Hedge Funds and Upward Pressure on Executive Compensation

The financial crisis resulted in extensive additional regulation.  One thing that came out largely unscathed was exective compensation.  The SEC was given some additional authority to regulate compensation committees and financial regulators had some additional authority to regulate certain compensation practices.  But on the whole the subject was left untouched.  This was the case despite the fact that compensation had been identified as a factor in causing the financial crisis.

Nonetheless, for a period, executive compensation seemed to stabilize and even come down a bit.  There were a few notable gestures, such as when Goldman declined to pay bonuses to top officials.  But absent any permanent change, the reality was that compensation practices would go back to the excessiveness that preceded the financial crisis.  This was true because of the dynamics of the compensation process.  As we have noted on this Blog, boards decide compensation and must do so consistent with their fiduciary obligations.  Fiduciary duties under state law impose no meaningful restraints on compensation decisions, effectively resulting in compensation without limits.  See Returning Fairness to Executive Compensation.  

There have been a few scattered reports indicating a climb in executive compensation.  Most interestingly, however, was the article in the WSJ about funds streaming back into hedge funds.  The numbers look to soon surpass the amounts that preceded the financial crisis.  As the article noted:  "Total hedge-fund assets are approaching $2 trillion and are soon expected to surpass their peak in early 2008, according to industry analysts. Even start-ups and smaller funds, which were shunned by many investors in the wake of the crisis, are benefiting."  In addition, a number of new funds have entered the field.

What does this have to do with compensation?  Some funds will do disastrously; most will probably do not much better than the market.  But if past experience is any indication, there will be some funds that make spectacular profits and pay spectacular amounts to employees (who can forget the eye popping $5 billion earned by John Paulson personally in 2010). 

Firms like Goldman justify compensation practices by arguing that they need to avoid losing key employees to hedge funds.  As hedge fund compensation increases, so will the compensation of top financial institutions.  As the compensation of financial firms increases, so will the compensation at other types of companies.  Hedge fund compensation, therefore, is the canary in the mine.  It is a predictor of future excesses among public companies.  And, from the report in the WSJ, this warnings of this canary are sounding.