If you meet someone who insists most hedge funds have a “2 and 20” structure, ask what car they drive, because it might be a time-traveling DeLorean that just arrived here from the ‘90s. There has been a notable shift in hedge fund fee arrangements.
Although 2% management fees and 20% performance fees served as the standard model for years, that’s changed since the 2008 financial crisis. Increased pressure to deliver double-digit returns that beat the market and a dramatic increase in the number of hedge funds during the past 25 years has intensified the competition for investor’s capital.
At STRAIT, we’ve observed fund managers responding to these industry dynamics with more flexibility in fee arrangements. They recognize that investors are looking for better value, in the form of fee models that align with their interests. Read on to discover the trends we see as investment managers adapt their fee structures to attract investor capital.
Management Fees: Market Share Increases for Funds Charging Below 1.5%
Ever since the last financial crisis, more than a decade ago, we’ve watched investment managers step away from the traditional 2% management fee. That trend is reflected in a study by Eurekahedge. It shows that in 2008, the market share held by funds charging less than 1.5% was about 30%. By June 2019, the figure had jumped to about 55%.
This doesn’t mean management fees are in a race to the bottom. During that same period, there was a drop in the proportion of assets managed by funds charging at least 2% in management fees. From 2008 to June 2019, it declined from about 35% to about 28%, according to the Eurekahedge study.
Management fees will vary based on factors like the complexity of the fund’s strategy and asset class liquidity. Here at STRAIT, we have witnessed fund managers charging up to a maximum management fee of 2% and tying the amount to the actual fund expenses.
Performance Fees: Market Share Grows Dramatically for Fund Managers Charging Below 20%
When hedge fund investors push back on fees, performance fees receive the most scrutiny. Some funds use measures that help link the fund’s performance to the investment manager’s compensation to offer investors protection. There are two common methods for this purpose:
- Hurdle Rate: The minimum gains the fund manager must return before a performance fee is charged;
- High-Water Mark: This is based on the peak value of a fund’s net asset value over a period of time. Performance fees are then charged on the gain, which exceeds the high-water mark.
When it comes to demand for lower performance fees, new funds face extra pressure, because they must convince investors to take a chance on them. As investors push back on those fees, many funds have obliged. For fund managers charging performance fees below 20%, market share more than doubled during the past decade — from 16.3% of the industry assets by the end of 2008 to 41.3% in June 2019, according to the Eurekahedge study.
That said, a significant portion of the hedge fund industry has resisted this fee-lowering trend, based on the Eurekahedge study. As of June 2019, 58.7% of the global hedge fund industry AUM was managed by funds charging at least 20% performance fees.
Here at STRAIT, a common trend we’ve noticed is the use of a Graduated Performance Fee. This fee structure is characterized by fees that change based on returns of the partnership. It’s typically calculated on gross returns and often incorporates a hurdle rate. To help illustrate how this works, here's an example:
- Returns up to 20% will be charged a 20% performance fee
- Returns of 20% - 40% will be charged a 25% performance fee
- Returns 40% - 50% will be charged a 35% performance fee
- Returns greater than 50% will be charged a 40% performance fee
Additional Flexibility to Entice Investors: Founder Class, Asset Aggregation, Longer Lock-Ups
To entice investors, hedge fund managers are thinking beyond the basics of performance fees and management fees. Consider these creative arrangements that some funds are exploring:
- Founder Class: This approach is offered by emerging hedge fund managers. Founder Class investors typically pay a 25% to 50% lower performance fee than other classes in the fund until the fund reaches a certain asset size or an agreed upon period of time has elapsed.
- Asset Aggregation: Many outsourced CIOs, consulting firms, and multi-family offices offer a “recommended” list of hedge funds that their clients invest in directly. In recent years, these firms have been negotiating fee discounts based on aggregate assets invested across their client base.
- Longer Lock-Ups: In exchange for reduced fees, an investor may agree to a longer lock-up period.
Creativity: The Competitive Edge
As competition for capital continues to intensify, fee structures have evolved into something much more nuanced than the standard 2 and 20. Hedge fund managers are shifting away from one-size-fits-all structures, and instead, they’re emphasizing customized, flexible arrangements that are aligned with investors’ interests.
Creative fee structures can help attract investors, but the additional complexity can also bring operational burdens. Reach out to a member of the STRAIT team to learn how we can help your fund navigate fee structure changes.