The asymmetry of a performance-based fee is often seen as a “free option” for hedge fund managers. After all, say critics, managers can win but they can’t lose.
Throughout the brief history of hedge funds, academics and researchers have attempted to measure the value of this option. And quite often regulators implicitly acknowledge the existence of this transfer of value from investor to manager by banning performance fees or by requiring them to be symmetrical (the SEC’s regulation of mutual funds jumps to mind).
But when a hedge fund is under its high water mark, no performance fees are charged and the value of the option is minimal (at least until the fund gets close to the high water mark). Put another way, investors in under water hedge funds have earned a performance fee holiday. But when they redeem their investment during this holiday, the holiday ends. If/when they buy another hedge fund, the high water mark is reset at the subscription NAV and the performance fees begin anew.
In aggregate, this amounts to self-destructive behavior on the part of investors and is tantamount to a transfer of wealth from investors to managers. As we pointed out in June:
“…many investors did not stick around in the bad times. By redeeming their investments, those investors have voluntarily relinquished their right to a hard-earned performance fee holiday. While some former hedge fund investors may have sworn off them for good, many who redeemed last year will likely re-invest in hedge funds in the near future.”
But now a new service promises to allow investors in under water funds to effectively redeem without relinquishing their performance fee holiday and releasing managers from their obligation to make up for losses before charging performance fees once again.
The service is from hedge fund secondary market provider 2n20.com (yes, “2n20.com“, get it?) As we’ve discussed on these pages, hedge fund secondary markets like Hedgebay exist to help investors (mainly funds of funds) to redeem during lock-ups or gates. Much like closed-end mutual funds, these stakes sell at discounts or premiums depending on the demand for the particular fund.
Unlike a traditional secondary market transaction, however, 2n20.com’s market will involve stakes in funds that are not gated and where redemption is not an issue (i.e. sellers could redeem these funds by simply submitting a redemption notice to the manager.)
So why use a secondary market then? 2n20.com believes that investors won’t want to give up the extra performance fee holiday they have earned by enduring previous negative returns. By sharing this holiday with the buyer of their stake, they can at least recapture some of the value due to them as a result of their previous losses.
The company provides the following example on its website:
“Fund C has a current NAV of 500 USD per share, but the seller of the shares of Fund C was already invested when the fund had a value of 600 USD per share. Therefore the seller’s HWM is at 600 USD per share, meaning that unless the fund reaches its old high the owner of these specific shares doesn’t have to pay any performance fees to the fund manager. Hence the buyer of these shares has a potential saving of 600-500=100 USD per share multiplied with the performance fee of the fund. If the old high water mark is reached again or the fund has at least a positive performance within one year (in this case a NAV higher than 500 USD per share), the fees will be split up between the buyer and the seller according to the Scale of Fees and Charges.
In other words, the buyer actually begins paying performance fees from day one, but those fees are effectively reimbursed as the fund rises back to the seller’s original high water mark. This de facto reimbursement is then shared with the seller. Continues 2n20.com:
“This means the seller of the fund shares has the opportunity to participate on the fund earnings even after having sold the shares, while the new owner of the shares saves on the performance fees.”
The net result of this transaction is to isolate the performance fee option from the fund itself, allowing the investor to sell the fund but not cancel the option (which from their perspective as a party who was expecting to pay a performance fee, is now effectively “in the money”).
2n20.com makes money two ways – from transaction fees at the time of the sale (% of NAV) and from a 20% cut of the overall performance fee savings generated.
We’ll see if this “High Water Mark Market” catches on. But one thing is for sure: 2n20.com gets full marks for creativity.