Thursday, May 21, 2009

The crisis for dummies: Incentives

Incentives in the financial industries have been out of whack for a long time it seems. There is a lot of grand standing around the pay of CEOs but the rot goes much deeper. I also believe that it is in the nature of the beast by definition of managing "OPM" (Other People's Money).

Asymmetry of payouts
An investor is paid out at exit, when he gets his money back. But when the payout for the manager is yearly he has an interest in front-loading risk. What that means is that he takes on a bunch of risk that he knows will blow up but meanwhile will pay handsomely. When you think about it, the yearly yield payout is there to compensate for that future blowup. So that on a "risk-adjusted" you are making not that much. A bond may pay 20% yearly because it has such a high chance of default.

The manager knows that, buys it anyway and generates 20%/year in the first years. It looks great, you are getting 20 a year! But on a risk adjusted basis, accounting for the rate of default of the investment, he may only be bringing in 1% and costing you 20% of "cash flow profit" or 20x20=4%.

Get it? It is a bit of a scam. If your bonus is yearly then you juice yearly returns at the expense of loading up on tail-end risk.

Loading up on debt
One way to juice up the yearly returns is in fact to take on a bunch of debt. If every dollar brings 20c a year and it cost you 5c a year to get $1, you are bringing an extra 15c for every dollar you load up. Leverage 10x and you are bringing in $1,50 a year for every $1 invested. That is right boys and girls, 150% a year! now doesn't that look good? It pays to leverage. But then again, and even more violently than in the previous scenario, your capital will get wiped out quickly (before debt). This has the effect of blowing credit bubbles.

Payout on exit is fairer
Not all pools of capital are managed the same. Venture capital pay at liquidation of the fund for its limited partners. This means that the investor AND the manager are paid mainly on exit. This minimizes the asymmetry. This is fine for funds that are highly illiquid and where "liquidity" is in fact such an event (the sale of a company) that it triggers distribution.

Socialize losses, privatize gains
Perhaps the most disturbing asymmetry is the one we are validating right now. The machine sets up incentives to keep on growing and growing, isn't it what real companies do anyway? It has a tendency to rig itself so that the capital will blow up long term to generate short term juice. So they grow huge. But when it blows up, the company is so big, it is considered "Too Big to Fail" (TBF) and so the blowup hits the public treasury. Trillions of dollars have been thrown at the problem in the name of stability of our financial system. When the too big to fail are indeed failing, bail it out. This underlying assumption, the TBF-put, sets up all kinds of incentives that go the wrong way.


Anonymous said...

and this is the reason my friend that the model of public ownership of companies(i.e > 80% owned as liquid stock) will have to be revisited.

To better align the interests the manager should be forced to be an investor with interests > 35% of the investment.

Anonymous said...

Also if you have > 35% kinda ownership in the investment - the Too Big to Fail notion gets diluted because it will be in the interest of the Manager to diversify and not put all eggs in one basket. So the manager will not allow the investment to grow beyond a point and will probably start a new investment based on the returns from the previous investment rather than growing the existing invetment

Marcf said...

I don't know about public companies in general but in the case of banks, public ownership of banks comes with its own set of problems such as "blow the mosquito up until it blows up".

I do believe that management is running wild in most corporate america at the expense of the stockholders. Having management own 35% seems impractical
a/ who can afford to own 35% of GE, the workers?
b/ and then they move on and the new management needs 35%?
c/ if you own 35% of GE do you really want to be managing it?

Anonymous said...

exactly my point. why does GE need to be so big and consequently too big to fail.

and on >35% does not mean ownership by an individual. It could be a holding management company.

Hint: look into the company structure of reciprocal exchange. EG: USAA and Farmers Insurance. also look into the relationship structure of Farmers and Zurich for more insignts