Let me explain. Like almost everything involving hedge funds, we’re talking about money. Hedge funds are largely unregulated investment pools consisting of money from wealthy clients, be they individuals or institutions, such as pension funds or college endowments. Think of hedge funds as mutual funds on steroids. They’re free to do all sorts of high-risk, high-reward things, such as speculating in currencies and committing huge portions of their assets to a single investment, which mutual funds aren’t allowed to do. And unlike mutual-fund managers, who generally get a fixed percentage of the fund’s assets as a fee, hedgies work for a piece of the action. Their typical fee is 1 and 20: 1 percent of their funds’ assets and 20 percent of the profits that the fund makes.
While the annual fee can be substantial–1 percent of $1 billion is $10 million–it generally covers little more than office expenses, overhead and maybe a six-digit salary to some key employees. The real money hedgies make is their piece of the profits.
Here’s where the high-water mark comes in. Unless a hedge fund’s investors are totally clueless, the manager doesn’t collect 20 percent of what the fund makes in any year. The manager gets 20 percent of the profits above the previous highest level–the high-water mark. Say you start with $10 million and run it up to $100 million. If the fund then goes into a swoon and sinks to $80 million, it’s got to claw its way back to $100 million before the managers start sharing in the profits again. Unlike your typical troll-like corporation that reprices stock options if a stock’s price falls but lets option holders cash in if the price rises, hedgies can’t recut their deals with investors to “heads I win, tails I don’t lose.”
Now let’s do a little math. Say your fund has fallen 35 percent from its high, not an unusual event this year. That shrinks you to $65 million from $100 million. To get back to $100 million, you’ve got to make 54 percent: $35 million on a base of only $65 million of assets. If the market isn’t going your way, it could take you years, if not forever, to make that 54 percent. Until you get back to the high-water mark, you’ll be working for the hedgie equivalent of slave wages. In which case, if you’ve been running money for years and your 20 percent cut has made you very rich, there’s an enormous temptation to say, “What do I need this for?,” get out of the management business, head for the beach and manage your own money. Even if your investors never see the high-water mark again, you don’t have to give back any of the fees you’ve already earned.
By now, if your mind is only somewhat devious, you’ve figured out the obvious dodge: fold up the old fund, whose high-water mark is hopelessly out of reach, and open a new fund where you’re starting fresh. Which brings us to the guys who used to run Long Term Capital Management. You remember LTCM, don’t you? It’s the giant hedge fund that hit the rocks in the fall of 1998 and was kept afloat by a rescue orchestrated by the Federal Reserve Board. LTCM’s investors took a huge haircut, which means the managers had to make a zillion percent to return to the high-water mark. Good luck. Especially since the rescuers intended to close the fund and get their money back, not shoot for high returns.
As LTCM liquidated, the rescuers told the hedgies they could start a new fund. Showing how short Wall Street’s memories are, investors actually put money into it. Old LTCM investors are being offered a far better fee deal than totally new investors–but running a new fund is still a better deal for LTCM’s managers than the old high-water mark would have been.
So have a good time on the water this summer. And when you see the tide come in, think of all those beached hedgies. They’re probably still richer than you are–but you don’t have nightmares about high-water marks.
