Tag Archives: management fee

Revising the Hedge Fund Compensation Structure

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Syndicated Post on Hedge Fund Fees

I have recently come across a very good blog called Ten Seconds Into the Future by Bryan Goh of First Avenue Partners, a hedge fund seeder.  Bryan’s posts are very insightful and I recommend all managers take a look at his writings.  The post below discusses some possible ways which hedge fund fees may be designed in the future – this is an especially good topic as I am often asked for suggestions on alternative fee structures.

Please feel free to comment below or contact me if you have any questions or would like more information on starting a hedge fund.

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Hedge Fund Fees. Suggestions for the Future

I have argued before that hedge fund fees were poorly designed, and in that article had suggested a possible design for performance fees. Here I provide more detail into what I think is a practical solution which addresses some but not all of the problems with current fee structures.

Management fees:

This is the simpler issue to deal with. First of all, one has to question what is the purpose of management fees. In traditional long only mutual funds, management fees are the compensation for the manager for managing the fund. With the rise of absolute return funds, and their performance fees, management fees were no longer intended to be the primary compensation for managing of assets. The industry generally represents that management fees are compensation for overheads and the costs of running the asset management business.

If this is in fact the case, then the current flat percentage of assets management fee does not do as represented. The costs and overheads of running an asset management business are not linear in the size of assets under management. There are economies of scale. By charging a flat percentage of assets under management, these economies of scale accrue to the investment manager and not to the investor.

If management fees are indeed intended to cover overheads and costs, then a sliding scale is closer to the intended purpose. One can envisage management fees being charged as follows: 2% of assets as long as assets under management in the fund are under a certain amount, 1.5% when assets rise to a certain level, and 1% whenever assets are over a certain amount. This is just an example of course and there are other ways management fees can be designed to reflect the represented purpose.

A further finessing of management fees which is useful is to waive management fees for side pocketed investments. This encourages the manager to think carefully about side pocketing any assets. Certainly investors would not appreciate management fees being charged on assets that have been ‘gated’ or suspended.

Performance Fees:

Hedge funds fees typically include a profit share by the manager. This can range from 15% to 30% but for the vast majority of funds is 20% of profits. Pre-2005 there were a significant minority of funds which had a hurdle rate (strictly positive). That is, performance fees were only applied once the fund’s returns were higher than some positive return. In the later years, this practice had mostly disappeared as demand outstripped supply and hedge fund managers were able to increase their prices. Almost all hedge funds still operate a ‘High Watermark’ by which is meant that the investor pays fees only if the fund’s NAV is above the previous high. Should the fund’s value fall, performance fees are not collected until the previous high NAV is exceeded again.

This all sounds fair except that there are timing issues. Fees are accrued and at some point crystallized. This usually happens annually. A situation can arise therefore where performance fees are paid out at the end of the year or quarter, the NAV falls thereafter. Even if there is a recovery but the high watermark is not re-attained, fees paid out are not reclaimed.

A simple solution is as follows:

  • Fees are accrued semi-annually.
  • 50% of the performance fee is paid out semi-annually.
  • 50% of the performance fee is retained in Escrow (not to be invested in the fund.)
  • Each retained performance fee vests and is paid out 30 months later (for example, the delay can be made equal to the lock up for example).
  • All retained fees in Escrow are subject to negative performance fees = 20% of loss from the NAV of last performance fee calculation period.
  • When redemptions are paid in full, fees held back are released to the manager.

This design has the following features:

  • The investor pays performance fees on the net performance for their holding period, unless the performance is negative over the entire holding period. Unfortunately the manager cannot be expected to pay a negative performance fee over the entire holding period if the performance turned out to be negative over the holding period.
  • The manager is incentivized to make money over the long term instead of making money only in a given year.
  • The manager has 50% of their performance fee at risk on a rolling basis. On a cumulative basis, the manager may have a whole year’s performance fee at risk.
  • It has the same kind of incentive as a private equity clawback fee structure.
  • The above fee structure can be adjusted for the length of the holdback. The longer the holdback, the more performance fee is at risk.
  • A manager who is confident in generating returns over the length of their lock up should not object to such a fee schedule.
  • It incentivizes a manager to force redeem investors if they do not expect to be able to make money.

The Future:

Customers are the ultimate regulator of an industry, so it is investors who ultimately regulate the hedge fund industry. As long as investors are small and numerous, there may not be the aggregation of bargaining power to negotiate with fund managers. The huge concentration of assets under control in the fund of funds industry afforded funds of funds the opportunity to negotiate, not harshly but fairly with hedge fund managers. Not just on fees but on liquidity terms, transparency and controls. This was an opportunity that was missed. The battering taken by funds of funds in 2008 has greatly impaired their powers. We can only hope that investors find some way of communicating their needs to fund managers. And we can only hope that fund managers are enlightened enough to see that investors are not deliberately antagonistic, although it may seem so today.

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Other related hedge fund law blog articles:

Survey of Hedge Fund Costs

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All too often start up hedge fund managers do not realize that starting a hedge fund is really starting a business and that considerations need to be given to managing the business as well instituting the trading program.  In a perfect world the hedge fund manager would be able to simply implement his program and have all of the back office, IT, compliance and other services outsourced.  One option obviously is a hedge fund hotel which provides this type of support to beginning managers.  For those managers who do not use hedge fund hotels, greater emphasis needs to be placed on understanding the business they are getting into.

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Hedge Fund Management Fees

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The hedge fund management fee, or asset management fee, is a periodic fixed fee payable to the hedge fund manager based on the amount of the hedge fund’s assets.

How often do most managers take the asset management fee?

The management fee can be taken during any period of time but most managers will take the management fee either monthly or quarterly.  Some managers may take the fee annually, or semi-annually, but this is much less common.

What is the most common management fee?

Most management fees range from 1% to 2% of assets under management.

The amount of the management fee will differ from manager to manager based on a number of factors including the strategy of the fund.  In theory, the management fee is supposed to cover all of the manager’s expenses and costs such as the manager’s rent, salary for employees, computer equipment, etc.  For certain strategies, the above expenses will be relatively low and for other strategies the expenses will be high.  This should be one of the factors that a manager considers when deciding on the asset management fee.

Another consideration is the historical returns of the fund.  Many of the major blue chip hedge funds will charge a larger management fee (in addition to a larger performance fee), which may be anywhere from 2.5% to 5%.

Hedge fund-of-funds will usually charge a management fee of 0.5% to 1.5%, with a vast majority of managers charging 1%.  For hedge fund-of-funds, I most typically see a quarterly management fee that usually corresponds with the quarterly reports sent to investors.

HFLB note: if a manager is a state-registered investment advisor, the manager may not be able to have a management fee higher than 3%.  Specifically, California has said a California-registered investment advisor cannot have a management fee which exceeds 3%.   Additionally, the manager would probably need to include a disclaimer stating that a 3% management fee is in excess of the industry standard.

Management fees and leverage

Some hedge fund managers utilize leverage in their investment programs and they will want to receive the management fee based on the amount of assets being managed with the leverage as opposed to simply the capital account balances of the limited partners.  Depending on what is provided in the offering documents, this may or may not be the default and managers who wish to receive the higher management fee should discuss this with their hedge fund attorney.

Some other articles you may be interested in:

Please feel free to contact us if you have any questions.

What expenses does a hedge fund pay for?

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Question: What costs does a hedge fund pay for and what costs does the hedge fund management company pay for?

Answer: This is another very common question. Most hedge fund offering documents provide a boilerplate approach for splitting costs between the hedge fund and the management company. The general rule of thumb is that any cost which is directly associated with the fund’s investment activities (e.g. brokerage costs) will be paid for by the hedge fund. Any cost which is directly associated with the management company’s operations or overhead (e.g. salaries) will be paid for by the management company.

There are some costs which, arguably, could go either way – one such item is a Bloomberg terminal. A Bloomberg terminal could arguably be an expense of the management company (a Bloomberg is an informational tool similar to magazines and other information that a manager must use to shape its decision-making process) or of the hedge fund (information from the Bloomberg is directly attributable to investment decisions which are made). I do not have a bias as to which entity should pay these fees; however, a hedge fund manager with a smaller asset base that pays for the Bloomberg out of the fund must beware of the effect of Bloomberg’s costs on the fund’s performance.

Hedge Fund Expenses

  • hedge fund management fee
  • hedge fund performance allocation
  • offering and other start-up related expenses (often the management company will pay these expenses)
  • the administrator’s fees and expenses
  • accounting and tax preparation expenses
  • auditing
  • all investment expenses (such as brokerage commissions, expenses related to short sales, clearing and settlement charges, bank service fees, spreads, interest expenses, borrowing charges, short dividends, custodial expenses and other investment expenses)
  • costs and expenses of entering into and utilizing credit facilities and structured notes, swaps, or derivative instruments
  • quotation and news services (Bloomberg, NASDAQ) (or can be a management company expense)
  • ongoing sales and administrative expenses (e.g. printing)
  • legal and fees and expenses related to the fund (include Blue Sky filing fees)
  • optional: professional fees (including, without limitation, expenses of consultants and experts) relating to investments
  • optional: the management company’s legal expenses in relation to the Partnership
  • optional: advisory board fees and expenses
  • optional: reasonable out-of-pocket expenses of the management company (such as travel expenses related to due diligence investigations of existing and prospective investments)
  • other expenses associated with the operation of the hedge fund, including any extraordinary expenses (such as litigation and indemnification)

Hedge Fund Management Company Expenses

  • offering and other start-up related expenses (often the fund will pay these expenses)
  • salaries, benefits and other related compensation of the management company’s employees
  • rent
  • maintenance of its books and records
  • fixed expenses
  • telephones
  • computers
  • general purpose office equipment

While the above list of expenses is fairly standard, please remember that these expenses can be switched around to a certain extent. If you are a hedge fund manager, you should discuss with your attorney how the expenses are split between the hedge fund and the management company.