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Wednesday, November 16, 2005

Hedge Funds: What Compensation Do Managers "Deserve"

Over at the newly redesigned Conglomerate, there is an interesting discussion about the level of compensation that hedge fund managers deserve.  In his post, Vic Fleischer posits that the defining characteristic of hedge funds may the compensation provided to managers -- generally a 2% asset fee and 20% of the profits made by the fund.  As Vic notes, this has interesting ramifications for the theory of the firm:

Hedge funds are an efficient way for the most talented managers to extract out as much rent as they deserve (and maybe more).  And because the human capital talent here is mobile (not tied to physical capital or even firm-specific capital), stars are free agents, able to move around or start a new fund, extracting nearly all the surplus they create from the investors who put up the financial capital. . . .  Think of it as the exact opposite of team production -- more like A Terrell Owens Theory of the Firm.

In the comments, Kate Litvak raises a concern about Vic's use of "deserve":

. . . I would abstain from commenting about who “deserves” what compensation. In the market economy, the only price that one “deserves” is the price that someone is willing to pay. I can’t think of intrinsic ways of determining who deserves what, much less to compare someone’s intrinsic worth at several hypothetical alternative employments (e.g., public company and hedge funds).

What do folks "deserve" to make?  I think this is the most fascinating question in economics.  Because economics has an answer, but if you stop there, it's really no answer at all.

The economics answer, as Kate Litvak points out, is that people make whatever someone will pay them to do a particular job.  In other words, the market decides compensation.  The market has no friends, it makes no normative conclusions -- it simply determines what you will make based on the interaction of supply and demand curves.

True enough.  But what drives the market?  This is where economists sometimes forget what they're dealing with.  At the root of any market economy is culture -- a culture of wants, needs, and desires that are constantly changing and subject to exogenous and endogenous influence.  Sure, the market sets the price for gasoline based on an incredbily complicated set of interactions.  But why do Americans buy SUVs?  Sure, market incentives are necessary to protect copyrights to music, movies, and other intellectual property.  But why was Britney Spears, or a set of movies about dwarves and elves,  so popular?  Underlying these market decisions are completely cultural notions about what we enjoy and desire.

Compensation may seem less cultural, and more about the numbers of supply and demand.  But who sets the CEO's salary?  Who determines how much of the profit (or loss, heaven forfend) of the overall company should be attributable to the CEO?  Sure, stock options incentivize -- but how many stock options are appropriate?  These are decisions made by boards -- men and women trying to figure out what numbers will get them the best talent.  Those numbers are largely determined by what everyone else is paying.  Cultural influences shape the boundaries of what the market provides.

Hedge fund managers may seem a weak link for my argument -- isn't their pay purely determined by what they bring in?  Well, it's true that hedge fund investors voluntarily chose to invest in funds with certain merit-based compensation schemes.  But you're telling me that "2 + 20" isn't a culturally shaped expectation?  Plus, who is in a position to be a hedge fund manager?  Would Billy Ray Valentine make a nice living off the "2 + 20" if he were in a position to do so?

The market is probably the best way to set compensation -- experiences with central command and control have gone extremely poorly.  But it's foolish to forget that supply and demand are not simply scientific, mathematic, extra-cultural concepts.  Salaries may be a number, but at the heart of that number is a tangle of subjective, cultural, normative judgments.

Posted by Matt Bodie on November 16, 2005 at 10:00 AM in Corporate | Permalink


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I think Kate's childcare vs. fancy meal is an interesting hypo. Why would someone pay more for a fancy meal? Are they that unconcerned about their kids? Or is it that, given $3X in disposable income, they can pay $X to the sitter and still have $2X left over for the dinner? If the sitter charged $2X, then maybe they'd only spend $X on dinner. But why might sitters only charge $X? The short answer is, of course, that if any particular sitter charged more than $X, he or she would be undercut by someone else willing to do it more cheaply. But it's easy to imagine a world where everyone pays sitters $2X because that is the going rate, no?

Look, I agree that as a general matter it's a lot better to leave prices to the market, rather than Ministry of Kultur. But can't we try to shape market culture when we think it's out of whack? For example, corporate law and finance academics have some responsibility for the CEO pay spikes at the end of the 1990s. The "align pay with incentives" movement made it culturally acceptable to give absurdly high stock option grants. Hopefully the widespread disapproval of such pay packages will lead to some moderation going forward. But if not, would it be beyond the pale to take stronger steps to change the culture? Can't the SarbOx prohibition on loans to officers be explained as a way of trying to change the culture?

Posted by: Matt Bodie | Nov 18, 2005 11:22:37 PM

Oh, in terms of "wanting someone else to pay, people can externalize the costs of their desires to minorities through the market just aa much as through democracy.". Yes, a majority can vote its pro-nanny preference on the backs of the minority who prefer masseuses. However, this too can be turned on its head. The majority who want to pay their masseuses more impose a cost on the minority who want to have skilled nannies enter the market when only a few are willing to pay their worth. We've seen just this problem in the dearth of qualified schoolteachers who are willing to work for the insulting salaries they're offered.

Posted by: Paul Gowder | Nov 18, 2005 9:12:09 PM

I'll see your revealed preferences and raise you some wealth effects. We can toss flaws of democracy and the market back and forth at each other until Dan bans our IP addresses in disgust without getting anywhere, because we both know that they're both dreadfully flawed.

That being said, however, I don't think you're more entitled to appeal to "freedom" than I. It seems that I privilege political autonomy, while you privilege market autonomy - both of which are perfectly tenable positions, but you can't define one set of preferences as non-real.

Revealed preferences just pushes the opposition further back, to saying/doing. It is not obvious that we should decide that how people spend their money reflects what they "really" want, while how people vote or report their opinion in polls reflects what they - what? Feel pressured to say? Want, but don't want as much? A lot of theory goes wrong, I think, by assuming people don't really want what they say they want, but do really want what they do or buy.

The "revealed preferences" story could just as easily be turned around. People might be socially conditioned into certain behavior notwithstanding the fact that their emotions and hungers and rational conclusions point somewhere else. People often don't do what they want. (this is notwithstanding the fact that "want" and "want to pay for" are not necessarily the same, and that maximizing utility would maximize satisfaction of wants irregardless of whether the wanting corresponded to payment motivation.). Let me recommend some of Jon Hanson's recent work (particularly an article called "obesity and justice" - I can probably dig up a cite if needed) on this sort of problem.

Posted by: paul Gowder | Nov 18, 2005 9:01:16 PM

Paul: we were talking about the use of the price system to promote social goodness, so let’s not suddenly slip into the use of taxes and subsidies to promote social goodness. I may or may not agree to the latter (mostly not), but the former is always a bad idea no matter how you slice it. You simply cannot force me to pay my nanny more than I pay my masseuse without creating a massive black market, massive evasion, and massive deadweight losses.

As to your suggestion that voting with dollars should not be privileged over voting with votes: the issue is what economists call “revealed preferences” aka “put your money where your mouth is.” People will tell you they value Macbeth more than Cats, but they are consistently willing to pay more to see Cats than Macbeth. Likewise, they will tell you that they value high-quality child care higher than frivolities and pleasures, but they are willing to pay more for a meal at a fancy restaurant than for a whole day of high-quality child care. Generally, when people tell you that they value something at more than they are willing to pay for it, they mean that they actually value it at less than they claim, but want someone else to pay the difference.

That’s why the “democratic process” is such a bad way to encourage socially optimal production. Voting always involves implicit demands for redistribution and therefore (a) doesn’t reveal true preferences, and (b) encourages over-production of goods favored by politically powerful groups. In contrast, when people are told to put their money where their mouth is, they shut their mouth rather quickly (that is, reveal their true preferences).

Posted by: Kate Litvak | Nov 18, 2005 6:35:32 PM

Kate, your rhetoric is obscuring a very serious question. What if you're right, that most people value an hour of shiatsu massage more than an hour at the opera, but I'm also right that most people value the availability of the opera in general more than they value the availability of shiatsu massage in general? (I realize I'm making a factual assertion here that I can't immediately back up with evidence, but I also don't think it's terribly controversial. For example, although the polling data, last I checked, was hotly disputed by both sides, many argue that polls have shown broad public support for art funding with taxpayer dollars.)

If that's true, then we can't hide from the fact that people's aggregate market behavior might threaten the existence of the opera (or their desired level of availability of the opera), and thus that their aggregate market behavior might defeat their aggregate social goals.

If you're undisturbed by this possibility, it means you are privileging the freedom to make marginal market choices over the freedom to make aggregate social choices despite the fact that exactly the same people would be doing the choosing in each case. Lets emphasize that last proviso. I'm not suggesting that Coltrane and Macbeth be forced down the throats of a disinterested populace. I'm suggesting that the populace, if given the choice directly rather than having the choice they're making concealed by their daily "marginal" market behavior, would choose in a heartbeat to have Macbeth over Cats -- that's what our society values.

In fact, the whole binary opposition between "marginal market valuation," associated with freedom and choice, and "social value," associated with "outright taste/thought control" and "forc[ing] [stuff] into the throats of disintrested population"" is something of a crock. The two are exactly the same thing. The people can vote with their dollars or they can vote with their votes. If they vote with their dollars for Cats, but vote with their votes for Macbeth, why do you say that they "really" want Cats? Assuming the decisions of their political leaders reflect their preferences, if the political leaders go for Macbeth, can't I just as well say they "really" want Macbeth?

In a democratic society, what the state does is generally understood to be what the people want. If regulators act for a certain end ("knee-jerk" or otherwise), or if the legislature raids your wallet for that end, absent some reason to believe there has been a democratic failure, it is to be presumed that the population is interested indeed in that end.

Posted by: Paul Gowder | Nov 18, 2005 1:51:13 PM

Paul: “moderate and carefully selected public intervention based in shared values” is something that should be (and is) done through narrowly-tailored taxes and subsidies, rather than through taking the price-setting process from the markets and handing it over to a committee.

Besides, your suggestions to force Coltrane and Macbeth into the throats of disinterested population are far, far beyond a “moderate and carefully selected” intervention. That’s exactly why we should worry about the “moderate and carefully selected” rhetoric even when it involves more benign intervention proposals like taxes. This rhetoric starts with “moderate and carefully selected” and balloons into an outright taste/thought control. If you think it’s an outrage that most people value an hour of shiatsu massage more than an hour at the opera, send a check to the Met and stop raiding my wallet to promote your pet version of virtue.

Posted by: Kate Litvak | Nov 18, 2005 12:57:11 PM

Kate, I'd really love to wholeheartedly adopt your manichean rhetoric and start signing my correspondence "Comrade Gowder, chair of the central moralizing busybody committee." Alas, I find myself unable to do so, bothered as I am by the nagging sense that just maybe there is something in-between complete unrestrained market capitalism and central planning socialism. Perhaps ... dare I say it ... even moderate and carefully selected public intervention based in shared values?

Posted by: Paul Gowder | Nov 18, 2005 12:07:54 PM

Matt: “understanding marginality” means more than saying something very vague about culture affecting prices. It also means understanding why, in the market economy, prices have nothing to do with “social value” of things as announced to the world by some moralizing busybodies.

So, before you rush to agree with Paul: did you notice that he was suggesting that prices be set by a committee in response to the “democratic process,” rather than by the market in response to consumers’ revealed preferences? And that, to him, the purpose of the price system should be to reward activities that some virtue-setting authority finds “more important,” rather than to encourage production in response to revealed preferences and to ensure efficiency of resource allocation?

Can you think of a few good reasons for why these ideas aren’t terribly good? Hint: remember one very big, very failed social experiment?

Posted by: Kate Litvak | Nov 18, 2005 10:18:58 AM

I agree with what Paul's saying. We understand marginality. But marginality itself is shaped by cultural constructs. There may be a very small pool of good baseball players in the world. But if no one gives a hoot about baseball, then baseball players aren't going to make much money. Why are baseball skills more valuable than the ability to make clever anagrams, which may be an equally scarce skill?

CEOs are paid more because the assumption is that, based on the value to bring to the corporation and the scarcity of their skills, you have to pay them $X million to attract them away from another corporation or relaxing in the Bahamas. But who really knows how much value the CEO brings to the corporation? The board makes an assement, but that assement is culturally shaped. If you try to quantify it, then you're trying to figure out what they "deserve." And you can't do that, right?

Posted by: Matt Bodie | Nov 17, 2005 9:42:26 PM

One more remark. One of the 30 or 40 most irritating things about the behavior of economists is their staggering methodological hubris. This is manifested in Geoffrey's blithe assertion that those who disagree with the application of the concept of marginality simply fail to understand it, and also to the bald assertion that the word "value" is used "in [a] colloquial sense" (and hence presumably without the kind of rigor or theoretical strength of the economist-favored usage) simply when it is used in a sense that tracks something other than market valuations. In fact, that kind of marginalization of non-market notions of value is a classic economist's move, and one that I think is the crux of what Matt was asking in the original post in the first place.

On what grounds do we privilege, as a normative matter, the individual marginal valuations of market actors over the collective aggregate valuations of society as a whole as expressed through, say, the democratic process and via regulation?

Posted by: Paul Gowder | Nov 17, 2005 3:07:08 PM

Oh, and another thing: I think everyone in this virtual room understands both marginality and the water-diamond paradox. However, marginality is a positive feature of the universe, it should not be a normative one. Merely because a marginal teacher is valued in the marketplace less than a marginal ad executive does not mean that the aggregate teachers should be valued less than the aggregate ad executives. The reason for this is that scarcity is not connected to merit.

Posted by: Paul Gowder | Nov 17, 2005 2:35:28 PM

The main point is that "value" in the colloquial sense you are using it here does not map onto price, nor should it.

And is there an argument to support the "nor should it," beyond sheer assertion?

Posted by: Paul Gowder | Nov 17, 2005 2:30:48 PM

Kate's right -- This is a total non-starter. I refer you again to the water-diamonds paradox she mentioned. A quick Google searchs finds one of many, many explications here: http://www.mises.org/fullstory.aspx?control=1584. There're several hundred more if you don't like that one.

The "problem," such as it is, is in the failure to understand the concept of marginality, but I'm not going to explain it here. Maybe Kate will (but I doubt it).

The main point is that "value" in the colloquial sense you are using it here does not map onto price, nor should it. Attempting to force it to do so by regulation will lead to (does lead to) massive wasteful dislocations (and failure in the intended result, to boot).

Matt said: "One might say that a CEO's skills are scarce, and thus a firm has to pay more in order to lure that CEO away from other lucrative opportunities. But how much higher? If all CEOs were paid in the range of $100,000 to $200,000, because that's what every board in America suddenly decided to pay, would the talent pool really shrink? Would CEOs work less hard? It's hard to say. It would depend in part on the other employment opportunities out there for potential CEOs, but those opportunities are similarly shaped by cultural expectations and the allocation of resources."

I can tell you with certainty: The talent pool would shrink. The talent that remained would work less hard. The alternatives would not only be other sources of income but also, of course, leisure. Relative price is not at all about "cultural expectations"; it is all about "the allocation of resources."

I agree that we lack a theory to enable us to predict precise prices -- to deduce price from the mass of inputs that goes into it. Only the market can do that. One of those inputs may, in an attenuated way, be "cultural": Surely preferences are affected by social norms. But what that has to do with whether CEOs "deserve" the compensation they get is beyond me.

Posted by: geoffrey manne | Nov 17, 2005 2:10:09 PM

Kate: one can only believe that "there is simply no such thing as an intrinsically 'fair' or 'unfair' price for anything" if one uncouples all the rest of our values from the marketplace. While I understand that econ dogma proposes to do just that, that simply establishes why economists should not be permitted to set social policy.

It is not reasonably contested in our society that elementary school teachers, for example, are better than advertising executives on our non-economic value scale. If you ask any hundred people who aren't either schoolteachers or admen which one they'd shoot, if they were forced to shoot one or the other, I rather strongly suspect that at least 99 would unhesitantly say they'd shoot the adman. Much the same goes for asking the hundred people if they'd ban all future stage productions of Macbeth versus Cats. Ditto with all performances of Coltrane's A Love Supreme versus Spears's Oops I Did It Again. Macbeth and schoolteachers and Trane are more important to society, under the values that we hold dear, than Cats and admen and Spears. And I submit to you that these social valuations are independent of their "market value" (an oyxmoron if there ever was one), or even their consumer preferences. Even if I might willingly pay 50 bucks to see a performance of Cats, yet only pay 20 to see Macbeth, I might still believe that, should one be preserved, it should be Macbeth. Do you disagree? (I doubt it, but I suppose if you do, it would be my job to find empirical evidence...)

In that sense, the people who perform Macbeth, on a social scale, do "deserve" more reward than the people who perform Cats, because they do something which our society thinks is more important. Schoolteachers do "deserve" more reward than admen. Or, in many cases, CEOs and hedge fund managers.

The market does not agree. Perhaps someone does need to "open up the conversation" about why that might be. Why would regulation to make the market correspond with our social values necessarily have the quality of being "knee-jerk?" (Leaving aside utilitarian effects.)

Posted by: Paul Gowder | Nov 17, 2005 11:30:25 AM

Again, not only do CEOs not intrinsically “deserve” what they get, but no producer of ANY good or service intrinsically “deserves” anything either. There is simply no such thing as an intrinsically “fair” or “unfair” price for anything. In its susceptibility to cultural forces, the employment market is not any different from the markets for diamonds, beef, cars, housing, or music albums.

I very much hope that this simple bit of introductory price theory does NOT “open up the conversation … about how the employment market should be constructed, regulated, or culturally shaped.” There is nothing special about the employment market in this respect. Enough knee-jerk regulation already.

Posted by: Kate Litvak | Nov 17, 2005 9:52:04 AM

I'm glad we are all in agreement. I suppose what I'm saying is not all that controversial. But I think it's important to say, like Kate did over at the Glom, that people don't really "deserve" what they make. There is a real American sense that people earn every cent they bring in, and that taxes are really taking away money somewhat illegitimately. That may not be a rigorous academic position, but it's a strong cultural current.

Perhaps more importantly, though, people want to feel like they deserve what they make. If you don't really deserve what you make, then what is the point of trying to say you should make more? The fact is, we feel that our pay should be linked to our innate talents and our hard work in using them. But some talents are rewarded a lot more highly than others.

An economist would say that the talents that are rewarded more highly are scarcer, or create more overall utility, and therefore are rewarded by the market. But while that may be true, it may also be true that certain talents are valued more highly, as a cultural matter, by those with the resources to reward those talents. Why are CEOs paid so much more than line workers? One might say that a CEO's skills are scarce, and thus a firm has to pay more in order to lure that CEO away from other lucrative opportunities. But how much higher? If all CEOs were paid in the range of $100,000 to $200,000, because that's what every board in America suddenly decided to pay, would the talent pool really shrink? Would CEOs work less hard? It's hard to say. It would depend in part on the other employment opportunities out there for potential CEOs, but those opportunities are similarly shaped by cultural expectations and the allocation of resources.

So I think it's a cheat, really, to say that pay is just related to the impersonal workings of the market. Yes, that's true, but why is the market the way it is? And if CEOs, or any other employees, for that matter, don't really "deserve" their pay, then it opens up the conversation a bit about how the employment market should be constructed, regulated, or culturally shaped.

Posted by: Matt Bodie | Nov 17, 2005 8:52:19 AM

Matt: if all you are trying to say is that market price is affected by culture, that’s surely correct and completely trivial. These sorts of ideas have been known to the world for more than a century as the subjective theory of value (and its voluminous progeny), which is a perfectly mainstream economic theory. Water is cheap and diamonds are expensive not because diamonds are intrinsically more worthy or because it takes more labor to produce them, but because under normal circumstances, people desire diamonds and willing to pay more for them than for water. If people suddenly decide that diamonds aren’t pretty or aren’t a cool status symbol, the demand for diamonds will collapse and so will the price. Same goes for Manolo Blahniks, waterfront properties, and pop albums. Believe it or not, this is a completely mainstream economics.

If you are trying to say that compensation markets are different, you are again partly right – compensation markets often involve layers of agents making purchasing decisions on behalf of their principals (e.g., board members set up CEO’s salaries on behalf of shareholders), and these agency costs pollute the market price. You are only partly right, though, because (a) many compensation markets do not involve intermediaries (e.g., markets for nannies, personal lawyers, housing contractors, and hedge fund managers – when investors are individuals), and (b) many non-compensation markets involve intermediaries as well, making oddities of compensation markets not unique. All of this agency stuff is again trivial and known to the world.

The bottom line is, I am not sure which economists you are debating with. Perhaps Marxists? I recall, they still believe in the labor theory of value – so, for them, culture would probably not matter much.

Posted by: Kate Litvak | Nov 16, 2005 4:38:26 PM

What you are syaing is that we don't have a good theory of price formation. We don't know exactly how all of those complicated interactions result in price X for a given transaction, in part because the interactions are, well, so complicated. I think that's true. But it doesn't seem to me to undermine Kate's point. Whatever the complicated interactions that yield value, it's silly to speak of anyone's or anything's "intrinsic" value. For example, even if it's culture that, at some level, induces the "2 + 20" formulation in the short run, as Armen Alchian pointed out (http://cepa.newschool.edu/het/profiles/alchian.htm), it's impersonal market forces -- evolution through trial and error -- that ultimately determines whether that price was "correct" or not. As for the Britney Spears point -- no one has an explanation for that.

Posted by: geoffrey manne | Nov 16, 2005 1:49:07 PM

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