In the wake of one of the most severe liquidity crises in recent memory, the vast majority of hedge fund managers have seen their assets under management shrink considerably over the past twelve months.  Whether in the name of paring back on risk, exiting losing positions, reducing portfolio volatility, or simply rebalancing portfolios, investors have used a litany of reasons to withdraw several hundred billion dollars in capital from their hedge fund accounts.  This, in turn, has drastically shrunken managers’ ability to generate fees on these accounts.  As a result, hedge funds are increasingly reworking their fee structures in order to satisfy existing investors, as well as attract new capital to their funds.

Let’s start out with a primer on the basics of hedge fund fees structures.   Hedge funds typically earn their income through a variety of fee structures charged to their clients.  These fees are not only meant to cover fund administrative and operating costs, but also to reward employees and managers for providing positive returns to investors.  The most common and well-known hedge fund fee structure combines both management and performance-based fees.

First, the “management” fee represents an annual, base fee levied on the amount of assets managed by a firm.  This fee can represent anywhere from 1-4% of net assets, however 1-2% is the most common range.  Thus, as an example, if a hedge fund has a management fee of 2%, then investors are charged $2,000 for every $100,000 invested in the fund, per year.  However, rather than being levied on the investor as one flat charge, management fees are usually deducted incrementally, on a monthly or quarterly basis.  These fees are traditionally used to cover fund administrative and operating costs, which may range from paying a full-time staff or third party administrator, to renting office space or attending conferences.

The second common fee structure within the hedge fund industry is a “performance,” or incentive-based fee.  Performance-based fees, on an ideological level, are intended to properly align the interests of the fund manager with investors.  The fee, which represents a percentage of the year’s profits, is thus only awarded to the manager in the event that he provides positive returns to his clients.  Performance fees typically range from 10-40%, however 20% appears to be the accepted industry norm.  Often, these fees are allotted to firm employees and managers in the form of bonuses, used as a way to reward positive performance by managers on behalf of their clients.  Hence, when a hedge fund’s fee structure is referred to as “2 and 20,” this means that it charges a 2% management fee and a 20% performance fee.

Increasingly in the past year, hedge fund managers have moved to reduce these fees in order to appease investors (after all, fees generally reduce investor returns).  Some managers, such as Bill Ackman, have vowed to halt the charging of fees to existing investors until previous fund losses have been reversed.  Oftentimes referred to as the implementation of a “high water mark,” this is typically done to appease existing investors who may feel jilted due to excessive fund losses.  It essentially prevents managers from charging double layers of fees.

Meanwhile, support is mounting for funds to abandon the traditional “2 and 20″ fee structure.  A recent report by Barclays Capital suggests that a growing number of investors favor the implementation of “hurdle rates,” which prevent managers from levying annual performance fees until they have met and passed a predisclosed benchmark performance rate.  This would hold managers more accountable, as they would only be rewarded for posting returns in excess of, say, the risk free rate.  Additionally, some managers are facing pressure to lower all fees in order to attract new investors.    For example, investors, particularly in the pension fund industry, are beginning to seek out funds with lower expense ratios, such as a “1 and 10″ structure.   These lower fee funds help to better-preserve investor capital, especially during years of negative fund performance.

The combination of charging both management and performance fees should continue as an industry-accepted standard.  While the management fee is used to cover basic fund expenses, the performance or “incentive” fee properly aligns the interests of the manager with his investors.  Furthermore, while hedge fund assets under management have fallen considerably over the past year (recent estimates put the value at about $1.3 trillion under management, down from an estimated $2.5 trillion), potential investors actually wield a considerable amount of power.  As investors reenter the hedge fund arena, managers may be forced to make concessions in order to win back their hard-earned capital, not to mention their trust.

In the coming years, it will be interesting to gauge whether investors, indeed, pressure the entire industry into lowering its fees.  In my opinion, managers will be willing to make concessions on fees in the near term.  In fact, investors would be wise to make these demands while the hedge fund industry is scaling back, and perhaps in its most vulnerable state.  If investors demand incentives to return to hedge funds, retooling fee structures represents a logical starting point.

That being said, investors need to make those demands right now.  If they fail to act now, then several years down the road, as industry-wide returns stabilize and improve, investor uproar over fees will likely evaporate.  As a result, investors seeking concessions would be wise to strike while the proverbial iron is hot.  If not now, then when?

Tags: Ackman, assets, Barclays, concessions, hedge fund, hedge fund fee structures, hedge fund managers, Investors, liquidity, Management Fee, performance-based fees, portfolio volatility, third party administrator

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