Go ahead, admit it, you’ve thought about becoming a billionaire. Maybe you are already: “Good on ya”, then, as they say in Australia. But if you’re not, read on.
The recent Forbes 400 (richest American billionaires) list has about 112 people, by my count, who made their fortunes in some form of Finance, Investments, Hedge Funds, insurance or banking. The rest of the 400 either inherited, invented or own businesses that have become significant to the US and world economy over time. There are also other financiers who may not have made the Top 400 billionaire list.
As a reference point the BLS/Census figures indicate that these financial industries employ around 6.7 million people across 988,000 firms, out of total US employment of 157 million. The financial industries have a 2% unemployment rate, an average annual wage of $72,000 per person, and represent over $2 trillion or 7- 8% of national GDP. Interestingly, these industries generate roughly 25-30% of all US corporate profits.
So while the ratio of billionaires to total financial employees is pretty small, the superstars in the financial news have been the folks who manage investment funds. They make their money the old-fashioned way, — by extracting wealth from others. How does this work you ask?
Let’s examine the formula for success. Assume a hedge fund has accumulated or sold shares of an investment fund pool totaling $1 billion, - a relatively small fund in practice, but used here for ease of computation. A portion of the capital, usually small, is put in by the general partner (GP) and the rest comes from pension and insurance funds, university or charitable endowments, rich individuals including foreigners, and other essentially “other people’s” money. The LP’s are in the fund ‘for the long term’.
In a recent Goldman Sachs podcast, for example, the co-founder of Kohlberg Kravis Roberts, aka KKR, Henry Kravis, stated that the partnership was started with under $150,000 of the 3 general partner’s (GP) money, 40+ years ago. KKR is now, of course, one of the largest LBO/Private Equity/Hedge fund/ investment companies in finance, with at least $500 billion in investments, according to their website.
So the funds make investments in many types of (mostly) private and public assets using the pooled money for acquisitions, which then generate the cash flow profit which is returned to investors (LP’s). There’s not enough space here to discuss the investment types, or the ways additional borrowed loans raise the total of investable capital amounts, so we’ll focus on the rates of return and fee structures in the remaining paragraphs.
Assume our sample fund has a $1 billion starting pool, and its investments earn a total of 4% in the course of a year. (This is a conservative amount, but over the past 20 years including the 2008 Great Financial Crisis and COVID, this is not far off the average earnings rate). The typical fee structure for the GP has historically been 2% of assets under management (AUM) and 20% of profits from investments, with the remainder made available or paid to the limited partners/investors.
So with the simple assumptions, in the first scenario below, our fund would grow to $1.040 billion on earnings of $40 million, with the GP collecting $20 million in base AUM fees and $8 million in performance fees, or $28 million in total, with $12 million available for the rest of the investors.
Fund Returns and Expenses Under Different Earnings Rates
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In this simple example, by varying the Earnings Rate you can see the impact the fee structure has on returns to the GP’s versus the rest of the investors. With a 10% earnings rate on fund assets, the GP gets $40 million, and the rest of the investors get $60 million. In the early days of Leveraged Buyouts (LBO)’s, first mover funds could generate higher returns, often well above 10%, through better management of acquired company assets, but more likely through asset stripping, like liquidating defined benefit pension plans, dividend recaps, real estate sales, and hidden or advisory fees from the acquired asset companies. The GP’s expenses to manage the fund are small in relation to the investment returns.
Some of these options for extracting cash from fund investments have become less available over time, and the 2 and 20 fee structure has become subject to greater negotiation by prospective LP’s and more knowledgeable investors, but the underlying economics (and tax benefits from the so called carried interest loophole which treats the GP’s earnings as capital gains and not ordinary income) still strongly favor those individuals who control and manage these investment funds.
The other aspect of returns is demonstrated in the two remaining scenarios, where the fund has either no return for the year, or in fact a loss, as many LBO and PE funds had in 2008 and 2022. The fees to the GP would still be substantial, - $20 million in each scenario in our $1 billion investment fund example, with the other investors earning nothing or in fact losing ground for the year.
Our simple example assumes a ‘small’ fund of $1 billion in Assets Under Management (AUM). If you assume a fund with a larger AUM base, -say a $50 billion fund, - the management fees that have been earned or could be earned by the GP grow exponentially. So over 10-15 years, becoming a billionaire is simple, if you can create and control a fund. And most GP’s run multiple investment funds.
As a final observation, Total US AUM in 2022 by one estimate were $109 trillion, down from $123 trillion in 2021, reflecting the decline in markets in 2022. Most estimates for 2023 assume an increase in AUM, although definitive details take time to accumulate and are becoming more difficult to obtain due to the proprietary (secretive) nature of the relatively unregulated nonpublic portion of the financial markets. Perhaps up to one third of the AUM are subject to the 2 and 20 type of fee structure, since a larger proportion of AUM by companies like Vanguard, Fidelity, Schwab, some Blackrock, State Street, and other non-wealth management companies charge no or relatively small fees to hold investor (such as index funds and retail investor) assets. But there are plenty of AUM available for the willing billionaire.
Remember that one of the more famous books about investing is the 1940ish classic, “Where Are The Customer’s Yachts”, by Fred Schwed…..
