Hedge Funds Still Winning the Fee Battle With Investors

Managers are bending on fees, but investors continue to give back a big slice of returns.

(Paul Yeung/Bloomberg)

(Paul Yeung/Bloomberg)

Hedge fund managers are yielding to pressure from investors to lower their fees — but many still don’t offer investor protections like hurdle rates and clawbacks, new research shows.

The standard structure of 2 percent management fees and 20 percent performance fees that hedge fund managers historically charged continues to evolve, according to a paper from the Alternative Investment Management Association released Wednesday, with managers exploring new and nontraditional fee arrangements. And some fees are falling, with the average hedge fund management fee dropping to 1.3 percent, according to AIMA’s findings.

In addition, almost 80 percent of managers said they would cut management fees in exchange for keeping a larger cut of performance if they outperform. This suggests that managers are willing to earn less simply for managing assets.

But only 37 percent of the 118 global hedge fund managers that responded to the survey use hurdle rates, which require returns to hit a benchmark before performance fees kick in, according to AIMA. This is a slight increase from the 33 percent AIMA reported in 2016, the last time the organization conducted the survey.

AIMA also found that 14 percent of funds use a pre-agreed alpha hurdle rate and 16 percent allow so-called clawbacks by investors. Clawbacks allow investors to get a portion of past performance fees refunded if returns then turn negative.

“Two-and-twenty is no longer the only game in town,” said Michelle Noyes, head of Americas for AIMA, in an interview. “It used to be a joke that a hedge fund is a fee structure. But now there is a tremendous amount of nuance in fee structures. There are a lot more levers that can be pulled to fine tune the fee equation.”

Hurdle rates are more common at small funds. Forty percent of funds with $5 billion in assets or less used hurdle rates, while only 20 percent of large funds (with assets of more than $5 billion) did so.

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According to the paper, which was based on research including face-to-face interviews and roundtable discussions with survey participants, managers should pocket about one-third of the excess returns they generate.

“When it comes to reconciling the most appropriate fee structure being charged to investors, between 20% to 30% of the alpha earned being paid to the hedge fund feels about right,” the survey’s author’s wrote. “Our discussions with managers and investors reveal a shared belief that the manager share of any alpha earned should be about one third, with the remainder going to the investor.”

Global hedge fund managers with combined assets under management of $440 billion participated in the study. The alternative investments organization also included input from a committee of global investors with $100 billion allocated to hedge funds.

In spite of the limited use of hurdle rates and clawbacks, AIMA determined that hedge funds are becoming more investor-friendly.

“Hedge-fund managers are responding to investor needs by putting in place arrangements that are more closely aligned both to the requirements of the client and the underlying investment strategy,” wrote the survey’s authors.

Other investor-friendly moves documented by AIMA include an increased use of tiered fees. As funds grow in size, 35 percent of funds are offering fee discounts.

More than half of the hedge funds surveyed think it’s important to offer customized mandates and co-investments in an effort to be better aligned with investors. That figure is up from only 14 percent in 2016. Approximately one in five hedge funds now offer co-investments, a practice common in the private equity world.

In a positive move for investors, 92 percent of hedge fund manager respondents use high-water marks, which ensure that investors only pay incentive fees on net new increases in a fund’s value.

Thirty-two percent of hedge fund managers offer reduced management fees in exchange for longer periods when an investors’ money is locked up.

Hedge funds also no longer use one-size-fits-all strategies. They’re using a variety of options, including lower-priced founders’ shares, lower fees for larger investors, and discounts based on the type of hedge fund strategy.

Investors are willing to pay for consistent excess returns, the authors found.

“Investors are saying, ‘If you deliver, we’ll pay you, and if net returns look good, that should be a fair trade,’” said Noyes.

In the end, investors don’t want to pay anything for poor performance.

“Their tolerance for paying hedge funds who deliver anything less than what is value accretive to their investment portfolio is rapidly diminishing,” according to the report.