Copyright Bloomberg
I write from time to time about the economic structure of modern multi-strategy “pod shop” hedge funds. Stereotypically a hedge fund invests its clients’ money and gives the clients the returns, after taking some fees — classically 2% of assets and 20% of returns — for itself. The modern pod shops are not like that. They charge “pass-through fees,” meaning that they invest their clients’ money, earn returns, pay their expenses out of the returns, pay their employees large performance-based bonuses out of the returns, and then give most of what’s left to the clients. The deal with the clients is not “we get 20% of the returns and you get 80%.” The deal with clients is more like “we aim to meet our cost of capital by giving you a risk-adjusted return, net of fees, that you are generally happy with.” In this, I have argued, the hedge funds are like banks, or really like any other business: They do not give their investors (bank shareholders, hedge fund limited partners) a fixed share of their revenue; instead, they (1) pay their employees what they need to pay in a competitive market for talent and (2) aim to compound returns for their investors at a rate that exceeds their cost of capital. The “cost of capital” is a somewhat hypothetical thing. But in the long run, either you give your investors enough returns to make them happy, and your fund grows, or you don’t, and the investors take their money back. And unlike shareholders in a bank, hedge fund investors can — eventually — take their money back.
