Fund Manager Compensation, Inflation and Moral HazardApril 1st, 2011
In my day job at Spinoff & Reorg Profiles, it’s not every day I have a chance to report on a Zimbabwean spinoff. Yet conglomerate Meikles Africa Ltd (MIKM.L) this month completed the distribution of Kingdom Financial Holdings to its shareholders. Both will relist “soon,” says the parent.
Once listed, these two would seem excellent opportunities for a performance-compensated fund manager, if he were unabashedly sociopathic. Zimbabwe’s recent inflation rates, which reached 231 million percent in 2008, practically guaranteed nominal equity returns well over a thousand-to-one every year. Suppose the manager is compensated as a percentage of nominal Zimbabwean dollar returns. He simply puts 100% of assets into MIKM or its spinoff; shares go nowhere, or even fall in real terms; but they rise, say, a hundred thousand percent nominally; the manager collects a 20% override on the gain.
In effect, he transfers almost 20% of his partners’ wealth to himself every year.
This reductio ad absurdum illustrates a potential moral hazard in performance-based compensation under conditions of high price inflation. Investing to keep up with inflation is vastly easier than investing to beat it; thus, from a return-on-effort perspective, when inflation is high, the portfolio manager with a performance incentive and a fixed hurdle is well paid just to do the minimum, easily clearing the compensation hurdle without increasing his partners’ real wealth. Sometime in the next several years, we may have a chance to see what ensues under such conditions.