Investors and Hedge Funds Are Quarreling: Should the Risk-Free Rate Heighten Their Hurdle?
The two are at odds over the most preferred hedge fund fee.
Marc Lasry, CEO and co-founder of distressed investor Avenue Capital Group, told Institutional Investor in January that higher interest rates would change everything for hedge funds. Now, investors are demanding that some of those changes happen to the fees they are paying.
The risk-free rate of return — what an investor could earn on a super-safe investment like Treasuries — is about 4.5 percent and investors want hedge funds to adjust their hurdle rates, the performance threshold they have to cross in order to charge a performance fee.
Ninety percent of investors think that hurdle rates should be in line with the risk-free rate, or a relevant benchmark, but only 42 percent of hedge fund managers agree, according to a survey of 84 investors and managers by BNP Paribas.
A high percentage of managers might have disagreed with investors because they don’t think hurdle rates would be appropriate for their strategy, according to BNP Paribas. However, only 6 percent of managers explicitly said that hurdles adjusted for the risk-free rate should depend on the investment strategy.
Managed futures, for example, can earn the risk-free rate on the collateral they need to put up for transactions. Even before they trade, they’re now earning 4 or 5 percent out of the gate, lowering the hurdle to delivering strong returns.
“It can be inferred that the 52 percent that opted no for hurdle rates believed that it does not make sense for their strategy,” the BNP Paribas report said.
“However, investors rationale is not to pay performance fees on the portion of return coming from the risk-free rate.”
In other words, the vast majority of investors are effectively saying that they don’t want to pay a high fee for returns that have little risk and that they could easily get elsewhere.
Hurdle rates are the most preferred performance fees by investors and many hedge funds have them. Investors surveyed by BNP Paribas said that 42 percent of funds they allocated to had hurdle rates of 1 to 10 percent, 10 percent of funds had rates of 10 to 20 percent, and 15 percent had rates of 20 to 30 percent. Some hedge funds had much higher hurdle rates; 6 percent of funds had rates between 30 and 50 percent, and 4 percent had rates more than 50 percent.
Managers shared a few reasons why their hurdle rates don’t require an adjustment. They told BNP Paribas that hedge funds have already given up a lot of ground when it comes to fees. The average hedge fund management fee and performance fee have been falling steadily for years. In 2022, investors paid average management and performance fees of 1.46 percent and 16.9 percent, respectively.
They also say higher yields on cash and other low-risk investments are embedded in their investment process, and that investors already make allocation decisions with higher interest rates in mind.
Hedge fund managers also said changing hurdle agreements because of the risk-free rate is not the industry norm, another way of saying that competitors aren’t doing it so there’s not much of an incentive to make the adjustments, according to BNP Paribas.
Investors acknowledged that sought-after hedge funds have the upper hand; they don’t have cut fees to attract inventors. Some managers are also delivering high net returns, 8 to 12 percent or more, so investors don’t mind paying them performance fees. Recalculating fees with the risk-free rate is also complex and could raise costs, offsetting some of the money an adjusted hurdle rate might have saved. Still, hedge funds and investors aren’t deadlocked. Half of investors surveyed (49 percent) said that hedge funds were willing to negotiate their hurdle rates.