P
rofessor Kenneth A. Merchant wrote this teaching note as an aid to instructors using the Raven Capital LLC case.
Marshall School of Business
University of Southern California
Raven Capital, LLC
Teaching Note
Purpose of Case
The Raven Capital case was written to illustrate an interesting apparent contradiction in many
firms in the hedge fund industry, including Raven Capital. These firms have access to many
objective performance measures, and sector performance benchmarks are available for
evaluating performance, yet the performance evaluations of many of the hedge fund employees
are done totally subjectively. The focus of this case is on the performance evaluations of hedge
Suggested Assignment Questions
1. Play the role of a Raven portfolio manager who has to allocate a bonus pool to the four
analysts working for him. Assume that Raven earns a 20% incentive fee and that all of the
2009 returns were above the funds high water marks. Use 30% of the incentive fee as the
bonus pool to be allocated to the four analysts whose backgrounds and 2009 portfolio
performances are described in Assignment Figures A and B (appended at the end of this
teaching note).
a. How would you allocate bonuses to these four analysts? What alternatives did you
consider? Why did you make the choices you did?
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
b. Is there any other information you would like to have had available before making your
decisions? If so, which?
c. Do you think you should pay out the entire bonus pool this year, or hold some money in
a bonus bank reserve? Why or why not?
d. Should the proportions of the bonuses allocated vary depending on the size of the bonus
pool available? Redo the allocations of the bonus pool to these four analysts assuming
that because of a high water mark constraint, the incentive fees earned in 2009 were
only $300,000.
2. Evaluate the Raven performance evaluation and incentive compensation system. What
changes would you recommend, if any?
Case Analysis
A. Background Discussion
It is useful to start the class by clarifying what a hedge fund is, and is not. I write the following
labels on the board:
Hedge fund
I ask students to compare and contrast these types of organizations. Here are the conclusions
that I want them to reach:
2. The first three solicit monies from qualified or accredited investors who are
sophisticated enough that they can fend for themselves. This limitation exempts these
3. Private equity funds invest their own monies (in the sense that they are typically fixed-term
4. There is considerable variety even within the private equity, hedge fund, and venture capital
fund categories, as the organizations can have different goals, different investment
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5. Mutual funds have smaller capital requirements, so they can accept monies from smaller
Focusing more specifically on hedge funds, I ask the following questions:
1. What is the objective of a hedge fund? Create value. Generate risk-adjusted returns in
2. Where do hedge funds get their money? From large investment pools, such as retirement
3. Where do they invest? Stocks, bonds, commodities, real estate. Actually potentially any
4. How do they make money? Generally they earn 13% of assets under management (AUM)
5. What constraints and regulations do they face? There are many. For example, hedge funds
cannot approach prospective clients directly. They must be introduced.
If instructors deem it worthwhile, they could explain why US-based hedge funds are being
required to register with the federal government for the first time in their history. They are
being asked to provide information about their size, their investors, and their risk (e.g., who they
B. Raven
Then the attention should be directed to Raven. Students should understand some of the basic
facts describing Raven and how Raven is different from other hedge funds in terms of:
size (less than $1 billion in AUM)
sources of funds (pension funds, funds of funds, high net worth individuals)
investment strategy
Focus on domestic equities in five industries;
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investment goal (beat the S&P by 610% per year)
fees (1% of AUM, which is lower than the hedge fund average)
Direct students attention to Exhibit 4 in the case, which shows the performance of Ravens
largest fund, which is called The Fund. I find it useful to go down the list to make sure that
students know what the abbreviations (e.g., LMV, SMV) and terms (e.g., VaR 95%, Sharpe
C. The Bonus Allocation Exercise
The bonus allocation question requires the allocation of $5,607,000 to the four analysts. The
total return is $93,450,000. Ravens share of that is 20%, which equals $18,690,000. The
analysts get 30% of that amount.
I suggest asking several students to reveal and explain their bonus allocation answers. I have
found that students answers vary significantly. It is informative for all to see those differences
and understand the reasons for them. Some students rely heavily on the quantitative
When I had Max Stoneman come to class, he revealed his answer to the assignment question,
which is shown in Teaching Note Exhibit 1. Max started his analysis by calculating each
analysts fair share of the bonus pool based solely on the returns generated. Since the
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(+) greatest seniority, well respected by PMs
James: (+) very well hedged
Kate: (+) second biggest contributor to performance
(+) highest ROIC on net exposure
Chris: ( ) smallest contributor to performance
(+) stocks beat the index, but PMs under allocated exposure
Note: Max said that none of the analysts at Raven runs a book as short as that attributed to
Chris in the assignment example. At Raven, they do not make overall bets against the
market or against individual industries.
Some other judgments by Max:
In making his judgments, he started with the outliers (Chris, and then James). He would pay
out the entire bonus pool in 2009 since 2008 was a bad year for compensation.
D. Other Issues
Depending on instructor preferences, other issues might also be raised, including the following:
1. Is the high compensation in this industry justified or evidence of poor governance or
regulation?
Most business students conclude that the high compensation is justified. After all, the few
people in this industry create significant value. They bear considerable risk, although the
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2. Why not provide a formal incentive for beating indices?
One danger here is that the firm is not paid that way. If the analysts beat their indices in
a down market, Raven might be obligated to pay more in bonuses than the firm earned.
3. Why not reward multiyear performance? For example, put earnings in a bonus bank that
could smooth compensation through lean years. This could also help with retention, as
4. Would it be a good idea to do the performance reviews in September and then allocate the
bonuses in December?
E. Evaluation of the Raven System
As with almost all systems, the Raven evaluation system has some plusses and minuses:
Plusses:
1. Takes a lot of factors into consideration.
Minuses:
1. A lot of objective data are not being used.
2. The high use of subjectivity is not scalable. Max conceded that Raven could not use this
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F. Other Observations by Max
Other observations by Max that might be usefully inserted in the class discussion, as appropriate:
The fund cannot pay directly for ideas that are not earning money.
The analysts do not write checks for losses they might generate.
Analysts prefer to invest long. They have to be ordered to take short positions for the good
of the team.
Tracking hypothetical portfolios based on analyst suggestions would create a lot of work. It
would also raise some questions that would be impossible to answer. For example, if the
recommendation was to sell, at what price would the firm have been able to exit at? It might
be an illiquid stock. How would the hypothetical portfolio deal with the stop loss rule that
the firm uses?
Is all this perceived as fair? Not always.
G. The Advantages and Disadvantages of Evaluating Performance Subjectively
I find it useful to close the class by getting students to consider generically the advantages and
disadvantages of evaluating performance subjectively. This discussion can be summarized as
follows:
Advantages
1. Can correct for bad measures (e.g., those that are incomplete or excessively short-term
oriented.
a. Raven managers believe that everyones ideas contribute to the good of the firm.
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b. Everybody has a specialty, and the market favors only some stocks over any given short
2. Can exploit new, relevant information that arises during the measurement period
Disadvantages
2. Can be perceived to be unfair, particularly if the evaluators judgments are not trusted.
4. Can cause ambiguity in the reasons for evaluation. Poor feedback.
Pedagogy
The focus for the class discussion should be the analyst performance evaluation exercise.
Instructors should leave adequate time to solicit multiple student solutions, to have the class
consider the merits of those solutions, and to think about why, with all the performance metrics
available in this industry, the performance evaluations are (and should be?) done subjectively.
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
Teaching Note Exhibit 1
Analyst Bonus Determination (prepared by Max Stoneman)
Gross
Exposure ($M)
Total
Return
Net
Exposure ($M)
ROIC
@6% Flow-
through ($M)
Bonus
Recommendation ($M)
Nick (Consumer) 900.0 43.2 400.0 11% 2.6 1.8
(% of total) 40% 19% 19% 38%
Kate (Tech) 300.0 30.0 90.0 33% 1.8 1.2
(% of total) 13% 32% 17% 21%
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271
Assignment Figure A
Background Information about Four Raven Analysts
Nick Steinberg (NS) has been with Raven for 10 years, longer than any other analyst. He has a
BA from Cal Tech and an MBA from USC. Nick analyzes consumer stocks, a sector which
performed very well in 2009. Nicks stocks were responsible for most of Ravens funds long
returns. He communicates well with the PMs, and there is a great deal of trust between them.
James Johnston (JJ) has been with Raven for 8 years. He has a BS from UC San Diego.
James analyzes healthcare stocks. He is thought to have been a consistently strong performe
r
during his tenure at Raven. In 2008 his stocks generated significant profits for Raven, but the
Kate Landry (KL) has been with Raven for 5 years, with a prior industry focus on technology
stocks. She has a BA from USC and an MBA from Wharton. Kates stocks delivered strong
Christopher (Chris) Frost (CF) has been with Raven for 3 years. His specialty is financial
stocks. He has a BS from Columbia University. The financial sector was down in 2009, and very
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
Assignment Figure B
Information on the Performances of the Portfolios of Four Raven Analysts, 2009
Short Long Total Industry
Benchmark
Analyst
Dollars
Allocated
($000)
%
Return
Dollar
Return
($000)
Dollars
Allocated
($000)
%
Return
Dollar
Return
($000)
Dollars
Allocated
($000)
%
Return
Dollar
Return
($000)
%
Return
NS $250,000 1.2% $3,000 $650,000 6.2% $40,200 $900,000 4.8% $43,200 9%
JJ $400,000 6.8% $(27,000) $500,000 9.0% $45,000 $900,000 2.0% $18,000 8%