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The hedge fund industry is gearing up for significant growth. Consider for example where all that trading talent from Lehman and Bear is going. How about all those decimated trading desks of Deutsche (NYSE:DB) and UBS? And what about TARP constrained traders from Citi (NYSE:C) and BofA/Merrill (NYSE:BAC)? If you are talented enough to make millions for the firm you work for, why not be able to keep some of that for yourself? Particularly in the days of pay caps and angry anti-financial-services mob. And that's what many traders will be doing - starting new hedge funds (beats working for a bank and being called a "bankster"). The second half of 2009 and early 2010 just may see records of new fund launches.

But how can these guys raise money after what happened in 2008? Well, if the fraud issue can be addressed with independent audits, transparency, and regulation, investor's memory on performance can be quite short. This is particularly the case because hedge funds continue to outperform most asset classes especially during corrections. The outperformance is evident both on an absolute basis as well as on a risk adjusted basis. The chart below (click to enlarge) shows the latest comparison of the HFR broad hedge fund index against the S&P500.



Institutional investors are taking notice, and wealthy individuals and family offices are sure to follow. But there will be one key change (beyond transparency and regulation) - compensation structures, particularly for new funds may become more investor-friendly.

The traditional hedge fund compensation structure is "2/20": 2% management fee (on AUM) and 20% performance fee. So if you invest $100, the manager will keep $2 no matter what happens (mutual funds tend to take 1-1.75%), plus if the fund makes 10%, the manager keeps an additional $2, and you get $8. Some highly successful managers charged 3/30 or even 3/50 (for example SAC). Citadel simply charged all of their operating costs as fees (in addition to the incentive fees), so the management fees were uncapped.

2/20 may work for some new managers, but many are compromising in order to attract institutional money. Here are some examples of the newer compensation schemes:

  • Simply 1.5/15 or even 1/10 (for some separately managed accounts)
  • 20% incentive compensation, but only if the return is above 8%.
  • 20% incentive fee, but paid only when life-to-date realized P&L reaches a certain percentage of the total P&L. This incentivizes the manager to turn inventory and stay liquid.
  • 20% compensation, but 10% gets deferred for 3 years. This structure may have a "claw-back" provision that allows investors to recoup some of the earlier fees if the fund is down significantly.
  • 20% compensation, but 15% gets invested in the fund with a lock-up (period during which an investor can not redeem,) which for the manager's money is one year longer than the investors' lockup.
  • 2% management fees, but a portion gets put into an escrow account to be used to retain talent when the fund is down significantly, or to retain the team if the fund needs to be liquidated (or if redemptions are suspended).
  • 2% management fee, but all operating expenses are disclosed and anything that hasn't been spent gets distributed back to investors. This is usually a temporary scheme by a "seed" investor.
  • 2/20 for investors under $25 MM, 2/15 for investors between $25 and $50MM, 1.5/15 for investors over $50 MM or seed investors. This type of structure is not new, particularly for seed investors, but will become more common now.
  • 2/20 for investors with quarterly liquidity, 1.5/20 for investors with a one-year lock-up, 1.5/15 for investors with a 2-year lockup.

These are examples (the actual numbers above can vary) that some institutional investors ask for and new managers sometimes implement. Most schemes are structured to give those who are serious partners of the fund a break on fees and certain protections, as well as to align interests of managers with that of the investors. Even some of the established hedge funds are asked to adjust their fees to keep existing investors in or to raise new money. This development should create a more stable investor/manager relationship, with investors taking a more active role.

Source: Hedge Fund Compensation Schemes: New Funds, New Tricks