other investors at current market prices, sale prices are discounted by the market’s evaluation of current management. Hedge fund investors, by contrast, have rights to get their money back from the company.
In other words, it’s the “capital lock-in” of the corporate structure – which some commentators have credited for the rise of modern capitalism, that is to some extent responsible for its recent fall.
This should be fertile territory for regulators and others to explore, as a new Wall Street is re-imagined. How can banks with trading operations more properly align incentives, and get past the pitfalls of capital lock-in?
Unfortunately, if we’re only going to think of hedge funds as big risk takers with greedy compensation, we’re likely to move in the other direction.
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