Exploring The Alignment Of Interests Between Hedge Fund Managers And Investors
I am delighted to contribute the foreword to this important new AIMA paper, “In Concert ? Exploring the alignment of interests between hedge fund managers and investors” on behalf of the AIMA Investor Steering Committee (ISC).1
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Since the global financial crisis, the nature of the relationship between hedge fund managers and investors has undergone tremendous change. Driven in large part by investor demands for greater transparency, fund managers and investors are increasingly forging partnerships with each other. As a previous paper2 authored jointly by the AIMA Investor Steering Committee (“AIMA ISC”), and Barclays Capital Solutions found, many institutional investors such as pensions, endowments and foundations are looking for relationships with their external investment managers that may include greater knowledge sharing, customised solutions, co-investment opportunities, product seeding and/or equity investing. As fees continue to come down, “2 and 20” is increasingly the exception, rather than the norm.
This new report builds on those findings. The survey and report were overseen by AIMA’s Research Committee, which comprises executives at fund managers and service providers. The report was reviewed by the AIMA ISC, and AIMA also consulted with the Hedge Funds Standards Board (HFSB), the global standardsetting body for the hedge fund industry. As the report shows, investors are increasingly asking for, and obtaining, tiered fee structures (so that, for example, management fees come down as the assets under management of the hedge fund firm grows), hurdle rates (where performance fees are paid only if a target is met) and claw-backs (where a portion of past fees are returned to investors in down years).
These efforts are of course welcome, but they follow a longer-term trend. Interests between hedge funds and investors, thanks to decades-old concepts like “skin in the game” and the high water mark, have always been aligned. In recent years, hedge fund managers have listened to investor feedback and gone further than before. As hedge funds continue to evolve and institutionalise, we look forward to an even closer alignment of interest.
We are pleased to present AIMA’s latest research paper “In Concert ? Exploring the alignment of interests between hedge fund managers and investors”, an initiative of AIMA’s Research Committee.
Over the past several years, hedge funds have become an established player in the institutional asset management space. As the hedge fund share of institutional assets under management continues to grow, hedge fund managers have developed new investment strategies, technology and risk management solutions that have been driven by their investor demands for greater transparency, sound governance and more favourable investor terms.
More than ever, fund managers are likely to find that operational considerations such as how to structure investment management fees in a way that is consistent with their funds’ investment strategy and investors’ expectations, are critical to setting the ground for a successful hedge fund enterprise. Institutional investor demands have brought about significant changes that affect the overall industry.
This paper brings together the perspective of a broad range of managers from a variety of geographic regions and strategies to identify ways in which fund managers have developed an even closer business partnership with their investors.
In a highly competitive environment for the asset management industry, this AIMA survey provides keen insight on how hedge fund managers continue to take the lead in finding solutions that drive growth and innovation and add value to their investors.
Michelle McGregor Smith
Chairman, AIMA Investor
John T. Hague
Services Industry Leader
RSM US LLP
In this paper we investigate the methods that are being employed to align the interests of managers of hedge funds (‘managers’), and investors in hedge funds (‘investors’). Our findings are based on an extensive manager survey comprising 120 respondents with assets under management (AUM) of over $500bn. The respondents are varied in terms of strategic approach and size. AUMs range from below $100m to more than $20bn.
We analyse the findings based not only on what is currently being done, but also in terms of potential future developments and how these could best be implemented.
We begin by investigating the measures which, if put in place, can reduce fees. We find that high water marks are extremely popular, with 97% of managers using the structure. Hurdle rates also prove to be commonly used (employed by one third of the managers) and, for fixed percentage thresholds, are usually in excess of 3% (60% of managers who have a target set it in excess of this benchmark). Indirectly, we discuss how investors can negotiate lower fees by accepting a longer lock-up period on their capital. We consider how this could further enhance returns by allowing the manager to execute his investment thesis more efficiently, without having to compromise performance by having to maintain cash buffers to offset potential redemption requests.
We then look at other features managers have employed to make their offering more attractive to potential investors. We think about transparency and observe how the disclosures made by managers have greatly increased since the global financial crisis of 2008. We also discuss the importance of managers having “skin in the game” or personal capital invested in their strategies. We find that 61% of managers currently use this as their primary means of aligning interests with their investors.
Our third section examines the varying fee structures that managers can employ. We look at the cost-push factors that led to the 2% management fee and 20% incentive fee (or as it is more colloquially called “2 & 20”) becoming the norm in the recent past and discuss the special types of share classes used to provide discounts to certain groups of investors. We look particularly closely at tiered fee structures, where the fees paid reduce as the AUM of the fund grows. Almost 77% of hedge fund managers who participated in our research said they are considering implementation of this measure.
The final section seeks to demonstrate that, in achieving a closer and more aligned relationship, both managers and investors stand to benefit. We see the advantages as threefold. First, as the investor attains more knowledge about the manager they will gain a deeper understanding of how the fund will behave. This will help to avoid short-termism which can damage performance. Second, the enhanced clarity of relationship enables the sharing of expertise which can benefit both parties: the manager because he will gain a better understanding of the client’s needs, and be able to cater to them more effectively, and the investor because they will be able to take advantage of the manager’s unique market insights to the betterment of their overall portfolio. Thirdly, closer collaboration enables new products and services ? such as co-investments and managed accounts ? to be developed which will give the investor a greater range of products to enhance their portfolio returns.
We conclude the paper by highlighting the flexibility of the tools that have been discussed. We assert that there is no one-size-fits-all when aligning investor and manager interests and that the different methods should be calibrated to the specifics of the individual situation. The aim should be to reach a point where manager and investor are incentivized to act in a way which is mutually beneficial, and that in doing this a relationship of symbiotic collaboration might develop.
- Hedge fund manager survey with input from 120 hedge fund managers globally representing approximately $500bn in assets under management (AUM)
- In-depth one-on–one interviews with hedge fund managers to help get a better understanding of the key findings from the manager survey
- Input from a global investor steering committee which manages approximately $1 trillion AUM and allocates c.$100bn AUM to hedge funds
- Input from a variety of thought leadership and external research across a variety of hedge fund industry stakeholders including investors, hedge fund managers, hedge fund industry service providers and policy-makers
Popular fund tools that managers make available to investors to help moderate their fees.
It is evident that managers are responding to client’s needs by putting in place a number of tools that help ensure that their investment strategies are carried out as is intended, and fees are structured in a way so that the alpha capture is split appropriately between managers and investors.
These measures are:
- Imposing a high water mark on the fund;
- Imposing a hurdle rate on the fund;
- Imposing fund claw-backs and other related tools; and
- Having longer lock-ups agreed by investors.
1.1 Imposing a high water mark on the fund
The deployment of a high water mark in hedge funds is a very popular tool among investors to help managers remain focused on producing the best possible returns for investors. A high water mark can be applied to the calculation of the fund’s performance fees, so that the fee is only paid on net new increases in the fund’s asset value. A high water mark means that, where the net asset value (NAV) of the fund drops below its peak, no performance fee can be charged on any subsequent profit until the NAV reaches its previous high. As per the responses from our survey, 97% of managers deploy a high water mark in the design of their fund’s performance fee.
Some hedge fund managers make use of a modified high water mark. This allows a hedge fund to collect its performance fees in any winning year even if it comes after a losing period. However, this is very much the exception rather than the norm.3 Related to this, funds that have provisions to reset their high water marks (where the fund can erase any fund losses after a defined period of time has elapsed) are becoming less and less acceptable among hedge fund investors, irrespective of the fund’s size or its history of a strong performance track record.
An example of another modified structure among some of the manager respondents in this survey includes the deployment of an amortising high water mark which spreads out any fund losses over the longer term enabling the hedge fund manager to earn at least some of the performance fees despite the fund being below the high water mark. In return for this concession being provided, managers would continue to receive the lower performance fee until its performance beat the previous high water mark set plus any carry forward loss amount; for example 150% of the carry forward loss amount. Arguably this measure will benefit the investor, as it reduces the pressure on managers to take further risks in pursuit of attaining the high water mark, and/or to close the fund prematurely, when faced with an unattainable and permanent high water mark. Further, as investors continue to compensate the fund, it enables the manager to retain and incentivise his staff. It is generally the case that, for a long-term client who has experienced some years where the fund has not beaten its high water mark, they will generally have paid less incentive fees under an amortising high water mark than they would have done with the more conventional structure.
Suppose the high water mark of the fund was $100m but losses cause assets of the fund to fall by 10% to $90m. Under the traditional high water mark, no performance fee would be paid to the hedge fund manager until the high water mark of $100m was exceeded. At that point the fund manager would then receive his performance fee (and for simplicity, let’s say this is 20%).
Under a modified high water mark arrangement, the hedge fund manager is paid a reduced performance fee (let’s say 10%) on profits between $90m to $100m until it exceeds $100m. To make this arrangement more attractive for investors, the manager will be paid the reduced performance fee beyond the previous high water mark level, for example 150% of prior losses, or in this case $15m above the previous high water mark to a new high water mark of $115m. Assuming the manager will eventually generate profits so that the new high water mark is exceeded, the investor ends up saving $0.5m in performance fees than under the traditional arrangement where they would have been paying 20% on all profits.
See the full PDF below.