Hedge Fund Fees and Liquidity: Setting it Straight

The current fallout associated with DB Zwirn is causing a renewed focus on both mark-to-market practices and, by association, pay-for-performance practices. The way it's being depicted in the media, it's almost as if someone woke up and realized, "Hey, if hedge funds have illiquid investments kind of like private equity firms, then shouldn't they get paid like private equity firms (e.g., upon realization)?" 

I've been beating this drum for a long, long time, because if you've spent much time in the industry and have experience with both liquid and illiquid assets it becomes very clear, very quickly that there is an inherent conflict. How, exactly, can a manager justify a quarterly mark on a fundamentally illiquid position and deem it fair to get paid on an upward revision in value? You can't eat that revision, you can't monetize it, yet somehow you should get compensated for it? Interestingly, these are often the same managers who squawk about being judged on a quarterly basis when their strategy is fundamentally long-term. Why should one really be surprised about this asymmetry - heads I win, tails I don't lose. It is this ego and greed that drives many - but clearly not all - good hedge fund managers.

I actually think I wrote a pretty good post on this issue last year, with the following paragraphs being particularly relevant to the current media frenzy:

If positions are held for trading, meaning that short-term assets are being funded with short-term liabilities, then you've got to use either market prices or prices privately received from, say, five dealers, who are quoting based upon taking the bid (or at least the mid) side of the trade. And these are the prices that should be used for both NAV and performance fee calculations for funds, and carrying values for banks and other kinds of asset managers. Let me repeat: if the asset is a trading asset funded with short-term trading liabilities, then you need true marks. No marking to model. Period. Because as we all know, models don't begin to reflect the realities of financial distress, and are inevitably skewed in favor of the manager, if not intentionally then at least subliminally because managers, by definition, tend to love their positions.

Conversely, if positions are held for investment, it must be demonstrated that such investments are funded with liabilities of like or longer duration. This way, an investor can take comfort in knowing that while the values used might not be market-based, the manager can ride out adverse market conditions and not be forced to liquidate at the worst time. However, investment assets should not attract performance compensation until they are sold, and Management must provide clear documentation as to the process used to value these assets for NAV calculation purposes. This necessarily sets a higher return threshold for investment assets relative to trading assets, as should be the case: if one is giving up liquidity and the ability to collect quarterly performance compensation, then the expected return on these assets better be huge. This is where Management's view comes into play. This approach treats investment assets as if they were private equity in nature, being funded with long-term liabilities and attracting performance fees only when sold.

It all seems brutally straight-forward to me. It always has. But in an industry where the words "hedge fund" have come to mean a fairly standard set of terms and conditions - 2% management fee, 20% performance fee, fees paid quarterly - investors have gotten locked into a compensation paradigm that no longer fits portfolios that have become increasingly chocka-block with illiquid assets.

Theoretically, in a perfect world, I'd argue that managers should get paid on positions as they get closed out, whether they are held for one day or five years. This eliminates the impact of marks on compensation, offers 100% transparency and truly aligns the motives of managers and investors. Sure, record keeping would suck, but this can be figured out.

I'd be interested in the arguments contrary to this position, except those which say "The best managers simply won't accept this." Over time things can change but it depends upon investor resolve and insight, two things that have clearly been lacking in this latest wave of hedge fund melt-downs.

Comments

[BigJames]

Please provide some empirical evidence that hedge fund portfolios are chocka-block full of illiquid investments. Player hating might get you everywhere on Seeking Alpha, but ill-informed rants just don't hold a lot of water.

[Omar Little]

What a well thought out article. Of course anyone who has been in the financial services industry for more than ten minutes knows how many hedge funds hold illiquid assets - LTCM was famously brought down by illiquidity, Blackstone is currently holding $15bn of subprime, the distressed debt sector speaks for itself. Unless managers are marking to market and taking the cost of crossing bid/ask into consideration it's pretty dubious to say they are showing genuine returns.

[Cleanhedge]

A potential risk of compensation tied to crystallizing returns is it may encourage managers to increase turn-over to obtain more frequent pay-out.

[notsosmart]

cmon-if you put your money in a hedge fund you have to be prepared(all know this) to pay for services perhaps not rendered & a chance that you will lose your money.its not as quick as vegas or the indians but for most it does not really matter if they lose. so the managers will continue heads i win tails you lose.