As certain investors continue to seek out passive index strategies, fund managers running strategies that rely on active management have come under some pressure on their fees. In fact, industry tracker Preqin found in a recent survey that 43% of the fund managers they surveyed indicated their clients’ primary concern was fee structure, up from 28% in December. Some of this concern is triggered by pension funds that are under pressure themselves to reduce fees, in part, due to their underfunded status. The impact of this has been felt across both hedge fund and private equity fund managers, and many fund managers have been providing investors with alternative fee structures or are considering doing so.
If structured properly, a fund’s fee structure can help maintain investor capital and attract new investor capital while creating a sufficient level of revenue from which to compensate and build out a fund manager’s team. To enhance a firm's ability to strike the right balance, this article provides a brief summary of some recent developments in this regard.
Although the media would have you believe that hedge fund investors are redeeming from these funds in droves, plenty of institutional investors will continue to rely on hedge funds in the second half of this year. Based on a recent Credit Suisse report, although 84% of the investors surveyed indicated that they had redeemed from hedge funds this year, 82% of those redeemers indicated that they would invest their redemption proceeds in other hedge funds. In addition, according to a Financial Times report, U.S. endowments and sovereign wealth funds increased their allocation to hedge funds last year.However, a fund’s fee structure is a prominent factor in investors’ minds. Recently, the Orange County Employees Retirement System publicly announced that it no longer wants to pay a performance fee when a fund manager fails to beat an applicable benchmark. This reiterates a call by the investor group, known as AOI, back in late 2014, to better link compensation to performance and reduce a fund manager’s incentive to simply gather assets. In addition, AOI has called for clawbacks to be inserted into fund documents to recover performance fees if future losses arise and for a management fee that reduces as the size of the fund increases.
Although a reduction in the management fee as the size of the fund increases is being introduced in various fund documents, a hurdle rate and clawback have not been broadly adopted by hedge funds. Nevertheless, the focus on these fees has had some effect. According to Hedge Fund Research Inc., hedge funds on average charge a 1.5% management fee and a 17.7% performance fee, down from the historical 2/20 rates, and the media has recently reported reductions in the standard fees charged by various large hedge funds. In addition, hedge fund managers have often been willing to agree to reduced management fee and performance fee rates for locked-up capital, and we have seen significant reductions for early investors that were admitted as part of a founder’s share class.
Private Equity Funds
Since the 2008 financial crisis, there has been continued pressure on the management fee charged by private equity funds and even calls for “budget based” management fees, although we have not seen these structures adopted. However, there have been modifications with respect to the management fee offset set forth in private equity fund documents.
The management fee offset related to the receipt of transaction fees from underlying portfolio companies by the fund manager has increased from 50-50 or 80-20 to 100% in many cases. This has been compounded by ILPA’s introduction of a fee reporting template and by the SEC’s focus on the fee and expense practices of private equity funds, both of which have resulted in more focus on the fees charged by private equity funds. Nevertheless, most of the change in this regard has been focused on the carried interest charged by private equity funds. Historically, U.S. private equity fund managers charged the carried interest on an investment-by-investment basis (the so-called American style distribution waterfall). In recent years, this has become difficult to maintain unless the fund manager agreed to an interim clawback with respect to excess carried interest or some type of an escrow arrangement to prevent the front-loading of the carried interest. As a result, to enhance their funds’ acceptance by prospective investors, many private equity fund managers have moved to the so-called European style distribution waterfall whereby all capital contributions must be returned plus a preferred return thereon before the carried interest may be charged. A hybrid approach has emerged whereby an investment-by-investment carried interest is permitted (with the escrow or interim clawback approach referenced above) so long as all capital contributions applied to the payment of expenses and a preferred return on the capital contributions applied to such expenses and the acquisition of all realized investments through such date are received by the investors before the fund manager may receive its carried interest.
Most recently, two large private equity funds are publicly reported to have taken two different approaches to the fee structure they offered to their investors. On its eighth flagship fund, Advent International did not provide investors with a preferred return or hurdle (generally 8%) that must be achieved before the fund manager can receive a carried interest. In exchange, Advent has reportedly agreed not to charge the fund fees for business services related to the appointment of its operating partners to the fund’s portfolio companies. Vista Equity, on the other hand, is said to have offered fee choices to its investors for its latest buyout fund. Based on public reports, investors had the choice to select either (i) a 1% management fee that has a 30% carried interest with a 10% hurdle attached to it, or (ii) a 1.5% management fee and a 20% carried interest above an 8% hurdle.
As mentioned above, fund managers must strike a balance here to entice investor capital to stay in the fund while not reducing the fund manager’s revenue base so much that it has difficulty retaining the talent needed to properly execute on its strategy. What approaches will stick and what will fee structures look like in the next year or two? Part of the answer depends on the performance of these funds and the ability of fund managers to predict the needs of investors.