Performance fees for hedge funds, I consider, are a rip-off for patrons. Few phenomena illustrate this higher than round-tripping stocks. These are stocks that, for whatever reason, record enormous price gains over the course of several years, only to then fall back to roughly their original value.
During the COVID-19 era, many firms have experienced such back-and-forths. That’s to not say they were bad investments or that their stocks were overvalued: stocks rise and fall for reasons that are not all the time related to fundamentals. But the extent to which hedge funds cash in on these round trips on the expense of their investors is astonishing.
Consider the performance of online used automotive dealer Carvana.
Carvana generated an 87% annualized return (1112% cumulative return) between January 1, 2018 and year-end 2021, increasing its market capitalization from $2.8 billion to $40 billion during that period.
But 2022 hasn’t been so kind. After peaking at $41 billion in 2021, Carvana’s market cap fell to $3.6 billion, with shares falling 91% within the calendar yr starting July 1. That means the stock has returned a cumulative 9.7% since January 1, 2018, essentially occurring a “round trip.”
Carvana’s 4.5 yr tour
So what would this mean for hedge funds and their limited partners (LPs)?
Near Carvana’s peak in Q2 2021, based on data from whale wisdomWe estimate that hedge funds owned about 21% of the corporate’s shares. These include such respected firms as 683 Capital, Tiger Global, D1 Capital, Lone Pine, Whale Rock, Sands Capital and plenty of others with excellent long-term track records.
Let’s assume that over the 4.5 years in query, hedge funds owned a mean of 20% of Carvana’s outstanding shares and charged a 20% annual performance fee above a 0% hurdle rate. How much would hedge funds have generated from their customers over time by owning Carvana? By our calculations, they might have earned $1.2 billion in fees over the three years between 2018 and 2020.
This is solely stunning. Between January 1, 2018 and July 1, 2022, Carvana’s market cap increased from $2.8 billion to $3.6 billion. Nevertheless, hedge funds would have earned 150% of this market capitalization profit in the shape of fees. This is only a transfer of wealth from the hands of the allocators to those of the hedge fund managers.
| 2018 | 2019 | 2020 | 2021 | 2022 | Sperm. | Current | |
| Carvana stock Prize return |
71.1% | 181.4% | 160.2% | –3.2% | –91.0% | 9.7% | |
| Carvana Market Cap, off January 1 (billion) |
$2.8 | $5.4 | $12.0 | $45.0 | $40.1 | $3.6 | |
| Percentage owned by Hedge funds |
20% | 20% | 20% | 20% | 20% | ||
| Hedge fund Performance Fee |
20% | 20% | 20% | 20% | 20% | ||
| Implicit hedge fund Performance Fees (Millions) |
$79 | $392 | $771 | $0 | $0 | $1,242 |
Of course, that is just an estimate and should overstate the performance fees generated by this stock. For example, negative-yielding stocks held by hedge funds reduce the performance fees of positive-yielding stocks like Carvana. In addition, different hedge funds have different performance fee crystallization requirements, corresponding to: E.g. highs, hurdles, etc. Still, our estimate just isn’t an unreasonable approximation, and it actually underestimates the general impact given the sheer variety of stocks which have experienced a round trip.
Oh rattling! Another return flight*
In fact, Carvana’s performance is hardly an outlier. In recent years, shares of Facebook, Roku, Sea Limited, Shopify, Snapchat, Zoom and plenty of others have experienced similar “round trips.” The takeaway is solely that the annual performance fees paid to hedge funds produce absurd results on the expense and detriment of LPs.
Return to reality and gravity is gone pic.twitter.com/813RLGbgxs
— Bucco Capital (@buccocapital) July 21, 2022
Why shouldn’t hedge funds do it this manner?
Hedge fund managers are incentivized to act in their very own interest and maximize their very own wealth. They can be rational in the event that they committed $1.2 billion in performance fees to their clients in return for delivering a net annual return of -5.6%. It’s a really attractive source of income for them, but a really bad one for his or her LPs.
| 2018 | 2019 | 2020 | 2021 | 2022 | Sperm. | Ann. | |
| caravan Stock price return |
71.1% | 181.4% | 160.2% | –3.2% | –91.0% | 9.7% | 2.0% |
| Carvana as Net return of a hedge fund |
56.9% | 145.1% | 128.2% | –3.2% | –91.0% | –23.2% | –5.6% |
| S&P 500 TR | –4.4% | 31.5% | 18.4% | 28.7% | –19.8% | 53.6% | 9.8% |
| Carvana hedge fund Excess return |
61.2% | 113.6% | 109.8% | –31.9% | –71.1% | –76.8% | –15.4% |
Our example, while extreme, shows how performance fees can create perverse incentives for hedge fund managers. Far from higher aligning their interests, allocators who insist on paying for performance could also be making the bad situation worse.
With stocks like Carvana for the past 4.5 years, hedge funds have been given a round-trip, all-expenses-paid ticket – by their LPs.
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Photo credit: ©Getty Images/BogdanV
