Friday, December 08, 2006

Paradoxical Incentives

And so Marshall Wace has raised $2billion from investors for a closed-end vehicle called "MW Tops" that will pursue "hedge fund strategies". I could be accused of professional jealousy - after all, who wouldn't want to win the lottery - but that is precisely what a $2bn closed-end fund is akin to for a manager with an elevated management fee + incentive fee structure.

With no disrespect to Mssrs. Marshall & Wace, who've performed admirably andd consistently over a long period such that their success is unlikely the product of the coin-flipping survivalism. And perhaps they've discovered the "Philosphers' Stone", and imbued it into a fund management method, or engaged sufficiently talented vassals such that performance could survive the principals' extended holidays, sabbaticals to ashrams in India, election campaigns for Parliament, etc. But along with ever-more restrictive gates in top-performing firms such as Citadel, locked in capital seems at odds with the shifting sands inherent to the Fund Management business. The fortunes of even the best firms waxes and wanes with the turnover of personnel, changes in corporate culture and hunger of the founder, principals or key persons, as well as the frequent inability of even the most successful people and firms to change with the times.

All that is fine and understood for someone seeking a firm offering to manage money on flexible terms for modest fees. But the relationship deteriorates assymetrically when one turns over money to a rockstar of finance with little to no recourse, oversight, transparency, covenants against excessive leverage (Citadel is already >10x levered) or risk-taking, or in the case of Citadel, any exit. One cannot simply "vote with their feet" and walk from a heavily gated fund structure. Nor is itan appealing proposition to dump one's closed-end shares into a market where the prevailing price is a hefty 15% to 20% discount to stated NAV, a level of discount frequently seen in the market for less-than-popular closed-end vehicles where one's star manager, investment strategy, or asset-class objective has sunk.

I understand all the arguments for "dedicated capital": preventing investors from doing the "wrong thing", insuring "dry powder" when market chaos (read: opportunity) presents itself, insuring business stability and thus enterprise quality, and so on. Yet there is nothing to protect an investor, from the equally deleterious and known demons of delegated agency investment managent such (for example: hubris, excessive risk-taking, massive errors in judgement, benign fiduciary negligence), save faith itself. And in danger of being a cynic, when I look at "faith" such as UK government's "faith" that competition will insure that public retail energy prices will rise and fal symmetrically, or the faith that companies have thoroughly tested the safety of chemicals inherent in their products, or the veracity of claims that Saddam must be brought down because he possesses weapons of mass destruction, I think one (and investors) would show wisdom in being skeptical that their interests will be equally served and protected, as those interests of the concentrated beneficiaries of such highly-gated or closed end structures. Caveat emptor!

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