Hedge fund earnings
A public-company chief executive officer has two main ways to make money from her job each year:
- She gets a paycheck, or rather a pay package (salary, bonus, stock options, etc.), in which her company pays her a negotiated amount for her services; and
- She owns stock in her company, and if she does a good job the stock goes up and she is richer.
A company could go with all one or the other, and some companies do: A family-owned company might hire an outside manager, give her no equity, and pay her purely in cash; a startup founder-CEO might take no salary and be motivated solely by her part-ownership of the company. But for most normal public companies, it’s a mix of the two.
It is a convention, in discussing public-company executive compensation, to talk exclusively about #1 and ignore #2. The compensation package—the amount of stuff the company affirmatively grants her each year for doing her job—counts as “pay”; the amount that her wealth goes up from owning stock in her company usually does not. This is mostly just a convention, a generally accepted way of using words, and it is not universally followed, but there are some pretty good reasons for talking this way. It roughly tracks how tax law thinks about income (getting a check is income; having your stock go up is not). If the CEO quit her job, she would still own her stock and would thus still profit from the stock going up (though of course it might not go up as much), so isolating #1 focuses on her income that is purely job-related. And if you are interested not in her income but in the company’s expenses—not “how rich is the CEO” but “how much does she cost shareholders”—#1 is a reasonable approximation of that, while #2 is not really an expense at all.
But you can’t get carried away and assume that this convention represents the entire truth of the matter, because then you might start thinking things like “wait, Warren Buffett only makes $100,000 a year for running Berkshire Hathaway Inc.? He’s so good at stock-picking; I should offer him $125,000 and have him come work for me.” (Or: “Mark Zuckerberg only makes $1 a year for running Facebook Inc.? I should offer him $3 to stop.”) No, come on, these people have vast amounts of wealth tied to the performance of their companies; Warren Buffett gets, in effect, a base salary of $100,000 and a bonus of 17 percent of the value he creates for Berkshire Hathaway shareholders. In good years, that comes to billions of dollars: Berkshire was up 23 percent in 2016, handily beating the S&P 500, and Buffett personally got about $14 billion richer. In mediocre years, it … also comes to billions of dollars: Berkshire was up 2.8 percent in 2018 (also handily beating the market, to be fair), and Buffett’s take came to more than $2.3 billion. That is not formally part of his pay package, but it is surely part—virtually all—of the economic reward that he receives for doing his job each day.
I feel like we don’t quite have a convention for how to talk about hedge-fund-manager pay, but to the extent we do, it’s the opposite of the public-company convention: Every dollar of increased wealth that a hedge fund manager gets from her hedge fund, whether it’s a fee paid by investors or returns on her own investment in the hedge fund, tends to be discussed as “pay.” There is nothing particularly wrong with this convention either! Again, it is just a question of how you use words, and there are good arguments for talking this way too. For instance, if you want to answer questions like “how many world-historically expensive homes can Ken Griffin buy,” focusing solely on his fee income, rather than his investment income, would be a mistake. It’s all money. More broadly, if the question that you want to answer is “who is really good at running a hedge fund,” a quite plausible scoring mechanism would be to rank managers based on how much money they have made—both as a manager and as an investor—from their hedge funds. High investment returns mean that you are good at investing; high fee income means that you are good at gathering assets and extracting fees from them; those are the main skills, so why not add them together to get your score?
But, again, you can’t get carried away. If you are counting the manager’s own investment returns as part of her income, which is perfectly reasonable and relevant, you can’t also pretend that the number you get is all fees. And so every year Institutional Investor’s Alpha publishes a list of the world’s “best-paid” hedge fund managers, and every year Alpha quite prominently explains that it is counting both fee income and investment returns, and every year people publish commentary on the list saying essentially “I can’t believe all of these hedge-fund managers got paid so many millions of dollars of fees despite not beating the market, what a grift,” and every year I publish a post saying, well, wait, actually, the income seems to be mostly investment returns on the managers’ own portion of the fund, meaning that it’s not fee income at all, and then we all agree to meet up next year and have the same conversation again.
Today Bloomberg published its first ranking of hedge-fund-manager earnings. It too ranks managers based on total earnings, combining fees and investment returns; again, I think this is perfectly sensible, depending on what you want to measure. Jim Simons of Renaissance Technologies tops the list for 2018, making $1.6 billion in “total hedge fund income.”[1] Ray Dalio of Bridgewater Associates, Ken Griffin of Citadel, and John Overdeck and David Siegel of Two Sigma round out the top 5.
But Bloomberg also disaggregates the numbers:
To compile the ranking, Bloomberg broke out “total income” figures to show estimates of dividend income and return on personal assets. Dividend income is our calculation of the share of performance fees that the manager takes home as owner of the hedge fund. Return on personal assets is our estimate of how much managers earned on their own cash invested in their funds.
(It does not count management fees, assuming I suppose that those are mostly spent on staff and expenses.) And there’s a little bar chart breaking down the splits. Most of the top 10 made the majority of their 2018 earnings from investment returns, though fees were usually a substantial contributor. Not always: “Michael Platt of Bluecrest Capital Management returned 25 percent, although hedge fund investors didn’t benefit after he kicked out clients,” and his $680 million of earnings is all investment returns.[2]
But from Bloomberg’s chart, the top five total earners were also the top five fee earners, and in almost the same order,[3] which is sensible but also a bit boring. Really 2018 was an anomalously straightforward year for hedge funds: The stock market was down, most hedge funds did poorly, but the hedge funds that did wellwere disproportionately the big, old, historically successful ones. If you have run a gigantic hedge fund successfully for a long time, and it did well in 2018, then (1) you collected a lot of performance fees on your gigantic pot of assets, and (2) you had a lot of your own money in the fund, and it went up. That’s not how it works every year, but it is kind of how it’s supposed to work.
Revenge-driven M&A
My usual role around here is to tell you about interesting financial things that have happened, or to argue that boring financial things that have happened are actually interesting, or at least to make fun of dumb financial things that have happened. Occasionally though, we indulge in a bit of speculative fiction and talk about how nice it would be if some really interesting financial thing had happened, even though it didn’t. Here is a Vanity Fair story about Jeff Bezos, an extramarital affair, nude selfies, politics, the National Enquirer, etc., but I just want to focus on this amazing passage about what might have been:
One option even included Bezos buying A.M.I.—not such an outlandish consideration given the seriousness of the breach and the fact that, for Bezos, the price of the tabloid company is essentially a rounding error—to find out the source of the leak. “We discussed the possibility to buy A.M.I.—not to kill the story, but to find out the source. They said that’s not a bad idea. We discussed numbers and the name of the LLC that we’d use. It would be called BOBO LCC”—short for Lauren’s helicopter filming company, Black Ops, and Bezos’s space company, Blue Origin—“that’s the level of detail we went into.”
Quick explainer: The National Enquirer, a tabloid owned by American Media Inc., acquired some embarrassing photos of Amazon.com Inc. founder and squazillionaire Jeff Bezos, and of Lauren Sanchez, with whom he was having an extramarital affair. Sanchez’s brother Michael has been accused of leaking the photos to the Enquirer, though he denied that in the Vanity Fair article. (“I’m not saying I didn’t do something,” he says, though.) The quote in that paragraph is from Michael Sanchez, and he is describing a discussion that he had with Bezos and Lauren Sanchez last month after the National Enquirer started asking about their affair. One possibility they apparently considered was for Bezos to buy AMI, not kill the story (???), and I suppose, once in possession of AMI’s records, find out who leaked the information to the Enquirer.
Now:
- This didn’t happen;
- The person saying that it almost happened is not necessarily an unbiased source; and
- AMI is not a public company (though it is owned by a hedge fund), so a hostile takeover might not have been possible anyway.
But I think I am justified in saying: Never mind all of that, let’s just imagine if it had happened! Imagine if a tabloid owned by a public company threatened to publish nudes of Jeff Bezos, and Jeff Bezos just lobbed in a hostile bid—funded by his personal fortune, not by Amazon—to buy the publisher at a premium. He would have to put out a tender-offer disclosure document, and in the “Purpose of the Offer” section he would just write “revenge,” and in the “Plans for the Target” section he could write “I am going to find out who leaked my nudes and exact ruinous vengeance on them, and that’s it, I haven’t thought about any other plans.” And then management and Bezos would make their respective cases to shareholders: Management and its investment bankers would put together a detailed slide deck explaining their long-term business plans and financial projections, while Bezos would put out two slides, one saying “Vengeance Will Be Mine” over that picture of him looking buff in a vest, and the other printing the price of his all-cash offer in a really big font. And then management’s investment bankers would issue an opinion saying that Bezos’s offer was inadequate and he’d be like “fine double it then, I don’t care, how much could a newspaper publisher possibly cost, do you know how rich I am.” And politicians would rail against short-termism in corporate America, and point to the fact that valuable productive companies could be bought by corporate raiders just to strip them down to a single piece of information, and Bezos would be like “yes that’s true but have you considered how much money I have.”
And then he’d win, of course, and he’d gain control of the company and install his board, and they’d appoint a new Bezos loyalist CEO, and Bezos would show up at the office and be like “okay who’s my leaker,” and he and the new CEO would call every employee in one by one to grill them until someone told him what he wanted to know. And then he’d go, you know, write a withering blog post about the leaker or whatever his plan was.
But then there’d still be a whole company there! Like he bought this company just to ask one question and exact his amazing personal revenge, but meanwhile there are all the reporters and editors and printers and people who work in accounting, and they all show up to work to be grilled about the leaker, but then after that, like, they just … go on producing a tabloid … for an owner whose … only interest in it has passed? Like I guess he could sell it then, for some fraction of what he paid for it, but what’s the fun in that? Or he could shut it down out of spite, fine, but that seems wasteful. Maybe he could keep running the tabloid, but dedicate it exclusively to publishing mean stories about the person who leaked his nudes.
Anyway corporate finance is amazing, but the point here is that it could so easily be so much more amazing.
Oh also Amazon won’t be building a big new office in New York.
Revenge-driven M&A valuation
The way appraisal lawsuits work is that a company agrees to buy another company, and pays for it, and some shareholders of the target vote against the deal and sue the buyer for more money. They go to a Delaware Chancery Court judge and argue that the target was worth more than the buyer paid for it; the buyer argues that it was worth what it paid, or even less. And then the judge decides how much it was worth and orders the buyer to pay that amount. It’s kindof weird! A lot of corporate finance is, you know, willing buyers and willing sellers, negotiated transactions, etc., but then at the end of a merger, you go to a judge and he gets to decide if the market was right or wrong.
The way he decides is mostly that each side has a valuation expert to say how much the company was worth, and then the judge makes a decision about which one was more persuasive. These valuation experts tend to be finance professors, hired by the parties through economic consulting firms, who do discounted cash flow analyses of the company to come up with their values; the judge will generally take the more compelling DCF as a starting point for his own valuation.
You might expect there to be a sorting process in which the plaintiffs hire an expert who believes that the company was undervalued and the defendants hire an expert who doesn’t. Or yes fine fine fine you might instead expect there to be an entirely cynical process in which each side hires an expert who doesn’t believe anything, but who says whatever they want for a fee.
But it could be worse! When Verizon Communications Inc. bought AOL Inc. in 2015, some shareholders sued for appraisal. Last year they lost that lawsuit, when Delaware Vice Chancellor Sam Glasscock III ruled that the fair value of AOL was $48.70 per share, a bit below the deal price of $50. The vice chancellor wrote at the time:
The Petitioners hired a well-qualified academic, Dr. Bradford Cornell, a visiting professor at the California Institute of Technology, as their expert witness. Cornell performed a financial analysis, and concluded that the fair value of AOL stock was $68.98 per share. For reasons not necessary to detail, however, the Respondent questioned Dr. Cornell’s impartiality in this matter, and the Petitioners seem content to use the DCF model presented by the Respondent’s expert as a starting point for my analysis.
Oh but no, those reasons are necessary to detail, and a few weeks ago the shareholders detailed them, in a new hilarious lawsuit against their own expert:
What [Cornell] failed to disclose was that Cornell had only taken on the engagement for Plaintiffs [i.e. the shareholders] to satisfy an admitted “grudge” he held against Plaintiffs’ litigation opponent [i.e. Verizon], which had spurned hiring Cornell in favor of a competing testifying expert. While trying to solicit Plaintiffs’ litigation opponent, Cornell expressed negative views about the strength of Plaintiffs’ case. Plaintiffs and their counsel knew none of this when they retained him.
When Cornell’s undisclosed communications surfaced in the midst of the Appraisal Action—after Plaintiffs had disclosed Cornell as their expert and expert reports were issued—the consequences for Plaintiffs were devastating. The disclosure of these communications effectively destroyed Cornell’s testimony, which forced Plaintiffs to essentially abandon him as their expert …
It seems that Cornell (who is a visiting professor of finance at Caltech) pitched Verizon on retaining him as an expert, and allegedly sympathized with Verizon over email about “what a nuisance these [appraisal] cases can be.” But they went with his colleague/competitor/frenemy, Professor Daniel Fischel, who was associated with the same economic consulting firm as Cornell. So Cornell switched consulting firms and pitched his services to the appraisal plaintiffs, but not before sending Fischel this email[4]:
Dan,
Like you I tend to bear grudges. And though I see you as perhaps the best general expert witness in the country, when it comes to appraisal, particularly for tech companies, I think I am uniquely well qualified. So when Verizon/Wachtell chose you without even talking to me further that leads to a grudge against them.
Consequently, I have had some conversations with plaintiffs. …
Later he allegedly told Fischel that his “main concern is that plaintiffs have a [expletive] case (that is not based on conversation just what I have read online) so I will have to be careful to avoid letting my grudge lead to a situation where I threaten my reputation.” Well: oops!
Anyway there are absolutely no broader lessons to be learned here[5] and I am telling you all of this out of pure gleeful cynicism. I had a professor in law school whose theory was that any bitter lawsuit over seemingly trivial stakes was really about a love triangle, but it is pleasing to find that a high-stakes litigation over a multi-billion-dollar merger could turn on a valuation expert who was miffed that the other side didn’t hire him.
Santander
We talked the other day about how Banco Santander SA did not call its Additional Tier 1 Capital securities when investors expected it to, leaving those investors outraged and stuck holding securities worth, um, 98 cents on the dollar. I was fine with all of this: Santander had an absolute right not to call the securities, and taking the holders’ concerns seriously would undermine the usefulness of AT1 securities as bank capital. “I struggle to find any reason to sympathize with the investors here,” I wrote.
But I neglected to mention one actually decent reason to sympathize with them, which is that Santander had just gone out and raised another AT1 security days before the expected call date on this one. If you were an investor in Santander’s old bond, you might reasonably have thought that Santander was raising the new AT1 to pay to retire the old AT1, and you might have participated in the new AT1 deal expecting that you’d quickly get some money back from your old AT1. Santander didn’t exactly say that that was the plan, but it was a reasonable guess, and if you thought that then you got played. So, fine, a little sympathy.
One aspect of the new AT1 that particularly made investors expect a call of the old one is that the new AT1 had a short settlement cycle, meaning that Santander would get the cash from the new offering a bit quicker than it normally would. Investors sensibly thought that this was so that Santander would have the cash in time to pay off the old AT1. But in fact that guess was wrong, for this very strange reason:
The bond also had an unusually short settlement date of two days, meaning that Santander would have the money in its hands last Friday — which investors believed was the bank’s deadline for calling the coco. This is because a notice had to be filed 30 days before March 12, which fell on a Sunday.
But the bank then told investors that they actually had until Tuesday February 12 to make a decision. This is because the bank had legal advice that 30 days should be interpreted as a month, disregarding that there are 28 days in February.
None of this actually mattered, in the end, since Santander never exercised the call. Still: what? When bonds don’t work out for investors, in ways that are explicitly allowed by the documents, it is tempting to say—and I often succumb to the temptation—“hahaha, that’s on you, you should have read the documents.” Here, for instance, Santander’s AT1 explicitly said that Santander never has to pay it back, though it could at its option decide to pay it back this month; investors who interpreted that to mean “Santander will definitely pay it back this month” were, I insist, only deluding themselves. Read the documents!
On the other hand, if you did read the documents, you would have seen that Santander had to call the AT1 30 days in advance. But Santander’s lawyers said—and for all I know they’re right—that, nah, 30 days actually means 28 days. Reading the very clear words (and numbers) in the document would have gotten you nowhere, would have actively misled you, because the words apparently mean something other than what they say.
By Matt Levine
Non Prototype Language... 