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No 2-and-20? No Problem

As hedge fund investors continue to push back on fees, some managers looking to attract and keep clients are fundamentally changing how they charge for their services.

Hedge fund managers are finally finding ways to change the long-held perception that the way they charge for their services is unfair.

While the actual sticker price charged by many hedge fund firms has been declining for some time — albeit not as much as some investors would like — experts say managers are now changing not just their prices, but the industry-standard fee structure itself. With investors having soured on hedge funds in recent years owing to a combination of lackluster performance and high prices, managers are looking to novel structures to attract new clients and keep existing ones.

These methods can range from offering sliding-scale fees — such as an upfront fee break for so-called founding-class investors for taking a chance on a new firm — to multi-year incentive allocations that are based on performance in a given year, according to Steven Nadel, a partner at law firm Seward & Kissel who works with hedge fund firms.

The changes may be working: A recent Preqin survey of hedge fund managers said 30 percent think the fundraising environment today is tougher than it was a year ago, compared with nearly 50 percent who said the same a year earlier.

“Investors are happy that hedge funds have responded to their concerns,” says Mark Doherty, a managing principal at hedge fund consultant PivotalPath.

Hedge fund managers have historically employed the so-called 2-and-20 fee structure, in which they charge clients a management fee of 2 percent of assets and take a 20 percent cut of the year’s performance gains.

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But that structure has come under fire from investors who feel it provides incentive for managers to grow their asset base at the expense of performance, which allows them to view their management fee as a profit center.

“There’s been pushback on management fees [charged] by some of the big firms,” says Nadel. “It arguably is a disincentive to earn your carry because you’re already making a lot of money.”

As a result, fund managers are looking to new fee structures to alleviate investor concerns.

One option, according to Nadel, is the sliding-scale fee, in which the management fee decreases as the assets under management increase. Allocators, as a result, have an incentive to invest more money in a hedge fund that offers this fee structure.

Nadel says between 20 and 25 percent of hedge fund launches over the past year are offering this fee structure.

According to Doherty, this strategy is common among startup hedge funds that want to impress potential clients with a different strategy. It’s also more common, he notes, with hedge funds that can easily raise $500 million or more.

Funds that raise less than $500 million from their founding class often flip this strategy on its head, according to Doherty. Instead of offering a preferred fee to investors when the assets under management increase, these funds offer incentives for investors to be among the first to allocate to their fund.

Another strategy, according to Nadel, is to offer a fee structure that takes into account the changing nature of hedge funds.

“What we’ve been seeing, especially this year, is a bit of an increase in managers who are engaging in strategies that are long-term buy-and-hold or activist in nature,” Nadel says.

More funds are now offering multi-year incentive allocations. Instead of charging the same rate for management and performance every year, that rate is adjusted yearly to reflect returns over the period of the investment.

For example, if an allocator invested $1 million in a strategy that returned 10 percent in its first year but lost 50 percent the following year, the hedge fund manager wouldn’t collect $20,000 in fees for the first year, but would instead adjust its initial fee to reflect the loss in the second year of the strategy by giving investors a fee rebate.

According to Nadel, this strategy better matches incentive compensation with investor liquidity.

“Capital is more stable,” Doherty adds. “There’s value to that.”

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