Call for fees re-think as hedge fund industry grows

GLOBAL - Towers Watson has called for investors to take advantage of their “considerable” negotiating power and push harder for more fairly structured fees when negotiating with hedge fund managers.

The release of the consultancy’s report ‘Hedge fund investing - opportunities and challenges’ coincides with the publication of the ninth edition of investment software provider PerTrac’s exhaustive annual survey of the size of the hedge fund industry, which found it had grown to 13,395 funds - including funds of funds - managing $2.3trn (€1.7trn) - growth of 3.37% despite a challenging 2011.

While PerTrac’s study found the single-manager hedge fund industry in rude health, with the number of funds rising almost 7% to 10,007 and the assets under management (AUM) up 4.19% to $1.798 trillion, the same could not be reported of the fund of fund industry where AUM remained flat at $447bn and the number of players actually fell nearly 5% during 2011, to 3,388.
 
Within this declining trend, however, the biggest funds of funds continue to grow, PerTrac found. It said the number of funds of funds managing in excess of $1bn grew by 17.8% during 2011, while the asset-base in every size bucket below $1bn shrank. The heart of the sector - funds managing between $251m and $500m - shrank by almost 16%.
 
By contrast, the asset-base for every size bucket of single-manager funds grew, and while those managing more than $1bn saw assets increase by a healthy 6.1%, it was the funds managing between $501m and $1bn that saw the biggest percentage growth during 2011, at 11.5%.
 
Therefore, while funds managing in excess of $1bn still accounted for around 60% of total hedge fund investments, the figures - which consolidate and clean data from 11 data providers and convert non-US dollar according to the end-2011 exchange rates - suggested good demand for small and medium-sized, and perhaps lesser-known, funds.

As fund of funds money is being concentrated with the largest vehicles, which are often curtailed by their size from allocating to smaller underlying funds, the numbers lend some weight to anecdotal evidence that more and more institutional investors are disintermediating their hedge fund investments.
 
The reported disintermediation, often driven by a desire to escape a double layer of fees, coincided with Towers Watson finding, and encouraging, reports of applying of pressure on hedge fund terms - despite growing demand for the alpha that hedge funds promise.
 
Damien Loveday, the consultant’s global head of hedge fund research, said: “Skill is a scarce commodity and investors should expect to reward managers that are able to produce it consistently. Those rewards had become skewed but, since the events of 2008, managers are more responsive to engaging in discussions with investors on fees and terms.

“Many have moved towards structures that better align the interests of investors and managers, and this has been crucial to the revival and growth of the industry,” Loveday added.

Towers Watson recommended “significant contract negotiation” around levels of transparency and liquidity - including the length of initial lock-up periods and the protocols around gates and side pockets - and on ‘key-man’ clauses.

On fees, it said that “well-aligned” structures would include management fees set to reflect the true operating costs of the business rather than the value of assets invested, and incentive fees calculated on an extended period of performance, with “appropriate” hurdles, non-resetting high water marks and clawback provisions.

“Managers share profits, but there is often no mechanism for them to share losses so there is an incentive to take excessive risk rather than targeting high long-term returns,” said Loveday. “Structures that contain hurdles, high watermarks and those that defer fees with the ability to claw back in the event of subsequent drawdowns are therefore preferable.”

The consultant also felt that the level and calculation of incentive fees is currently skewed too far in favour of managers.

Rather than the 20% of returns that it cited as the industry standard, it suggested 30-40% of ‘total gross alpha’ should go to managers in fees; the estimate of total gross alpha would be smaller than the gross return, but also potentially smaller than the return over many of the industry’s standard hurdle rates - which still contained significant market return.

“Hedge fund managers should be compensated for their skill and not for delivering market returns,” Loveday said. “The separation of these two elements is complex, but in our view worth analysing in detail.”

A recent study by The Centre for Hedge Fund Research at Imperial College in London, ‘The Value of the Hedge Fund Industry to Investors, Markets and the Broader Economy’, commissioned by KPMG and the Alternative Investment Management Association (AIMA), found that hedge fund investors earn about 72% of profits, versus the 28% share for the managers. This estimate was based on an assumption of average management fee of 1.75% and an average incentive fee of 17.5%.

Towers Watson reported progress in some these negotiations.

During 2009, its hedge fund managers reduced management fees to an average of 1.5%, while a year ago, Hedge Fund Research reported a decline in incentive fees to an average of 18.95% (the lowest level since it began tracking such data) and average management fees of 1.58%.