Why Goldman Sachs Shareholders Don't Get Angry Over High Pay

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There are some reasons to be angry about the huge bonuses Goldman Sachs (GS) employees will get this year. Some view it as a matter of overall justice. Others think it’s wrong for anyone to get rich working at a company that’s taken government assistance. And there’s also the question of incentives; do the bonuses encourage the same risk-taking that caused the crisis?

Just about the only thing you don’t hear is frustration coming from shareholders. They never ask why employees get half of the company’s profits.

Eric Falkenstein has a smart observation on this:

In the first half of 2009 suggested an average employee compensation of $700k per year. In general, GS pays about as much in bonuses they do in profits to shareholders. This suggests those on the ground, making the deals, are able to get about half of the profit.

This is often the case for alpha generators, as for example consider that hedge funds make 2 per cent of assets and 20 per cent of profits. Then over the glory years of convertible bonds from 1994 through 2003 when those funds returned 10 per cent to investors with minuscule volatility, the owners of these funds pulled in about 4 per cent of assets in profits for themselves, while investors received about 4.5 per cent in annual returns above the LIBOR. As one might expect when you have two inputs, equally necessary, the split seems to be near 50–50. That is, in any investment with alpha, you have two things, equally necessary: he who identifies the alpha, and he with the capital. In any particular case the proceeds are split according to negotiating strength, but on average we should expect an approximate equal split, as there appears to be in high alpha strategies (I go over this in my book (of course) Finding Alpha).

The net result is that if you pay these lucky bastards a lot of money, as an equity owner you can make a lot of money too. There are surely a lot of overpaid Goldman employees as you would expect in any large organisation (I know several!), and much of their value comes from Goldman’s alpha: connections, brandname, and monopoly access. Yet on average these people are being rewarded appropriately and if you want a growing economy you have to accept this.

We could see objections to that last part — along the lines of the common argument that Goldman is an extractor of value, rather than a creator (though it’s something we don’t really care to get into for now) — but the general insight about the 50-50 split being common in these situations, explains why the capital providers never seem to be the ones complaining.

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