In part two of our investigation into fund manager fees, Charlotte Moore explores how innovative new fee structures can save you money
Recent research by Cass Business School calls for reform of active managers’ fee structure to align the interests of investors and fund managers. While the research’s recommendation for symmetric fees is impractical, lessons can be learnt from investment consultants and hedge fund of fund managers to find more equitable solutions for members.
Righting the balance
Nathan Gelber, chief investment officer at Stamford Associates, broadly agrees with the Cass Business School research. “We think that fees are skewed in favour of the fund managers unless there is a very low base fee linked to a performance related fee which should be designed to be as symmetric as possible.”
Truly symmetric incentive fees are impractical”
However, Gelber argues that it is virtually impossible to achieve a perfectly symmetric fee structure. He says: “It’s not a commercially viable proposition for managers as their capital requirements do not allow them to dip into their pocket to pay back the investor for the underperformance.”
Greg Fedorinchik, senior managing director at Mesirow Advanced Strategies, agrees: “Truly symmetric incentive fees are impractical.”
First, there are challenging tax complications. The manager pays tax on the fees when earned. They could also create cash flow problems for the managers’ businesses in an especially difficult year or environment – which from a business stability standpoint could be exceptionally punitive, he adds.
But there is a way to mitigate the inequality of paying the manager one year for outperformance yet receiving no recompense if the fund then underperforms.
Gelber says: “When a fund outperforms, we pay out 50% of the performance fee and retain the balance in escrow until the manager outperforms the previous high water mark where the last incentive fee was paid.”
For example, if a fund in the first year grows the fund from £100m to £110m while the benchmark index is flat. “If we agree to pay a performance fee of 10%, half of this will go to the manager and the other half will be retained in an escrow account,” says Gelber.
If, in the second year, the performance of the fund is flat, then the manager does not earn a performance fee. And in the third year, the fund underperforms by 10% so it is now worth £99m.
For the fund to earn the next incentive fee and the amount that has been kept in reserve, the value of fund has to exceed £110m. If, the following year, the fund increases in value to £111m, the reserve is unlocked and the fund receives 50% of the outperformance above £110m.
An incentive fee structure will almost always be better at aligning incentives between fund managers and investors”
If the fund never recovers, then the manager will have to forfeit the half of the incentive fee which has been kept in escrow.
Fund of hedge fund managers have also spent considerable time thinking about to ensure that the interests of investors and fund managers are more closely aligned. There are some policies which fund of fund managers employ that could be adopted with more mainstream active managers.
Fedorinchik says: “An incentive fee structure will almost always be better at aligning incentives between fund managers and investors.”
Hedge fund performance is often highly volatile so a year of strong performance is frequently be followed by a year of underperformance. Using fees linked to ‘high water marks’ are a good way to ensure that both the investor and manager share the burden of volatile performance equally.
Fedorinchik says: “This avoids the situation created by an asymmetric fee environment where the manager would still receive a flat management fee despite underperforming.” High water marks ensure that fees are not paid until the value of the fund is more than the highest net asset value it reached.
Another very useful way of ensuring that the interests of investors and fund managers are more closely aligned is to use hurdle rates. Fedorinchik says: “Hurdle rates mean that no incentive fees are paid at all unless a certain performance rate is achieved.”
Even better are cumulative hurdle rates – where they are compounded”
In the hedge fund universe, it’s becoming increasingly popular to add hurdle rates. Fedorinchik says: “An example of this would be something like 1 in 10 over a 5% hurdle.” That means the manager would first have generate outperformance of more than 5%, net of management fees, in order to receive 10% incentive fees.
Fedorinchik adds: “Even better are cumulative hurdle rates – where they are compounded.” In the private equity space, these are referred to as preferred returns. “In this arrangement, a fund would have to pay the investors an annualised return of, for example, 6% before they could start to take their incentive fee.
Fedorinchik adds: “The best possible solution is to only pay incentive fees on the capital which has been returned to investors.” That is easier to do for a private equity fund which has a fixed investment horizon but much harder for a fund with no fixed investment period.
Many hedge funds, however, are starting to implement fixed time periods. As well as making it easier to structure an appropriate incentive fee, this also avoids helps funds to ensure the fund does not become too large – which can water down the investment philosophy and creates underperformance.
Savvy trustees could apply these techniques – high water mark fees, hurdle rates and fixed investment periods – to ensure that their interests and those of the fund manager are much more closely aligned.