How Should I Be Paid?

For my more up-to-date views about industry pay, see my blog post from February 2018: How to Better Align Money Managers With Their Clients

Over the past couple months I have written and talked about management compensation quite a bit. This has led to me thinking about my own compensation recently, and just like with CEOs, I’m not sure if any fee structure is perfect. Non-qualified investors can’t legally be charged performance-based fees so those clients are easy—2% of assets under management (AUM) is what I charge which is pretty standard. More discrepancies come into play with qualified investors ($2 million net worth excluding primary residence) who can legally be charged a percentage of profits that the money manager earns.

The industry standard for hedge funds is 2 & 20. That is, the money manager earns 2% of AUM (the management fee) plus 20% of net profits (the performance-based fee). Thus, if a manager returns 32% one year, the client pays him 2% of assets plus 20% of the net profits, which is 20% of 30%, or 6%. Altogether the money manager gets paid 8% of that client’s AUM that year, and most people would say it was well deserved for such large returns. But what if the overall market gained 35%—does the manager still deserve to be paid so well even though they underperformed the broader market?
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Embrace Volatility!

S&P 500 returns

As I’m sure most you are aware, that’s what the market has done the past week. Just today the market opened down 1,000 points only to regain almost all of those losses by mid-day and then crash back down in the afternoon. I knew the panic was real when multiple people (who have very little interest in the stock market) reached out to me asking what’s going on. I think one of my friends thought I was out of a job by 10:00 am 🙂
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VirTra Systems: When Compensation Matters

After my recent blog post on why management’s compensation matters, I’ve been wanting to give a more concrete example. VirTra Systems (VTSI, $0.11) is a company that I was initially very interested in—great product, sales are ramping up and tailwinds to continue that growth. Unfortunately, when I delved into management’s compensation it was an absolute deal breaker.

Business overview
Let’s take a step back and look at what they do. VirTra makes combat simulators for police officer and military training. They offer simple single-screen virtual shooting ranges all the way up to a 300 degree, five screen combat simulator that fully immerses the officer in a real life scenario. These scenarios are filmed with real actors (some competitors use CGI) and then played back on the video screens for the officers. Whoever is training the officer watches and alters the scenario based on the officer’s actions. So if the officer adequately talks down the offender the scenario will go one direction. If the officer pulls out his gun the offender will react much differently. Officers also get an electronic shock when fired upon to increase realism. Below is a picture that shows their largest simulator.
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Compensation Matters

Perhaps the most important rule in management is ‘Get the incentives right.’
— Charlie Munger

If you don’t know, Charlie Munger is Warren Buffett’s long-time partner and Vice-Chairman of Berkshire Hathaway. And if you haven’t read his book, Poor Charlie’s Almanack, I cannot recommend it enough. It’s more about psychology and general life advice than it is investing, but it nonetheless had a major positive effect on my investing career. Mr. Munger ends his book with a discussion of 25 psychological tendencies he feels are the most common sources of human misjudgment. The first one on his list, because he feels it’s the most underestimated, is what he calls “reward and punishment superresponse tendency.” In more normal speak, “incentives are extremely powerful.”

On a regular basis I am shocked at how many investors will write about a company and not mention management pay. It is one of the first things I look at and is, in my opinion, one of the most important (and overlooked) parts of an investment thesis. It is human nature to be selfish and act in one’s own interest and many CEOs are incentivized not to act in the best interest of shareholders.
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