Help us determine a fair compensation structure and non-competes for a new HF

Your feedback will be critical in determining some key points our build out of a HF. I'll be showing this to the largest owner of the GP.

TLDR:
1. What is the lead PM (design, trade, manage, research, and market) portion of a 20% performance fee for a high return/high vol but with a very attractive sharpe ratio HF? I’ve seen numbers such as half (50% of the total performance fee, or 10% of the excess performance for a 2&20).
2. What is the typical length of a non-compete is such a scenario, and what pay should be provided during the non-compete period?

Story:
I currently am a portfolio manager at a small asset manager (about $1B, but growing fast). We manage a few equity mutual funds (average about 4.5 stars). It’s a quant/fundamental mix and there are a few PMs named on each fund (I am one of them, owner/CIO another, and one more PM). We also do some basic asset allocation strategies for some clients (I primarily built the AA process). I’m paid base + bonus I have no problems with my firm and I’m currently quite happy.

I’ve been here 3+ years, but I have 13 years total in some form of a PM role in asset management. Part of my background pre-joining this firm is in building/designing/trading quantitative tactical strategies. In this case it was all in long only ETFs, so it wasn’t a hedge fund. Last year we had a client that had a need for such a strategy so I built something for him that fit his long only parameters.

I saw an entrepreneurial opportunity, so I greatly expanded on that and built a potential HF (primarily using futures) to pitch to the owner/CIO. At a high level think various interconnected/independent risk on/off signals tied to factors, technicals, economics, some additional quant techniques etc. Arguably 100% of the design and coding was solely done by myself (technically I bounced a couple ideas around, so you can round it down to 99%). I pitched the idea last year, got good interest, but nothing imminent. After all it was just a great backtest, so it is reasonable to be skeptical. I’ve been running it live on ‘paper’ this year, and it is up around 80% YTD (this is not my long-term expectation). Regardless a month or two ago the decision was made to launch. All the paperwork/legal/ops are getting finalized. We are expecting somewhere in the $30-$50m range to start with. It will be 2% and 20%.

My role will be to design/code the entire strategy (already done), manage it daily, continue to research, trade it daily (if needed), and create any marketing materials for it. A couple of the other lead PMs (owner/CIO, plus another key PM) will be passively involved, think firm level oversight. If I got hit by the bus it would generally still run automatically (as it is quant), but they would lose maybe 20% of the things that only I could do. If I got hit by a bus and something in the code broke it would be really hard for them to fix it (but possible). I’m certainly going to train them up on it, but that key man risk will always exist to some degree.

First let me say I’m happy here, and I think both of us (myself and the owner/CIO) wants us to have a long-term happy business relationship. So, it is a matter of coming up with something that is fair and market-like. We are just new to the HF world.

1. So, the first part of the negotiation has to do with compensation. Remember I’m already being paid base + bonus for running the mutual funds. My research has shown lead hedge fund PMs in this type of role generally get about 50% of the performance fee (or 10% of the overall excess performance in the case of a 2&20). In my opinion, that is near market rate PLUS the HF doesn’t have to pay me a base (since I already get it). I recognize my research in this case could be wrong (hence why I’m posting here!).

The owner/CIO is coming from a lower tracking error/less key man world of mutual funds where bonuses are a bit more discretionary but tied to performance. Either way, that seemed very high to him. His other point is I am already ‘working’ for the company (although nothing in my current role had anything to do with designing, managing, trading, marketing a HF), but the reality is it is already built. Plus he is providing the ops, paid for the legal and all set up, and has the connections for initial capital. All fair points.

So in my opinion I should sign a contract for 50% of the performance fee (no additional base, even though it is more work) to manage the strategy. If I needed to hire any help, their bonus would come out of my 50%. The worst case scenario would be my additional bonus up to his discretion. Another important note is I will be part of the GP (about 5 to 10%). While that is good and I’m thankful for that, I’m obviously looking at the total package.

In this very unique scenario, what type of performance-based compensation is fair (forget the units in the GP, I can scale things down to make it equivalent)? What would the ‘market’ rate be if someone was recruited to manage such a HF?

2. Next what about non-competes? I fully expect that I’ll be expected to sign one, especially as part of the GP. I have no problems with this, provided the comp is fair. Worst case scenario would be an awful comp package plus a long non-compete, but as I said before I do think we want to come up with something fair and market like. What is the typical length of a non-compete? During the non-compete period does the firm typically pay the (former) employee? If so, how much? Is there any relationship between the length of the non-compete and the compensation package?

I do plan on showing him the replies to this thread as I do think we want something fair, but we are handicapped with our newcomer knowledge of the HF world. So your responses can be quite critical in us coming to a fair agreement.

 

Might come back w/ more detailed response later but take everything w a grain of salt. Can't comment on lead PM part as that's way above my pay grade but on non-competes you're seeing a lot of half yr deals. Think 1 yr would be cruel and unusual, Bwater hitting 2 yr on the egregious end. Usually base salary is paid on non compete, but some HFs have been skimping on this if the employee who leaves double dips. so for junior person base of 100-175k depending on seniority is my guess

 

I’m not a tax advisor. Lot to reply to there but I don’t know you well enough to opine fully.

One piece I’ll give you is to take your pay via voting ownership in the GP. should be tax advantaged and makes it much harder for them to boot you.

You should also negotiate for the right to own the strategy or at least take a copy of code if you were to leave.

Otherwise you’re in a position where they let you build it, grow it and cut you out.

I am sure they are great people. But when the income stream is tens or hundreds of millions (assuming this scales), people behave differently.

 

All great points. Thanks. Worst case scenario is exactly what you mentioned, especially given it is a quantitative strategy. In fact, this is what is already working against me.

What you mentioned is kind of part of the the owner/CIOs point, I was an employee of the firm when I built it, therefore technically it is the firm's IP. The reality is I've seen people leave many firms and effectively 'recreate' what they had previously (even if there were some protections in place). No matter what they can't own your brain. Obviously I couldn't straight up take the code, but I could recreate, rebuild, and enhance if it came to me doing it on my own or joining another firm. A non-compete is a bigger roadblock IMO. Of course I hope (and I don't think it will) come to that.

Also agree how money can corrupt, which is why it is extra important for me to get this ironed out right now.

 

Can you expand a bit more on taking pay via GP? At most I'd picture myself with 10% ownership in the GP. Obviously I think the market value of what I've done is worth a lot more than 10% of the carry. Could I potentially get more of the carry than what my ownership stake is via the GP?

I was picture a scenario where I would get 40% of the carry as an employee, then split the remaining 60% through the GP (for which I'd get 6% of). Ignoring costs for now. Is it possible to get the full amount straight through the GP?

 

Not a tax advisor.

W2 income is taxed as ordinary income. Carried interest taxed at LTCG.

Say fund manages 100mm and puts up 30% returns with a 20% incentive to keep it simple. 6mm of revenue to the GP. If you want to capture 50% of that, own 50% of the GP - you get better tax treatment, actually own an asset, etc.

If you take 2mm of expense our - i.e., 1/3 of revenue as w2 income and leave 4mm for GP (of which you own 25%), then you get much worse to treatment, they can fire you and you lose 2/3 of your upside, etc.

 

Honestly I would never do that. If I ended up getting cut out or not given a fair shake I would eventually have to move on. They'd have the code to do whatever they wish with. But any investor doing serious DD would have a red flag if the lead dev left. Plus they'd lose a lot of the ongoing work with it, but I'd never do something malicious. In fact that is probably against CFA ethics (as well as some laws). lol.

 

Length of non compete is often related to how large and profitable the business is or what your comp is. So if their platform/cap intro allows you to get scale, it should be more expensive for you to spin out than if it doesn't.

Another factor is how easy it is for them to fire you/renegotiate comp. If your equity is less secure, point for point, you need more of it.

 

Thanks for the reply. Certainly makes sense how they are interrelated.

In terms of comp, assuming no equity (I can scale it), how much should I get of the performance fee in terms of market value? Like half?

What would you consider fair in this case? I concede potentially lower than market but I’m not sure what

 
Most Helpful

Some data points to consider:

  • For a multi-manager (Baly, Millenium etc.) you take home 15% of your P/L and get billed for most reasonable costs (bbg's, repo, etc.).
  • For a broker-dealer (Cantor), you take 50% split with sales, other half to the house
  • For a SS desk, you normally take 3 - 5% of your P/L (includes commissions)

I would try and solve for 20 - 30% of the economics here - ideally you have created unique IP that is accretive to the fund brand, but launching on an established platform is significantly easier than starting fresh. New funds tend to run cash-negative for the first 1-2 years unless they are superstars; after paying for rent and Bloombergs you're in a financial hole.

The mix between GP and perf generally is a personal choice - lean towards the GP. It's a lucrative, steady base of revenue. High vol strategies don't always perform year-in, year-out. Try and get some blocking or voting rights about termination, funny things can always happen.

For non-competes, 1 year is standard and 2 years is the long end. Typically you are paid a base which would reflect a below-average year but keeps the lights on ($150 - 250k).

 

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