Hedge Fund Managers Are Expensive

Here’s the classic life cycle of a hedge fund. You quit your job at Goldman Sachs Group Inc., or at someone else’s hedge fund, and you start a new fund with some of your own savings and some money from your former clients, bosses, etc. You charge a management fee of 2% of assets, which you use to pay for rent and Bloomberg terminals and stuff, and a performance fee of 20% of profits, which you use to pay bonuses to a couple of analysts and a bigger bonus to yourself. Living, as you do, on performance fees, you care a lot about performance, and you perform well. This has two effects: (1) you attract more clients who like the performance and (2) you pay yourself large bonuses out of your large performance fees. The former effect tends to increase the size of your fund while reducing your percentage ownership (more outside money), while the latter tends to increase your percentage ownership (you pay yourself more than you can spend and, as a matter of course, keep your savings in the fund).

If you continue this way for a while, and performance remains good, then your fund will grow and eventually you will reach some capacity cap where you run a lot of money and don’t want any more. Investors will come to you begging to put in more money and you will say no. You will close your fund to new investors, maybe you’ll start handing money back to old investors, maybe you’ll increase your fees. This will all tend to increase your percentage ownership of the fund. Eventually, if all goes well, you will return all the outside money and have like a $20 billion family office where you run only your money and keep 100% of the profits.