The halcyon days when hedge funds’ “2 and 20” fee structure went unchallenged may be over.
The debate over the amount hedge funds charge their clients – famously a 2 per cent cut on assets under management and a 20 per cent cut on returns – is a perennial controversy.
But with hedge funds still flattened by the financial crisis, and huge inflows of new money into alternative strategies anticipated in coming months, pension funds and other large institutional investors find themselves in a position to negotiate lower fees.
As a survey by Prequin, the investment consultancy, found last week, the average hedge fund is now charging on average 1.63 per cent in annual management fees and 17.2 per cent in performance fees.
“It is clear that the ‘2 and 20’ structure as the industry standard is becoming outdated,” says Amy Bensted, Preqin’s manager of hedge fund products.
“Fees are now being driven down as investors become more powerful in the manager/client relationship. US pension funds such as Calpers and the Utah Retirement System have been vocal in their belief that the hedge fund remittance structure needs to evolve.”
Calpers is California’s state employee retirement scheme and the US’s biggest pension fund, with $180bn under management and more than $6bn in hedge funds.
Joe Dear, Calpers’ chief investment officer, says the fund has had “extensive discussions” with 26 hedge funds and nine funds of hedge funds over fees, notably annual management fees, as well as about the transparency of holdings and reporting positions.
“It is most important to get a better alignment of interests [between managers and investors],” he says. “It is aggravating when a manager profits on a fund that loses us money.”
As one hedge fund manager says, “Calpers has the clout” to force managers to cut fees. But smaller investors are also negotiating.
In a report this year, Casey Quirk, the consultancy group, estimated that over the next four years $252bn would be allocated to hedge funds by US pension funds alone, a sharp increase in pension funds’ traditional allocations.
With this financial input comes bargaining power. Many hedge funds – particularly those that suffered from damaging investor redemptions last year – are already restructuring their funds and offering fee discounts to hold on to investors and catch early allocations.
Centaurus Capital, the London-based risk arbitrageur and activist fund, has relaunched itself with a 1.5 and 15 model for its new flagship CIRAF fund.
SRM Global, the Monaco fund run by former UBS trader Jon Wood, is in the process of offering investment in a new fund to clients in its existing portfolio and is offering to waive performance fees until initial investments have doubled.
Even so, established hedge fund group SAC, run by Steven Cohen, continues to raise money for its flagship strategy with fees of 3 and 50 per cent – the highest in the industry.
Many managers are adamant they will not lower fees, despite the pressures.
Investors do not necessarily see this as a bad thing either. “We’re happy paying 2 and 20 for genuine alpha,” says a representative of one London-based fund of hedge funds. “The way we look at it, strategies that charge less, historically speaking, have delivered less.”
Emily Porter, hedge fund portfolio manager at the Universities Superannuation Scheme, which plans to invest some £1bn ($1.7bn) in about 25 hedge funds over the next year or so, thinks that while fees are coming down, there is a limit to by how much.
“The infrastructure of [running] hedge funds can be expensive and capacity within the funds is often limited so fees won’t come down that much,” says Ms Porter.
“Funds with exceptional track records that have raised assets from new investors to replace redemptions and re-closed to new investment, are not dropping their fees.”
Instead the real focus is on the “alignment” of interests between managers and their clients.
Calpers and others are working hard behind the scenes to insert lock-up clauses, clawback provisions and even requirements for managers to co-invest more of their own money to make investors more comfortable. Even the biggest and best managers are open to client requests for more information that enables them to form a clearer view of the risks within a portfolio, says Ms Porter.
One London manager says: “The bottom line is that if we’re going to be making as much as they are, investors want to see us losing as much as they are too. Managers are going to have to start showing they’ve got a lot more skin in the game.”
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