Smaller hedge funds may exit industry on fee pressures, says Agecroft Partners’ Don Steinbrugge
Don Steinbrugge, managing member of Agecroft Partners, says that pressure remains on the hedge fund industry to lower fees, despite a 15% average decline in management fees on net assets received by hedge funds since 2008.
Hedge fund platforms, 40 ACT and Ucits funds
Since 2008 there has been large demand for increased liquidity and transparency which has driven growth of hedge fund platforms, Ucits funds and ‘40 Act funds.
Hedge fund platforms require a managed account by the manager and usually ask for 50 to 100 basis points fee discount which is used to run their business. This discount is not passed on to the investors. Managers potentially will also earn a lower performance fee due to the fact that the account might not be run pari passu to the main fund because less liquid securities were omitted.
In addition, some platforms allocate significant administrative expenses to the fund that reduces performance.
Ucits funds have higher expense ratios than standard hedge funds. As a result many hedge fund managers charge a lower management fee for Ucits funds so investors total fee will be in line with the main fund. Performance fees could also be lower for similar reasons relative to the hedge fund platforms. Finally we are seeing significant growth in 40 Act funds, a majority of which charge no performance fees
Hedge Fund Seeding/Acceleration Allocators, First Loss Programs and Founders Shares
Since 2008 it has become increasingly difficult for start-up and smaller hedge funds to raise capital. As a result, many are turning to alternative sources of capital.
Start-up hedge funds often sign deals with hedge fund seeding companies that agree to make an allocation in the hedge fund and in return they receive a percentage of the hedge fund management firm’s revenue, in addition to the performance on their investment. A good benchmark on revenue sharing is 25% of the firms revenues annually with a buy-out clause after year five.
Other start up hedge funds are offering founder’s shares, which give day one investors better terms than investors who come in later. Founder’s share terms vary widely and often involve a fee reduction in exchange for the investor committing to a substantial lock-up on invested capital. Current trends in Founders’ shares were explained well in a recent white paper written by hedge fund legal expert Brian Farmer of Hirschler Fleischer.
For smaller hedge funds having difficulty raising assets, many are turning to accelerator capital, which is structured in a similar as hedge fund seeding, and first loss programs.
First loss programs require a managed account where the hedge fund manager supplies approximately 10-20% of the account balance and the remainder is furnished by the first loss program. There is usually not a management fee charged and the hedge fund manager gets to keep 50% of the upside, but is responsible for 100% of the downside up to a specific limit.
Large institutional investors
The large institutional investor class includes any investor that can allocate $100m or more in a single manager and is dominated by pension funds and fund of funds.
An increasing number of large institutional investors are demanding fee discounts when making large allocations to managers. This was first broadly experienced by hedge fund of funds who often significantly discount their fees, but is now also occurring with direct investments into hedge funds.
Large pension funds are in the habit of paying a lower fee than smaller investors. Their viewpoint is that the effort level to manage a $100m account is not ten times more difficult than a $10m account, so why should they pay total fees that are ten times greater? The exception to this case is managers with limited capacity or those managers that bring a unique attribute to the portfolio.
Almost all large long-only managers that focus on the pension fund market place offer a graduated fee schedule that scales down for larger account sizes.
The most common type of discount we are seeing relative to single strategy hedge funds is a reduction in management fee. However, to a much lesser extent, we are also seeing a discount in performance fees.
The reduction in performance fees is taking two structures with the first being a discount on the standard 20% model, and the second being a performance hurdle that must be achieved before earning a performance fee. Before discounting a fee, hedge funds should make sure they are comfortable with offering the same fee structure to other investors of similar sizes due to the growth of most favored nation clauses.