free leverage
the secret behind hedge fund wealth is not investing prowess as commonly believed. nor is it superior risk management, (sometimes too) timely access to information, broker relationships, not even institutionalization. all of the above helps, but one needs to give credit where due. hedge fund wealth is primarily the result of an uncanny ability to take advantage of “other people’s money”. the performance fee structure already smacks of free leverage: you bear the risk, but 20% of any upside is mine to keep. this much is well known.
but citadel, perennially an innovator, takes free leverage one step further. as i briefly discussed in a prior post:
citadel has the right to defer fees so that they are invested alongside investor capital. not only this, but citadel gets, at its option, up to 3x leverage on the deferred amounts! investors foot the bill through reduced returns. as of august ‘06, deferred amounts totaled close to $2b. the actual amount of leverage employed was not disclosed, but the ken griffin in me still cackles with joy.
this bears further examination. to that end, a quick perusal of kensington’s ytd financials. on the revenues side:
- $1.75b in investment gains
- $3.75b in investment income
and expenses:
- $3.6b of investment expenses (primarily interest)
- $600mm of operating expenses (mostly compensation, up to $550k for each of 1100 employees)
all in, $1.3b of income to be divvied up. ken gets first dibs:
- $300mm to returns on deferred fees (18.5% on $1.65b)
- $200mm in performance fees (20% of $1b)
and leaves $800mm for investors (13% on $6.2b of capital). in case the significance of this hasn’t yet set in, let me repeat. investment returns were 20% of $6.2b in investor capital (or 17% of $7.85b if one includes deferred fees). yet citadel earned 18.5% on deferred fees, while investors collected only 13% on invested capital. of $1.3b in income, citadel took $500mm while investors kept just $800mm.
if that’s not pure arb, i don’t know what is.