The Importance of Incentives
There are two concepts that I’ll highlight in this talk. First, the importance of incentives in influencing behavior in the hedge fund context. Second, the process of backward thinking to identify legal risks with hedge fund investing. I associate both points with Charlie Munger.
Munger is, of course, Warren Buffett’s longtime investment sidekick. Prior to hooking up with Buffett, Munger was a successful investor in his own right and was trained as a lawyer.
Like Buffett, he’s given a lot of thought over the years to developing good mental models for decision making. Like Buffett, he’s been willing to share those thoughts in speeches and writings that I’ve found useful.
“Never, ever, think about something else when you should be thinking about the power of incentives.”
— Charlie Munger
Munger’s quote should be considered a cornerstone of any legal framework focused on hedge fund investing.
In my opinion, the power of incentives to influence manager and investor behavior in the hedge fund context cannot be overstated enough.
More than any other investment vehicle that I’m aware of, hedge funds are engineered to permit managers maximum behavioral flexibility based on changing circumstances faced over the life of a fund. The incentives that can influence their behavior are embodied in a fund’s legal terms.
That may not be a bad thing in certain cases.
However, if an investor or its adviser choose to ignore the influence that legal terms have in defining a manager’s incentives and thereby potentially shaping future action, they do so at their own peril.
So it’s important to analyze hedge fund legal terms in how they may influence incentives and future behavior, not as an academic exercise.
The second point I want to discuss here is the process of analyzing a hedge fund’s terms by employing a technique of inversion or thinking backwards about what can go wrong once a desired investment outcome is determined.
Thinking Backward
“A lot of success…in business comes from knowing what you really want to avoid”
— Charlie Munger
What are your hedge fund investment goals? Let’s flip that question: What do you want to avoid? Obviously investment loss is one. How about excessive fund expenses? Fund proceeds that are locked up? Onerous indemnification claims or conflicts of interest?
There’s a terrific book that I recommend called “Seeking Wisdom: From Darwin to Munger” by Peter Bevelin. It focuses on practices to improve critical thinking based on the works of Munger, Buffett and many others.
There’s a section in the book called “Guidelines for Better Thinking” and it lists 12 principles.
Number 10 is “Backward Thinking” which we can define as the process of starting with an end goal in mind and working backwards to identify everything that can go wrong with the achievement of that goal as a means of identifying risk.
Using that technique, once we have a clear investment goal in mind and work backwards to identify factors that can mess up that desired outcome, we can make an assessment as to whether those factors are ones that:
1) we can live with,
2) seek to modify or
3) simply avoid.
Title Slide: Risky Business
Why is this method important to identify legal and regulatory risk associated with hedge fund investing?
Because a lot of risk associated with hedge fund investing beyond the investment risk lies buried in the documents. It’s the latent contractual terms and provisions that can spring to life if certain conditions are met.
Hedge fund documents are often dense and loaded with terms and provisions that may have no applicability at any one point in time. They may look innocuous.
The problem is that it’s often difficult to properly assess those risks if an investor focuses its analysis strictly at the front end of the hedge fund investment process when an investment is made.
Also, hedge fund documents may not address certain risks that an investor considers material to a desired investment outcome. So it’s important to review those documents not only for what’s in them but also what’s not to properly assess risk.
By defining the investment end-goals first and thinking backwards, a person is better able to review the terms of a hedge fund’s legal documents to determine what in the documents can mess up that desired outcome and any gaps that should be addressed.
Once identified, sensitivity analysis can be done on those terms to determine whether an investor with a desired investment outcome can live with a specific term, seek to modify it or simply not make the investment.
Next Up
Throughout our talks, we’ll go through a process of inverting our thoughts with respect to different hedge fund legal terms and couple that process with a focus on the power of incentives to assess legal and regulatory risk.
Next we’ll turn to defining what a hedge fund starting with a “top down” approach.