The controversy surrounding the bonus promised to Andrew Hall, the phenomenally successful energy trader at Phibro, a unit of Citi, is coming to a head. Hall's contract entitles him to a $100 million bonus. But in order to make good on the deal, Citi, which is now hugely supported and partially owned by taxpayers, must get the blessing of Kenneth Feinberg, the Solomonic attorney who administered the 9/11 Victim Compensation Fund and is now the Obama administration's Wall Street pay czar. Feinberg will have to consider whether it is proper for an institution that, without substantial taxpayer support, couldn't pay $100 bonuses to pay a $100 million one.
There's another question he should consider. Do Citi's shareholders benefit from owning what is, in effect, a hedge fund? Citi's management argues that it needs Phibro because it has been profitable over the last many years. The more it makes, the better off the company's shareholders—including reluctant shareholders like us taxpayers—will be. But the last few years have taught us that such gains don't always find their way into shareholders' pockets.
Hedge funds and private equity funds—siblings in the alternative asset management industry—are essentially compensation vehicles. At a business like Wal-Mart, most of revenues gets spent on merchandise, and about 20 percent goes to employee compensation. On Wall Street, it's typical for investment banks to pay out 50 percent to 55 percent of revenues as compensation. But in the hedge fund/private equity world, where people are pretty much the only assets firms have, that ratio is even higher. A huge chunk of the revenues earned from asset-management fees and profit-sharing is spent on employee compensation and benefits, as well as on other things that make employees comfortable and happy, such as fancy offices, art, planes, car services. When hedge funds and private equity funds are partnerships, owned and controlled by the founders, it is a high-wire proposition in which the owners reaped the rewards of smart moves and suffered the impact of stupid moves. A few missteps could wipe out the value of the whole enterprise.
But in 2007, at the top of the credit bubble, alternative-asset managers began to go public, essentially swapping a few owners (partners) for ownership by major institutions or shareholders. It's still a high-wire, zero-sum game. Except the alignment between owners and employees is out of whack. The folks who work at the firms that have gone public, such as the Blackstone Group, Fortress Investment Group, and Och-Ziff Management, get pretty much all the benefit of the revenues and the shareholders get pennies.
Look through the complicated earnings reports, and it's clear that an extremely high percentage of the revenues they make winds up in the pockets of employees. As its second-quarter earnings report shows, in the first half of 2009 the combined cost of overhead and employee compensation ($445 million) ate up nearly all of the $451 million in revenues pulled in by the Blackstone Group. (And that's before calculating hundreds of millions of dollars obligated as compensation to employees as part of its 2007 initial public offering.) In the first half of 2009, Och-Ziff had revenues of $193 million and combined compensation and overhead costs of $171.8 million. In the first half of 2009, the Fortress Investment Group reported that compensation and overhead were $260 million, while revenues were $261 million. (Like Blackstone, Fortress also owed hundreds of millions of dollars to employees per its IPO deal.) Meanwhile, the shareholders—the very people who own the firms—are suffering. With accounting and other charges, each of these firms has reported hefty losses for shareholders. Their stocks have been stinkers, as this chart tracking the performance of Blackstone, Och-Ziff, and Fortress against the S&P 500 over their lifetimes as public companies shows.
Shareholders are paying an awful lot for the services of smart traders at these publicly owned hedge funds. But they haven't seen much in the way of benefits. Which brings us back to Citi's Phibro dilemma. Should Hall not get paid as he sees fit, he could simply retire or take his band of traders elsewhere, thus depriving Citi—and its shareholders—of the profits he could create. But given the compensation dynamics of the industry, it's unlikely shareholders would see a lot of those gains were he to stay. What's more, hot hands can turn cold quickly. Atticus Capital, one of the hottest hedge funds in recent years, announced this week that it would largely wind down its operations. One of its founders, who was already insanely wealthy, had lost his hunger for the game after suffering losses.
Citi CEO Vikram Pandit, of all people, should know that committing huge sums of shareholders' capital to retain the services of a hot trader doesn't always pay off. In the spring of 2007, Citi spent close to $800 million to acquire the hedge fund Old Lane. Essentially, Citi was paying for the privilege of employing its founders, who had racked up impressive results. A year later, after the fund suffered losses, Citi basically folded it. One of the co-founders of the hedge fund was Vikram Pandit.