Coronavirus Upside? Hedge Fund Fees
With some alternatives managers gaining and others losing in the market turmoil, MATTHEW FEARGRIEVE looks at the changing fee model of hedge funds and the evolutionary context of their performance in down markets.
Few hedge funds in today’s pandemic-stricken markets will get close to emulating Pershing Square’s success, as the US fund banks a US$2.6 billion profit on a US$27 million bet that coronavirus would trigger a crash in world markets. Pershing’s investors may well be feeling quite sanguine right now about the fees they pay to the fund’s manager.
The traditional “2 and 20” hedge fund fee model has been on the slide since the financial crisis of 2008, when the majority of hedge funds failed to deliver the uncorrelated returns they promised. And hedge fund performance has not exactly bounced back, with the ten years since 2008 being something of a lost decade for the alternatives industry, thanks in part to low interest rates, a long-running US bull market and high stock valuations.
These doldrums have served only to make investors feel entirely justified in putting pressure on managers to drive fees down.
The standard “2 and 20” fee model has taken many knocks, and estimates now suggest that fees at this level are levied by around a quarter (in number) of hedge funds, with the majority of managers lowering their fees in return for higher, locked-in allocations. A hefty 2% of AUM plus 20% of profit has for some time been an unpalatable chunk of gross performance, given that performance has been distinctly lacklustre. As yields have fallen, so have the fees, and it has become more commonplace to speak of “1 and 20” or, in some cases, “1 and 15”.
The mystique of the jeans-wearing, maths-genius hedge fund geek still persists to some extent: most of the downward pressure since 2008 has been on the asset-based (“management”) fee and not on the potentially lucrative “performance” fee; although, this may be reflective of the fact that performance has in recent years been notable by its absence and, to some extent, that hedge fund investors have an enduring willingness to pay for alpha (as opposed to beta) performance generated by a manager’s skill.
There are currently several alternative fee models for investors and managers who want to get creative.
“1 and 20”
For allocations of US$25 million or less, some managers are still able to insist on an asset-based fee of 1% and a performance fee (subject to high water mark, or HWM) of between 15% and 20%. But the once- ubiquitous performance fees at the 20% level are these days the preserve of established managers with a track record of performance.
The larger, more established managers are in any case constrained by existing clients with “Most Favoured Nation” (MFN) clauses in place, which effectively prohibit the manager from agreeing lower fees with new investors.
“1–10–20”
One variation on the “1 and 20" model is the “1–10–20” structure. Managers take a management fee of 1%, together with a 10% performance fee on net returns up to 10% and a 20% fee for net returns above 10%.
The attraction of this kind of model is clear: the manager is incentivized to deliver higher rates of return in order to earn a higher upside reward. The 1–10–20 structure has found favour with a number of investors over the past five years, solving as it does the problem of the chunky 20% commission that had been charged on years of mediocre performance that investors felt did not truly deserve rewarding at such a rate.
Performance hurdles: “1 or 30”
In addition to the level of performance compensation, institutional investors have sought to diligence performance produced by market beta and establish a value separation from the true alpha, the upside produced by the manager’s own skill and ingenuity in all markets. The main value control that investors are using to qualify “performance” in this sense, and its related rewards for the manager, are private equity- style hurdle rates.
Performance hurdles come in different guises, one of the most straightforward being the “1% or 30%” whereby the manager receives either a 1% asset-based fee or a 30% upside fee. Aggregated amounts of asset-based fee paid to the manager over time acts as a de facto hurdle and are subtracted from the yearly value of the upside fee (which may still be subject to a high water mark).
First loss programmes/managed accounts
First loss programmes are effectively a logical extension of the managed (or separate) account model, enabling institutional investors to adapt the size of their risk capital proportionately to the manager’s performance. The manager will receive a higher than normal performance fee (typically 50% in this kind of structure) in return for which the capital it contributes to the managed account (typically 10% to 20% of the account balance) will be first used to meet any losses, with the balance of losses being met by the investor.
The separate account allows the institutional investor effectively to monitor the portfolio and begin liquidating based on drawdown trigger points. Any gains that follow losses are allocated in priority to the manager’s account until it has made up its lost capital.
Lock-ups
Institutional investors of any size will rub up against the MFN problem when agreeing terms with larger, established managers (see “1 and 20”, above). No matter how juicy an investment proposition may be, it may cost a manager more to breach MFN terms in place with its existing clients which commercially would entail having to offer them the same, lower fees on offer to the new investor.
Investors find ways around this however, the principal solution being to find a suitable small- to mid- sized fund (one with an AUM of between US$200m and US$1bn), with which a flexible fee arrangement can be negotiated. Such arrangements typically centre on lock-ups: the investor pays a lower performance fee in return for committing its capital to the manager for a guaranteed period (the “lock-up”) during which the investor may not redeem its investment from the fund (or may do so only on penalty of a stiff redemption fee).
We consider lock-ups and other liquidity constraints (voluntary and otherwise) on fund investors in our video on Liquidity Management here:
Founder Shares
Institutional investors with an appetite for start-up or smaller funds are also able to negotiate a fee discount in return for being a founder shareholder in the fund. The investor (along with other significant investors, if applicable) will subscribe shares in a Founder Share Class, which will typically pay a 25% to 50% lower performance fee than other share classes in the fund, until either the fund reaches a certain level of AUM or an agreed period of time has elapsed.
The fee discount is grandfathered for all holders of Founder Shares when the AUM threshold is met.
Revenue sharing and buy-outs
In addition to lock-ups (discussed above), some seed or cornerstone investors in small hedge funds agree to their investment being locked up not only in return for lower performance fees but also a percentage of the manager’s annual revenue.
The paradigm arrangement here for an institutional investor is a 20% to 30% share of revenue with a buy-out clause after three to five years.
The Evolution of Manager Compensation
The US$3 trillion hedge fund industry has been contracting since 2008. The market turmoil caused by the coronavirus, together with the regrettable fact that many alternatives managers will fail, just as they did in 2008, to hedge their portfolios and deliver uncorrelated returns to their investors, will force many funds and management companies to the wall, particularly if the pandemic ushers in a global recession or something worse.
Against this backdrop, hedge fund investors seem set to retain and maybe augment their negotiating power when it comes to the manager’s fees. The alternatives industry will see a continuing evolution of its fee models in line with the extent to which it contracts over the coming decade.
In our next article here, we consider the ways in which the coronavirus pandemic will impact the hedge fund industry in the short- and the long- term:
