How are hedge funds coping with management-fee expectations?

As investors get more price-sensitive and more flexibly priced alternatives abound, the industry is exploring new options

How are hedge funds coping with management-fee expectations?

Because of a broad shift in cost-consciousness across the investment industry, asset managers face increasing pressure to lower their fees or offer concrete value to their investors. Among those besieged are hedge fund managers and their historical “2 and 20” fee model — though there’s change afoot.

Drawing from a global survey of hedge-fund managers, the Alternative Investment Management Association (AIMA) recently released a paper titled In Harmony, which examined how hedge funds are pursuing increased collaboration, communication, and customisation to align their interests with that of investors.

“Our research shows that both hedge-fund managers and investors understand the importance of the management fee to meet the day-to-day costs of operating a hedge fund,” the paper said, stressing the importance of balancing such costs against the magnitude of fees charged to the investor.

As an alternative to reducing headline fees, hedge-fund managers are looking at other potentially equitable compensation arrangements. One example involves providing lower fund fee structures to early-stage investors, a concession that 76% of all managers surveyed by the AIMA agreed should be offered. An advisable option for start-up or emerging funds, such an “early bird” discount could be made available until a fund reaches a certain age or level of AUM.

Institutional share classes are another popular option. Cited by two thirds of all respondents, it entails offering certain investors — depending on the size of the ticket taken by the allocator — certain preferential terms. One possible arrangement is for the manager to charge reduced fees for a set period of time.

Nearly half (46%) of all respondents also cited the option of lowering management fees in return for an increased performance fee. Under this arrangement, investors will feel that they are paying a lower regular management fee, adding a larger performance fee only if they deliver on a certain level of agreed-on performance. But while this results in lower regular costs for investors, it also results in them taking a lower share of a hedge fund’s profits overall.

To deal with the problem of high operating costs in the early, typically low-asset stages of a hedge fund’s life, managers may also opt for a tiered management fee system. Investors would agree to pay a higher management fee when the fund AUM is low, and discounts would be offered on the percentage paid as the fund AUM grows. The dollar amount of the fee would remain relatively constant, best matching the fund’s operating costs as it grows.

“Discounted management fees are becoming increasingly popular amongst hedge funds across many strategies,” the AIMA paper said, noting that strategies with lower operating cost structures are more likely to accommodate investors demanding such concessions.

The report also discussed the use of most Favoured Nation (MFN) clauses a side-letter provision along an investor to align themselves to any more favourable contract clauses that a newer investor might have agreed on. Hedge-fund managers may also offer rebates on management fees, agreeing to lower it in exchange for a relative increase in the performance fee.


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