If one were to examine the current global financial system, it is apparent that capitalism works well during the boom part of the boom-bust cycle but not so much during the bust phase that recurs with alarming regularity. In an increasingly complex system, the financial referees generate hundred and thousands of well-intended checks and balances: laws, rules, regulations, etc. that try to restrict or dampen the system risk using a hodgepodge of conflicting and inconsistent guardrails to prevent the systemically important institutions from self-immolation. But “there was a flaw in my ideology” as a famous central banker once said to Congress. One should bank on the cadre of incredibly smart seven-figure lawyers, eight-figure investment bankers, nine-and-ten-figure private equity firms and hedge funds will always outwit six-figure accountants, politicians, and regulators. Always have, always will. The job of the Olympic champions of finance to legally circumvent the best of intentions of the watchmen and protectors of the public good who will always come up short in this mismatch. Think of it as IQ arbitrage.
Archimedes famously espoused that with a large enough plank and a fulcrum he could leverage the universe. Great wealth has inured to those who have mastered this principle: it’s all about the leverage. Surely this metaphor must have been the inspiration of Tom Wolfe’s Masters of the Universe trope. Deployed wisely capitalism thrives on leverage but only in the boom part of the economic cycle. When things go south we bring out the workout artists and I don’t mean Jane Fonda. The opening chapters of Wolfe’s “A Man in Full” feature the character Charlie Croaker, a composite of real estate developers from Atlanta including John Portman who I had the privilege of representing in the 1990s.
The scheme is actually quite simple and brilliant. Invest at 12% with borrowed money at 6% leveraged 50% and the return on equity will be 18%; if leverage is increased to 80%, and suppose the price of debt increases to 8%, the return increases to 28%. A typical hedge fund or private equity deploying vast amounts of capital under the “2 & 20” model, it is easy to see how Stephen Schwartzman, Ken Griffin, Ray Dalio, Leon Black, and Henry Kravis got so rich. It’s all about Assets Under Management (AUM). Walk into any Park Avenue cocktail party and see how long it takes to be subtly informed by any serious player what their AUM is.
If a firm/individual has $100 billion AUM, they are making $2 billion a year give or take, just from their 2% annual investment management fees. Of course, the firm has to pay its employees, rent and operating expenses but the economics of the AUM model scale brilliantly. While there are a million variations of the scheme, it is generally referred orto as the “2 and 20” model: which means 2% annual management fees plus 20% of the profits. These management fees are taxed as ordinary income; financial rewards from the carried interests, ( a percentage, typically 20%, of the profits (the “carry” or “promote”), are taxed as capital gains. To Steven Schwartzman this preferential tax treatment of the carried interest is the single most import foundational pillar of good old fashion American capitalism. and in turn democracy There are a million variations of the 2 & 20 scheme: prefs (preferred returns), waterfalls, look-backs, catch-ups, ratchet-ups. It is the carried interest that what makes the world go round. As the returns to investors, known as the limited partners or LPs, increase, the carry (aka: the promote) to the General Partners or GPs (known as Masters of the Universe) also might get them an even bigger piece of the profit pie. Not surprisingly the math is pretty straight forward: that’s why we have so many billionaires spewing forth from the investment management industry. America. What a great country! Income and social inequality be damned. Some might even say its time for a new model to avoid the “heads on pikes” annoyance of the French Revolution.
Even though Albert Einstein was deeply troubled by Quantum Mechanics that obliterated Newtonian Physics as things start moving at the speed of light, he famously stated that “reality is an illusion, but a very persistent one.” All finance is relative, change the price of one asset or commodity and the prices of every other in the financial system also. The more volatility the more profits traders make simply trading the volatility. Hmmm. The Fed wants price stability and traders want volatility? Sounds like a recipe for disaster. But as Pope Francis famously said, “Who am I to judge?”
