The Broken Hedge-Fund Model

It's becoming increasingly clear that the standard hedge fund incentive model breaks when a fund plunges in value.

If the value of a hedge fund is rising, then 2-and-20 works as intended: the fund manager gets paid more the more that the value of the fund goes up. And if the value of the fund falls a little, then the high-water-mark system stops the fund manager from being paid twice for getting to the same spot. But if the value of the fund falls a lot, then suddenly the fund manager loses pretty much all of his incentives, things start going rather pear-shaped, and there's a good chance that fund investors will end up getting shafted by their fund manager.

Consider the fight between Carl Icahn and fund manager Warren Lichtenstein. Lichtenstein had a bright idea when his hedge fund -- full of illiquid assets -- faced a lot of redemption requests: he'd take it public, and investors could then sell their investments at whatever price the market put on them, without the fund itself having to liquidate. Investors might have to take a very low price -- but Lichtenstein himself would continue to collect his management fee in perpetuity.

And there's no shortage of fund managers with underperforming funds who have announced that they're going to set up new funds: both John Meriwether and Michael Zimmerman are in the news today planning to do just that, following the lead of Jeffrey Gendell.

In all these cases, investors in the old flagship funds end up getting either liquidated or ignored, while the fund manager concentrates on the new fund where he has a much greater chance of earning a performance fee.

What's more, hedge-fund investors are well aware of this dynamic, and that's one reason why they tend to issue redemption requests when a hedge fund falls more than about 10%, even if that fund has significantly outperformed something like the S&P 500. They know that the high-water mark means their fund manager has lost a lot of his incentive, and/or is now incentivized to take reckless risks in order to get back to the high-water point. So they bail.

I'm not sure how to fix this broken system, but there's clearly something very wrong with the way that things are set up right now. Most likely the total amount of money invested in hedge funds is simply going to shrink dramatically: it was an experiment which didn't work out very well. Which is fine. But anybody interested in seeing the system live on indefinitely will need to come up with some way of ensuring that investors don't get doubly shafted when a fund falls sharply in value.