Drivers of change in the hedge fund industry: fees
December 2016 | SPECIAL REPORT: INVESTMENT FUNDS
Financier Worldwide Magazine
Hedge fund fees have come under increased scrutiny lately as some investors, disappointed with the recent performance of their portfolios, have begun to pay closer attention to the costs of their investments.
A number of institutional investors withdrawing from the asset class have cited hedge fund fees as a factor in their decision. Although CalPERS’ widely discussed decision to withdraw from the asset class in 2014 was primarily motivated by factors other than fees, costs were nonetheless cited as an issue.
More recently, other investors such as Railways Pension Trustee Company (Railpen) and New York City Employees’ Retirement System (NYCERS) have also attributed their decision to reduce or liquidate their hedge fund portfolios to the fees associated with these investments.
We have witnessed a growing proportion of institutional investors that actively invest in hedge funds paying closer attention to fee arrangements and the alignment of interests with their hedge fund managers. Forty-seven percent of investors we recently surveyed identified fees as one of the key issues facing the hedge fund industry in the second half of 2016, making this the joint most cited concern (alongside fund performance).
With fees set to be a key discussion point between fund managers and investors over the coming months, it is important to see how investors are approaching the issue, and how this debate has been affecting the fees charged by the industry.
The decline of the ‘2 and 20’ fee structure
Disappointment with recent returns has increased concern among investors with the way hedge fund fees are charged. In our latest survey of hedge fund investors (June 2016), 79 percent reported that their portfolios had fallen short of their performance expectations over the past 12 months. At a time of lower returns for the industry as a whole, management fees represent a larger proportion of the overall gains investors might expect, and have become the target of some institutions looking to reduce fixed costs in their portfolios.
Similarly, although performance fees have long been a ubiquitous aspect of fund structures, some investors have questioned whether current fee levels are appropriate given the performance climate, and whether the way these fees are charged rewards genuine long-term outperformance. Partly as a result of these concerns, over half of institutional investors believe that fund manager and investor interests are not currently suitably aligned.
However, investors did also report that they have seen improvements in fund terms and conditions. Fifty-eight percent of investors felt that fund terms had changed in favour of investors over the past 12 months, compared with only 8 percent that felt that these had changed in favour of hedge fund managers. Sixty-three percent had noticed an improvement in management fees, and 32 percent observed improvements in the level of performance fees and how these are charged.
Despite these changes, investors felt that there was room for further improvement in several areas, particularly hurdle rates, where only 15 percent had noticed improvements over the past year and 57 percent wanted to see further change. Similarly, fund-level transparency was another area in which there was a significant difference between the proportion of investors that had observed improvements (27 percent), and those that felt further changes needed to be made (56 percent).
Increased investor scrutiny and the possibility of further withdrawals have encouraged some prominent fund managers to reduce their fees in recent months, but the pressure to offer lower fees goes beyond individual managers and has been felt across the industry. The ‘2 & 20’ fee structure is still sometimes referred to as the standard for hedge funds, but at present only 35 percent of single manager hedge funds charge these rates; across the industry, the current average is a 1.57 percent management fee and 19.29 percent in performance fees.
We have also witnessed a trend toward falling fees over recent years; for instance, hedge funds launched in 2016 YTD have a mean management fee of 1.53 percent, compared with 1.66 percent for hedge funds launched in 2007. The mean performance fee has also fallen, with funds launched in 2016 YTD having a mean performance fee of 19.13 percent, compared with 19.55 percent for funds launched a decade prior.
However, amid the growing number of active funds worldwide – which now exceeds 13,500 – investors are finding it increasingly difficult to find attractive funds. Almost half (46 percent) of investors we surveyed in June 2016 reported that they find it harder to source attractive investment opportunities compared to 12 months ago. At the same time, the characteristics which make certain funds attractive to investors – a strong track record, differentiated strategy, institutional grade infrastructure – also give them bargaining power with investors when setting their fee terms.
For instance, those funds with a proven track record retain the ability to charge above-average performance fees: funds with top quartile performance on a five-year annualised basis charge a mean performance fee of 19.67 percent, compared with 18.75 percent for bottom quartile funds. Similarly, larger funds generally charge higher fees than others in the industry – while at the smaller end of the industry – greater competition among managers looking to raise capital for emerging vehicles has driven down fees. The average fees charged by a fund with over $5bn in assets under management is a 1.69 percent management fee and 20.32 percent performance fee, compared with only 1.55 percent and 18.93 percent respectively – for funds with less than $100m.
The future of hedge fund fees
Although investors we surveyed recognise that some improvements have been made with regard to fund terms recently, they are also demanding further changes in the future. Almost three-quarters are looking for management fees to improve further over the next 12 months, and over half feel similarly about performance fees. The terms that govern when and how performance fees are triggered and charged are likely to receive particular attention in the near future, given that recent lower industry performance has encouraged investors to review the fees awarded, and to seek fee structures which reward longer-term outperformance.
Various mechanisms around the charging of performance fees already exist in the industry, but they are not all widely utilised by funds. High water marks, which withhold performance fees until previous losses have been recovered, are already used by the majority of funds we track. However, hurdle rates, which allow performance fees to be charged only once a fund has surpassed a given benchmark, are of growing interest to investors. Despite only 15 percent of investors having observed improvements in hurdle rates over the past 12 months, 57 percent indicated that they would like to see improvements in the coming year.
Only one-tenth of the hedge funds we track are known to have a hurdle rate, which means that this may be an area where we see further changes in future. In the longer term, investors may seek to invest in funds that make performance fees subject to considerations more closely matching their own interests. Structures such as clawback provisions, which allow investors to recover some of the previous performance fees should these funds subsequently lose money, may become more common as investors seek to encourage performance payouts that reward longer-term outperformance, without encouraging excessive risk-taking over the short term.
Overall, the topic of fees is likely to remain a key discussion point between fund managers and investors over the coming months. As with previous issues that have captured investors’ attention, such as hedge fund transparency, institutional pressure is likely to result in further changes to general industry practices, as investors seek to reallocate capital away from vehicles that do not meet their fee requirements. Investors can have a particular influence in this regard: 94 percent of investors we surveyed stated that they have previously decided not to invest in a vehicle due to its terms and conditions, and funds that do not offer competitive terms may find it difficult to raise and retain capital in future.
Amy Bensted is head of hedge fund products at Preqin. She can be contacted on +44 (0)20 3207 0230 or by email: firstname.lastname@example.org.
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