Insider Investment

In our recent post on the 2 and 20 structure, we touched on the issue of whether hedge fund managers choose to reinvest incentive fees in their funds. We received a couple of questions related to our comment:

"Things can get even more sneaky: don’t expect that just because a manager has x hundred million dollars “in the fund” that it is necessarily at risk with fund performance. There are certainly managers who will index part of their personal investment (usually when held as part of a tax deferral scheme) to other assets."

To give a little more detail on this point, it is possible that some (or even all) of a Manager's investment in a hedge fund can be linked or indexed to the performance of other assets and not the hedge fund itself. While unlikely onshore (at least for managers subject to US personal taxation), this is a situation which can arise in an offshore fund. In offshore vehicles, US taxable managers can elect to defer payment of incentive fee income for up to 10 years, which then grows on a tax free basis. Over time, these deferred fee balances can become very substantial and represent a material portion of offshore fund assets.

In some instances, the manager may elect, for reasons of personal investment diversification, to index some of these deferred fees to something other than fund performance. Treasuries are the most usual choice, which, in the scheme of things, is relatively uncontroversial. Things become more worrisome when managers index to other assets such as equity indices or even buy a portfolio of investments (such as holdings in other hedge funds) which are allocated solely to the deferred fee account, and not to external investors. Some funds also adopt leverage mechanisms on insider capital, which can add still more complexity.

The due diligence point, therefore, is to understand whether insider investment is allocated on a pari passu basis with external investors. Is there some indexation to assets other than the hedge fund and, if so, what assets are involved and to what proportion? It is also important to understand whether insiders choose to allocate some of their personal investment to co-investment vehicles or separate "partners funds" which might follow different strategies (more risk, less risk, more concentration, more private investments etc. etc. etc.) These structures, in turn, introduce additional potential for conflicts of interest.

So, when a manager claims that a large dollar amount of firm assets are held by the principals, it's always a good idea to check that those assets are invested in the same things as you.

Comments

[Espen Robak]

Chris, for what it's worth, I think the main problem is that most of what we're paying incentive fees for just ain't alpha. I'm not just talking about paying for the risk-free rate of return (and typically we do when we "catch up") but, also, way too much of the return these days is just the return on illiquidity (long the most illiquid stuff, short the most liquid stuff, harvest the return increment - yawn), goosed up with leverage. Anyone can do this, it takes very little skill, so why pay for it? Anyway, just my 2c. Getting rid of the catch-up might be the best way to make sure the incentive fee really pays for performance.