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Warren Buffett describes how the Gotrocks family members can fritter away their fortunes (turning into the Hadrocks) by hiring “Helpers” to invest for them. He notes that Helpers – hedge fund and private equity managers, say – share in winnings, but their clients take the losses.
Suppose you are a Wall Street trading star. You quit and use the $20m you have stashed to start a hedge fund. You attract another $80m of other people’s money, charging them 2 per cent a year for the privilege. With ability, luck and leverage, you make a 20 per cent gross return every year. You take 20 per cent of any upside as a performance fee and absorb your modest expenses. You reinvest most of what is left over but take in no new outside money.
Fast forward 10 years and your $100m fund has grown to nearly $600m. Your own money accounts for almost half that. Your investors have enjoyed a decent 14 per cent net annual return. But including reinvested fees you have made, on average, nearly 30 per cent a year. Had you been able to charge 3-and-50 instead of 2-and-20 (as some managers do), you would have owned half your fund about five years earlier.
If you lose your touch and the fund makes just 5 per cent gross every year – scarcely more than Treasury bonds pay – your investors, with a net 2 per cent return, might take their money back. (Unless you had the foresight to lock them in.) But assuming they stay around, you, the Helper, would still make 10 per cent on your own money.
Hedge funds do uncover hidden value. Investors lucky enough to find the best managers will get big returns and think the fees well spent. But the numbers explain why Goldman Sachs, academics and others are trying to replicate hedge fund strategies at a fraction of the cost – and in the process help the Gotrocks hold on to more of their money.