Incentives
Private equity and hedge funds are making it really hard to love them. Most funds charge huge fees, both as a percent of assets and as a percent of returns, for managing client assets.
They argue that the fees are justified by the performance of their funds. For some of them, the fees may be justified, but for others they clearly are not. The problem is that it is nearly impossible to know whose fees are justified until it’s too late. Until the tide goes out, as it is currently with the subprime mortgage mess, there are very few ways to know who is naked.
Managers argue that incentive fees align their interests with the interests of investors. Presumably, without the huge performance bonuses, they would be satisfied with mediocre returns.
I have a better idea: managers should have their own capital in the funds. This will provide a similar incentive and cost investors nothing. I’m confused why investors should have to pay for the managers to take an interest in what they are doing. Especially when increasing returns should already line their pockets by (1) increasing the value of their own interest and (2) would help them attract more capital and therefore more fees.
On the one hand, managers argue that they need this performance-based system to encourage them to do a better job. On the other hand, they argue that it is not a performance-based bonus and should be taxed like capital gains. It’s hard to empathize with them when everyone else’s bonuses, from the relatively (relative to fund managers) lowly CEOs to mid-level managers, are taxed as income.
Their argument against treating their bonuses as income is that any increase in their taxes will be passed on to their investors, in particular pension funds. So, the argument goes, if you want to hurt the average American worker, increase our taxes.
Like I said, it’s hard to love them. They charge excessive fees because without them they wouldn’t try. They need the high fees to care. In addition, if you increase the taxes they pay, they will make the average American worker worse off. They are, in effect, holding the average American worker hostage to convince Congress to keep giving them preferential tax treatment.
