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Hedge Fund Group Details How Fee Structures are Changing

The Alignment of Interests Association analyzes the new fee models investors are adopting in response to mediocre performance.

Members of the Alignment of Interests Association still believe in hedge funds — just not traditional hedge fund fees.

In a new white paper published on Tuesday, AOI, a trade group for institutional investors in hedge funds, revealed some of the alternative fee arrangements its members had adopted, while also offering guidance on the use of structures like hurdle rates and tiered management fees.

“Alpha exists. And it should be rewarded handsomely,” said Robert Lee, deputy CIO of Texas Tech University, in a statement. However, Lee, a board member of AOI, said investors often end up paying for beta that’s masquerading as alpha. “Fee structures that better align the manager and the allocator are necessary, and this study highlights several solutions to that end,” he added.

These solutions include alternative fee structures that modify the traditional combination of management and performance fees. Management fees, for example, might be tiered — where rates decrease as assets under management increase — or offered as an “advance” on performance fees.

Meanwhile, performance fees could be subjected to hurdle rates, requiring managers to achieve a certain level of performance before fees are paid, or clawbacks — a means of returning money when performance declines.

AOI said that most of these options come with pros and cons, and that there is no one-size-fits-all fee structure that works for everyone. However, the organization made it clear that better alignment of interests required that the majority of manager compensation comes from performance generation, not asset gathering.

The paper included examples of alternative fee models recently adopted by AOI members, which are institutional hedge fund investors, including pension funds and endowments. Some said they traded liquidity for lower fees, allowing managers to lock up money for longer in exchange for a reduction in cost. Others negotiated fee structures that shifted the risk of underperformance from the investor to the manager.

In addition, AOI said that members often targeted start-up, small, or distressed hedge funds, which are more flexible and amenable to alternative arrangements than larger, more established managers.

“It is clear that the industry is changing amid the various pressures facing both hedge fund managers and investors alike,” the paper concluded. “There is clearly an industry push toward attaining a better alignment of interests between managers and investors.”

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