CIM -- Investment Structure

As I wrote in the previous post, CIM is essentially a publicly traded hedge fund structured as a mortgage REIT which means they have to pay at least 90% of their income out as dividends every quarter.

For shareholders this structure exhibits two of the most attractive aspects of investing in hedge funds and one very unattractive aspect.

The first attractive aspect is that the group at FIDAC that will be managing Chimera will be paid on a standard hfund 2/20 structure. Particularly, FIDAC will charge 1.75% of book value as a base fee and will take 20% of anything CIM earns beyond LIBOR + 50 bps. The incentive fee makes perfect sense because FIDAC needs to earn a premium to LIBOR (which any shareholder can get themselves) before they start sharing in the bounty. Also with this structure, FIDAC’s interests are directly aligned with shareholders’ interests.

It also appears that all fees that CIM pays to FIDAC will be adjusted downward to exclude any fees paid on Annaly sponsored products that Chimera might buy. This eliminates the possibility of FIDAC double dipping on fees and benefiting NLY shareholders at the expense of CIM shareholders.

The second attractive aspect of CIM’s structure is that FIDAC has “skin in the game” along with other CIM shareholders. As part of the IPO, FIDAC bought 9.8% of CIM’s stock spending roughly $50M dollars of its own money. Technically, it was Annaly that bought the stock but I am using FIDAC and Annaly interchangeably. Having a large chunk of their own money invested along side fund investors is very common with hfunds and is a substantial advantage to shareholders as interest are perfectly aligned.

The only unattractive aspect of this type of structure is one that is unavoidable and not unique to CIM. Whenever investors hand money over to professional asset managers whether it’s to a stock broker, a hfund, a mutual fund, or a vehicle like CIM the asset manager always has higher incentive to take greater risks than warranted by the mandate. The reason for this is simply that the career/financial benefits to a professional asset manger of taking big risks and being right are almost always much greater than the downside of being wrong.

Every professional money manager knows that if they take unnecessary risks and underperform or even blow up they might get fired or will have to shut down their firm. But professionals also know that if they get fired they can go hide out at a trust department or an insurance company somewhere. If they really screw up, they might have to get out of the business for a couple of years. But everyone knows that things will be forgotten in a few years and they will get another chance to manage money.

But if the managers take the big risks and are right ....... they will become superstarts.

For professional money mangers -- like the people that will be managing CIM -- taking big, unessasary risks is like buying a call option on your career. If you are wrong you lose the small premium (maybe your job or some bonus money) but if you are right, you win big. The problem for investors is that while the manager might lose a little they might lose a lot.

The incentive fee and having the manager’s money along side shareholders is there to minimize the negative aspect that can never be completely eliminated. In subsequent posts I will also make the argument that looking at the track record of Annaly provides substantial evidence that this management team will be very good stewards of shareholder’s capital and CIM’s hedge fund like structure is a net benefit to shareholders.


* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.