In this article I discuss with Michael Beart (FCA), founder of Larkstoke Advisors, the commercial drivers impacting Portfolio Manager compensation packages at hedge funds at various stages of evolution. I believe this is a useful insight for hedge fund CEOs or Business Developers seeking to engage internal Portfolio Managers given the ongoing competition for talent/alpha generators. Whether you are looking for benchmarks or seeking informal advice in this area then please get in contact.
By way of reminder, compensation structures link directly to Condition A in the salaried member legislation. An additional 13.8% National Insurance charge can be mitigated if 20% or more of the total expected amount payable by an LLP to an individual member is neither:
- fixed, or
- variable, but not with reference to the overall amount of the profits or losses of the LLP, or
- is not, in practice, affected by the overall amount of those profits or losses.
The test is forward looking and is to be applied on the basis of the parties’ reasonable expectations, typically at the beginning of the accounting period, when a new partner joins, or there is a change to the partnership sharing arrangements in place.
In what scenarios do investment managers look to enter profit share arrangements?
It depends largely on where the business is in its life cycle. Start-ups will often offer relatively junior staff a share in overall profits as an incentive for talent attraction and retention. Single strategy managers that are still in the growth phase may also adopt the same approach. Established businesses are less likely to offer profit shares, particularly where they have a diverse range of products that can drive profits. The exception to this may be if the business is entering a new growth phase, are seeking to hire exceptional individuals or in recognition of long service for existing personnel. This could also feature in succession planning. Failure to demonstrate a flexible approach to accommodate ‘rising stars’ or consistently high performers may ultimately result in them either going alone or joining a competitor. Constructing incentives to remain or disincentives to leave through, for example, compensation deferral schemes, are a balancing act that requires careful consideration.
What is the typical profile of individual with a profit share?
Beyond the founders, it is typically unlikely to extend beyond members of the executive committee and portfolio managers but, as previously mentioned, start-ups need to provide innovative ways of attracting key talent in their formative years, as such in these scenarios profits may be shared more widely.
With the exception of founders, what kind of terms / metrics would a new PM joining a firm expect to negotiate on?
Typically a share of either fees or profits generated by their strategy. They are likely to have a base salary which can vary significantly but typically lies in the £150k-£250k bracket. This is simply there to provide day-to-day cashflow for the individual and may be taken as a quarterly drawdown in line with performance fee calculations. The bulk of the remuneration would be linked to performance. The ‘house’ return would typically make up at least 50% of the profits, but the precise deal will depend on the relative strength of the negotiating parties.
How does the existence of a pass-through fee structure impact the deal for a new PM?
The PnL percentage allocation to a PM will be negotiable but the ultimate level is pre-determined by whether the fund operates a pass-through fee structure. Some of the larger multi-manager platforms are able to offer Lead PMs in excess of 30% whereas those operating a netting risk model typically won’t exceed 15%. According to a recent Barclays analysis, over the past 3 years, despite the additional costs borne by investors, multi-managers operating an expense pass-through model produced after-fee returns of 11.8% versus 6.4% for peers without pass-through billing.
How commonplace is it for investment managers with multiple strategies to share overall profits, as opposed to segregated profit pools?
The majority of managers operate an ‘eat what you kill approach’ whereas others take a more holistic approach. According to a survey by Preqin, the global hedge fund research and data provider, 61% of hedge funds use a profit-sharing arrangement. Of those funds, 42% use a single profit pool for all strategies, while 19% use separate profit pools for each strategy.
How would you approach transitioning between these methodologies?
With great care. A hybrid solution may be the only feasible way to achieve this. However, whatever approach is taken it is important to stress test for a range of scenarios.
What cache do individuals attach to be a ‘partner’ in an asset management business?
The contractual terms and conditions for each new hire/engagement are negotiated and agreed on a case by case basis. There is no one size fits all. Ultimately the asset and budget allocation, partner or employee designation and reporting line comes down to the value the business places on a PM, as determined by a verifiable, successful track record. For some, being made a partner or not is a deal breaker, but more often than not the attractiveness of the commercial aspects will determine the success of any negotiation.
Have you seen a shift in recruitment patterns across the industry in recent years?
The relative success of CTA/Systematic Macro during the global financial crisis of 2007/8 saw significant investor inflows into those strategies resulting in an explosion of hiring, specifically in the drive to diversify systematic strategies, over the next decade. The more recent outperformance of quant, macro and multi-strat strategies has resulted in the larger discretionary funds allocating significant resources to the build out of more advanced technology infrastructure, increased automation and an increase in systematic and semi-systematic strategies. Quant, systematic and data driven trading which was once niche, is becoming all pervasive as discretionary in addition to systematic managers, seek to increasingly diversify their strategies and seek new sources of alpha.
Final thoughts…
Compensations structures form the foundation of every investment management business. They are core in setting the commercials and culture within the firm, but also need to evolve with the business – what works at the start-up phase does not necessarily work well for a mature business. Profit sharing arrangements may need to be overhauled as managers diversify their product range / launch new strategies. Equally as founders near retirement thought needs to be given to succession planning and how the next generation will be compensated. The tax implications need to be understood, particularly if there is a risk someone will pick up a larger tax bill as a result, but fundamentally the tax analysis should not be leading the discussion.