Working beyond the Minimum
The greatest risk in investing within a hedge fund is that the manager will not have the same interest in keeping your investment profitable as you yourself would have. Unfortunately for the investor, they normally do not have any of the skills that are essential in running a great hedge fund. This forces them to engage investment adviser whose commitment may not match their own. One way of getting round this problem is to force the wage structure to reflect the efforts of the manager.
If they work hard and create a great profit, then the wage structure should reflect that by way of increased payment. If they are not sharp and make a loss, the likewise the wage structure should reflect that by way of a reduced fee.
The logic behind this is that the fund manager will eventually come to the conclusion that the harder he works, the higher the wages he is likely to command. This would discourage him or her from making bad investment decisions because they have effectively become an investor in the business. It is a powerful motivational tool because it taps into the natural human capacity for self interest and the desire to get to the top of the business world. The hedge fund will usually employ people who are particularly ambitious and who may even have dedicated their private lives to the service of getting rich.
Therefore the idea of creating a bonus structure that recognizes their efforts and compensates them for risk is much welcome. This kind of structure compares very favorably to a fixed structure where the worker is not interested in the profit side of the business. They know that as long as they turn up for work on time, their wages will be paid at the end of the month. These are the kind of wage structures that have crippled the public service in many countries. The hedge fund wanted to avoid all these problems.
At the negotiating table the level of bonus was set as a percentage of the profits. The negotiator for the fund managers would then be interested to see whether there were minimum guarantees as to the amount of money that can be paid to the manager. There were also issues of dispute resolution that would have to be made part of the deal if there was to be any realistic prospect for success.
Minimum guarantees could be made by either reference to the normal wage or the management fee. It would them be up to the worker themselves to set the wage by working towards a certain target each year or month as the case may be.
The problem with this structure is that unless there are specific controls placed on employees, they will be forced to take unmitigated risks to such an extent that any possibility of profit will far be far outweighed by the resultant losses. This is exactly what happened during the global economic downturn. Therefore this bonus structure does not always guarantee good returns.