Charlie Munger, Warren Buffett's sidekick, has a favorite story about employee incentives.
It starts at FedEx (NYSE:FDX). The night shift just can't seem to get things right -- packages are never processed on schedule. This is unfortunate because the night shift is the most important link in the chain of on-time delivery. Delays during the night shift result in late packages.
So, finally, FedEx made a simple change to compensation. The night shift would no longer receive hourly pay. Instead, workers received a flat rate per shift. When the work is complete, employees can go home. Whether they work for one hour or eight hours doesn't matter -- the pay is the same.
After this simple change in compensation, the night shift had an uncanny ability to get its work done on time. What happened? Nothing, really. The interests of workers were finally aligned with the interests of their employer. Workers didn't have to stretch out their work to make more money, and it was in their interest to get done early, so they could leave before the shift was over.
Incentives are everything
The story about FedEx is applicable to any company. I used to own shares in a golf products company that paid its CEO based on sales. You'd never guess why it had this terrible problem of producing too much inventory every single year.
When you incent behavior -- getting work done promptly, or selling more golf products even at a loss -- you get more of it.
In following the business development company industry, I've seen more than my fair share of bad incentive schemes. Almost all BDCs pay their management teams based on assets under management, and a percentage of the return on the company's assets.
This creates maligned incentive structures:
- Managers make more money by managing more assets, even if managing more assets may be a disadvantage to investors.
- Managers who are compensated based on a percentage of the company's return have an incentive to make riskier investments.
Neither of these should be mind blowing to anyone who invests in high-yield BDCs. After all, these two compensation issues are routinely cited in the "risk factors" section of a BDC's annual report. But as frequently cited as they may be, they are, in my view, one of the most important things that will eventually separate bad and good performers in the industry.
The old model
Compensation structures made dramatic changes after the 2008 financial crisis. Although almost all BDCs still compensate their managers based on a percentage of assets and a percentage of returns, newer BDCs have substantially better incentive structures than prefinancial crisis BDCs.
Prospect Capital Corporation (NASDAQ:PSEC) is a BDC that can trace its IPO back to 2004, well before the financial crisis. Its compensation structure is pretty simple -- 2% of gross assets plus 20% of returns in excess of 1.75% per quarter. Unfortunately, this structure can result in fees even when performance isn't that good.
In one quarter, its investments could perform poorly. The next quarter, they could return to normalcy. Prospect Capital would collect an incentive fee when assets return to their "normal" level of performance. Most older BDCs, from Ares Capital Corporation (NASDAQ:ARCC) to Fifth Street Finance (NASDAQ:FSC), work this way.
The new model
Newer BDCs generally have better protection for shareholders. FS Investment Corp. (NYSE:FSIC), which went public in 2014, requires that shareholders receive an 8% return over the last three years before it can take an incentive fee. Thus, incentive fees are only paid in the event shareholders earn good returns over three years, not just a single quarter.
Likewise, Golub Capital BDC (NASDAQ:GBDC), which went public in 2010, structures its fee such that its 20% incentive fees on returns cannot exceed 20% of its cumulative (since inception) returns.
TCP Capital (NASDAQ:TCPC), a company which went public in 2012, has an 8% total return requirement since inception. Thus, only once its shareholders have earned 8% over the long run can it begin to collect 20% of the returns for managers.
No longer can a single good quarter create fees for the management team, thus forcing management teams to think for the long haul. They'll always earn their fees on assets under management, but they won't always earn their "incentive fee" for good performance.
Importantly, the hurdle rates of return apply to the performance of the underlying portfolio, not the returns on the stock. But, as you might expect, the returns on a BDC stock will inevitably mirror returns on the underlying portfolio of investments.
Legacy BDCs have work to do
It's my steadfast belief that the legacy BDCs with old school fee structures will have to modernize their incentive compensation schemes to be attractive to investors. Further, I think the future will bring even more shareholder-friendly structures in which the bulk of the fee structure is based on performance, not size.
The fact is that Golub Capital BDC and FS Investment Corp. have arguably some of the best management teams in the business. Combine that with shareholder-friendly fee arrangements, and I think they're at a clear advantage to the old school BDCs.
As you think about which BDCs to invest in, I'd think carefully about how a management team earns its compensation. The truth is that almost every management team is incentivized to manage more money. However, not all management teams are equally incented to drive returns for shareholders.
If I had to make a broad prediction about future returns for BDCs for the next 20 years, it would be my view that internally managed BDCs will be the best performers, hands down. BDCs with shareholder-friendly incentive fee structures would perform toward the middle, as their management teams are incentivized to think for the long run. Finally, the legacy BDCs would, as a group, likely underperform all others, due to their fee structures which place no emphasis on long-run returns.
It's a simple case of getting what you pay for.