With Sprott, the funds may be best bet

Date: Friday, May 16, 2008
Author: Fabrice Taylor, the globeandmail.com

Money managers around this country will have enjoyed a moment of catty glee yesterday when Sprott Inc. shares traded down slightly off its initial public offering.

Investment types are even more envious than the rest of us when it comes to money, so you can rest assured that every one of them was bitterly aware of the amazing pay days Eric Sprott and his team enjoy. Sprott paid almost $300-million out in discretionary bonuses from 2005 to 2007, chump change by New York or London hedge fund standards, but in Canada? Please.

Mr. Sprott and his team earned the money. They don't get paid unless their investors make money (or lose less than some benchmark, as is the case with some of the hedge funds) and their investors have, in the main, done very well over that period and since the launch of the first Sprott fund more than a decade ago.

Do the shares sound like a good investment? Rather than trying to answer that question in its own right, investors might consider comparing an investment in a Sprott fund to an investment in the stock. Don't buy the mutual fund, buy the mutual fund company, is a saying you'll hear from time to time. It might not apply in this case.

Here's my reasoning for this conclusion. Last year, Sprott earned $108-million in management fees. This is the money the company takes from the assets it manages come rain or shine - just as, say CI Funds takes a fee. Sprott also earned $129-million in performance fees - the money fund investors give up if their funds outperform some benchmark. Total fee income was $237-million. Deduct operating expenses, including trailer fees, and that left $190-million. Sounds good, except talent like Sprott's isn't cheap: performance bonuses $131-million, leaving, in theory, about $70-million pretax for shareholders, who were mostly employees anyway. Bonuses paid actually exceeded the performance fees collected over the past three years - and by a healthy margin.

Perhaps sensing that the optics of this kind of division of income might not appeal to prospective shareholders, Sprott is going to change the way it pays bonuses to its personnel.

Henceforth, and until 2010 when the board will revisit the issue, the new bonus pool, from which incentives will be paid, will be made up of 25 per cent of net operating income and up to 25 per cent of the performance fee. Net operating income is management fees less certain operating expenses.

Assuming a full 25 per cent of the performance fee, bonuses for 2007 would have been about $50-million on total fee income of $233-million.

One way to look at it is that the bonus fee was 21 per cent of the "return," while the expense ratio - operating costs including trailer fees - was 18 per cent. That's a lot more than the standard 2 plus 20 charged by most hedge funds (Sprott isn't just hedge funds, and the mutual funds have a lower performance component.)

The market capitalization on Sprott is roughly $1.5-billion. If we recast last year's numbers, the "return" on that market cap is around 9 per cent - a far cry from the average returns on the better Sprott funds.

The fund company is supposed to be a better investment than the funds. In this case, it might be the opposite. Sprott has a great franchise and high profit margins, but it also has high expenses and, more importantly, the purchase price may be relatively high, making the stock look less attractive than the funds.

After all, you buy a fund of public securities for what it's worth (assuming you think the market is reasonably efficient). You don't necessarily buy Sprott shares for what they're worth. They're pretty hard to value given the volatility of the performance fees. Sure they've been going up a lot in recent years, but that's on the back of a bright and bold bet on commodities. Brains alone wouldn't do it. You needed a bull market.

The good news is that the people making the trades every day have an incentive to work hard. While their bonuses are going down, the crew of big names - Jean-François Tardif, Peter Hodson, Allan Jacobs, Eric Sprott, to name a few - will have a lot of their wealth tied up in the shares. They'll be motivated to post good fund return numbers.

If you think market returns are coming down for whatever reason (a slowing commodities cycle for instance), the funds might still post good numbers while the shares might not.

Not convinced? You might take your cue from Mr. Sprott, who intends to reinvest some of more than $100-million he'll get from selling his stock into his funds.