Long Term Capital Management is well-researched hedge fund for its participation in the market. The essay attempts to tackle issues related to incentives of funds that uses advanced financial methods found in swaps, options, derivatives and risk management.
Are the incentives of the Principals and employees of Long Term Capital Management aligned with the investors?
Long Term Capital Management Investors
Long Term Capital Management investors are majority institutions and wealthy individuals (of less than 4% of fund size).
Compensation is structured into 2 components. First component is base fee (or management fee) of 2% per annum payable every quarter of ½%, of net asset value of fund. Second component is incentive fee of 25% of yearly increase in fund’s NAV above the highest NAV recorded in history of the fund.
Analysis Of Monetary Incentives
The first payment can be viewed as a top premium paid to fund managers who are supposed to be part of one of top fund houses. This incentive is collected irrespective of performance of fund. The fund managers can continue to command top dollars if and only if fund continues to perform, but they can merely give mere bit above market return to continue to qualify base management fee. The downside is that fund could be non-performing without penalty to fund managers.
The compensation model can be holistically viewed as geared towards building up the NAV of fund as the quantum of payment is tracked backed on gross NAV as well as NAV growth. When NAV is small, management incentive is small only 2% of gross NAV, but large incentive to grow fund as change in fund NAV from historic high NAV attracts reward of 25% of the change.
Example, where x is net growth in NAV above previous high water mark, 1 is normalized NAV, then Long Term Capital Management managers needed an annual compounded annual NAV rate of growth at 8.69% for NAV incentives become equal with management incentive.
However, compounded annual growth rate is unsustainable as it is more difficult to make additional NAV due to size, then management fee could take up significant component of payment to managers.
The requirement to beat the previous “high water mark” of the equity on the firm created a problem. The investment strategy of the fund included lavish use of leverage, averages at 22.5 times. When equity grows, leverage increases the fund’s quantum of participation in the market. The fund experienced increasing difficulties in moving money in the market without causing market reaction. The report mentioned that Long Term Capital Management participation in market has grown so large that Long Term Capital Management moved from a market participant to a market maker or liquidity provider. Hence, by leveraging on equity, Long Term Capital Management could have hit a limit to its compounded annual growth rate.
Specific Behavioral Incentives
Investors allowed Long Term Capital Management staffs to make additional investment in the hedge fund while investor’s are generally disallowed to make additional investments. Long Term Capital Management principals had elected to reinvest into the fund nearly all their after tax earnings. Long Term Capital Management employees (nearly all) had chosen a deferred compensation scheme, where payment is deferred and is linked to returns of the fund.
Analysis Of Behavior
It is possible to view that the principals demonstrated confidence in Long Term Capital Management by adding positions into the fund with own earned money on a regular basis. On the other hand, the principals are diluting the shareholding of existing investors.
The deferred compensation scheme to employees serves as a “carrot” to ensure that employee’s personal profit targets are aligned to the investor’s target, at least in the medium term, by the number of years of the deferred compensation. While details of deferred compensation was not defined, generally staffs will ensure that fund performs during their tenure within deferred period, but nothing to stop current staff from taking risk to cause fund to “blow up” in the long term.
Such incentive models are widely used in fund management like hedge funds and mutual funds etc. However, where compounded annual growth of fund is large, fund will reach size limit as there could be no sizeable counterparties to take on opposing positions in the market of their specialization. This is further magnified by its lavish use of leverage.
These incentives seemed to work the fund generally increased from 1.0 to 2.68 (indexed of net performance) from Mar 94 to Aug 97 compounding return of 1.325 times per annum over approximately 3.5 years of Long Term Capital Management analysis period.