The Little Book of Hedge Funds

Chapter Four

Heads We Win; Tails You Lose

Eating Your Own Cooking while Enduring Symmetrical Glories and Punishments

Ever since the 1960s, the 20 percent performance fee has excited envy and alarm—surely this heads-I-win-tails-you-lose format promotes wild punts with clients’ capital . . . these complaints about hedge fund incentives seem plausible—until you take a look at the alternative.

—Sebastian Mallaby, More Money Than God

On a cold, dark day in New York City, legend has it that Senator Chuck Schumer called 20 or so successful hedge fund gurus to meet with him at an Italian restaurant on the Upper East Side. The date was January 2007. Guests included Jim Chanos of Kynikos Associates, Rich Chilton of Chilton Investment Company, Steve Cohen of SAC Capital Advisors, Stanley Druckenmiller, Paul Tudor Jones II of Tudor Capital, and David Tepper of Appaloosa Management.1 Although the media waited with bated breath to receive leaks from any one of the notable legends gathered around the table, the only press that hit the newswire dealt with the combined assets under management of those men attending—which was estimated to be close to $200 billion! What was talked about none of us will ever know, but the size and magnitude of the wealth and assets under management, by itself, became a news sensation.

Where does all this wealth and money come from? According to hedge fund folklore the true essence of a hedge fund is defined by the way in which managers get paid. The typical hedge ...