Topic: the economics of running a hedge fund
How much money do you need to manage in a hedge fund?
Let’s say you manage to raise 100 million dollars from friends and family. How far would that get you?
Fixed fee: 1% of 100m = 1 million dollars a year
Performance fee: 20% of whatever your “outperformance” is, which depends on what you’ve promised, and if you have some catching up to do relative your high water mark or other promises.
We’ll leave that part for later, since you can’t really count on reliably amassing performance fees. On average fund managers don’t add any value relative their benchmarks, so on average fund managers can’t expect to get any performance fees.
Staff: 3 people (you, a partner, and one more for research and administrative work) at 150k$ each a year, which would be considered the bare minimum for running a 100m$ fund and attracting decent talent. 3*150=450k$.
In Sweden the cost of 150k$/yr amounts to less than 10k$/month (95k SEK) per employee before taxes but after social services fees. The take home pay for the employee after personal taxes will be around 5.5k$/month (55k SEK)
Travel expenses (eight trips per employee/yr to attend conferences, visit important companies, clients etc. NB just two trips per quarter, and at a cost of just 2k$ per trip for a few hotel nights, airplane tickets and expenses): 8*2k$*3 = 50k$
Premises: 50k$ per year for an average office in the CBD district
Equipment, computers, mobile phones: 2k$/yr per employee = 2*3=6k$ (could just as well be rounded to zero)
Information and trading systems, 3rd party research: 50k$ per employee = 3*50 = 150k$ (NB: the cost could easily run to twice that)
Regulatory fees, expenses, insurance, securities custody etc.: 0.1% of AUM = 0.1%*100m$ = 100k$ (could easily be twice as much)
Total costs: 450+50+50+6 (rounded to zero)+150+100 => 800k$ (or up to 1m$ depending on information costs nd regulatory expenses)
Income before performance fees and taxes: 1 000k – 800k =200k$ (or as little as zero)
Income after taxes (25%) per employee (3): 200 * (1-25%) /3 =50k$ (or zero)
Bonuses and dividends
The above example leaves just about no room for bonuses, and thus little chance of retaining high quality employees (including yourself). In addition if you can’t perform good enough for a performance fee, even your friends and family will jump ship before long.
Let’s say you outperform your threshold by 5-10 percentage points, how far would that get us?
Performance fees for 5-10pp outperformance: 20%*5%*100m = 1m$, and 20%*10%*100m = 2m$. That would leave 750k – 1.5m$ after taxes for distribution to the owners, or a decent 250-500k$ each in dividends that year. Now, I wouldn’t get my hopes up too much for repeating such a performance year after year.
In addition you’d run the risk of falling behind during difficult years. While struggling to catch up there could be periods of no performance fees in sight for years at a time. What if your fund lost just half of what the market lost in the crashes of 2002 and 2008? Even with such stellar performance, you’d still need 3-5 years per crash to catch up before earning variable fees again. Most actually give up altogether, after losing more than 20% from their high watermark.
Even a 100m$ hedge fund is more or less a break even operation, where its founders or employees get a basic annual compensation but no frills. The upside consists mostly of soft factors, like independence and freedom, plus the potential for landing a few lucky big years before enduring a crash. If, however, the order is reversed they get nothing extra.
Please note that if you simply had 5m$ of your own and made a 10% return, without the hassle of running a hedge fund (clients, authorities, regulations…), you’d net a clean half million dollars for yourself. In Sweden that would be after taxes, since personal capital gains are tax free here.
Running a billion dollar hedge fund or bigger is a whole different game. We, e.g., managed our +1B$ fund with more or less the same crew as when it was a tenth that size.
At fixed fees of +10m$ a year and performance fees of typically at least as much, and total costs before bonuses, taxes and dividends, of around 2m$, there was plenty to go around for us four principal owners. Now, try a 10B$ fund on for size in terms of its economics!