A new whitepaper by mid-Atlantic hedge fund law firm Hirschler Fleischer finds that hedge fund managers— particularly managers of new launches and emerging funds—are responding with unique, tailored fee arrangements in contrast to the “2 & 20” manager compensation that appeared monolithic in the industry until recently.
This trend is certainly not unique to hedge funds: private equity and other alternative managers are facing similar fee compression demands from institutional investors. What is making the new dynamism in hedge fund fees particularly interesting is that it is not simply a rush for the bottom in terms of fee discounting.
Although some less established managers simply cutting asset management or performance fees (or both) in hopes of staying competitive in raising capital, others managers are taking more creative approaches, often aimed at preserving a stable investor capital base critical to retaining key portfolio management talent.
Some of the more innovative fee structures noted recently include:
- sliding scale fees in which a seed investor’s asset management fee and/or performance fee declines as the hedge fund manager’s assets under management increase
- longer measurement periods for performance fees, often up to two and sometimes even three years
- hurdle rates measured over a multi-year lock-up period (or even the entire investment life) rather than being reset annually. More and more hurdle rates are tied to benchmark indexes rather than being a fixed annual percentage.
- performance fee clawbacks similar to private equity funds, but typically having a sunset under which the manager is not responsible for returning performance fees received more than a year prior to redemption
- expressly restricting fund expenses not associated with direct trading and margin activities—examples would include bans on extraordinary consulting fees or excessive travel expenses To be clear, we have not seen most managers rushing to give fee discounts in their fund offering documents. Instead, they are granting favorable fee arrangements through side letters to investors who make a significant dollar commitment that is locked for sufficient time for the manager to prove out its strategy.
Founders share classes are often viewed as a means of achieving better uniformity in fee arrangements with early investors, but unfortunately the availability of a founders share class does not always preempt further negotiations with aggressive investors seeking additional side letter concessions.
Our experience is that seed investors are typically able to negotiate favorable fees not only for initial capital, but for follow-on investments in the fund, up to a maximum dollar and/or time limit. For example, a seed investor making a meaningful investment in a newly launched hedge fund might receive a 25% discount on the standard asset management and performance fees discussed in the fund’s offering documents. This discount would apply to the investor’s initial commitment to the fund and follow-on investments made in the two years after the initial investment, plus all gains on those invested dollars.
Depending on fund strategy, the investor might agree in return to a 12 month hard lock-up, followed by an additional 12 month soft lock allowing the investor to redeem at a 3-5% redemption fee.
While not viewed as an ideal solution, some managers have found that granting equity in the manager’s management company to a significant seed investor is preferable to discounting asset management or performance fees for that investor. Often, these managers are looking to avoid the possibility of a later investor’s most favored nations clause allowing that later investor to take advantage of the fee agreement struck with seed investors who supported the manager during leaner times. Many larger pension plans have manager equity programs; some managers view these programs as a mixed blessing, in that these investors often end up taking an active role in the management of the manager’s business. Our advice to managers who grant equity in this fashion is to have the seed investor’s equity trimmed down as fund assets under management increase, so that the investor does not receive a windfall out of proportion to the fee savings it would otherwise have received had a more traditional fee discount been used.
For both the manager and the investor, it is important to view compensation tools such as sliding scale asset management fees, longer performance fee measurement periods and manager equity grants on a holistic basis.
The art is finding the right blend of investor incentives to attract capital with a long-term perspective that stabilizes and strengthens the portfolio management team, rather than making it more fragile.
As hedge fund managers—particularly new launches and emerging managers—choose flexible, tailored compensation over the once-standard “2 & 20” model, an underlying theme is present: the continuing need to align manager interests with those of the investor. Capital will continue to flow to managers with excellent pedigrees and strategies, and blanket discounting of fees won’t make a bad manager into an attractive one. The key for quality managers when setting compensation for a new launch or emerging fund is to be realistic about the likely returns investors will receive, while at the same time insisting that those investors commit sufficient capital for sufficient time so that the strategy can deliver.
Hirschler Fleischer is a leading mid-Atlantic law firm focusing on the investment management industry. The firm’s clients include top endowments and fund of fund investors, as well as private fund managers spanning the alternative investment asset class. The firm also represents numerous multi-family offices (MFOs) in addition to traditional registered investment advisors.
For more information, please contact Brian Farmer, Managing Partner, Investment Management and Private Funds Practice Group, Hirschler Fleischer (804) 771-9504 firstname.lastname@example.org.
Luis F. Ruiz