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Tuesday, September 27, 2011

Anatomy of a Hedge Fund

Last year, John Paulson, a hedge fund manager, made $5 billion dollars. There was a great deal of damage control on this news, including by Business Insider, explaining that $4 billion of that amount was gains from his own investment in his fund.

That lead me to the following analysis:

A typical hedge fund manager gets a 20%/2% to run the fund, which means 20% of the annual profit, and 2% of the value of the fund.

Assume no tax dodges, so that the investors (including the manager) pay 15% Capital Gains tax on the annual gains (directly from the fund).

Being confident in his own abilities, the manager invests his after-tax income in the fund.

At the start of a year, the investors have $M_old in the fund, the manager has $m_old, and the fund gains r%.

Capital Gains tax on the investor money is $0.15*r*M_old, 20% of the after-tax gain goes to the manager, and remainder gets rolled into the investor funds. The manager then gets 2% of the total.

For the manager, his share of the fund increases by $r*m_old, of which $0.15*r*m is Capital Gains tax. He also gains the 20% of the after-tax investor gains, and 2% of the fund, on which he pays a 35% tax rate.

Thus, we have

M_new = (0.98)*(1+(0.8)*(0.85)*r)*M_old

m_new = (1+(0.85)*r)*m_old+(0.2)*(0.85)*r*M_old+(0.65)*(0.02)*(1+(0.8)*(0.85)*r)*M_old

What is the result?

If the fund gains 20% per year, it only takes 16 years for more than half of the money in the fund to belong to the manager. At 10%, it takes 23 years.

4 comments:

James Higham said...

Assume no tax dodges, so that the investors (including the manager) pay 15% Capital Gains tax on the annual gains (directly from the fund).

Why do we assume no tax dodges?

Paddington said...

The result is close to the same, assuming that the investors and manager end up paying the same rate. If he can dodge the 35% rate on the 2% of the fund, it happens even faster.

Sackerson said...

I haven't done the math but I'm sure you're right. Just read yesterday that Michael Milken, the junk bond king, paid multimillions in fines and served 22 months in jail, but still ended up with $2 billion in personal wealth. thos percentages and fees add up.

Mark Wadsworth said...

Excellent work. I emailed you my own spreadsheet giving a slightly different and even worse answer, but yours is just as good.