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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Hedge fund regulation has long been a subject of debate, with the SEC pushing for tighter restrictions and managers doing all they can to avoid it. Both stances are understandable. Managers are known for their ambiguity. They provide just enough information to investors, but usually leave the tedious information about specific strategy details and asset allocation to themselves. The federal government and SEC claim to be looking out for the investor.

After the dozens of crimes involving hedge fund fraud over the last decade and the millions of dollars bilked from investors, the SEC rationalizes that somebody should step in to quell this epidemic of smooth talking swindlers. For that matter, even reputable names like the one time Bear Stearns don’t always adhere to the best practices.

Two hedge fund managers at Bear who are responsible for the implosion of two billion dollar funds swore to investors that the fund was doing fantastic. Performance reports showed no worries. Only internal emails to each other highlighted the scare and warned of the future demise of the fund. Could tighter regulation have prevented that problem? The SEC says yes.

In 2006, the SEC passed a rule that all hedge funds would have to register as investment advisors, only to have it overturned by the federal government. Dozens of high profile hedge funds wrote letters explaining why hedge fund regulation would result in more bad than good and that the SEC was overstepping the boundaries of its jurisdiction. Others argued that investors in hedge funds are highly sophisticated and they don’t need protecting. There are already rules set in place as to who may invest in a hedge fund, and as long as the investor knows there is risk involved, it is ultimately his decision.

Federalism then forced the arguments into the state’s hands, while some states pushed for tighter regulations and others like New York and Connecticut opted against it. After California called for stricter measures, it was ultimately overturned earlier this year after many prominent hedge funds expressed concerns that regulations would only push hedge funders into other states while taking their vast incomes and purchasing power with them.

One of the reasons that managers oppose greater transparency is the need for secrecy in their strategy. Since hedge funds may entertain a wide variety of strategies and combination of strategies, managers are very reluctant to let others view their moneymaker. Once a strategy is exposed, other managers may follow suit leading to the drying up of the waterhole so to speak. Particular strategies are the product of the brilliance behind the manager and other integral members of the staff and therefore do not want to be given up.

Also, since most hedge fund strategies are so complex, many investors might not understand the entirety of it anyways. Why disclose something that would only aid in confusion? Another reason is the obvious need for the non-disclosure of price. Buyers typically want to buy at the price you paid for it, not under the circumstances where you are going to make a killing off what they pay.

Size also correlates to the amount of transparency involved. Smaller, newer funds may have to disclose more information in order to attract capital and new investors. They may have to be entirely open on where investments are going and how they are allocating the cash. Larger, more established hedge funds are a different story. They may have an abundance of capital and are therefore not concerned with attracting new investors. If this is the case and the money is already locked up, they may become very secretive and start investing in riskier securities or use outlandish strategies to start reaping high returns in a short time frame.

But what is the investor’s role in all of this? Do they typically side with the openness pushed for by the SEC or the hush hush tendencies of hedge fund managers? One might think this is an obvious answer, with investors wanting to know exactly where their millions are going. But recent trends show just the opposite. Apparently, when it comes to hedge funds, trust is the key word.

Managers that have worked in the industry for years generally have a vast number of contacts and have gained the trust of many affluent individuals. I doubt that John Paulson, the man whose hedge fund has returned billions for investors, has to sit down and convince people of his accolades. If trust is directly related to experience, then established managers should have no problem recruiting investors.

Regulation or not, it is ultimately up to the investor to make the final decision. The SEC will never stop funds from collapsing, no matter how much light they shed on them. If hedge funds could promise massive returns and no losses, then everybody would invest. Reward only comes with risk. It always shocks me when investors are dismayed over an asset freeze. This is a real and distinct possibility that you knew could possibly happen going into the fund. Not that I think it’s fair or right. Keeping someone from their own money seems somewhat illogical. But still, it’s a pretty common practice. Some hedge funders just want to ride a bad wave out in the market and want to focus on strategy rather than dealing with withdraws and the liquidity crunch that would ensue. Unfortunately, a lot of the times, a redemption freeze is a precursor to the fund’s closing. These are things to think about. An investor in a hedge fund holds a certain responsibility.

Some choose to spend the money and perform a due diligence check. This is a smart idea and will raise any red flags in the manager’s past. Others choose to bypass this slightly expensive process and take faith in the manager. Whatever sleuthing they choose to participate in, the investor is always going to be exposed to risk. But the lure of the $3 trillion hedge fund industry and the very real possibility of massive returns will always ensure that there is no shortage in interest.

Tags: hedge fund managers, investor, Not Categorized, regulations, SEC, strategies

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While the overwhelming drama and non-stop media coverage of the democratic primaries has alas come to an end, a historic and monumental election awaits us. Never has there been such a divide on pertinent issues or such a stark difference in the socioeconomic backgrounds of the two candidates.

To some, Obama represents a long awaited revolution; a beacon of hope in the wake of a lagging economy and five years of a questionable war with no clear exit plan in sight. To others, he is merely an inexperienced congressman; a fish out of water whose rhetoric is far more appealing than his potential. McCain: A celebrated POW who endured years of hardship in Vietnam and who, more than anyone, understands the need to get us out of Iraq. To others, he is George W. Bush’s puppet; an obedient replica of our current leader with little variance to offer once he gets into office.

War debate aside, there is an extended agenda of issues on everyone’s mind this year. 47% of Americans cite tax issues as an area of great importance in the 2008 Presidential elections. So where do the two men stand? It has to be more complex than the cliché of the Republican standing behind the white collar worker, handing out tax breaks to corporate executives with the same enthusiasm they use to reject universal healthcare, doesn’t it? In fact, if the wealthy were so apt to align themselves with McCain, how did Obama garner such great support from the hedge fund industry?

Obama and his tirade of tax reform initiatives will no doubt shake up the current plan. From his “Universal Mortgage” credit to his “American Opportunity” initiative, Obama is certainly looking to put back into American’s pockets. But at what cost? While he seems eager to give back to the middle class, he won’t think twice about raising the capital gains tax to 25%. What does this mean?

Capital gains taxes are paid when an individual or corporation realizes a net profit on their assets, generally when an investment is sold at a higher price than what it was purchased for. For hedge fund managers, the capital gains tax is a huge factor, since millions of dollars of securities are traded within that fund.

Let’s say a fund manager takes home $3 million deriving from his 20% standard performance fee that he charges his clients. He will classify that as a capital gain, thus only having to pay $450,000, or 15%. If Obama’s proposal goes through, the fund manager now pays $750,000, or 25% of his income. While this may raise some complaints, supporters say this is still a tax break. If that $3 million were considered a salary as opposed to a capital gain, it would be charged the normal tax rate of 35%, or a little over $1 million.

With much less simpler (and for that matter, less confusing) initiatives, McCain’s focus is less on the middle class and more on the extreme ends of the spectrum. Both wealthy individuals and low-income families will get tax breaks, though the resulting after-tax income differences are no-doubt more prevalent on those who make substantially higher salaries. Rationalizing that low taxes on dividends and capital gains promote savings and financial planning, McCain will keep the current capital gains tax where it is, while fighting “anti-growth” measures brought on my dems. In this sense, he does mirror Bush. In fact, the only time he ever deviated away from his beliefs on the tax front was in 2001, fresh off a bitter primary defeat, where he voted against the Bush tax-cut initiatives. Lucky for the republicans, it didn’t take long before he was right back on track.

What’s interesting was the hedge fund involvement in the primaries that was surprisingly pro-democratic. Through extensive Wall Street contacts, Hillary Clinton amassed millions from prominent hedge funds. However, I think their support slowly faded after her intentions were announced to raise the capital gains tax to 35%, even if Marc Lasry does feign disgust at the “ridiculous” salaries made by hedge fund managers. Not far behind Clinton, Obama brought in a little over $1 million from hedge funds in 2007. McCain barely broke $400,000. One would think they would align themselves with the guy who is going to let them keep more of their income. Some hedge funds are saying they’re giving more to Democrats because of their impatience with Bush’s progress in Iraq and because they see a very real opportunity for them to win control of Congress for the first time in 12 years.

So maybe it is more than the number of zeros in a hedge fund manager’s paycheck. Regardless of the issue, importance is assigned to them by each individual. Maybe the tax issue is the highest for some. Maybe it’s gay marriage or whether or not steroid use in baseball should be persecuted. Either way, this election is unlike any that have come before, and the issue of capital gains is merely one issue that the voter should individually assess.

Tags: capital gains tax, elections, hedge fund managers, mccain, Not Categorized, obama

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Overview of “A Summary of Sound Practices for Hedge Fund Managers” which appeared in the Winter 2007-2008 issue of Financial Bridges magazine. View the entire article via the PDF.

Overview
The Managed Funds Association – a leading trade group for the hedge fund industry – recently released the fourth version of its highly regarded Sound Practices for Hedge Fund Managers (“Sound Practices”) manual. Since its first publication in 1999, this manual has been considered a cookbook or roadmap for prudent business and investment practices for hedge fund managers. The Managed Funds Association (“MFA”) publishes this manual, in part, to help fulfill its on-going self-described mission: to protect, assist and educate members, policy makers and the investing public.

The manual provides guidance to hedge fund managers by highlighting key components of sound practice in various areas, providing detailed practice suggestions in a series of appendices and by providing further reference to expert sources or additional highly detailed practice resources.

Tags: hedge fund managers, Managed Funds Association

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