NEW YORK (Reuters) – Hedge funds have struggled of late to keep up their reputation as the sports cars of the investment world, often overtaken in the race for returns by the public buses of portfolios, index funds.

But the proverbial Ferraris of investing – paid big to beat the market or protect from its gyrations – have so far shown little sign of curtailing their lavish spending on compensation, offices and employee perks.

Hedge fund operators still work out of trophy offices in Manhattan’s Plaza district, Greenwich, Connecticut or London’s Mayfair. They are keeping the free lunch and snacks, ski and beach junkets, and even in-house yoga. And they continue to lavish portfolio managers with multi-million dollar pay, all in the face of poor performance and declining fees.

“These guys aren’t living in reality,” said Brad Balter, chief executive of Boston-based hedge fund investor Balter Capital Management.

A critic of the industry’s extravagant ways and a longtime proponent of lower-cost mutual fund-like hedge funds, or liquid alternatives, Balter said many high-spending hedge funds will eventually have to change their ways and become more like their more humble mutual fund cousins in terms of compensation, perks and other costs.

But there are few signs of dramatic change.

PAY RAISE

Many hedge funds have underperformed the equities market this year, with stock-pickers burned by losing bets on Valeant Pharmaceuticals (VRX.TO), Allergan (AGN.N) and Home Depot (HD.N), among others, while macroeconomic managers have struggled to trade their way through global political and economic uncertainty.

But the average portfolio manager at a firm running more than $4 billion with middling-performance – up about 1 percent year-to-date – is expected to make an average of $2.23 million this year.

That is up from $2.21 million in 2015 and down from $2.42 million in 2014, according to 2017 Glocap Hedge Fund Compensation Report.

Top executives stand to make far more. The average wealth gain for the highest earning 25 hedge fund managers in 2015 was $517.6 million, according to a ranking by industry publication Alpha. Five firm founders – Ken Griffin, James Simons, Ray Dalio, David Tepper and Israel Englander – made at least $1 billion.

By comparison, the average mutual fund portfolio manager, regardless of size or performance, is expected to make $634,000 in 2016, according to Glocap, up from $630,000 in 2015.

“Even if performance is down, managers still understand the need to pay big for top talent to avoid losing the very people who will help them generate returns,” said Peter Friedman, chief executive of Integra Advisors, a recruitment firm that focuses on quantitative investing.

FEE CUTS

There are some small signs of a reckoning. Poor recent performance of late and predictions by McKinsey & Co and others of tepid returns for years to come – because of low interest rates, slow economic growth and more – have caused a small but high-profile group of clients to revolt.

Investors have pulled some $51 billion out of the approximately $3 trillion hedge fund industry over the first three quarters of 2016, according to data tracker HFR, on pace for the biggest drop since the financial crisis of 2008 and its immediate aftermath.

For those staying put, clients are demanding steep reductions to the classic fee model of 2 percent of assets and 20 percent of investment gains. A handful of major firms have acquiesced, including Brevan Howard Asset Management, Caxton Associates and Och-Ziff Capital Management Group (OZM.N).

Many new managers are launching their firms with fees closer to 1.5 percent of assets and 15 percent of gains, including so-called “hurdles” that prevent charging for performance before beating a benchmark.

FREE STUFF

Even so, there is little evidence so far of substantial changes to spending habits, according to recent conversations with more than two dozen industry participants.

Citadel, PDT Partners and Bridgewater all still provide copious free food for employees. Citadel has produced modest gains in its main funds this year while Bridgewater is down slightly in its flagship hedge fund. Performance for PDT was unavailable.

Decadent parties remain a perennial favorite. Balyasny Asset Management flew employees and their guests for a weekend at the Fontainebleau Miami Beach hotel last November for its annual business conference and holiday party event dubbed “BAM Bash.” The 2014 version of the same party in New York City featured pop star Taio Cruz and acrobatic performers. BAM funds have produced modest gains this year.

Renaissance Technologies still flies staff and their families for an all-expenses paid vacation weekend. This autumn the destination was a resort in Florida. And Two Sigma rented out the Intrepid Sea, Air & Space Museum in New York for its 2015 holiday party; the venue in 2014 was the nearby American Museum of Natural History.

Hedge fund offices continue to dazzle, even if returns do not. Och-Ziff Capital Management, which has suffered investor withdrawals due to a foreign bribery scandal and mediocre performance, works in the $200 per-square-foot Solow Building in Manhattan, one of the city’s most expensive office towers.

Two Sigma’s lower Manhattan office features spaces for playing games, recording music and working out – including fitness boot camps, meditation and same-day gym laundry service. D.E. Shaw & Co’s sleek midtown Manhattan headquarters feature nap pods, a gym, game room and back-up childcare.

D.E. Shaw, Two Sigma and Renaissance use computer-driven investment models, which means they compete for talent not just with other hedge funds but also top technology companies known for extensive employee perks, such as Alphabet Inc’s Google (GOOGL.O) and Facebook Inc (FB.O). Like many so-called quants, all three firms have produced strong returns of late.

“While costs are certainly being scrutinized, the fact that the environment is becoming more favorable to delivering performance means that talent has to be retained,” said Jack Inglis, chief executive of hedge fund lobbying group Alternative Investment Management Association. For that reason, he said, it makes no sense to yank perks or other relatively modest budget items.

SOME CRACKS

To be sure, some firms are making cuts.

Highland Capital Management slashed its conference budget in half, even though its public Global Allocation Fund is up more than 20 percent this year. It also recently traded its Solow Building outpost for less-pricey space in the Times Square Tower in New York

Brevan Howard, which has performed poorly this year, told employees to use their personal phones for company business and tightened its rules on travel.

Several hedge fund marketers, who drum up new customers for funds, said they planned to engage in conference freeloading: hanging around the venue of an event without entering, and meeting with clients after-hours, thereby avoiding the price of a ticket, which can cost between $5,000 and $15,000 per person.

Pershing Square, whose public fund is down 18.3 percent this year through mid-November, is soon moving into new offices that are 40 percent less expensive. There is one flourish in the planned Hell’s Kitchen, Midtown Manhattan space: a tennis court on the roof.

Other hedge funds are postponing real estate decisions this year, according to Ben Friedland, an executive vice president at CBRE, pointing to a more than 50 percent yearly decline in new leases signed by financial services firms, and a relatively high proportion of them renewing short-term contracts.

“Many firms are choosing to punt,” said Friedland.

Robert Olman, founder of recruitment firm Alpha Search Advisory Partners, said firms are becoming more cost-conscious given that performances fees are not yielding much.

“Twenty percent is not adding up to a lot these days,” Olman said, “So they are watching every dollar.”

SOUL SEARCHING

In some sign of change, a few large and relatively successful firms have announced restructuring efforts.

Ray Dalio’s Bridgewater, the world’s largest hedge fund manager with 1,700 employees and more than $150 billion under management, said in September it was planning “significant changes to people, processes and technologies,” to address a surge in staff numbers that led to its non-investment divisions becoming “bloated, inefficient, and bureaucratic.”

Billionaire hedge fund manager Paul Tudor Jones laid off roughly five dozen employees in August, or about 15 percent of his Tudor Investment Corp workforce. Pershing Square cut 10 percent of its staff in June when founder and head Bill Ackman laid off eight lower-level employees. And Daniel Och’s Och-Ziff has seen its headcount decline by about 17 percent this year, a combination of layoffs and departures.

Others have closed foreign offices, including TPG-Axon Capital and Hutchin Hill Capital, or shut down altogether, including Perry Capital and Nevsky Capital.

Lisa Baird, a hedge fund specialist at Heidrick & Struggles, said the executive search firm is now getting more inquiries related to restructuring. The discussions with clients include the issue of whether pay for some roles is too high, given lower salaries for similar roles outside of the hedge fund industry.

“There has definitely been a premium paid by hedge funds for many roles,” Baird said. “That is coming into question with the squeeze on fees.”

For now though, most thoughts of big changes have not translated into action.

Anthony Keizner, a partner at recruitment firm Odyssey Search Partners, said many fund managers know changes could be necessary, but it is hard to be among the first the make a big shift given the potential for loss of talent.

“I’ve heard people say ‘Maybe we’re the frog in the boiling water scenario – we don’t realize yet we should be changing.”

Article by: Lawrence Delevingne

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