Hedge Fund Fees: The Shape of Things to Come

Last week, Peter Douglas wrote on this website that growing competition in the hedge fund industry would lead to what he called “fee differentiation”:

Investors will be in control, given the new scarcity of investment capital. 2&20 may be the sticker price, tho’ some new funds may go for a more conciliatory 1 & 20, but the effective pricing of investment strategies is likely to disperse dramatically, through the use of separate accounts, co-investment rights, and advisory contracts, as well as through simple fee rebates.

Douglas is suggesting that the industry will move beyond the one dimensional view of compensation (low to high) and begin to trade off certain aspects of fees with other factors such as co-investment rights.

Last weekend, the FT quoted a hedge fund administrator who seemed to share Douglas’s view. John McCann of Trinity Fund Administrators told the paper:

The two and 20 has been under threat for a long time…There are now two tiers of hedge funds. The established ones charge two and 20 and that’s settled. But now there are newer ones where everything is on the table for negotiation, including fees.

The FT quotes one service provider who knows of a new hedge fund with a 0% performance fee. Despite this apparent fire sale, the service provider said, “There hasn’t been a flood of new money because of these creative fee structures, but they’re the beginning of the shape of things to come.”

Another expert - a manager - told the paper that “Institutional investors are going to use their power to influence the whole deal…Fees are a part of that.”

“Stanching Outflows”

Thomson reported recently that institutions are beginning to wield that power. Investors willing to stick around while others run for the exits are asking for fee cuts.

Hedge funds are trying stem the rising tide of investors taking out their cash but conditions they are imposing may result in a permanent reduction in the high management fees they charge…In return for accepting [redemption gates] investors are asking for, and getting, reduced fees. And once the current period of market turmoil subsides, funds may find it difficult to raise them again.

Since the dawn of the hedge fund industry, there has been an unstated assumption that hedge funds could always find investors willing to pay their posted rates. So accepting less had an opportunity cost for the manager (or at least this was a plausible state of affairs - even if not true for many managers).

As a result, fees were pretty static (think I-banking fees), and believing that the money would eventually find them, many managers were reluctant to pay third party marketers’ cuts.

But as Thomson points out, the gig is up (for now). If potential redeeming investors can extract fee concessions, then why can’t totally new investors? Bloomberg reports on several new funds that are dropping fees to attract investors.

Claw backs

Alexander Ineichen of UBS thinks that longer performance fee calculation periods are one way for hedge funds to assuage investors. He told the FT last month that :

The majority of people in the hedge fund industry believe two and 20 is not going to hold. The two will go to one, which was the original fee structure of hedge funds…The longer the lock-up, the lower the whole fee structure. Two and 20 is quite a stiff fee, even the 20 can be lower for five-year money

As we pointed out in a post we wrote on longer fee calculation windows back in 2006, this raises some new, although not insurmountable, issues.

“Fees Still Too High”

Two weeks ago, Watson Wyatt told its clients that fees (which it describes as “still too high”) are poised for a drop. Wrote the firm:

…there are early signs that increasing numbers of skilled hedge fund managers are becoming more flexible in the negotiation of fees having been persuaded of the benefits of receiving long-term capital, provided by the likes of pension funds, rather than ‘hotter money’ which comes from other investors.

Note that Watson Wyatt refers to a fee/lock-up trade-off, rather than through a simple fee reduction.

But…

According to Financial News, 80% of hedge funds tracked by Eurekahedge were below their high water mark by the end of October. This means that a) the all-in fees charged by hedge funds have fallen dramatically this year and b) that they will remain low next year and potential for some time after that. As a result, most investors are looking at hedge fund fees that are comparable to mutual fund fees this year and next.

Premium Pricing = Premium Product

However, not everyone is sure that fee cuts are the way to go. A Lipper official recently suggested that premium pricing reinforced the principles of scarcity and exclusivity with which many associate hedge funds. Said the official:

If that concept is put under pressure, then hedge funds will have some serious problems longer term because in principle they are selling themselves on the idea that they are delivering superior returns and you pay more for the privilege.

Mutual Funds Fees Actually Rising

While hedge fund AUM shrinkage is emboldening investors to negotiate lower fees, mutual fund AUM shrinkage seems to be having the opposite effect. According to Investment News, the average mutual management fee is likely going up in 2009. The magazine attributes this to the “sliding scale” used to calculate these fees. Since many costs are fixed, rates must rise when AUM falls.

Of course, hedge funds face the same economics. However, they are apparently more likely to absorb these costs by eating into their relatively higher management fees.

Fee-conomics

The bottom line seems to be that fees will likely no longer be viewed in isolation. Instead, fees will become part of a complex equation that attempts to place a value on things like lock-ups, hurdle rates, performance fee optionality/asymmetry, gates, tracking error, side letters, etc. By mathematically valuing, then combining these factors, a fair and objective fee can be established that also might empirically explain what hedge fund managers have long argued - that they are simply charging what the market will bear.

Comments

[Anthony Alfidi:]

How about a ten-year lockup, or longer? That would really help weed out those funds with no long-term performance prospects.

How about maximum contribution limits? If individual HNWIs were limited to putting no more than 1% of their liquid net worth into a hedge fund, they'd presumably have less incentive to run for the exits when performance goes south for some time.

2008 Dec 08 06:42 PM

[Paul V. Azz...:]

I agree with your "Fee-conomics" concluding paragraph and would like to suggest another factor: the source of the alpha, if any.

If one knows how to generate alpha, one can name the fee.

2008 Dec 09 02:14 PM