Time to rethink 2 and 20?

Hedge funds have a remarkable fee structure – typically a 2% fixed management fee plus 20% of performance. This structure comes in for frequent criticism from “traditional” investment consultants, who simply cannot understand why institutional investors pay hedge fund fees – there’s clearly a contradiction between the determination institutional investors have shown to drive down the cost of acquiring market beta (indexing, futures strategies etc.), with their readiness to pay 2 and 20 for what may – or may not be – hedge fund alpha. The most commonly given reason for this paradox is simple supply and demand: there is ever more money chasing a finite pool of “good” hedge fund managers, so obviously those managers see little need to reduce their fees. Indeed, some of the “best” hedge fund managers disregard even the 2 and 20 rule and can charge up to twice as much.

Perhaps, though, that it about to change. 2 and 20 is fine when markets go up, but recent events – and no doubt events over the coming months – may cause a lot more hedge fund investors to question the industry’s fees.

In many ways, the recent demise of the Peloton ABS fund is an excellent case study for the issues raised by 2 and 20. As a disclaimer before we go any further, we note that we have not completed due diligence on this fund or firm and our only knowledge of the circumstances of Peloton’s losses come from the news media.

We don’t want to pick on Peloton, but the case highlights the fact that hedge fund managers get rewarded on the way up – handsomely – but do not have to repay fees on the way down. It is this asymmetric fee structure which, we expect, will come in for sharper criticism when more investors find funds down 10% in a month, let alone down 100%.

It has been reported that Peloton posted a spectacular 87% gain in 2007. As this is the net return to investors, the fund itself must have been up about 110% gross in ‘07, as the net gain is stated after the management fee (which we assume was 2%) and the 20% performance fee. It’s hard to estimate the dollar value of fees earned by Peloton during 2007 (by Feb 2008 the fund is reported to have had assets of $1.8 billion, but the amount earned across the’07 year will depend on the timing of subscriptions as well as the degree to which Peloton shared fee income with third party marketers.) As a conservative guess, let’s say management fees and incentive fees were at least $100m.

Let’s think about a number of issues.

Firstly, if a manager generates a substantial incentive fee, has any of that income been reinvested in the Fund? Peloton is an extreme example when a manager generated very high incentive fee income one year but then blew up less than two months later. We don’t know the circumstances of this case, but we imagine that investors would have a different view if Peloton had reinvested all the $100 million back into the Fund (to take our “guesstimate”, as above) - which is now worth nothing - compared to a situation in which the firm’s principals had taken the full amount out of the Fund and reinvested it elsewhere. Investors are unlikely to be happy with a manager who is up $100 million while they are down 100%.

The problem, though, is that there is no “standard” formula for whether managers will reinvest in the Fund and, if so, to what extent. Some managers reinvest a great deal, while others withdraw a much higher percentage. Some firms employ multi-year deferred compensation schemes, others pay year to year. Even if the principals of the firm reinvest a lot, the portfolio managers lower down the chain may well get paid in cash (let’s think of Amaranth and Mr. Hunter.)

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.

In our mind, the question of whether hedge fund managers should reinvest performance fees in their funds raises a multitude of issues. One is the self evident moral hazard: unless the risk takers within each hedge fund are forced to reinvest a (significant) portion of their incentive fees in the fund, then performance objectives can become fixated on the annual compensation cycle, not long term performance. This is the prop desk mentality, not one of enduring alignment between manager and investor interests.

A second issue is much broader – is it actually a good idea that hedge fund managers should get their 20%, in full, on an annual basis?

1) Should there be a “look back period” for the performance fee? In other words, if the fund goes down, should the hedge fund manager return some of the fees earned in prior years? Taking a relatively mild application of this principle, should a manager return a pro rata proportion of the performance fee if the fund falls in the following year? In other words, if a fund is up 20% in the first year, but falls 10% in the next, should the performance fee be adjusted to reflect the fact that the fund was only up around 8% over the two year period?

2) Should the performance fee “vest” over a period of time? Would it be wiser for the 20% to vest, say, over three years on a one third, one third, one third basis? This would clearly act as a disincentive for short term hubris and risk taking – the strategy needs to sustain itself and generate ongoing performance if the manager is to receive the subsequent installments of the incentive fee.

3) Should the performance fee crystallize in line with manager redemption opportunities? If a fund imposes a three year lock up, for example, is it a good idea that the manager can nonetheless pay themselves every year? If a fund does follow a strategy with a multi year time horizon, should the manager receive their fees only at the point that investors can exit the fund and realize gains themselves?

There are no easy answers to any of these questions. What is clear, though, is that there should at least be more discussion of hedge fund fee structures. We are left with the thought that 2 and 20 provides an amazing “carrot” which has allowed a growing number of successful managers to generate stupendous personal wealth. It would certainly seem fair that investors make sure that there is a corresponding “stick”.

Comments

[A little bird]

I believe the FT said that managers and staff of Peloton had 100+m in it, but can't find the link.

[Timberland Footwear]

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