New York Times – Among the certain unalienable rights of finance in 2006 is that of successful hedge fund managers to make a lot of money.
That right is embedded in the compensation structure of the funds: most managers receive 2 percent of the assets they manage as a management fee and take home 20 percent of the profits as incentive pay.
Many academics and certainly the managers themselves promote the “2 and 20†compensation arrangement as a positive alignment of interests: the manager makes money if investors make money. Investors, after all, get 80 percent of the profits. The promise of great riches is great motivation.
But there are flaws to this compensation structure. If managers want to get paid every year, they might be encouraged to take risks to have those profits and take their 20 percent. But what if the manager believes that a stock has value that the market is not recognizing? Should he sell and bet on something hoping to get a short-term pop, or hold that investment because it could be worth a lot more?
Getting paid annually does not always jibe with some styles of managing money like value investing  the art of buying undervalued companies and waiting for them to be properly valued. If managers show poor returns, impatient investors might yank their money before the market recognizes the stock as undervalued. In investing parlance, that is called being dead before you are right.
Lisa Rapuano, a longtime value investor, grappled with these issues and came up with a compensation structure based on the radical notion of delayed gratification. In January, she will start a value-oriented hedge fund that pays her a hefty incentive fee, but only every three years.
